Form 10-Q
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
 
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2011
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 000-26481
 
(FINANCIAL INSTITUTIONS, INC. LOGO)
(Exact name of registrant as specified in its charter)
 
     
NEW YORK   16-0816610
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
incorporation or organization)    
     
220 LIBERTY STREET, WARSAW, NEW YORK   14569
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code: (585) 786-1100
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 þ No o
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 þ No o
Indicate by check mark whether the regsitrant 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.
             
Large accelerated filer o   Accelerated filer þ   Non-accelerated filer o   Smaller reporting company o
        (Do not check if a smaller company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The registrant had 13,805,830 shares of Common Stock, $0.01 par value, outstanding as of July 28, 2011.
 
 

 

 


 

FINANCIAL INSTITUTIONS, INC.
Form 10-Q
For the Quarterly Period Ended June 30, 2011
TABLE OF CONTENTS
         
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 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32
 EX-101 INSTANCE DOCUMENT
 EX-101 SCHEMA DOCUMENT
 EX-101 CALCULATION LINKBASE DOCUMENT
 EX-101 LABELS LINKBASE DOCUMENT
 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT

 

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Table of Contents

PART I. FINANCIAL INFORMATION
ITEM 1.  
Financial Statements
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Financial Condition
                 
    June 30,     December 31,  
(Dollars in thousands, except share and per share data)   2011     2010  
    (Unaudited)        
ASSETS
               
Cash and cash equivalents:
               
Cash and due from banks
  $ 45,990     $ 38,964  
Federal funds sold and interest-bearing deposits in other banks
    94       94  
 
           
Total cash and cash equivalents
    46,084       39,058  
Securities available for sale, at fair value
    706,958       666,368  
Securities held to maturity, at amortized cost (fair value of $24,797 and $28,849, respectively)
    24,091       28,162  
Loans held for sale
    14,511       3,138  
Loans (net of allowance for loan losses of $20,632 and $20,466, respectively)
    1,347,420       1,325,524  
Company owned life insurance
    26,632       26,053  
Premises and equipment, net
    32,940       33,263  
Goodwill
    37,369       37,369  
Other assets
    46,939       55,372  
 
           
Total assets
  $ 2,282,944     $ 2,214,307  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Deposits:
               
Noninterest-bearing demand
  $ 358,574     $ 350,877  
Interest-bearing demand
    376,306       374,900  
Savings and money market
    438,173       417,359  
Certificates of deposit
    699,186       739,754  
 
           
Total deposits
    1,872,239       1,882,890  
Short-term borrowings
    132,395       77,110  
Long-term borrowings
    26,702       26,767  
Other liabilities
    17,875       15,396  
 
           
Total liabilities
    2,049,211       2,002,163  
 
           
 
Shareholders’ equity:
               
Series A 3% preferred stock, $100 par value; 1,533 shares authorized and issued
    153       153  
Series A preferred stock, $5,000 liquidation preference per share, 7,503 shares authorized; 7,503 shares issued at December 31, 2010
          36,210  
Series B-1 8.48% preferred stock, $100 par value, 200,000 shares authorized, 173,253 and 174,223 shares issued, respectively
    17,326       17,422  
 
           
Total preferred equity
    17,479       53,785  
Common stock, $0.01 par value, 50,000,000 shares authorized; 14,161,597 and 11,348,122 shares issued, respectively
    142       113  
Additional paid-in capital
    66,724       26,029  
Retained earnings
    150,971       144,599  
Accumulated other comprehensive income (loss)
    5,062       (4,722 )
Treasury stock, at cost — 355,767 and 410,616 shares, respectively
    (6,645 )     (7,660 )
 
           
Total shareholders’ equity
    233,733       212,144  
 
           
Total liabilities and shareholders’ equity
  $ 2,282,944     $ 2,214,307  
 
           
See accompanying notes to the consolidated financial statements.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Income (Unaudited)
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
(Dollars in thousands, except per share amounts)   2011     2010     2011     2010  
Interest income:
                               
Interest and fees on loans
  $ 19,071     $ 18,714     $ 38,106     $ 37,332  
Interest and dividends on investment securities
    4,759       5,485       9,363       10,684  
Other interest income
          3             10  
 
                       
Total interest income
    23,830       24,202       47,469       48,026  
 
                       
Interest expense:
                               
Deposits
    2,934       3,730       6,131       7,514  
Short-term borrowings
    110       85       182       163  
Long-term borrowings
    533       711       1,065       1,421  
 
