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: June 30, 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 July 12, 2013, there were 60,393,761 shares of the registrant’s Common Stock, $.01 par value, outstanding.

Cullen/Frost Bankers, Inc.

Quarterly Report on Form 10-Q

June 30, 2013

Table of Contents


		Page

Part I - Financial Information

Item 1.	Financial Statements (Unaudited)

	Consolidated Balance Sheets	3

	Consolidated Statements of Income	4

	Consolidated Statements of Comprehensive Income	5

	Consolidated Statements of Changes in Shareholders’ Equity	6

	Consolidated Statements of Cash Flows	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	44

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	65

Item 4.	Controls and Procedures	66

Part II - Other Information

Item 1.	Legal Proceedings	67

Item 1A.	Risk Factors	67

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	67

Item 3.	Defaults Upon Senior Securities	67

Item 4.	Mine Safety Disclosures	67

Item 5.	Other Information	67

Item 6.	Exhibits	67

Signatures		68

Part I. Financial Information

Item 1. Financial Statements (Unaudited)

Cullen/Frost Bankers, Inc.

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)


	June 30,			December 31,
	2013			2012
Assets:
Cash and due from banks	$	595,733		$	790,106
Interest-bearing deposits		2,296,349			2,650,425
Federal funds sold and resell agreements		9,273			84,448

Total cash and cash equivalents		2,901,355			3,524,979
Securities held to maturity, at amortized cost		3,166,692			2,956,381
Securities available for sale, at estimated fair value		6,033,370			6,203,299
Trading account securities		16,777			30,074
Loans, net of unearned discounts		9,232,543			9,223,848
Less: Allowance for loan losses		(93,400	)		(104,453	)

Net loans		9,139,143			9,119,395
Premises and equipment, net		306,069			315,934
Goodwill		535,509			535,509
Other intangible assets, net		6,539			8,147
Cash surrender value of life insurance policies		139,704			138,005
Accrued interest receivable and other assets		326,356			292,346

Total assets	$	22,571,514		$	23,124,069

Liabilities:
Deposits:
Non-interest-bearing demand deposits	$	7,744,676		$	8,096,937
Interest-bearing deposits		11,333,543			11,400,429

Total deposits		19,078,219			19,497,366
Federal funds purchased and repurchase agreements		549,823			561,061
Junior subordinated deferrable interest debentures		123,712			123,712
Other long-term borrowings		100,000			100,007
Accrued interest payable and other liabilities		291,922			424,441

Total liabilities		20,143,676			20,706,587
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 June 30, 2013, none issued at December 31, 2012		144,486			—
Common stock, par value $0.01 per share; 210,000,000 shares authorized; 60,236,336 shares issued at June 30, 2013 and 61,479,189 shares issued at December 31, 2012		616			615
Additional paid-in capital		686,920			702,968
Retained earnings		1,524,638			1,475,851
Accumulated other comprehensive income, net of tax		155,602			238,048
Treasury stock, 1,396,128 shares at June 30, 2013, at cost		(84,424	)		—

Total shareholders’ equity		2,427,838			2,417,482

Total liabilities and shareholders’ equity	$	22,571,514		$	23,124,069

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Income

(Dollars in thousands, except per share amounts)


	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
Interest income:
Loans, including fees	$	103,316	$	98,336	$	205,372	$	195,687
Securities:
Taxable		25,485		34,399		52,862		70,465
Tax-exempt		28,690		22,125		56,644		44,628
Interest-bearing deposits		1,498		903		2,851		1,833
Federal funds sold and resell agreements		29		33		51		48

Total interest income		159,018		155,796		317,780		312,661

Interest expense:
Deposits		3,882		4,547		7,890		9,119
Federal funds purchased and repurchase agreements		29		34		59		68
Junior subordinated deferrable interest debentures		1,690		1,711		3,363		3,385
Other long-term borrowings		236		287		474		1,165

Total interest expense		5,837		6,579		11,786		13,737

Net interest income		153,181		149,217		305,994		298,924
Provision for loan losses		3,575		2,355		9,575		3,455

Net interest income after provision for loan losses		149,606		146,862		296,419		295,469

Non-interest income:
Trust and investment management fees		22,561		21,279		44,446		41,931
Service charges on deposit accounts		20,044		20,639		40,088		41,433
Insurance commissions and fees		9,266		9,171		22,336		21,548
Interchange and debit card transaction fees		4,268		4,292		8,279		8,409
Other charges, commissions and fees		8,578		7,825		16,333		15,175
Net gain (loss) on securities transactions		6		370		11		(121	)
Other		7,786		6,187		18,796		13,367

