Edgar Filing: CULLEN/FROST BANKERS, INC.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

FORM 10-Q

United States

Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended: March 31, 2013

¨	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)

N/A

(Former name, former address and former fiscal year, if changed since last report)

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 Web site, 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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 April 19, 2013, there were 60,009,212 shares of the registrant’s Common Stock, $.01 par value, outstanding.

Part I. Financial Information

Item 1. Financial Statements (Unaudited)

Cullen/Frost Bankers, Inc.

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)


	March 31, 2013			December 31, 2012			March 31, 2012
Assets:
Cash and due from banks	$	542,447		$	790,106		$	623,204
Interest-bearing deposits		2,659,691			2,650,425			1,497,478
Federal funds sold and resell agreements		16,322			84,448			8,052

Total cash and cash equivalents		3,218,460			3,524,979			2,128,734
Securities held to maturity, at amortized cost		3,068,008			2,956,381			365,603
Securities available for sale, at estimated fair value		5,857,525			6,203,299			8,568,215
Trading account securities		22,664			30,074			16,846
Loans, net of unearned discounts		9,162,351			9,223,848			8,126,713
Less: Allowance for loan losses		(93,589	)		(104,453	)		(107,181	)

Net loans		9,068,762			9,119,395			8,019,532
Premises and equipment, net		303,321			315,934			321,681
Goodwill		535,509			535,509			535,560
Other intangible assets, net		7,327			8,147			11,033
Cash surrender value of life insurance policies		138,898			138,005			135,035
Accrued interest receivable and other assets		277,247			292,346			314,942

Total assets	$	22,497,721		$	23,124,069		$	20,417,181

Liabilities:
Deposits:
Non-interest-bearing demand deposits	$	7,675,466		$	8,096,937		$	6,784,112
Interest-bearing deposits		11,368,438			11,400,429			10,124,909

Total deposits		19,043,904			19,497,366			16,909,021
Federal funds purchased and repurchase agreements		510,102			561,061			637,098
Junior subordinated deferrable interest debentures		123,712			123,712			123,712
Other long-term borrowings		100,002			100,007			100,022
Accrued interest payable and other liabilities		276,670			424,441			326,615

Total liabilities		20,054,390			20,706,587			18,096,468
Shareholders’ Equity:
Preferred stock, par value $0.01 per share; 10,000,000 shares authorized; 6,000,000 Series A shares ($25 liquidation preference) issued at March 31, 2013, none issued at December 31, 2012 or March 31, 2012		144,676			—			—
Common stock, par value $0.01 per share; 210,000,000 shares authorized; 61,632,464 shares issued at March 31, 2013, 61,479,189 shares issued at December 31, 2012 and 61,372,763 shares issued at March 31, 2012		616			615			614
Additional paid-in capital		684,141			702,968			688,150
Retained earnings		1,500,085			1,475,851			1,387,553
Accumulated other comprehensive income, net of tax		214,370			238,048			244,396
Treasury stock, 1,662,927 shares at March 31, 2013, at cost		(100,557	)		—			—

Total shareholders’ equity		2,443,331			2,417,482			2,320,713


Total liabilities and shareholders’ equity	$	22,497,721		$	23,124,069		$	20,417,181

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Income

(Dollars in thousands, except per share amounts)


	Three Months Ended March 31,
	2013		2012
Interest income:
Loans, including fees	$	102,056	$	97,351
Securities:
Taxable		27,377		36,066
Tax-exempt		27,954		22,503
Interest-bearing deposits		1,353		930
Federal funds sold and resell agreements		22		15

Total interest income		158,762		156,865

Interest expense:
Deposits		4,008		4,572
Federal funds purchased and repurchase agreements		30		34
Junior subordinated deferrable interest debentures		1,673		1,674
Other long-term borrowings		238		878

Total interest expense		5,949		7,158

Net interest income		152,813		149,707
Provision for loan losses		6,000		1,100

Net interest income after provision for loan losses		146,813		148,607

Non-interest income:
Trust and investment management fees		21,885		20,652
Service charges on deposit accounts		20,044		20,794
Insurance commissions and fees		13,070		12,377
Interchange and debit card transaction fees		4,011		4,117
Other charges, commissions and fees		7,755		7,350
Net gain (loss) on securities transactions		5		(491	)
Other		11,010		7,180

Total non-interest income		77,780		71,979

Non-interest expense:
Salaries and wages		66,465		63,702
Employee benefits		17,991		16,701
Net occupancy		11,979		11,797
Furniture and equipment		14,185		13,420
Deposit insurance		2,889		2,497
Intangible amortization		820		1,011
Other		41,485		32,912

Total non-interest expense		155,814		142,040

Income before income taxes		68,779		78,546
Income taxes		13,591		17,513

Net income		55,188		61,033
Preferred stock dividends and accretion		137		—

Net income available to common shareholders	$	55,051	$	61,033


Earnings per common share:
Basic	$	0.91	$	0.99
Diluted		0.91		0.99

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Comprehensive Income

(Dollars in thousands)


	Three Months Ended March 31,
	2013			2012
Net income	$	55,188		$	61,033

Other comprehensive income (loss), before tax:
Securities available for sale and transferred securities:
Change in net unrealized gain/loss during the period		(21,344	)		1,882
Change in net unrealized gain on securities transferred to held to maturity		(8,459	)		—
Reclassification adjustment for net (gains) losses included in net income		(5	)		491

Total securities available for sale and transferred securities		(29,808	)		2,373

Defined-benefit post-retirement benefit plans:
Change in the net actuarial gain/loss		1,640			1,229
Derivatives:
Change in the accumulated gain/loss on effective cash flow hedge derivatives		—			(427	)
Reclassification adjustments for (gains) losses included in net income:
Interest rate swaps on variable-rate loans		(9,345	)		(9,345	)
Interest rate swap on junior subordinated deferrable interest debentures		1,085			1,033

Total derivatives		(8,260	)		(8,739	)


Other comprehensive income (loss), before tax		(36,428	)		(5,137	)
Deferred tax expense (benefit) related to other comprehensive income		(12,750	)		(1,799	)

Other comprehensive income (loss), net of tax		(23,678	)		(3,338	)


Comprehensive income	$	31,510		$	57,695

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

(Dollars in thousands, except per share amounts)


	Three Months Ended March 31,
	2013			2012
Total shareholders’ equity at beginning of period	$	2,417,482		$	2,283,537

Net income		55,188			61,033
Other comprehensive income (loss)		(23,678	)		(3,338	)
Stock option exercises (395,425 shares in 2013 and 108,800 shares in 2012)		20,446			5,542
Stock compensation expense recognized in earnings		2,342			2,555
Tax benefits (deficiencies) related to stock compensation		(209	)		(377	)
Issuance of preferred stock (6,000,000 shares in 2013)		144,539			—
Purchase of treasury stock (1,905,077 shares in 2013)		(115,200	)		—
Accelerated share repurchase forward contract		(28,800	)		—
Cash dividends declared on preferred stock		—			—
Cash dividends declared on common stock ($0.48 per share in 2013 and $0.46 per share in 2012)		(28,779	)		(28,239	)


Total shareholders’ equity at end of period	$	2,443,331		$	2,320,713

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)


	Three Months Ended March 31,
	2013			2012
Operating Activities:
Net income	$	55,188		$	61,033
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses		6,000			1,100
Deferred tax expense (benefit)		(2,118	)		(2,539	)
Accretion of loan discounts		(2,900	)		(2,962	)
Securities premium amortization (discount accretion), net		8,710			4,539
Net (gain) loss on securities transactions		(5	)		491
Depreciation and amortization		9,464			9,497
Net loss on sale/write-down of assets/foreclosed assets		3,342			477
Stock-based compensation		2,342			2,555
Net tax benefit (deficiency) from stock-based compensation		(331	)		(418	)
Excess tax benefits from stock-based compensation		(122	)		(41	)
Earnings on life insurance policies		(893	)		(1,068	)
Net change in:
Trading account securities		7,410			(3,237	)
Accrued interest receivable and other assets		9,460			41,769
Accrued interest payable and other liabilities		(140,719	)		(9,286	)

Net cash from operating activities		(45,172	)		101,910

Investing Activities:
Securities held to maturity:
Purchases		(133,832	)		—
Maturities, calls and principal repayments		8,133			315
Securities available for sale:
Purchases		(4,498,091	)		(10,984,308	)
Sales		4,498,102			9,985,078
Maturities, calls and principal repayments		321,322			218,136
Net change in loans		47,259			(133,759	)
Net cash paid in acquisitions		—			(7,199	)
Proceeds from sales of premises and equipment		12,550			214
Purchases of premises and equipment		(6,834	)		(8,276	)
Proceeds from sales of repossessed properties		2,142			4,522

Net cash from investing activities		250,751			(925,277	)

Financing Activities:
Net change in deposits		(453,462	)		152,273
Net change in short-term borrowings		(50,959	)		(85,104	)
Principal payments on long-term borrowings		(5	)		(4	)
Proceeds from stock option exercises		20,446			5,542
Excess tax benefits from stock-based compensation		122			41
Proceeds from issuance of preferred stock		144,539			—
Purchase of treasury stock		(115,200	)		—
Accelerated stock repurchase agreement		(28,800	)		—
Cash dividends paid on common stock		(28,779	)		(28,239	)
Cash dividends paid on preferred stock		—			—

Net cash from financing activities		(512,098	)		44,509


Net change in cash and cash equivalents		(306,519	)		(778,858	)
Cash and equivalents at beginning of period		3,524,979			2,907,592


Cash and equivalents at end of period	$	3,218,460		$	2,128,734

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Notes to Consolidated Financial Statements

(Table amounts in thousands, except for share and per share amounts)

Note 1 - Significant Accounting Policies

Nature of Operations. Cullen/Frost Bankers, Inc. (Cullen/Frost) is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its subsidiaries, a broad array of products and services throughout numerous Texas markets. In addition to general commercial and consumer banking, other products and services offered include trust and investment management, investment banking, insurance, brokerage, leasing, asset-based lending, treasury management and item processing.