                       
Total interest expense
    3,577       4,526       7,378       9,098  
 
                       
Net interest income
    20,253       19,676       40,091       38,928  
Provision for loan losses
    1,328       2,105       2,138       2,523  
 
                       
Net interest income after provision for loan losses
    18,925       17,571       37,953       36,405  
 
                       
Noninterest income:
                               
Service charges on deposits
    2,243       2,502       4,348       4,732  
ATM and debit card
    1,123       1,054       2,139       1,988  
Broker-dealer fees and commissions
    402       359       788       739  
Loan servicing
    249       140       598       420  
Company owned life insurance
    279       282       545       551  
Net gain on sale of loans held for sale
    117       115       341       177  
Net gain on disposal of investment securities
    4       63       7       69  
Impairment charges on investment securities
                      (526 )
Net (loss) gain on sale and disposal of other assets
    (8 )           37       2  
Other
    565       451       1,319       897  
 
                       
Total noninterest income
    4,974       4,966       10,122       9,049  
 
                       
Noninterest expense:
                               
Salaries and employee benefits
    8,854       8,044       17,255       16,291  
Occupancy and equipment
    2,644       2,670       5,487       5,441  
Professional services
    571       478       1,253       1,084  
Computer and data processing
    648       615       1,251       1,186  
Supplies and postage
    424       431       876       876  
FDIC assessments
    168       634       775       1,236  
Advertising and promotions
    253       352       418       539  
Other
    1,591       1,646       3,188       2,955  
 
                       
Total noninterest expense
    15,153       14,870       30,503       29,608  
 
                       
Income before income taxes
    8,746       7,667       17,572       15,846  
Income tax expense
    3,027       2,469       6,033       5,320  
 
                       
Net income
  $ 5,719     $ 5,198     $ 11,539     $ 10,526  
 
                       
Preferred stock dividends
    370       840       1,140       1,679  
Accretion of discount on preferred stock
          91       1,305       181  
 
                       
Net income available to common shareholders
  $ 5,349     $ 4,267     $ 9,094     $ 8,666  
 
                       
Earnings per common share (Note 2):
                               
Basic
  $ 0.39     $ 0.39     $ 0.73     $ 0.80  
Diluted
  $ 0.39     $ 0.39     $ 0.72     $ 0.80  
See accompanying notes to the consolidated financial statements.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Shareholders’ Equity (Unaudited)
Six months ended June 30, 2011
                                                         
                                    Accumulated                
                    Additional             Other             Total  
(Dollars in thousands,   Preferred     Common     Paid-in     Retained     Comprehensive     Treasury     Shareholders’  
except per share data)   Equity     Stock     Capital     Earnings     Income (Loss)     Stock     Equity  
 
                                                       
Balance at January 1, 2011
  $ 53,785     $ 113     $ 26,029     $ 144,599     $ (4,722 )   $ (7,660 )   $ 212,144  
Comprehensive income:
                                                       
Net income
                      11,539                   11,539  
Other comprehensive income, net of tax
                            9,784             9,784  
 
                                                     
Total comprehensive income
                                                    21,323  
Issuance of common stock
          29       43,098                         43,127  
Purchases of treasury stock
                                  (205 )     (205 )
Repurchase of warrant issued to U.S. Treasury
                (2,080 )                       (2,080 )
Redemption of Series A preferred stock
    (37,515 )           68                         (37,447 )
Repurchase of Series B-1 8.48% preferred stock
    (96 )                                   (96 )
Share-based compensation plans:
                                                       
Share-based compensation
                576                         576  
Stock options exercised
                (28 )                 119       91  
Restricted stock awards issued, net
                (991 )                 991        
Excess tax benefit on share-based compensation
                64                         64  
Directors’ retainer
                (12 )                     110       98  
Accretion of discount on Series A preferred stock
    1,305                   (1,305 )                  
Cash dividends declared:
                                                       
Series A 3% preferred-$1.50 per share
                      (2 )                 (2 )
Series A preferred-$53.24 per share
                      (399 )                 (399 )
Series B-1 8.48% preferred-$4.24 per share
                      (739 )                 (739 )
Common-$0.22 per share
                      (2,722 )                 (2,722 )
 
                                         
 
                                                       
Balance at June 30, 2011
  $ 17,479     $ 142     $ 66,724     $ 150,971     $ 5,062     $ (6,645 )   $ 233,733  
 
                                         
See accompanying notes to the consolidated financial statements.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
                 
    Six months ended  
    June 30,  
(Dollars in thousands)   2011     2010  
Cash flows from operating activities:
               