Total non-interest income		72,509		69,763		150,289		141,742

Non-interest expense:
Salaries and wages		66,502		62,624		132,967		126,326
Employee benefits		14,629		14,048		32,620		30,749
Net occupancy		12,645		12,213		24,624		24,010
Furniture and equipment		14,986		13,734		29,171		27,154
Deposit insurance		2,835		2,838		5,724		5,335
Intangible amortization		788		994		1,608		2,005
Other		37,373		36,085		78,858		68,997

Total non-interest expense		149,758		142,536		305,572		284,576

Income before income taxes		72,357		74,089		141,136		152,635
Income taxes		12,694		16,027		26,285		33,540

Net income		59,663		58,062		114,851		119,095
Preferred stock dividends		2,688		—		2,688		—

Net income available to common shareholders	$	56,975	$	58,062	$	112,163	$	119,095


Earnings per common share:
Basic	$	0.95	$	0.94	$	1.86	$	1.94
Diluted		0.94		0.94		1.85		1.93

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Comprehensive Income

(Dollars in thousands)


	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Net income	$	59,663		$	58,062		$	114,851		$	119,095

Other comprehensive income (loss), before tax:
Securities available for sale and transferred securities:
Change in net unrealized gain/loss during the period		(74,025	)		20,968			(95,369	)		22,850
Change in net unrealized gain on securities transferred to held to maturity		(9,745	)		—			(18,204	)		—
Reclassification adjustment for net (gains) losses included in net income		(6	)		(370	)		(11	)		121

Total securities available for sale and transferred securities		(83,776	)		20,598			(113,584	)		22,971
Defined-benefit post-retirement benefit plans:
Change in the net actuarial gain/loss		1,639			1,428			3,279			2,657
Derivatives:
Change in the accumulated gain/loss on effective cash flow hedge derivatives		(33	)		(64	)		(33	)		(491	)
Reclassification adjustments for (gains) losses included in net income:
Interest rate swaps on variable-rate loans		(9,345	)		(9,345	)		(18,690	)		(18,690	)
Interest rate swap on junior subordinated deferrable interest debentures		1,103			1,044			2,188			2,077

Total derivatives		(8,275	)		(8,365	)		(16,535	)		(17,104	)


Other comprehensive income (loss), before tax		(90,412	)		13,661			(126,840	)		8,524
Deferred tax expense (benefit) related to other comprehensive income		(31,644	)		4,782			(44,394	)		2,983

Other comprehensive income (loss), net of tax		(58,768	)		8,879			(82,446	)		5,541


Comprehensive income	$	895		$	66,941		$	32,405		$	124,636

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

(Dollars in thousands, except per share amounts)


	Six Months Ended June 30,
	2013			2012
Total shareholders’ equity at beginning of period	$	2,417,482		$	2,283,537

Net income		114,851			119,095
Other comprehensive income (loss)		(82,446	)		5,541
Stock option exercises (662,224 shares in 2013 and 140,311 shares in 2012)		34,189			7,211
Stock compensation expense recognized in earnings		4,985			5,398
Tax benefits (deficiencies) related to stock compensation		(73	)		(414	)
Issuance of preferred stock (6,000,000 shares in 2013)		144,486			—
Purchase of treasury stock (1,905,077 shares in 2013)		(115,200	)		—
Accelerated share repurchase forward contract		(28,800	)		—
Cash dividends – preferred stock (approximately $0.45 per share in 2013)		(2,688	)		—
Cash dividends – common stock ($0.98 per share in 2013 and $0.94 per share in 2012)		(58,948	)		(57,757	)


Total shareholders’ equity at end of period	$	2,427,838		$	2,362,611

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)


	Six Months Ended June 30,
	2013			2012
Operating Activities:
Net income	$	114,851		$	119,095
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses		9,575			3,455
Deferred tax expense (benefit)		(1,739	)		(3,977	)
Accretion of loan discounts		(5,790	)		(5,663	)
Securities premium amortization (discount accretion), net		18,124			9,222
Net (gain) loss on securities transactions		(11	)		121
Depreciation and amortization		19,081			18,942
Net loss on sale/write-down of assets/foreclosed assets		3,023			2,598
Stock-based compensation		4,985			5,398
Net tax benefit (deficiency) from stock-based compensation		(448	)		(490	)
Excess tax benefits from stock-based compensation		(375	)		(76	)
Earnings on life insurance policies		(1,699	)		(2,074	)
Net change in:
Trading account securities		13,297			(2,954	)
Accrued interest receivable and other assets		(42,461	)		23,261
Accrued interest payable and other liabilities		(163,670	)		597