Basis of Presentation. The consolidated financial statements in this Quarterly Report on Form 10-Q include the accounts of Cullen/Frost and all other entities in which Cullen/Frost has a controlling financial interest (collectively referred to as the “Corporation”). All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and financial reporting policies the Corporation follows conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry.

The consolidated financial statements in this Quarterly Report on Form 10-Q have not been audited by an independent registered public accounting firm, but in the opinion of management, reflect all adjustments necessary for a fair presentation of the Corporation’s financial position and results of operations. All such adjustments were of a normal and recurring nature. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q adopted by the Securities and Exchange Commission (SEC). Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with the Corporation’s consolidated financial statements, and notes thereto, for the year ended December 31, 2012, included in the Corporation’s Annual Report on Form 10-K filed with the SEC on February 8, 2013 (the “2012 Form 10-K”). Operating results for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for a full year or any future period.

Use of Estimates. 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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. The allowance for loan losses, the fair value of stock-based compensation awards, the fair values of financial instruments and the status of contingencies are particularly subject to change.

Cash Flow Reporting. Additional cash flow information was as follows:


	Three Months Ended March 31,
	2013		2012
Cash paid for interest	$	6,056	$	9,377
Cash paid for income tax		—		—

Significant non-cash transactions:
Loans foreclosed and transferred to other real estate owned and foreclosed assets		274		1,071
Deferred gain on sale of building and parking garage		1,318		—
Accretion of preferred stock		137		—

Note 2 - Securities

A summary of the amortized cost and estimated fair value of securities, excluding trading securities, is presented below.


	March 31, 2013								December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
Held to Maturity
U. S. Treasury	$	248,286	$	28,433	$	—	$	276,719	$	248,188	$	29,859	$	—	$	278,047
Residential mortgage-backed securities		10,552		304		—		10,856		10,725		300		—		11,025
States and political subdivisions		2,808,170		13,544		30,856		2,790,858		2,696,468		15,397		4,993		2,706,872
Other		1,000		—		7		993		1,000		—		—		1,000

Total	$	3,068,008	$	42,281	$	30,863	$	3,079,426	$	2,956,381	$	45,556	$	4,993	$	2,996,944

Available for Sale:
U. S. Treasury	$	3,020,596	$	35,313	$	—	$	3,055,909	$	3,020,115	$	37,806	$	—	$	3,057,921
Residential mortgage-backed securities		2,182,312		123,611		108		2,305,815		2,382,514		135,514		25		2,518,003
States and political subdivisions		427,345		32,602		45		459,902		552,056		39,427		—		591,483
Other		35,899		—		—		35,899		35,892		—		—		35,892

Total	$	5,666,152	$	191,526	$	153	$	5,857,525	$	5,990,577	$	212,747	$	25	$	6,203,299

All mortgage-backed securities included in the above table were issued by U.S. government agencies and corporations. At March 31, 2013, approximately 98.8% of the securities in the Corporation’s municipal bond portfolio were issued by political subdivisions or agencies within the State of Texas, of which approximately 78.5% are either guaranteed by the Texas Permanent School Fund, which has a “triple A” insurer financial strength, or secured by U.S. Treasury securities via defeasance of the debt by the issuers. Securities with limited marketability, such as stock in the Federal Reserve Bank and the Federal Home Loan Bank, are carried at cost and are reported as other available for sale securities in the above table. The carrying value of securities pledged to secure public funds, trust deposits, repurchase agreements and for other purposes, as required or permitted by law was $2.5 billion at March 31, 2013 and $2.7 billion and December 31, 2012.

During the fourth quarter of 2012, the Corporation reclassified certain securities from available for sale to held to maturity. The securities had an aggregate fair value of $2.3 billion with an aggregate net unrealized gain of $165.7 million ($107.7 million, net of tax) on the date of the transfer. The net unamortized, unrealized gain on the transferred securities included in accumulated other comprehensive income in the accompanying balance sheet as of March 31, 2013 totaled $156.6 million ($101.8 million, net of tax). This amount will be amortized out of accumulated other comprehensive income over the remaining life of the underlying securities as an adjustment of the yield on those securities.

As of March 31, 2013, securities, with unrealized losses segregated by length of impairment, were as follows:


	Less than 12 Months				More than 12 Months				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Held to Maturity
States and political subdivisions	$	2,175,897	$	30,856	$	—	$	—	$	2,175,897	$	30,856
Other		993		7		—		—		993		7

Total	$	2,176,890	$	30,863	$	—	$	—	$	2,176,890	$	30,863

Available for Sale
Residential mortgage-backed securities	$	7,668	$	108	$	—	$	—	$	7,668	$	108
States and political subdivisions		4,918		45		—		—		4,918		45

Total	$	12,586	$	153	$	—	$	—	$	12,586	$	153

Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. In estimating other-than-temporary impairment losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in cost.

Management has the ability and intent to hold the securities classified as held to maturity in the table above until they mature, at which time the Corporation will receive full value for the securities. Furthermore, as of March 31, 2013, management does not have the intent to sell any of the securities classified as available for sale in the table above and believes that it is more likely than not that the Corporation will not have to sell any such securities before a recovery of cost. Any unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of March 31, 2013, management believes the impairments detailed in the table above are temporary and no impairment loss has been realized in the Corporation’s consolidated income statement.

The amortized cost and estimated fair value of securities, excluding trading securities, at March 31, 2013 are presented below by contractual maturity. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Residential mortgage-backed securities and equity securities are shown separately since they are not due at a single maturity date.


	Held to Maturity				Available for Sale
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Due in one year or less	$	24,466	$	25,158	$	1,512,771	$	1,516,143
Due after one year through five years		335,997		367,129		1,576,602		1,612,052
Due after five years through ten years		177,104		176,648		77,656		84,092
Due after ten years		2,519,889		2,499,635		280,912		303,524
Residential mortgage-backed securities		10,552		10,856		2,182,312		2,305,815
Equity securities		—		—		35,899		35,899

Total	$	3,068,008	$	3,079,426	$	5,666,152	$	5,857,525

Sales of securities available for sale were as follows:


	Three Months Ended March 31,
	2013			2012
Proceeds from sales	$	4,498,102		$	9,985,078
Gross realized gains		5			2,137
Gross realized losses		—			(2,628	)
Tax (expense) benefit of securities gains/losses		(2	)		172

Trading account securities, at estimated fair value, were as follows:


	March 31,		December 31,
	2013		2012
U.S. Treasury	$	14,013	$	14,038
States and political subdivisions		8,651		16,036

Total	$	22,664	$	30,074

Net gains and losses on trading account securities were as follows:


	Three Months Ended March 31,
	2013			2012
Net gain on sales transactions	$	294		$	323
Net mark-to-market gains (losses)		(3	)		(60	)

Net gain on trading account securities	$	291		$	263

Note 3 - Loans

Loans were as follows:


	March 31,			Percentage			December 31,			Percentage			March 31,			Percentage
	2013			of Total			2012			of Total			2012			of Total
Commercial and industrial:
Commercial	$	4,252,568			46.4	%	$	4,357,100			47.2	%	$	3,709,450			45.7	%
Leases		281,106			3.1			278,535			3.0			193,162			2.4
Asset-based		174,991			1.9			192,977			2.1			140,240			1.7

Total commercial and industrial		4,708,665			51.4			4,828,612			52.3			4,042,852			49.8
Commercial real estate:
Commercial mortgages		2,520,298			27.5			2,495,481			27.1			2,357,206			29.0
Construction		647,862			7.1			608,306			6.6			493,600			6.1
Land		223,349			2.4			216,008			2.3			184,078			2.2