Net income
  $ 11,539     $ 10,526  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    1,701       1,776  
Net amortization of premiums on securities
    2,825       1,002  
Provision for loan losses
    2,138       2,523  
Share-based compensation
    576       542  
Deferred income tax expense
    1,206       828  
Proceeds from sale of loans held for sale
    14,162       14,284  
Originations of loans held for sale
    (11,618 )     (14,594 )
Increase in company owned life insurance
    (545 )     (551 )
Net gain on sale of loans held for sale
    (341 )     (177 )
Net gain on disposal of investment securities
    (7 )     (69 )
Impairment charges on investment securities
          526  
Net gain on sale and disposal of other assets
    (37 )     (2 )
Decrease in other assets
    1,204       294  
Increase in other liabilities
    1,204       1,322  
 
           
Net cash provided by operating activities
    24,007       18,230  
 
           
Cash flows from investing activities:
               
Purchases of investment securities:
               
Available for sale
    (124,096 )     (196,238 )
Held to maturity
    (7,428 )     (8,251 )
Proceeds from principal payments, maturities and calls on investment securities:
               
Available for sale
    88,512       100,160  
Held to maturity
    11,649       19,979  
Proceeds from sales and calls of securities available for sale
    8,900       33,090  
Net loan originations
    (37,715 )     (28,178 )
Purchases of company owned life insurance
    (34 )     (33 )
Proceeds from sales of other assets
    165       411  
Purchases of premises and equipment
    (1,410 )     (1,250 )
 
           
Net cash used in investing activities
    (61,457 )     (80,310 )
 
           
Cash flows from financing activities:
               
Net (decrease) increase in deposits
    (10,651 )     78,990  
Net increase (decrease) in short-term borrowings
    55,285       (12,657 )
Repayments of long-term borrowings
    (65 )     (79 )
Proceeds from issuance of common stock, net of issuance costs
    43,127        
Purchases of common stock for treasury
    (205 )      
Repurchase of warrant issued to U.S. Treasury
    (2,080 )      
Redemption of Series A preferred stock
    (37,447 )      
Repurchase of Series B-1 8.48% preferred stock
    (96 )      
Proceeds from stock options exercised
    91       129  
Excess tax benefit on share-based compensation
    64        
Cash dividends paid to preferred shareholders
    (1,380 )     (1,679 )
Cash dividends paid to common shareholders
    (2,167 )     (2,164 )
 
           
Net cash provided by financing activities
    44,476       62,540  
 
           
Net increase in cash and cash equivalents
    7,026       460  
Cash and cash equivalents, beginning of period
    39,058       42,959  
 
           
Cash and cash equivalents, end of period
  $ 46,084       43,419  
 
           
See accompanying notes to the consolidated financial statements.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
Financial Institutions, Inc., a financial holding company organized under the laws of New York State (“New York” or “NYS”), and its subsidiaries provide deposit, lending and other financial services to individuals and businesses in Central and Western New York. The Company owns all of the capital stock of Five Star Bank, a New York State chartered bank, and Five Star Investment Services, Inc., a broker-dealer subsidiary offering noninsured investment products. The Company also owns 100% of FISI Statutory Trust I (the “Trust”), which was formed in February 2001 for the purpose of issuing trust preferred securities. References to “the Company” mean the consolidated reporting entities and references to “the Bank” mean Five Star Bank.
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to U.S. generally accepted accounting principles (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary to present fairly the consolidated balance sheet, statements of income, shareholders’ equity and cash flows for the periods indicated, and contain adequate disclosure to make the information presented not misleading. Prior years’ consolidated financial statements are re-classified whenever necessary to conform to the current year’s presentation. These consolidated financial statements should be read in conjunction with the Company’s 2010 Annual Report on Form 10-K. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.
Use of Estimates
The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for loan losses, assumptions used in the defined benefit pension plan accounting, the carrying value of goodwill and deferred tax assets, and the valuation and other than temporary impairment considerations related to the securities portfolio.
Cash Flow Information
Supplemental cash flow information addressing certain cash payments and noncash investing and financing activities was as follows (in thousands):
                 
    Six months ended  
    June 30,  
    2011     2010  
Cash payments:
               
Interest
  $ 7,699     $ 9,115  
Income taxes
    2,173       4,539  
Noncash investing and financing activities:
               