Net cash from operating activities		(33,257	)		167,455

Investing Activities:
Securities held to maturity:
Purchases		(221,107	)		—
Maturities, calls and principal repayments		9,723			489
Securities available for sale:
Purchases		(8,910,706	)		(17,060,846	)
Sales		8,495,587			15,987,480
Maturities, calls and principal repayments		517,698			401,078
Net change in loans		(26,446	)		(501,622	)
Net cash paid in acquisitions		—			(7,199	)
Proceeds from sales of premises and equipment		16,301			3,613
Purchases of premises and equipment		(18,520	)		(16,032	)
Proceeds from sales of repossessed properties		4,081			9,530

Net cash from investing activities		(133,389	)		(1,183,509	)

Financing Activities:
Net change in deposits		(419,147	)		520,369
Net change in short-term borrowings		(11,238	)		(66,177	)
Principal payments on long-term borrowings		(7	)		(9	)
Proceeds from stock option exercises		34,189			7,211
Excess tax benefits from stock-based compensation		375			76
Proceeds from issuance of preferred stock		144,486			—
Purchase of treasury stock		(115,200	)		—
Accelerated stock repurchase agreement		(28,800	)		—
Cash dividends paid on preferred stock		(2,688	)		—
Cash dividends paid on common stock		(58,948	)		(57,757	)

Net cash from financing activities		(456,978	)		403,713


Net change in cash and cash equivalents		(623,624	)		(612,341	)
Cash and equivalents at beginning of period		3,524,979			2,907,592


Cash and equivalents at end of period	$	2,901,355		$	2,295,251

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:


	Six Months Ended June 30,
	2013		2012
Cash paid for interest	$	12,039	$	16,007
Cash paid for income tax		32,623		27,894

Significant non-cash transactions:
Loans foreclosed and transferred to other real estate owned and foreclosed assets		2,913		4,697
Deferred gain on sale of building and parking garage		1,120		—

Note 2 - Securities

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


	June 30, 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	$	248,386	$	22,629	$	—	$	271,015	$	248,188	$	29,859	$	—	$	278,047
Residential mortgage-backed securities		10,262		118		109		10,271		10,725		300		—		11,025
States and political subdivisions		2,907,044		8,864		127,843		2,788,065		2,696,468		15,397		4,993		2,706,872
Other		1,000		—		2		998		1,000		—		—		1,000

Total	$	3,166,692	$	31,611	$	127,954	$	3,070,349	$	2,956,381	$	45,556	$	4,993	$	2,996,944

Available for Sale:
U. S. Treasury	$	3,021,080	$	21,643	$	—	$	3,042,723	$	3,020,115	$	37,806	$	—	$	3,057,921
Residential mortgage-backed securities		1,995,296		81,366		1,089		2,075,573		2,382,514		135,514		25		2,518,003
States and political subdivisions		863,754		21,526		6,105		879,175		552,056		39,427		—		591,483
Other		35,899		—		—		35,899		35,892		—		—		35,892

Total	$	5,916,029	$	124,535	$	7,194	$	6,033,370	$	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 June 30, 2013, approximately 95.9% 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 76.2% 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 $2.3 billion at June 30, 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 June 30, 2013 totaled $146.8 million ($95.4 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 June 30, 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
Residential mortgage-backed securities	$	7,270	$	109	$	—	$	—	$	7,270	$	109
States and political subdivisions		2,424,783		127,843		—		—		2,424,783		127,843
Other		998		2		—		—		998		2

Total	$	2,433,051	$	127,954	$	—	$	—	$	2,433,051	$	127,954

Available for Sale
Residential mortgage-backed securities	$	87,714	$	1,089	$	—	$	—	$	87,714	$	1,089
States and political subdivisions		338,904		6,105		—		—		338,904		6,105

Total	$	426,618	$	7,194	$	—	$	—	$	426,618	$	7,194

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 June 30, 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 June 30, 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 June 30, 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	$	24,390	$	24,863	$	1,512,694	$	1,514,523
Due after one year through five years		362,850		389,897		1,577,682		1,600,263
Due after five years through ten years		171,543		167,849		517,090		516,034
Due after ten years		2,597,647		2,477,469		277,368		291,078
Residential mortgage-backed securities		10,262		10,271		1,995,296		2,075,573
Equity securities		—		—		35,899		35,899

Total	$	3,166,692	$	3,070,349	$	5,916,029	$	6,033,370

Sales of securities available for sale were as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Proceeds from sales	$	3,997,485		$	6,002,402		$	8,495,587		$	15,987,480
Gross realized gains		6			371			11			2,508
Gross realized losses		—			(1	)		—			(2,629	)
Tax (expense) benefit of securities gains/losses		(2	)		(130	)		(4	)		42

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


	June 30,		December 31,
	2013		2012
U.S. Treasury	$	14,489	$	14,038
States and political subdivisions		2,288		16,036

Total	$	16,777	$	30,074

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


	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Net gain on sales transactions	$	282		$	299		$	576		$	622
Net mark-to-market gains (losses)		(377	)		(19	)		(380	)		(79	)