Total commercial real estate		3,391,509			37.0			3,319,795			36.0			3,034,884			37.3
Consumer real estate:
Home equity loans		312,429			3.4			310,675			3.4			288,961			3.6
Home equity lines of credit		188,142			2.1			186,522			2.0			190,371			2.4
1-4 family residential mortgages		36,215			0.4			38,323			0.4			43,284			0.5
Construction		13,170			0.1			17,621			0.2			18,910			0.2
Other		221,700			2.4			224,206			2.4			219,760			2.7

Total consumer real estate		771,656			8.4			777,347			8.4			761,286			9.4

Total real estate		4,163,165			45.4			4,097,142			44.4			3,796,170			46.7
Consumer and other:
Consumer installment		303,751			3.3			311,310			3.4			296,057			3.6
Other		7,597			0.1			8,435			0.1			8,415			0.1

Total consumer and other		311,348			3.4			319,745			3.5			304,472			3.7
Unearned discounts		(20,827	)		(0.2	)		(21,651	)		(0.2	)		(16,781	)		(0.2	)

Total loans	$	9,162,351			100.0	%	$	9,223,848			100.0	%	$	8,126,713			100.0	%

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.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Corporation’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Corporation’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Corporation’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Corporation avoids financing single-purpose

projects unless other underwriting factors are present to help mitigate risk. The Corporation also utilizes third-party experts to provide insight and guidance about economic conditions and trends affecting market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. At March 31, 2013, approximately 56% of the outstanding principal balance of the Corporation’s commercial real estate loans were secured by owner-occupied properties.

With respect to loans to developers and builders that are secured by non-owner occupied properties that the Corporation may originate from time to time, the Corporation generally requires the borrower to have had an existing relationship with the Corporation and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Corporation until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

The Corporation maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Corporation’s policies and procedures.

Concentrations of Credit. Most of the Corporation’s lending activity occurs within the State of Texas, including the four largest metropolitan areas of Austin, Dallas/Ft. Worth, Houston and San Antonio, as well as other markets. The majority of the Corporation’s loan portfolio consists of commercial and industrial and commercial real estate loans. Other than energy loans, as of March 31, 2013 there were no concentrations of loans related to any single industry in excess of 10% of total loans.

Foreign Loans. The Corporation has 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 March 31, 2013 or December 31, 2012.

Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. In determining whether or not a borrower may be unable to meet payment obligations for each class of loans, the Corporation considers the borrower’s debt service capacity through the analysis of current financial information, if available, and/or current information with regards to the Corporation’s collateral position. Regulatory provisions would typically require the placement of a loan on non-accrual status if (i) principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection or (ii) full payment of principal and interest is not expected. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income on non-accrual loans is recognized only to the extent that cash payments are received in excess of principal due. A loan may be returned to accrual status when all the principal and interest amounts contractually due are brought current and future principal and interest amounts contractually due are reasonably assured, which is typically evidenced by a sustained period (at least six months) of repayment performance by the borrower.

Non-accrual loans, segregated by class of loans, were as follows:


	March 31,		December 31,		March 31,
	2013		2012		2012
Commercial and industrial:
Energy	$	—	$	1,150	$	—
Other commercial		48,255		45,158		49,588
Commercial real estate:
Buildings, land and other		39,067		38,631		41,892
Construction		1,055		1,100		1,285
Consumer real estate		2,526		2,773		4,322
Consumer and other		741		932		783

Total	$	91,644	$	89,744	$	97,870

As of March 31, 2013, non-accrual loans reported in the table above included $275 thousand related to loans that were restructured as “troubled debt restructurings” during 2013. Had non-accrual loans performed in accordance with their original contract terms, the Corporation would have recognized additional interest income, net of tax, of approximately $608 thousand for the three months ended March 31, 2013, compared to $642 thousand for the same period in 2012.

An age analysis of past due loans (including both accruing and non-accruing loans), segregated by class of loans, as of March 31, 2013 was as follows:


	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due		Total Past Due Loans		Current Loans			Total Loans			Accruing Loans 90 or More Days Past Due
Commercial and industrial:
Energy	$	119	$	1,916	$	2,035	$	1,068,561		$	1,070,596		$	1,916
Other commercial		22,701		28,924		51,625		3,586,444			3,638,069			5,939
Commercial real estate:
Buildings, land and other		16,445		23,801		40,246		2,703,401			2,743,647			1,173
Construction		—		83		83		647,779			647,862			83
Consumer real estate		6,531		3,100		9,631		762,025			771,656			2,629
Consumer and other		3,578		212		3,790		307,558			311,348			170
Unearned discounts		—		—		—		(20,827	)		(20,827	)		—

Total	$	49,374	$	58,036	$	107,410	$	9,054,941		$	9,162,351		$	11,910

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectibility of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Regulatory guidelines require the Corporation to reevaluate the fair value of collateral supporting impaired collateral dependent loans on at least an annual basis. While the Corporation’s policy is to comply with the regulatory guidelines, the Corporation’s general practice is to reevaluate the fair value of collateral supporting impaired collateral dependent loans on a quarterly basis. Thus, appraisals are never considered to be outdated, and the Corporation does not need to make any adjustments to the appraised values. The fair value of collateral supporting impaired collateral dependent loans is evaluated by the Corporation’s internal appraisal services using a methodology that is consistent with the Uniform Standards of Professional Appraisal Practice. The fair value of collateral supporting impaired collateral dependent construction loans is based on an “as is” valuation.

Impaired loans are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired.


	Unpaid		Recorded		Recorded						Average Recorded
	Contractual		Investment		Investment		Total				Investment
	Principal		With No		With		Recorded		Related		Quarter		Year
	Balance		Allowance		Allowance		Investment		Allowance		To Date		To Date
March 31, 2013
Commercial and industrial:
Energy	$	—	$	—	$	—	$	—	$	—	$	535	$	535
Other commercial		75,350		25,880		18,218		44,098		5,340		42,452		42,452
Commercial real estate:
Buildings, land and other		45,158		18,740		17,777		36,517		3,290		36,338		36,338
Construction		1,479		1,055		—		1,055		—		1,078		1,078
Consumer real estate		947		834		—		834		—		849		849
Consumer and other		417		384		—		384		—		392		392

Total	$	123,351	$	46,893	$	35,995	$	82,888	$	8,630	$	81,644	$	81,644

December 31, 2012
Commercial and industrial:
Energy	$	1,255	$	—	$	1,069	$	1,069	$	900	$	535	$	214
Other commercial		56,784		21,709		19,096		40,805		4,200		44,941		42,630
Commercial real estate:
Buildings, land and other		44,652		19,010		17,149		36,159		3,137		41,126		40,258
Construction		1,497		1,100		—		1,100		—		1,122		1,392
Consumer real estate		961		864		—		864		—		879		1,617
Consumer and other		428		400		—		400		—		410		469

Total	$	105,577	$	43,083	$	37,314	$	80,397	$	8,237	$	89,013	$	86,580

March 31, 2012
Commercial and industrial:
Energy	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Other commercial		55,632		28,932		15,804		44,736		5,356		42,034		42,034
Commercial real estate:
Buildings, land and other		47,077		36,821		2,243		39,064		1,113		39,996		39,996
Construction		1,551		1,237		—		1,237		—		1,259		1,259
Consumer real estate		2,623		1,826		751		2,577		95		2,524		2,524
Consumer and other		547		535		—		535		—		544		544

Total	$	107,430	$	69,351	$	18,798	$	88,149	$	6,564	$	86,357	$	86,357

Troubled Debt Restructurings. The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules, reductions in collateral and other actions intended to minimize potential losses.

Troubled debt restructurings during the three months ended March 31, 2013 are set forth in the following table. Amounts represent the aggregate balance of the loans as of their individual restructuring dates. There were no troubled debt restructurings during the three months ended March 31, 2012.


Commercial and industrial:
Other commercial	$	275
Commercial real estate:
Buildings, land and other		1,680

	$	1,955

The modifications during the three months ended March 31, 2013 primarily related to extending amortization periods, converting the loans to interest only for a limited period of time and/or reducing required collateral. The Corporation did not grant interest-rate concessions on any restructured loan. The modifications did not significantly impact the Corporation’s determination of the allowance for loan losses. During the three months ended March 31, 2013, the Corporation charged-off $900 thousand related to loans restructured during 2012. Furthermore, loans restructured during 2012 with an aggregate balance of $419 thousand at March 31, 2013 were in excess of 90 days past due as of March 31, 2013. The aforementioned charge-off and past due loans did not significantly impact the Corporation’s determination of the allowance for loan losses.