Real estate and other assets acquired in settlement of loans
  $ 105     $ 70  
Accrued and declared unpaid dividends
    2,009       1,694  
Increase (decrease) in net unsettled security transactions
    960       (441 )
Net transfer of loans to held for sale
    13,576        
Accretion of preferred stock discount
    1,305       181  
Recent Accounting Pronouncements
In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-05 “Comprehensive Income (Topic 220) — Presentation of Comprehensive Income.” ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 is effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is assessing the impact of ASU 2011-05 on our comprehensive income presentation.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement (Topic 820) — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 changes the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. Consequently, the amendments in this update result in common fair value measurement and disclosure requirements in GAAP and IFRSs (International Financial Reporting Standards). ASU 2011-04 is effective prospectively during interim and annual periods beginning on or after December 15, 2011. Early adoption by public entities is not permitted. The Company is currently assessing the impact of ASU 2011-04 on the Company’s consolidated financial statements.
In April 2011, the FASB issued ASU No. 2011-03 “Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreement.” ASU 2011-03 removes from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company believes that the adoption of the standard will not have a significant impact on the Company’s consolidated financial statements.
In April 2011, the FASB issued ASU 2011-02 “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”, which clarifies when creditors should classify loan modifications as troubled debt restructurings. The guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the year. The guidance on measuring the impairment of a receivable restructured in a troubled debt restructuring, as clarified, is effective on a prospective basis. The Company believes that the adoption of the standard will not have a significant impact on the Company’s consolidated financial statements.
In January 2011, the FASB issued ASU No. 2011-01 “Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20.” The provisions of ASU No. 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses” required the disclosure of more granular information on the nature and extent of troubled debt restructurings and their effect on the allowance for loan and lease losses effective for the Company’s reporting period ended March 31, 2011. The amendments in ASU No. 2011-01 deferred the effective date related to these disclosures, enabling creditors to provide such disclosures after the FASB completed their project clarifying the guidance for determining what constitutes a troubled debt restructuring. As the provisions of ASU No. 2011-01 only defer the effective date of disclosure requirements related to troubled debt restructurings, the adoption had no impact on the Company’s statements of income and condition.
(2.) EARNINGS PER COMMON SHARE (“EPS”)
The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS for the three and six months ended June 30, 2011 and 2010 (in thousands, except per share amounts).
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Net income available to common shareholders
  $ 5,349     $ 4,267     $ 9,094     $ 8,666  
Less: Earnings allocated to participating securities
    10       29       20       59  
 
                       
Earnings allocated to common shares outstanding
  $ 5,339     $ 4,238     $ 9,074     $ 8,607  
 
                       
 
                               
Weighted average common shares used to calculate basic EPS
    13,631       10,761       12,489       10,754  
Add: Effect of common stock equivalents
    76       85       104       46  
 
                       
Weighted average common shares used to calculate diluted EPS
    13,707       10,846       12,593       10,800  
 
                       
 
                               
Earnings per common share:
                               
Basic
  $ 0.39     $ 0.39     $ 0.73     $ 0.80  
Diluted
  $ 0.39     $ 0.39     $ 0.72     $ 0.80  
 
                               
For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive:
 
                               
Stock options
    368       395       360       423  
Restricted stock awards
    2       2       7       1  
Warrant
                      188  
 
                       
 
    370       397       367       612  
 
                       

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(3.) INVESTMENT SECURITIES
The amortized cost and fair value of investment securities are summarized below (in thousands):
                                 
    June 30, 2011  
    Amortized     Unrealized     Unrealized     Fair  
    Cost     Gains     Losses     Value  
Securities available for sale:
                               
U.S. Government agencies and government sponsored enterprises
  $ 115,032     $ 1,090     $ 1,006     $ 115,116  
State and political subdivisions
    120,350       2,362       346       122,366  
Mortgage-backed securities:
                               
Federal National Mortgage Association
    118,616       1,482       181       119,917  
Federal Home Loan Mortgage Corporation
    77,337       591       16       77,912  
Government National Mortgage Association
    94,380       3,372       7       97,745  
Collateralized mortgage obligations:
                               
Federal National Mortgage Association
    31,241       779       11       32,009  
Federal Home Loan Mortgage Corporation
    27,996       656       1       28,651  
Government National Mortgage Association
    101,810       2,292       8       104,094  
Privately issued
    633       1,491             2,124  
 
                       
Total collateralized mortgage obligations
    161,680       5,218       20       166,878  
 
                       
Total mortgage-backed securities
    452,013       10,663       224       462,452  
Asset-backed securities
    541       6,483             7,024  
 
                       
Total available for sale securities
  $ 687,936     $ 20,598     $ 1,576     $ 706,958  
 
                       
 
                               
Securities held to maturity:
                               