Net gain (loss) on trading account securities	$	(95	)	$	280		$	196		$	543

Note 3 - Loans

Loans were as follows:


	June 30,			Percentage			December 31,			Percentage
	2013			of Total			2012			of Total
Commercial and industrial:
Commercial	$	4,292,893			46.5	%	$	4,357,100			47.2	%
Leases		304,717			3.3			278,535			3.0
Asset-based		175,007			1.9			192,977			2.1

Total commercial and industrial		4,772,617			51.7			4,828,612			52.3
Commercial real estate:
Commercial mortgages		2,552,174			27.6			2,495,481			27.1
Construction		588,743			6.4			608,306			6.6
Land		230,351			2.5			216,008			2.3

Total commercial real estate		3,371,268			36.5			3,319,795			36.0
Consumer real estate:
Home equity loans		318,339			3.4			310,675			3.4
Home equity lines of credit		193,464			2.1			186,522			2.0
1-4 family residential mortgages		33,671			0.4			38,323			0.4
Construction		13,654			0.1			17,621			0.2
Other		226,077			2.5			224,206			2.4

Total consumer real estate		785,205			8.5			777,347			8.4

Total real estate		4,156,473			45.0			4,097,142			44.4
Consumer and other:
Consumer installment		318,824			3.4			311,310			3.4
Other		6,498			0.1			8,435			0.1

Total consumer and other		325,322			3.5			319,745			3.5
Unearned discounts		(21,869	)		(0.2	)		(21,651	)		(0.2	)

Total loans	$	9,232,543			100.0	%	$	9,223,848			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 June 30, 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 June 30, 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 June 30, 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:


	June 30,		December 31,
	2013		2012
Commercial and industrial:
Energy	$	228	$	1,150
Other commercial		40,790		45,158
Commercial real estate:
Buildings, land and other		41,615		38,631
Construction		1,015		1,100
Consumer real estate		2,379		2,773
Consumer and other		687		932

Total	$	86,714	$	89,744

As of June 30, 2013, non-accrual loans reported in the table above included $3.2 million 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 $591 thousand and $1.2 million for the three and six months ended June 30, 2013, compared to $639 thousand and $1.3 million for the same periods in 2012.

An age analysis of past due loans (including both accruing and non-accruing loans), segregated by class of loans, as of June 30, 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	$	397	$	758	$	1,155	$	1,016,182		$	1,017,337		$	530
Other commercial		13,841		18,173		32,014		3,723,266			3,755,280			6,570
Commercial real estate:
Buildings, land and other		15,248		29,484		44,732		2,737,793			2,782,525			430
Construction		5,771		81		5,852		582,891			588,743			81
Consumer real estate		5,989		3,504		9,493		775,712			785,205			3,205
Consumer and other		4,103		485		4,588		320,734			325,322			408
Unearned discounts		—		—		—		(21,869	)		(21,869	)		—

Total	$	45,349	$	52,485	$	97,834	$	9,134,709		$	9,232,543		$	11,224

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
	Contractual		Investment		Investment		Total
	Principal		With No		With		Recorded		Related
	Balance		Allowance		Allowance		Investment		Allowance
June 30, 2013
Commercial and industrial:
Energy	$	—	$	—	$	—	$	—	$	—
Other commercial		47,024		28,127		8,437		36,564		4,150
Commercial real estate:
Buildings, land and other		46,772		23,442		14,986		38,428		3,344
Construction		1,460		1,015		—		1,015		—
Consumer real estate		933		802		—		802		—
Consumer and other		403		365		—		365		—

Total	$	96,592	$	53,751	$	23,423	$	77,174	$	7,494

December 31, 2012
Commercial and industrial:
Energy	$	1,255	$	—	$	1,069	$	1,069	$	900
Other commercial		56,784		21,709		19,096		40,805		4,200
Commercial real estate:
Buildings, land and other		44,652		19,010		17,149		36,159		3,137
Construction		1,497		1,100		—		1,100		—
Consumer real estate		961		864		—		864		—
Consumer and other		428		400		—		400		—

Total	$	105,577	$	43,083	$	37,314	$	80,397	$	8,237

The average recorded investment in impaired loans was as follows:


	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
Commercial and industrial:
Energy	$	—	$	—	$	356	$	—
Other commercial		40,331		41,970		40,489		41,090
Commercial real estate:
Buildings, land and other		37,473		39,055		37,035		39,680
Construction		1,035		1,717		1,057		1,572
Consumer real estate		818		1,928		833		2,109
Consumer and other		375		487		383		509

Total	$	80,032	$	85,157	$	80,153	$	84,960

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 six months ended June 30, 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 six months ended June 30, 2012.