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Corporation’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) the delinquency status of consumer loans (see details above) (iv) net charge-offs, (v) non-performing loans (see details above) and (vi) the general economic conditions in the State of Texas.

The Corporation utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 14. A description of the general characteristics of the 14 risk grades is as follows:

•

Grades 1, 2 and 3 – These grades include loans to very high credit quality borrowers of investment or near investment grade. These borrowers are generally publicly traded (grades 1 and 2), have significant capital strength, moderate leverage, stable earnings and growth, and readily available financing alternatives. Smaller entities, regardless of strength, would generally not fit in these grades.

•

Grades 4 and 5 – These grades include loans to borrowers of solid credit quality with moderate risk. Borrowers in these grades are differentiated from higher grades on the basis of size (capital and/or revenue), leverage, asset quality and the stability of the industry or market area.

•

Grades 6, 7 and 8 – These grades include “pass grade” loans to borrowers of acceptable credit quality and risk. Such borrowers are differentiated from Grades 4 and 5 in terms of size, secondary sources of repayment or they are of lesser stature in other key credit metrics in that they may be over-leveraged, under capitalized, inconsistent in performance or in an industry or an economic area that is known to have a higher level of risk, volatility, or susceptibility to weaknesses in the economy.

•

Grade 9 – This grade includes loans on management’s “watch list” and is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term.

•

Grade 10 – This grade is for “Other Assets Especially Mentioned” in accordance with regulatory guidelines. This grade is intended to be temporary and includes loans to borrowers whose credit quality has clearly deteriorated and are at risk of further decline unless active measures are taken to correct the situation.

•

Grade 11 – This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the accrual of interest has not been stopped. By definition under regulatory guidelines, a “Substandard” loan has defined weaknesses which make payment default or principal exposure likely, but not yet certain. Such loans are apt to be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business.

•

Grade 12 – This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the accrual of interest has been stopped. This grade includes loans where interest is more than 120 days past due and not fully secured and loans where a specific valuation allowance may be necessary, but generally does not exceed 30% of the principal balance.

•

Grade 13 – This grade includes “Doubtful” loans in accordance with regulatory guidelines. Such loans are placed on non-accrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance in excess of 30% of the principal balance.

•

Grade 14 – This grade includes “Loss” loans in accordance with regulatory guidelines. Such loans are to be charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

In monitoring credit quality trends in the context of assessing the appropriate level of the allowance for loan losses, the Corporation monitors portfolio credit quality by the weighted-average risk grade of each class of commercial loan. Individual relationship managers review updated financial information for all pass grade loans to recalculate the risk grade on at least an annual basis. When a loan has a calculated risk grade of 9, it is still considered a pass grade loan; however, it is considered to be on management’s “watch list,” where a significant risk-modifying action is anticipated in the near term. When a loan has a calculated risk grade of 10 or higher, a special assets officer monitors the loan on an on-going basis. The following table presents weighted average risk grades for all commercial loans by class.


	March 31, 2013				December 31, 2012				March 31, 2012
	Weighted				Weighted				Weighted
	Average				Average				Average
	Risk Grade		Loans		Risk Grade		Loans		Risk Grade		Loans
Commercial and industrial:
Energy
Risk grades 1-8		5.30	$	1,067,466		5.24	$	1,081,725		5.37	$	992,463
Risk grade 9		9.00		2,745		9.00		392		9.00		2,516
Risk grade 10		10.00		—		10.00		—		10.00		—
Risk grade 11		11.00		385		11.00		—		11.00		—
Risk grade 12		12.00		—		12.00		169		12.00		—
Risk grade 13		13.00		—		13.00		900		13.00		—

Total energy		5.31	$	1,070,596		5.25	$	1,083,186		5.38	$	994,979

Other commercial
Risk grades 1-8		5.89	$	3,367,114		5.81	$	3,367,443		6.20	$	2,803,976
Risk grade 9		9.00		122,482		9.00		250,508		9.00		65,376
Risk grade 10		10.00		33,818		10.00		28,440		10.00		35,504
Risk grade 11		11.00		66,400		11.00		53,797		11.00		93,415
Risk grade 12		12.00		42,230		12.00		40,603		12.00		44,520
Risk grade 13		13.00		6,025		13.00		4,635		13.00		5,082

Total other commercial		6.21	$	3,638,069		6.21	$	3,745,426		6.55	$	3,047,873

Commercial real estate:
Buildings, land and other
Risk grades 1-8		6.63	$	2,502,845		6.63	$	2,460,448		6.67	$	2,233,155
Risk grade 9		9.00		86,783		9.00		92,041		9.00		104,727
Risk grade 10		10.00		34,120		10.00		42,603		10.00		33,641
Risk grade 11		11.00		80,729		11.00		77,658		11.00		127,869
Risk grade 12		12.00		35,880		12.00		35,602		12.00		40,486
Risk grade 13		13.00		3,290		13.00		3,137		13.00		1,406

Total commercial real estate		6.95	$	2,743,647		6.97	$	2,711,489		7.12	$	2,541,284

Construction
Risk grades 1-8		6.81	$	618,852		6.82	$	579,108		6.97	$	454,674
Risk grade 9		9.00		24,378		9.00		23,046		9.00		16,062
Risk grade 10		10.00		2,968		10.00		4,435		10.00		15,442
Risk grade 11		11.00		609		11.00		617		11.00		6,137
Risk grade 12		12.00		1,055		12.00		1,100		12.00		1,285
Risk grade 13		13.00		—		13.00		—		13.00		—

Total construction		6.92	$	647,862		6.94	$	608,306		7.19	$	493,600

The Corporation has established maximum loan to value standards to be applied during the origination process of commercial and consumer real estate loans. The Corporation does not subsequently monitor loan-to-value ratios (either individually or on a weighted-average basis) for loans that are subsequently considered to be of a pass grade (grades 9 or better) and/or current with respect to principal and interest payments. As stated above, when an individual commercial real estate loan has a calculated risk grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired. At that time, the Corporation reassesses the loan to value position in the loan. If the loan is determined to be collateral dependent, specific allocations of the allowance for loan losses are made for the amount of any collateral deficiency. If a collateral deficiency is ultimately deemed to be uncollectible, the amount is charged-off. These loans and related assessments of collateral position are monitored on an individual, case-by-case basis. The Corporation does not monitor loan-to-value ratios on a weighted-average basis for commercial real estate loans having a calculated risk grade of 10 or higher. Nonetheless, there were four commercial real estate loans having a calculated risk grade of 10 or higher in excess of $5 million as of March 31, 2013, which totaled $38.2 million and had a weighted-average loan-to-value ratio of

approximately 65.4%. When an individual consumer real estate loan becomes past due by more than 10 days, the assigned relationship manager will begin collection efforts. The Corporation only reassesses the loan to value position in a consumer real estate loan if, during the course of the collections process, it is determined that the loan has become collateral dependent, and any collateral deficiency is recognized as a charge-off to the allowance for loan losses. Accordingly, the Corporation does not monitor loan-to-value ratios on a weighted-average basis for collateral dependent consumer real estate loans.

Generally, a commercial loan, or a portion thereof, is charged-off immediately when it is determined, through the analysis of any available current financial information with regards to the borrower, that the borrower is incapable of servicing unsecured debt, there is little or no prospect for near term improvement and no realistic strengthening action of significance is pending or, in the case of secured debt, when it is determined, through analysis of current information with regards to the Corporation’s collateral position, that amounts due from the borrower are in excess of the calculated current fair value of the collateral. Notwithstanding the foregoing, generally, commercial loans that become past due 180 cumulative days are classified as a loss and charged-off. Generally, a consumer loan, or a portion thereof, is charged-off in accordance with regulatory guidelines which provide that such loans be charged-off when the Corporation becomes aware of the loss, such as from a triggering event that may include new information about a borrower’s intent/ability to repay the loan, bankruptcy, fraud or death, among other things, but in no case should the charge-off exceed specified delinquency timeframes. Such delinquency timeframes state that closed-end retail loans (loans with pre-defined maturity dates, such as real estate mortgages, home equity loans and consumer installment loans) that become past due 120 cumulative days and open-end retail loans (loans that roll-over at the end of each term, such as home equity lines of credit) that become past due 180 cumulative days should be classified as a loss and charged-off.