Commercial and industrial:
Other commercial	$	2,138
Commercial real estate:
Buildings, land and other		4,165

	$	6,303

The modifications during the six months ended June 30, 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. One loan totaling $169 thousand restructured during 2012 was in excess of 90 days past due as of June 30, 2013. During the six months ended June 30, 2013, the Corporation charged-off $1.1 million related to loans restructured during 2012 and 2013. These charge-offs and the aforementioned past due loan 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.


	June 30, 2013				December 31, 2012
	Weighted				Weighted
	Average				Average
	Risk Grade		Loans		Risk Grade		Loans
Commercial and industrial:
Energy
Risk grades 1-8		5.28	$	1,009,557		5.24	$	1,081,725
Risk grade 9		9.00		7,395		9.00		392
Risk grade 10		10.00		—		10.00		—
Risk grade 11		11.00		385		11.00		—
Risk grade 12		12.00		—		12.00		169
Risk grade 13		13.00		—		13.00		900

Total energy		5.31	$	1,017,337		5.25	$	1,083,186

Other commercial
Risk grades 1-8		5.91	$	3,481,071		5.81	$	3,367,443
Risk grade 9		9.00		148,192		9.00		250,508
Risk grade 10		10.00		28,187		10.00		28,440
Risk grade 11		11.00		56,811		11.00		53,797
Risk grade 12		12.00		36,070		12.00		40,603
Risk grade 13		13.00		4,949		13.00		4,635

Total other commercial		6.21	$	3,755,280		6.21	$	3,745,426

Commercial real estate:
Buildings, land and other
Risk grades 1-8		6.56	$	2,564,596		6.63	$	2,460,448
Risk grade 9		9.00		74,938		9.00		92,041
Risk grade 10		10.00		38,397		10.00		42,603
Risk grade 11		11.00		62,929		11.00		77,658
Risk grade 12		12.00		38,321		12.00		35,602
Risk grade 13		13.00		3,344		13.00		3,137

Total commercial real estate		6.86	$	2,782,525		6.97	$	2,711,489

Construction
Risk grades 1-8		6.85	$	563,561		6.82	$	579,108
Risk grade 9		9.00		20,977		9.00		23,046
Risk grade 10		10.00		2,490		10.00		4,435
Risk grade 11		11.00		700		11.00		617
Risk grade 12		12.00		1,015		12.00		1,100
Risk grade 13		13.00		—		13.00		—

Total construction		6.95	$	588,743		6.94	$	608,306

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 three commercial real estate loans having a calculated risk grade of 10 or higher in excess of $5 million as of June 30, 2013, which totaled $31.0 million and had a weighted-average loan-to-value ratio of approximately 75.6%. 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 June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Commercial and industrial:
Energy	$	—		$	—		$	(900	)	$	4
Other commercial		(2,883	)		(3,180	)		(18,510	)		(4,855	)
Commercial real estate:
Buildings, land and other		(244	)		493			(29	)		(1,867	)
Construction		116			12			230			22
Consumer real estate		15			(519	)		(261	)		(285	)
Consumer and other		(768	)		(694	)		(1,158	)		(973	)

Total	$	(3,764	)	$	(3,888	)	$	(20,628	)	$	(7,954	)

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 124.5 at May 31, 2013 (most recent date available) and 123.8 at December 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 June 30, 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
June 30, 2013
Historical valuation allowances	$	24,910		$	12,741		$	2,591		$	7,896		$	—	$	48,138
Specific valuation allowances		4,150			3,344			—			—			—		7,494
General valuation allowances:
Environmental risk adjustment		4,896			3,073			620			2,041			—		10,630
Distressed industries		8,005			512			—			—			—		8,517
Excessive industry concentrations		3,705			1,303			—			—			—		5,008
Large relationship concentrations		1,335			944			—			—			—		2,279
Highly-leveraged credit relationships		4,497			761			—			—			—		5,258
Policy exceptions		—			—			—			—			2,190		2,190
Credit and collateral exceptions		—			—			—			—			1,707		1,707
Loans not reviewed by concurrence		1,994			2,145			2,178			1,035			—		7,352
Adjustment for recoveries		(2,678	)		(1,250	)		(472	)		(6,842	)		—		(11,242	)
General macroeconomic risk		—			—			—			—			6,069		6,069

Total	$	50,814		$	23,573		$	4,917		$	4,130		$	9,966	$	93,400

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 three and six months ended June 30, 2013 and 2012. 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
Three months ended:
June 30, 2013
Beginning balance	$	51,085		$	24,809		$	5,148		$	3,724		$	8,823		$	93,589
Provision for loan losses		2,612			(1,108	)		(246	)		1,174			1,143			3,575
Charge-offs		(3,586	)		(415	)		(159	)		(2,374	)		—			(6,534	)
Recoveries		703			287			174			1,606			—			2,770

Net charge-offs		(2,883	)		(128	)		15			(768	)		—			(3,764	)

Ending balance	$	50,814		$	23,573		$	4,917		$	4,130		$	9,966		$	93,400

June 30, 2012
Beginning balance	$	45,869		$	20,003		$	3,699		$	8,715		$	28,895		$	107,181
Provision for loan losses		10,786			7,123			2,055			(4,372	)		(13,237	)		2,355
Charge-offs		(4,474	)		(353	)		(606	)		(2,229	)		—			(7,662	)
Recoveries		1,294			858			87			1,535			—			3,774

Net charge-offs		(3,180	)		505			(519	)		(694	)		—			(3,888	)

Ending balance	$	53,475		$	27,631		$	5,235		$	3,649		$	15,658		$	105,648

Six months ended:
June 30, 2013
Beginning balance	$	54,164		$	29,346		$	5,252		$	3,507		$	12,184		$	104,453
Provision for loan losses		16,060			(5,974	)		(74	)		1,781			(2,218	)		9,575
Charge-offs		(20,738	)		(681	)		(495	)		(4,551	)		—			(26,465	)
Recoveries		1,328			882			234			3,393			—			5,837

Net charge-offs		(19,410	)		201			(261	)		(1,158	)		—			(20,628	)

Ending balance	$	50,814		$	23,573		$	4,917		$	4,130		$	9,966		$	93,400

June 30, 2012
Beginning balance	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147
Provision for loan losses		15,552			8,564			1,980			(8,013	)		(14,628	)		3,455
Charge-offs		(7,486	)		(3,195	)		(895	)		(4,214	)		—			(15,790	)
Recoveries		2,635			1,350			610			3,241			—			7,836

Net charge-offs		(4,851	)		(1,845	)		(285	)		(973	)		—			(7,954	)

Ending balance	$	53,475		$	27,631		$	5,235		$	3,649		$	15,658		$	105,648

The following table details the amount of the allowance for loan losses allocated to each portfolio segment as of June 30, 2013, December 31, 2012 and June 30, 2012, detailed on the basis of the impairment methodology used by the Corporation.


	Commercial
	and		Commercial		Consumer		Consumer
	Industrial		Real Estate		Real Estate		and Other		Unallocated		Total
June 30, 2013
Loans individually evaluated for impairment	$	11,330	$	4,531	$	—	$	—	$	—	$	15,861
Loans collectively evaluated for impairment		39,484		19,042		4,917		4,130		9,966		77,539

Balance at June 30, 2013	$	50,814	$	23,573	$	4,917	$	4,130	$	9,966	$	93,400

December 31, 2012
Loans individually evaluated for impairment	$	13,171	$	4,366	$	—	$	—	$	—	$	17,537
Loans collectively evaluated for impairment		40,993		24,980		5,252		3,507		12,184		86,916

Balance at December 31, 2012	$	54,164	$	29,346	$	5,252	$	3,507	$	12,184	$	104,453

June 30, 2012
Loans individually evaluated for impairment	$	17,983	$	2,728	$	—	$	—	$	—	$	20,711
Loans collectively evaluated for impairment		35,492		24,903		5,235		3,649		15,658		84,937

Balance at June 30, 2012	$	53,475	$	27,631	$	5,235	$	3,649	$	15,658	$	105,648

The Corporation’s recorded investment in loans as of June 30, 2013, December 31, 2012 and June 30, 2012 related to each balance in the allowance for loan losses by portfolio segment and detailed on the basis of the impairment methodology used by the Corporation was as follows:


	Commercial
	and		Commercial		Consumer		Consumer		Unearned
	Industrial		Real Estate		Real Estate		and Other		Discounts			Total
June 30, 2013
Loans individually evaluated for impairment	$	126,402	$	147,196	$	802	$	365	$	—		$	274,765
Loans collectively evaluated for impairment		4,646,215		3,224,072		784,403		324,957		(21,869	)		8,957,778

Ending balance	$	4,772,617	$	3,371,268	$	785,205	$	325,322	$	(21,869	)	$	9,232,543

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

June 30, 2012
Loans individually evaluated for impairment	$	183,964	$	198,000	$	1,279	$	439	$	—		$	383,682
Loans collectively evaluated for impairment		4,125,925		2,921,902		760,781		316,564		(19,091	)		8,106,081

Ending balance	$	4,309,889	$	3,119,902	$	762,060	$	317,003	$	(19,091	)	$	8,489,763

Note 4 - Goodwill and Other Intangible Assets

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


	June 30,		December 31,
	2013		2012
Goodwill	$	535,509	$	535,509

Other intangible assets:
Core deposits	$	4,115	$	5,296
Customer relationship		1,944		2,262
Non-compete agreements		480		589