Net (charge-offs)/recoveries, segregated by class of loans, were as follows:


	Three Months Ended March 31,
	2013			2012
Commercial and industrial:
Energy	$	—		$	4
Other commercial		(16,527	)		(1,675	)
Commercial real estate:
Buildings, land and other		215			(2,360	)
Construction		114			10
Consumer real estate		(276	)		234
Consumer and other		(390	)		(279	)

Total	$	(16,864	)	$	(4,066	)

In assessing the general economic conditions in the State of Texas, management monitors and tracks the Texas Leading Index (“TLI”), which is produced by the Federal Reserve Bank of Dallas. The TLI is a single summary statistic that is designed to signal the likelihood of the Texas economy’s transition from expansion to recession and vice versa. Management believes this index provides a reliable indication of the direction of overall credit quality. The TLI is a composite of the following eight leading indicators: (i) Texas Value of the Dollar, (ii) U.S. Leading Index, (iii) real oil prices (iv) well permits, (v) initial claims for unemployment insurance, (vi) Texas Stock Index, (vii) Help-Wanted Index and (viii) average weekly hours worked in manufacturing. The TLI totaled 124.3 at February 28, 2013 (most recent date available) and 123.8 at both December 31, 2012 and March 31, 2012. A higher TLI value implies more favorable economic conditions.

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 follows the accounting guidance set forth in U.S. generally accepted accounting principles and the Interagency Policy Statement on the Allowance for Loan and Lease Losses, which was jointly issued by U.S. bank regulatory agencies. In that regard, the Corporation’s allowance for loan losses 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 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, 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.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss and recovery experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. 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 determination of the appropriate level of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including, among other things, the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. The Corporation monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time.

The Corporation’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other risk factors both internal and external to the Corporation.

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan has a calculated grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things.

Historical valuation allowances are calculated based on the historical gross loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Corporation calculates historical gross loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical gross loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical gross loss ratio and the total dollar amount of the loans in the pool. The Corporation’s pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer real estate loans and consumer and other loans.

The components of the general valuation allowance include (i) the additional reserves allocated as a result of applying an environmental risk adjustment factor to the base historical loss allocation, (ii) the additional reserves allocated for loans to borrowers in distressed industries and (iii) the additional reserves allocated for groups of similar loans with risk characteristics that exceed certain concentration limits established by management.

The environmental adjustment factor is based upon a more qualitative analysis of risk and is calculated through a survey of senior officers who are involved in credit making decisions at a corporate-wide and/or regional level. On a quarterly basis, survey participants rate the degree of various risks utilizing a numeric scale that translates to varying grades of high, moderate or low levels of risk. The results are then input into a risk-weighting matrix to determine an appropriate environmental risk adjustment factor. The various risks that may be considered in the determination of the environmental adjustment factor include, among other things, (i) the experience, ability and effectiveness of the bank’s lending management and staff; (ii) the effectiveness of the Corporation’s loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) the impact of legislative and governmental influences affecting industry sectors; (v) the effectiveness of the internal loan review function; (vi) the impact of competition on loan structuring and pricing; and (vii) the impact of rising interest rates on portfolio risk. In periods where the surveyed risks are perceived to be higher, the risk-weighting matrix will generally result in a higher environmental adjustment factor, which, in turn will result in higher levels of general valuation allowance allocations. The opposite holds true in periods where the surveyed risks are perceived to be lower.

General valuation allowances also include amounts allocated for loans to borrowers in distressed industries. To determine the amount of the allocation for each loan portfolio segment, management calculates the weighted-average risk grade for all loans to borrowers in distressed industries by loan portfolio segment. A multiple is then applied to the amount by which the weighted-average risk grade for loans to borrowers in distressed industries exceeds the weighted-average risk grade for all pass-grade loans within the loan portfolio segment to derive an allocation factor for loans to borrowers in distressed industries. The amount of the allocation for each loan portfolio segment is the product of this allocation factor and the

outstanding balance of pass-grade loans within the identified distressed industries that have a risk grade of 6 or higher. Management identifies potential distressed industries by analyzing industry trends related to delinquencies, classifications and charge-offs. At March 31, 2013 and December 31, 2012, contractors were considered to be a distressed industry based on elevated levels of delinquencies, classifications and charge-offs relative to other industries within the Corporation’s loan portfolio. Furthermore, the Corporation determined, through a review of borrower financial information that, as a whole, contractors have experienced, among other things, decreased revenues, reduced backlog of work, compressed margins and little, if any, net income.

General valuation allowances also include allocations for groups of loans with similar risk characteristics that exceed certain concentration limits established by management and/or the Corporation’s board of directors. Concentration risk limits have been established, among other things, for certain industry concentrations, large balance and highly leveraged credit relationships that exceed specified risk grades, and loans originated with policy, credit and/or collateral exceptions that exceed specified risk grades. Additionally, general valuation allowances are provided for loans that did not undergo a separate, independent concurrence review during the underwriting process (generally those loans under $1.0 million at origination). The Corporation’s allowance methodology for general valuation allowances also includes 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 adjustment for recoveries is based on the lower of annualized, year-to-date gross recoveries or the total gross recoveries for the preceding four quarters, adjusted, when necessary, for expected future trends in recoveries.

The following table presents details of the allowance for loan losses, segregated by loan portfolio segment.


	Commercial
	and			Commercial			Consumer			Consumer
	Industrial			Real Estate			Real Estate			and Other			Unallocated		Total
March 31, 2013
Historical valuation allowances	$	25,233		$	12,873		$	2,553		$	7,555		$	—	$	48,214
Specific valuation allowances		5,340			3,290			—			—			—		8,630
General valuation allowances:
Environmental risk adjustment		4,980			3,194			631			2,027			—		10,832
Distressed industries		7,494			876			—			—			—		8,370
Excessive industry concentrations		3,815			2,042			—			—			—		5,857
Large relationship concentrations		1,288			927			—			—			—		2,215
Highly-leveraged credit relationships		3,418			727			—			—			—		4,145
Policy exceptions		—			—			—			—			2,197		2,197
Credit and collateral exceptions		—			—			—			—			2,152		2,152
Loans not reviewed by concurrence		2,052			2,213			2,207			1,035			—		7,507
Adjustment for recoveries		(2,535	)		(1,333	)		(243	)		(6,893	)		—		(11,004	)
General macroeconomic risk		—			—			—			—			4,474		4,474

Total	$	51,085		$	24,809		$	5,148		$	3,724		$	8,823	$	93,589

December 31, 2012
Historical valuation allowances	$	30,565		$	15,687		$	3,013		$	7,344		$	—	$	56,609
Specific valuation allowances		5,100			3,137			—			—			—		8,237
General valuation allowances:
Environmental risk adjustment		6,593			3,682			684			1,816			—		12,775
Distressed industries		5,883			1,182			—			—			—		7,065
Excessive industry concentrations		4,291			2,795			—			—			—		7,086
Large relationship concentrations		1,420			981			—			—			—		2,401
Highly-leveraged credit relationships		2,905			699			—			—			—		3,604
Policy exceptions		—			—			—			—			2,466		2,466
Credit and collateral exceptions		—			—			—			—			1,635		1,635
Loans not reviewed by concurrence		2,277			2,413			2,411			1,159			—		8,260
Adjustment for recoveries		(4,870	)		(1,230	)		(856	)		(6,812	)		—		(13,768	)
General macroeconomic risk		—			—			—			—			8,083		8,083

Total	$	54,164		$	29,346		$	5,252		$	3,507		$	12,184	$	104,453

The Corporation monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time. In assessing the general macroeconomic trends/conditions, the Corporation analyzes trends in the components of the TLI, as well as any available information related to regional, national and international economic conditions and events and the impact such conditions and events may have on the Corporation and its customers. With regard to assessing loan portfolio conditions, the Corporation analyzes trends in weighted-average portfolio risk-grades, classified and non-performing loans and charge-off activity. In periods where general macroeconomic and loan portfolio conditions are in a deteriorating trend or remain at deteriorated levels, based on historical trends, the Corporation would expect to see the allowance for loan loss allocation model, as a whole, calculate higher levels of required allowances than in periods where general macroeconomic and loan portfolio conditions are in an improving trend or remain at an elevated level, based on historical trends.

The following table details activity in the allowance for loan losses by portfolio segment for the reported periods. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.