	$	6,539	$	8,147

The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2013 is as follows:


Remainder of 2013	$	1,507
2014		2,271
2015		1,489
2016		777
2017		215
Thereafter		280

	$	6,539

Note 5 - Deposits

Deposits were as follows:


	June 30,		Percentage			December 31,		Percentage
	2013		of Total			2012		of Total
Non-interest-bearing demand deposits:
Commercial and individual	$	7,057,425		37.0	%	$	7,186,105		36.9	%
Correspondent banks		323,992		1.7			436,381		2.2
Public funds		363,259		1.9			474,451		2.4

Total non-interest-bearing demand deposits		7,744,676		40.6			8,096,937		41.5
Interest-bearing deposits:
Private accounts:
Savings and interest checking		3,495,530		18.3			3,812,712		19.6
Money market accounts		6,438,506		33.8			6,127,256		31.4
Time accounts of $100,000 or more		523,944		2.7			514,346		2.6
Time accounts under $100,000		448,905		2.4			464,641		2.4

Total private accounts		10,906,885		57.2			10,918,955		56.0
Public funds:
Savings and interest checking		233,107		1.2			287,391		1.5
Money market accounts		42,548		0.2			50,600		0.3
Time accounts of $100,000 or more		146,300		0.8			140,191		0.7
Time accounts under $100,000		4,703		—			3,292		—

Total public funds		426,658		2.2			481,474		2.5

Total interest-bearing deposits		11,333,543		59.4			11,400,429		58.5

Total deposits	$	19,078,219		100.0	%	$	19,497,366		100.0	%

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


	June 30,		December 31,
	2013		2012
Deposits from the Certificate of Deposit Account Registry Service (CDARS) deposits	$	701	$	2,723
Deposits from foreign sources (primarily Mexico)		766,265		799,504

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:


	June 30,		December 31,
	2013		2012
Commitments to extend credit	$	6,169,000	$	5,710,448
Standby letters of credit		216,595		186,049
Deferred standby letter of credit fees		1,246		1,412

Lease Commitments. The Corporation leases certain office facilities and office equipment under operating leases. Rent expense for all operating leases totaled $6.2 million and $12.0 million during the three and six months ended June 30, 2013 and $5.6 million and $11.0 million during the three and six months ended June 30, 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 currently 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 June 30, 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 further discussed below, in July 2013, Cullen/Frost’s and Frost Bank’s primary federal regulator, the Federal Reserve, published final rules establishing a new comprehensive capital framework for U.S. banking organizations which will become effective on January 1, 2015 (subject to a phase-in period).

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
June 30, 2013
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	2,011,267		15.39	%	$	1,045,233		8.00	%	$	1,306,541		10.00	%
Frost Bank		1,767,524		13.54			1,044,199		8.00			1,305,249		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,857,867		14.22			522,616		4.00			783,925		6.00
Frost Bank		1,674,124		12.83			522,099		4.00			783,149		6.00
Leverage Ratio
Cullen/Frost		1,857,867		8.60			864,342		4.00			1,080,427		5.00
Frost Bank		1,674,124		7.75			863,558		4.00			1,079,448		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 June 30, 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 June 30, 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 below, new rules related to the implementation of the Basel III capital framework will require the phase-out of certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies beginning January 1, 2015.

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. 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 June 30, 2013, Frost Bank could pay aggregate dividends of up to $243.3 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.

Basel III Capital Rules. In July 2013, the Cullen/Frost’s and Frost Bank’s primary federal regulator, the Federal Reserve, published final rules (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including Cullen/Frost and Frost Bank, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach, which was derived from the Basel I capital accords of the Basel Committee, with a more risk-sensitive approach based, in part, on the standardized approach in the Basel Committee’s 2004 “Basel II” capital accords. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules. The Basel III Capital Rules are effective for Cullen/Frost and Frost Bank on January 1, 2015 (subject to a phase-in period).

The Basel III Capital Rules, among other things, (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specify that Tier 1 capital consist of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions/adjustments as compared to existing regulations.

When fully phased in on January 1, 2019, the Basel III Capital Rules will require Cullen/Frost and Frost Bank to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets (as compared to a current minimum leverage ratio of 3% for banking organizations that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk).

The Basel III Capital Rules also provides for a “countercyclical capital buffer” that is applicable to only certain covered institutions and is not expected to have any current applicability to Cullen/Frost or Frost Bank.

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

Under the Basel III Capital Rules, the initial minimum capital ratios as of January 1, 2015 will be as follows:

•

4.5% CET1 to risk-weighted assets.

•

6.0% Tier 1 capital to risk-weighted assets.

•

8.0% Total capital to risk-weighted assets.

The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however, non-advanced approaches banking organizations, including Cullen/Frost and Frost Bank, may make a one-time permanent election to continue to exclude these items. Cullen/Frost and Frost Bank expect to make this election in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s securities portfolio. The Basel III Capital Rules also preclude certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies, subject to phase-out. As a result, beginning in 2015, only 25% of the Corporation’s trust preferred securities will be included in Tier 1 capital and in 2016, none of the Corporation’s trust preferred securities will be included in Tier 1 capital. Trust preferred securities no longer included in the Corporation’s Tier 1 capital may nonetheless be included as a component of Tier 2 capital on a permanent basis without phase-out.

Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2015 and will be phased-in over a 4-year period (beginning at 40% on January 1, 2015 and an additional 20% per year thereafter). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

With respect to Frost Bank, the Basel III Capital Rules also revise the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category.

The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specifics changes to current rules impacting the Corporation’s determination of risk-weighted assets include, among other things:

•

Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.

•

Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due.

•

Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (currently set at 0%).

•

Providing for a risk weight, generally not less than 20% with certain exceptions, for securities lending transactions based on the risk weight category of the underlying collateral securing the transaction.

•

Providing for a 100% risk weight for claims on securities firms.

•

Eliminating the current 50% cap on the risk weight for OTC derivatives.

In addition, the Basel III Capital Rules provide more advantageous risk weights for derivatives and repurchase-style transactions cleared through a qualifying central counterparty and increase the scope of eligible guarantors and eligible collateral for purposes of credit risk mitigation.

Management believes that, as of June 30, 2013, Cullen/Frost and Frost Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect. The Basel III Capital Rules adopted in July 2013 do not address the proposed liquidity coverage ratio test and net stable funding ratio test called for by the Basel III liquidity framework. See the section captioned “Supervision and Regulation” in Item 1. Business of the Corporation’s 2012 Form 10-K for more information on these topics.

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 $49.3 million and $68.0 million ($32.0 million and $44.2 million on an after-tax basis) at June 30, 2013 and December 31, 2012. The remaining deferred gain of $49.3 million ($32.0 million on an after-tax basis) at June 30, 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.


	June 30, 2013					December 31, 2012
	Notional Amount		Estimated Fair Value			Notional Amount		Estimated Fair Value
Derivatives designated as hedges of fair value:
Financial institution counterparties:
Loan/lease interest rate swaps – assets	$	52,235	$	1,214		$	14,748	$	24
Loan/lease interest rate swaps – liabilities		55,405		(5,091	)		84,577		(7,186	)
Derivatives designated as hedges of cash flows:
Financial institution counterparties:
Interest rate swap on junior subordinated deferrable interest debentures		120,000		(2,201	)		120,000		(4,365	)
Non-hedging interest rate derivatives:
Financial institution counterparties:
Loan/lease interest rate swaps – assets		212,361		6,610			—		—
Loan/lease interest rate swaps – liabilities		542,431		(40,051	)		797,311		(60,994	)
Loan/lease interest-rate caps – assets		53,058		1,122			30,000		12
Customer counterparties:
Loan/lease interest rate swaps – assets		542,431		39,967			797,311		60,854
Loan/lease interest rate swaps – liabilities		212,361		(6,610	)		—		—
Loan/lease interest-rate caps – liabilities		53,058		(1,122	)		30,000		(12	)

The weighted-average rates paid and received for interest rate swaps outstanding at June 30, 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	%		0.19	%
Cash flow hedge interest rate swaps on junior subordinated deferrable interest debentures		5.47			1.82
Non-hedging interest rate swaps – financial institution counterparties		4.48			1.81
Non-hedging interest rate swaps – customer counterparties		1.81			4.48

The weighted-average strike rate for outstanding interest rate caps was 2.89% at June 30, 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.


			June 30, 2013					December 31, 2012
	Notional		Notional		Estimated			Notional		Estimated
	Units		Amount		Fair Value			Amount		Fair Value
Financial institution counterparties:
Oil – assets		Barrels		673	$	1,389			464	$	2,188
Oil – liabilities		Barrels		607		(965	)		402		(1,590	)
Natural gas – assets		MMBTUs		10,600		3,435			120		19
Natural gas – liabilities		MMBTUs		5,470		(829	)		120		(24	)
Customer counterparties:
Oil – assets		Barrels		387		595			402		1,636
Oil – liabilities		Barrels		567		(1,309	)		464		(2,139	)
Natural gas – assets		MMBTUs		5,796		1,236			120		24
Natural gas – liabilities		MMBTUs		10,600		(3,330	)		120		(19	)

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:

June 30, 2013

December 31, 2012

Notional

Estimated

Notional

Estimated

Currency

Amount

Fair Value

Amount

Fair Value

Financial institution counterparties:

Forward contracts – assets