	Commercial
	and			Commercial			Consumer			Consumer
	Industrial			Real Estate			Real Estate			and Other			Unallocated			Total
March 31, 2013
Beginning balance	$	54,164		$	29,346		$	5,252		$	3,507		$	12,184		$	104,453
Provision for loan losses		13,448			(4,866	)		172			607			(3,361	)		6,000
Charge-offs		(17,152	)		(266	)		(336	)		(2,177	)		—			(19,931	)
Recoveries		625			595			60			1,787			—			3,067

Net charge-offs		(16,527	)		329			(276	)		(390	)		—			(16,864	)

Ending balance	$	51,085		$	24,809		$	5,148		$	3,724		$	8,823		$	93,589

Period-end amount allocated to:
Loans individually evaluated for impairment	$	13,464		$	4,576		$	—		$	—		$	—		$	18,040
Loans collectively evaluated for impairment		37,621			20,233			5,148			3,724			8,823			75,549

Ending balance	$	51,085		$	24,809		$	5,148		$	3,724		$	8,823		$	93,589

March 31, 2012
Beginning balance	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147
Provision for loan losses		4,766			1,441			(75	)		(3,641	)		(1,391	)		1,100
Charge-offs		(3,012	)		(2,842	)		(289	)		(1,985	)		—			(8,128	)
Recoveries		1,341			492			523			1,706			—			4,062

Net charge-offs		(1,671	)		(2,350	)		234			(279	)		—			(4,066	)

Ending balance	$	45,869		$	20,003		$	3,699		$	8,715		$	28,895		$	107,181

Period-end amount allocated to:
Loans individually evaluated for impairment	$	17,842		$	2,879		$	95		$	—		$	—		$	20,816
Loans collectively evaluated for impairment		28,027			17,124			3,604			8,715			28,895			86,365

Ending balance	$	45,869		$	20,003		$	3,699		$	8,715		$	28,895		$	107,181

The Corporation’s recorded investment in loans as of March 31, 2013, December 31, 2012 and March 31, 2012 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Corporation’s impairment methodology was as follows:


	Commercial
	and		Commercial		Consumer		Consumer		Unearned
	Industrial		Real Estate		Real Estate		and Other		Discounts			Total
March 31, 2013
Loans individually evaluated for impairment	$	148,858	$	158,651	$	834	$	384	$	—		$	308,727
Loans collectively evaluated for impairment		4,559,807		3,232,858		770,822		310,964		(20,827	)		8,853,624

Ending balance	$	4,708,665	$	3,391,509	$	771,656	$	311,348	$	(20,827	)	$	9,162,351

December 31, 2012
Loans individually evaluated for impairment	$	128,544	$	165,152	$	864	$	400	$	—		$	294,960
Loans collectively evaluated for impairment		4,700,068		3,154,643		776,483		319,345		(21,651	)		8,928,888

Ending balance	$	4,828,612	$	3,319,795	$	777,347	$	319,745	$	(21,651	)	$	9,223,848

March 31, 2012
Loans individually evaluated for impairment	$	178,521	$	226,266	$	2,577	$	535	$	—		$	407,899
Loans collectively evaluated for impairment		3,864,331		2,808,618		758,709		303,937		(16,781	)		7,718,814

Ending balance	$	4,042,852	$	3,034,884	$	761,286	$	304,472	$	(16,781	)	$	8,126,713

Note 4 - Goodwill and Other Intangible Assets

Goodwill and other intangible assets are presented in the table below.


	March 31,		December 31,
	2013		2012
Goodwill	$	535,509	$	535,509

Other intangible assets:
Core deposits	$	4,693	$	5,296
Customer relationship		2,099		2,262
Non-compete agreements		535		589

	$	7,327	$	8,147

The estimated aggregate future amortization expense for intangible assets remaining as of March 31, 2013 is as follows:


Remainder of 2013	$	2,295
2014		2,271
2015		1,489
2016		777
2017		215
Thereafter		280

	$	7,327

Note 5 - Deposits

Deposits were as follows:


	March 31,		Percentage			December 31,		Percentage			March 31,		Percentage
	2013		of Total			2012		of Total			2012		of Total
Non-interest-bearing demand deposits:
Commercial and individual	$	7,014,286		36.8	%	$	7,186,105		36.9	%	$	6,006,806		35.5	%
Correspondent banks		307,469		1.6			436,381		2.2			331,114		2.0
Public funds		353,711		1.9			474,451		2.4			446,192		2.6

Total non-interest-bearing demand deposits		7,675,466		40.3			8,096,937		41.5			6,784,112		40.1
Interest-bearing deposits:
Private accounts:
Savings and interest checking		3,571,010		18.8			3,812,712		19.6			2,950,197		17.4
Money market accounts		6,404,140		33.6			6,127,256		31.4			5,750,104		34.0
Time accounts of $100,000 or more		531,936		2.8			514,346		2.6			532,544		3.2
Time accounts under $100,000		455,753		2.4			464,641		2.4			500,623		3.0

Total private accounts		10,962,839		57.6			10,918,955		56.0			9,733,468		57.6
Public funds:
Savings and interest checking		223,295		1.2			287,391		1.5			208,760		1.2
Money market accounts		45,266		0.2			50,600		0.3			42,488		0.3
Time accounts of $100,000 or more		133,157		0.7			140,191		0.7			136,817		0.8
Time accounts under $100,000		3,881		—			3,292		—			3,376		—

Total public funds		405,599		2.1			481,474		2.5			391,441		2.3

Total interest-bearing deposits		11,368,438		59.7			11,400,429		58.5			10,124,909		59.9

Total deposits	$	19,043,904		100.0	%	$	19,497,366		100.0	%	$	16,909,021		100.0	%

The following table presents additional information about the Corporation’s deposits:


	March 31,		December 31,		March 31,
	2013		2012		2012
Deposits from the Certificate of Deposit Account Registry Service (CDARS) deposits	$	901	$	2,723	$	25,541
Deposits from foreign sources (primarily Mexico)		767,702		799,504		830,685

Note 6 - Commitments and Contingencies

Financial Instruments with Off-Balance-Sheet Risk. In the normal course of business, the Corporation enters into various transactions, which, in accordance with generally accepted accounting principles are not included in its consolidated balance sheets. The Corporation enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Corporation minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

The Corporation enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Corporation’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Standby letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Corporation would be required to fund the commitment. The maximum potential amount of future payments the Corporation could be required to make is represented by the contractual amount of the commitment. If the commitment were funded, the Corporation would be entitled to seek recovery from the customer. The Corporation’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.

The Corporation considers the fees collected in connection with the issuance of standby letters of credit to be representative of the fair value of its obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, the Corporation defers fees collected in connection with the issuance of standby letters of credit. The fees are then recognized in income proportionately over the life of the standby letter of credit agreement. The deferred standby letter of credit fees represent the fair value of the Corporation’s potential obligations under the standby letter of credit guarantees.

Financial instruments with off-balance-sheet risk were as follows:


	March 31,		December 31,
	2013		2012
Commitments to extend credit	$	5,841,640	$	5,710,448
Standby letters of credit		198,205		186,049
Deferred standby letter of credit fees		1,294		1,412

Lease Commitments. The Corporation leases certain office facilities and office equipment under operating leases. Rent expense for all operating leases totaled $5.8 million and $5.5 million during the three months ended March 31, 2013 and 2012. There has been no significant change in the future minimum lease payments payable by the Corporation since December 31, 2012. See the 2012 Form 10-K for information regarding these commitments.

Litigation. The Corporation is subject to various claims and legal actions that have arisen in the 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.

Note 7 - Capital and Regulatory Matters

Regulatory Capital Requirements. Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).

Cullen/Frost’s and Frost Bank’s Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on securities available for sale, the accumulated gain or loss on effective cash flow hedging derivatives, the net actuarial gain/loss on the Corporation’s defined benefit post-retirement benefit plans, goodwill and other intangible assets. Tier 1 capital for Cullen/Frost also includes $144.7 million of 5.375% non-cumulative perpetual preferred stock and $120 million of trust preferred securities issued by its unconsolidated subsidiary trust. Cullen/Frost’s and Frost Bank’s total capital is comprised of Tier 1 capital for each entity plus a permissible portion of the allowance for loan losses. The Corporation’s aggregate $100 million of floating rate subordinated notes are not included in Tier 1 capital but the permissible portion (which decreases 20% per year during the final five years of the term of the notes) totaling $60 million at March 31, 2013 and $80 million at December 31, 2012, is included in total capital of Cullen/Frost.

The Tier 1 and total capital ratios are calculated by dividing the respective capital amounts by risk-weighted assets. Risk-weighted assets are calculated based on regulatory requirements and include total assets, excluding goodwill and other intangible assets, allocated by risk weight category, and certain off-balance-sheet items (primarily loan commitments). The leverage ratio is calculated by dividing Tier 1 capital by adjusted quarterly average total assets, which exclude goodwill and other intangible assets.

As more fully discussed in the 2012 Form 10-K, the Corporation’s primary federal regulator, the Federal Reserve, published two notices of proposed rulemaking in June 2012 (the “2012 Capital Proposals”) that would substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including Cullen/Frost and Frost Bank, compared to current U.S. risk-based capital rules. As proposed, one of the 2012 Capital Proposals was to come into effect on January 1, 2013 (subject to a phase-in period) and the other would come into effect on January 1, 2015 (with an option for early adoption); however, final rules have not yet been adopted and the proposed new capital framework is therefore not yet applicable to Cullen/Frost and Frost Bank.

Actual and required capital ratios for Cullen/Frost and Frost Bank were as follows:


	Actual					Minimum Required for Capital Adequacy Purposes					Required to be Considered Well Capitalized
	Capital Amount		Ratio			Capital Amount		Ratio			Capital Amount		Ratio
March 31, 2013
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	1,967,401		15.44	%	$	1,019,653		8.00	%	$	1,274,566		10.00	%
Frost Bank		1,740,052		13.66			1,019,045		8.00			1,273,806		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,813,812		14.23			509,826		4.00			764,739		6.00
Frost Bank		1,646,463		12.93			509,522		4.00			764,283		6.00
Leverage Ratio
Cullen/Frost		1,813,812		8.42			861,796		4.00			1,077,245		5.00
Frost Bank		1,646,463		7.65			861,162		4.00			1,076,453		5.00
December 31, 2012
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	1,947,974		15.11	%	$	1,031,526		8.00	%	$	1,289,408		10.00	%
Frost Bank		1,730,444		13.43			1,030,878		8.00			1,288,597		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,763,521		13.68			515,763		4.00			773,645		6.00
Frost Bank		1,625,991		12.62			515,439		4.00			773,158		6.00
Leverage Ratio
Cullen/Frost		1,763,521		8.28			851,483		4.00			1,064,354		5.00
Frost Bank		1,625,991		7.64			850,954		4.00			1,063,693		5.00

Management believes that, as of March 31, 2013, Cullen/Frost and its bank subsidiary, Frost Bank, were “well capitalized” based on the ratios presented above.

Cullen/Frost and Frost Bank are subject to the regulatory capital requirements administered by the Federal Reserve, and, for Frost Bank, the Federal Deposit Insurance Corporation (“FDIC”). Regulatory authorities can initiate certain mandatory actions if Cullen/Frost or Frost Bank fail to meet the minimum capital requirements, which could have a direct material effect on the Corporation’s financial statements. Management believes, as of March 31, 2013, that Cullen/Frost and Frost Bank meet all capital adequacy requirements to which they are subject.

Trust Preferred Securities. In accordance with the applicable accounting standard related to variable interest entities, the accounts of the Corporation’s wholly owned subsidiary trust, Cullen/Frost Capital Trust II, have not been included in the Corporation’s consolidated financial statements. However, the $120.0 million in trust preferred securities issued by this subsidiary trust have been included in the Tier 1 capital of Cullen/Frost for regulatory capital purposes pursuant to guidance from the Federal Reserve. As more fully discussed in the 2012 Form 10-K, the 2012 Capital Proposals would require the phase-out of certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies in equal installments between 2013 and 2016. However, because the final rules have not yet been adopted, the proposed new capital framework is not yet applicable and no portion of the Corporation’s trust preferred securities has been excluded from Tier 1 capital as presented in the above table as of March 31, 2013. Had a portion of the trust preferred securities been excluded in accordance with the proposed phase-out schedule as of March 31, 2013, Cullen/Frost’s Tier 1 capital to risk-weighted assets would have been 14.00% and the leverage ratio would have been 8.28%.

Preferred Stock. On February 15, 2013, the Corporation issued and sold 6,000,000 shares, or $150 million in aggregate liquidation preference, of it’s 5.375% Non-Cumulative Perpetual Preferred Stock, Series A, par value $0.01 and liquidation preference $25 per share (“Series A Preferred Stock”). Dividends on the Series A Preferred stock, if declared, accrue and are payable quarterly, in arrears, at a rate of 5.375%. The Series A Preferred Stock qualifies as Tier 1 capital for the purposes of the regulatory capital calculations. The net proceeds from the issuance and sale of the Series A Preferred Stock, after deducting underwriting discount and commissions, and the payment of expenses, were approximately $144.5 million. The net proceeds from the offering were used to fund the accelerated share repurchase further discussed below.

Accelerated Share Repurchase. Concurrent with the issuance and sale of the Series A Preferred Stock, on February 15, 2013, the Corporation entered into an accelerated share repurchase agreement (the “ASR agreement”) with Goldman, Sachs & Co. (“Goldman Sachs”). Under the ASR agreement, the Corporation paid $144 million to Goldman Sachs and received from Goldman Sachs approximately 1.9 million shares of the Corporation’s common stock, representing approximately 80%

of the estimated total number of shares to be repurchased. Goldman Sachs borrowed such shares delivered to the Corporation from stock lenders, and during the term of the ASR agreement, will purchase shares in the open market to return to those stock lenders. Final settlement of the ASR agreement is expected to occur in the third quarter of 2013, and may occur earlier at the option of Goldman Sachs. Upon final settlement, the Corporation expects to receive the balance of the shares repurchased under the ASR agreement. The specific number of shares that the Corporation ultimately will repurchase will be based on the volume-weighted-average price per share of the Corporation’s common stock during the repurchase period, subject to other adjustments pursuant to the terms and conditions of the ASR agreement. At settlement, under certain circumstances, Goldman Sachs may be required to deliver additional shares of the Corporation’s common stock to the Corporation, or, under certain circumstances, the Corporation may be required to deliver shares of the Corporation’s common stock or the Corporation may elect to make a cash payment to Goldman Sachs. The terms of the ASR agreement are subject to adjustment if the Corporation were to enter into or announce certain types of transactions. Furthermore, during the term of the ASR agreement, and subject to certain limited exceptions, the Corporation may only make repurchases of Cullen/Frost common stock with the consent of Goldman Sachs.

The ASR agreement is part of a stock repurchase program that was authorized by the Corporation’s board of directors in December 2012 to buy up to $150 million of the Corporation’s common stock. The Corporation accounted for the repurchase as two separate transactions: (i) as shares of common stock acquired in a treasury stock transaction recorded on the acquisition date; and (ii) as a forward contract indexed to the Corporation’s common stock that is classified as equity and reported as a component of additional paid in capital.

Dividend Restrictions. In the ordinary course of business, Cullen/Frost is dependent upon dividends from Frost Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of Frost Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years. Under the foregoing dividend restrictions and while maintaining its “well capitalized” status, at March 31, 2013, Frost Bank could pay aggregate dividends of up to $216.5 million to Cullen/Frost without prior regulatory approval.

Under the terms of the Series A Preferred Stock, the ability of the Corporation to declare or pay dividends on, or purchase, redeem or otherwise acquire, shares of its common stock or any securities of the Corporation that rank junior to the Series A Preferred Stock is subject to certain restrictions in the event that the Corporation does not declare and pay dividends on the Series A Preferred Stock for the most recent dividend period.

Note 8 - Derivative Financial Instruments

The fair value of derivative positions outstanding is included in accrued interest receivable and other assets and accrued interest payable and other liabilities in the accompanying consolidated balance sheets and in the net change in each of these financial statement line items in the accompanying consolidated statements of cash flows.

Interest Rate Derivatives. The Corporation utilizes interest rate swaps, caps and floors to mitigate exposure to interest rate risk and to facilitate the needs of its customers. The Corporation’s objectives for utilizing these derivative instruments is described below:

The Corporation has entered into certain interest rate swap contracts that are matched to specific fixed-rate commercial loans or leases that the Corporation has entered into with its customers. These contracts have been designated as hedging instruments to hedge the risk of changes in the fair value of the underlying commercial loan/lease due to changes in interest rates. The related contracts are structured so that the notional amounts reduce over time to generally match the expected amortization of the underlying loan/lease.

In October 2007, the Corporation entered into three interest rate swap contracts on variable-rate loans with a total notional amount of $1.2 billion. The interest rate swap contracts were designated as hedging instruments in cash flow hedges with the objective of protecting the overall cash flows from the Corporation’s monthly interest receipts on a rolling portfolio of $1.2 billion of variable-rate loans outstanding throughout the 84-month period beginning in October 2007 and ending in October 2014 from the risk of variability of those cash flows such that the yield on the underlying loans would remain constant. As more fully discussed in the 2012 Form 10-K, the Corporation terminated portions of the hedges and settled portions of the interest rate swap contracts during November 2009 and terminated the remaining portions of the hedges and settled the remaining portions of the interest rate swap contracts during November 2010. The deferred accumulated gain applicable to the settled interest rate swap contracts included in accumulated other comprehensive income totaled $58.6 million and $68.0 million ($38.1 million and $44.2 million on an after-tax basis) at March 31, 2013 and December 31, 2012. The remaining deferred gain of $58.6 million ($38.1 million on an after-tax basis) at March 31, 2013 will be recognized ratably in earnings through October 2014.

In October 2008, the Corporation entered into an interest rate swap contract on junior subordinated deferrable interest debentures with a total notional amount of $120.0 million. The interest rate swap contract was designated as a hedging instrument in a cash flow hedge with the objective of protecting the quarterly interest payments on the Corporation’s $120.0 million of junior subordinated deferrable interest debentures issued to Cullen/Frost Capital Trust II throughout the five-year period beginning in December 2008 and ending in December 2013 from the risk of variability of those payments resulting from changes in the three-month LIBOR interest rate. Under the swap, the Corporation will pay a fixed interest rate of 5.47% and receive a variable interest rate of three-month LIBOR plus a margin of 1.55% on a total notional amount of $120.0 million, with quarterly settlements.

The Corporation has entered into certain interest rate swap, cap and floor contracts that are not designated as hedging instruments. These derivative contracts relate to transactions in which the Corporation enters into an interest rate swap, cap and/or floor with a customer while at the same time entering into an offsetting interest rate swap, cap and/or floor with another financial institution. In connection with each swap transaction, the Corporation agrees to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on a similar notional amount at a fixed interest rate. At the same time, the Corporation agrees to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the Corporation’s customer to effectively convert a variable rate loan to a fixed rate. Because the Corporation acts as an intermediary for its customer, changes in the fair value of the underlying derivative contracts for the most part offset each other and do not significantly impact the Corporation’s results of operations.

The notional amounts and estimated fair values of interest rate derivative contracts are presented in the following table. The Corporation obtains dealer quotations to value its interest rate derivative contracts designated as hedges of cash flows, while the fair values of other interest rate derivative contracts are estimated utilizing internal valuation models with observable market data inputs.


	March 31, 2013					December 31, 2012					March 31, 2012
	Notional		Estimated			Notional		Estimated			Notional		Estimated
	Amount		Fair Value			Amount		Fair Value			Amount		Fair Value
Derivatives designated as hedges of fair value:
Financial institution counterparties:
Loan/lease interest rate swaps – assets		23,884	$	103			14,748	$	24			—	$	—
Loan/lease interest rate swaps – liabilities		84,404		(6,565	)		84,577		(7,186	)		67,517		(7,736	)
Derivatives designated as hedges of cash flows:
Financial institution counterparties:
Interest rate swap on junior subordinated deferrable interest debentures		120,000		(3,306	)		120,000		(4,365	)		120,000		(7,205	)
Non-hedging interest rate derivatives:
Financial institution counterparties:
Loan/lease interest rate swaps – assets		50,915		147			—		—			—		—
Loan/lease interest rate swaps – liabilities		741,344		(54,434	)		797,311		(60,994	)		637,356		(57,314	)
Loan/lease interest-rate caps – assets		33,058		12			30,000		12			20,000		28
Customer counterparties:
Loan/lease interest rate swaps – assets		741,344		54,312			797,311		60,854			637,356		57,105
Loan/lease interest rate swaps – liabilities		50,915		(147	)		—		—			—		—
Loan/lease interest-rate caps – liabilities		33,058		(12	)		30,000		(12	)		20,000		(28	)

The weighted-average rates paid and received for interest rate swaps outstanding at March 31, 2013 were as follows:


	Weighted-Average
	Interest Rate Paid			Interest Rate Received
Interest rate swaps:
Fair value hedge loan/lease interest rate swaps		2.57	%		0.20	%
Cash flow hedge interest rate swaps on junior subordinated deferrable interest debentures		5.47			1.84
Non-hedging interest rate swaps – financial institution counterparties		4.50			1.86
Non-hedging interest rate swaps – customer counterparties		1.86			4.50

The weighted-average strike rate for outstanding interest rate caps was 2.67% at March 31, 2013.

Commodity Derivatives. The Corporation enters into commodity swaps and option contracts that are not designated as hedging instruments primarily to accommodate the business needs of its customers. Upon the origination of a commodity swap or option contract with a customer, the Corporation simultaneously enters into an offsetting contract with a third party financial institution to mitigate the exposure to fluctuations in commodity prices.

The notional amounts and estimated fair values of non-hedging commodity swap and option derivative positions outstanding are presented in the following table. The Corporation obtains dealer quotations and uses internal valuation models with observable market data inputs to value its commodity derivative positions.


			March 31, 2013					December 31, 2012					March 31, 2012
	Notional		Notional		Estimated			Notional		Estimated			Notional		Estimated
	Units		Amount		Fair Value			Amount		Fair Value			Amount		Fair Value
Financial institution counterparties:
Oil – assets		Barrels		574	$	1,426			464	$	2,188			1,415	$	3,928
Oil – liabilities		Barrels		1,016		(2,816	)		402		(1,590	)		1,716		(11,286	)
Natural gas – assets		MMBTUs		3,050		733			120		19			1,290		2,862
Natural gas – liabilities		MMBTUs		9,035		(1,614	)		120		(24	)		300		(40	)
Customer counterparties:
Oil – assets		Barrels		1,016		2,909			402		1,636			1,716		11,384
Oil – liabilities		Barrels		574		(1,369	)		464		(2,139	)		1,415		(3,907	)
Natural gas – assets		MMBTUs		9,995		1,691			120		24			300		40
Natural gas – liabilities		MMBTUs		2,090		(728	)		120		(19	)		1,290		(2,830	)

Foreign Currency Derivatives. The Corporation enters into foreign currency forward contracts that are not designated as hedging instruments primarily to accommodate the business needs of its customers. Upon the origination of a foreign currency denominated transaction with a customer, the Corporation simultaneously enters into an offsetting contract with a third party to negate the exposure to fluctuations in foreign currency exchange rates. The Corporation also utilizes foreign currency forward contracts that are not designated as hedging instruments to mitigate the economic effect of fluctuations in foreign currency exchange rates on certain short-term, non-U.S. dollar denominated loans. The notional amounts and fair values of open foreign currency forward contracts were as follows:


			March 31, 2013					December 31, 2012				March 31, 2012
	Notional		Notional		Estimated			Notional		Estimated		Notional		Estimated
	Currency		Amount		Fair Value			Amount		Fair Value		Amount		Fair Value
Financial institution counterparties:
Forward contracts – assets		EUR		1,009	$	3			1,093	$	3		1,089	$	(6	)
Forward contracts – liabilities		CAD		19,432		(207	)		—		—		—		—
Customer counterparties:
Forward contracts – assets		CAD		19,380		258			—		—		—		—

Gains, Losses and Derivative Cash Flows. For fair value hedges, the changes in the fair value of both the derivative hedging instrument and the hedged item are included in other non-interest income or other non-interest expense. The extent that such changes in fair value do not offset represents hedge ineffectiveness. Net cash flows from interest rate swaps on commercial loans/leases designated as hedging instruments in effective hedges of fair value are included in interest income on loans. For cash flow hedges, the effective portion of the gain or loss due to changes in the fair value of the derivative hedging instrument is included in other comprehensive income, while the ineffective portion (indicated by the excess of the cumulative change in the fair value of the derivative over that which is necessary to offset the cumulative change in expected future cash flows on the hedge transaction) is included in other non-interest income or other non-interest expense. Net cash flows from interest rate swaps on variable-rate loans designated as hedging instruments in effective hedges of cash flows and the reclassification from other comprehensive income of deferred gains associated with the termination of those hedges are included in interest income on loans. Net cash flows from the interest rate swap on junior subordinated deferrable interest debentures designated as a hedging instrument in an effective hedge of cash flows are included in interest expense on junior subordinated deferrable interest debentures. For non-hedging derivative instruments, gains and losses due to changes in fair value and all cash flows are included in other non-interest income and other non-interest expense.

Amounts included in the consolidated statements of income related to interest rate derivatives designated as hedges of fair value were as follows:


	Three Months Ended March 31,
	2013			2012
Commercial loan/lease interest rate swaps:
Amount of gain (loss) included in interest income on loans	$	(623	)	$	(667	)
Amount of (gain) loss included in other non-interest expense		15			12

Amounts included in the consolidated statements of income and in other comprehensive income for the period related to interest rate derivatives designated as hedges of cash flows were as follows:


	Three Months Ended March 31,
	2013		2012
Interest rate swaps on variable-rate loans:
Amount reclassified from accumulated other comprehensive income to interest income on loans	$	9,345	$	9,345
Interest rate swaps on junior subordinated deferrable interest debentures:
Amount reclassified from accumulated other comprehensive income to interest expense on junior subordinated deferrable interest debentures		1,085		1,033
Amount of gain (loss) recognized in other comprehensive income		—		(427	)

No ineffectiveness related to interest rate derivatives designated as hedges of cash flows was recognized in the consolidated statements of income during the reported periods. The accumulated net after-tax gain related to effective cash flow hedges included in accumulated other comprehensive income totaled $36.2 million at March 31, 2013 and $41.6 million at December 31, 2012. The Corporation currently expects approximately $22.4 million of the net after-tax gain related to effective cash flow hedges included in accumulated other comprehensive income at March 31, 2013 will be reclassified into earnings during 2013, with the remaining amount expected to be classified into earnings in 2014. This amount represents management’s best estimate given current expectations about market interest rates and volumes related to loan pools underlying the terminated cash flow hedges. Because actual market interest rates and volumes related to loan pools underlying the terminated cash flow hedges may differ from management’s expectations, there can be no assurance as t