State and political subdivisions
  $ 24,091     $ 706     $     $ 24,797  
 
                       
                                 
    December 31, 2010  
    Amortized     Unrealized     Unrealized     Fair  
    Cost     Gains     Losses     Value  
Securities available for sale:
                               
U.S. Government agencies and government sponsored enterprises
  $ 141,591     $ 1,158     $ 1,965     $ 140,784  
State and political subdivisions
    105,622       1,516       1,472       105,666  
Mortgage-backed securities:
                               
Federal National Mortgage Association
    96,300       798       1,030       96,068  
Federal Home Loan Mortgage Corporation
    83,745       321       1,317       82,749  
Government National Mortgage Association
    102,633       2,422       7       105,048  
Collateralized mortgage obligations:
                               
Federal National Mortgage Association
    8,938       231       11       9,158  
Federal Home Loan Mortgage Corporation
    15,917       329       1       16,245  
Government National Mortgage Association
    106,969       1,761       289       108,441  
Privately issued
    981       591             1,572  
 
                       
Total collateralized mortgage obligations
    132,805       2,912       301       135,416  
 
                       
Total mortgage-backed securities
    415,483       6,453       2,655       419,281  
Asset-backed securities
    564       204       131       637  
 
                       
Total available for sale securities
  $ 663,260     $ 9,331     $ 6,223     $ 666,368  
 
                       
 
                               
Securities held to maturity:
                               
State and political subdivisions
  $ 28,162     $ 687     $     $ 28,849  
 
                       

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(3.) INVESTMENT SECURITIES (Continued)
Sales of securities available for sale were as follows (in thousands):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Proceeds from sales
  $ 8,900     $ 20,140     $ 8,900     $ 33,090  
Gross realized gains
    4       67       4       73  
Gross realized losses
          4             4  
The scheduled maturities of securities available for sale and securities held to maturity at June 30, 2011 are shown below (in thousands). Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.
                 
    Amortized     Fair  
    Cost     Value  
Debt securities available for sale:
               
Due in one year or less
  $ 27,488     $ 27,775  
Due from one to five years
    79,163       81,367  
Due after five years through ten years
    237,075       237,170  
Due after ten years
    344,210       360,646  
 
           
 
  $ 687,936     $ 706,958  
 
           
Debt securities held to maturity:
               
Due in one year or less
  $ 18,229     $ 18,368  
Due from one to five years
    4,690       5,050  
Due after five years through ten years
    994       1,160  
Due after ten years
    178       219  
 
           
 
  $ 24,091     $ 24,797  
 
           
The following tables show the investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2011 and December 31, 2010 (in thousands).
                                                 
    June 30, 2011  
    Less than 12 months     12 months or longer     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses     Value     Losses  
Securities available for sale:
                                               
U.S. Government agencies and government sponsored enterprises
  $ 48,427     $ 984     $ 7,828     $ 22     $ 56,255     $ 1,006  
State and political subdivisions
    30,993       346                   30,993       346  
Mortgage-backed securities:
                                               
Federal National Mortgage Association
    19,783       181                   19,783       181  
Federal Home Loan Mortgage Corporation
    11,662       16                   11,662       16  
Government National Mortgage Association
    4,902       7                   4,902       7  
Collateralized mortgage obligations:
                                               
Federal National Mortgage Association
                2,040       11       2,040       11  
Federal Home Loan Mortgage Corporation
    457       1                   457       1  
Government National Mortgage Association
    1,323       8                   1,323       8  
 
                                   
Total collateralized mortgage obligations
    1,780       9       2,040       11       3,820       20  
 
                                   
Total mortgage-backed securities
    38,127       213       2,040       11       40,167       224  
 
                                   
Total temporarily impaired securities
  $ 117,547     $ 1,543     $ 9,868     $ 33     $ 127,415     $ 1,576  
 
                                   

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(3.) INVESTMENT SECURITIES (Continued)
                                                 
    December 31, 2010  
    Less than 12 months     12 months or longer     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses     Value     Losses  
Securities available for sale:
                                               
U.S. Government agencies and government sponsored enterprises
  $ 47,752     $ 1,911     $ 8,821     $ 54     $ 56,573     $ 1,965  
State and political subdivisions
    38,398       1,472                   38,398       1,472  
Mortgage-backed securities:
                                               
Federal National Mortgage Association
    46,777       1,030                   46,777       1,030  
Federal Home Loan Mortgage Corporation
    60,707       1,317                   60,707       1,317  
Government National Mortgage Association
    5,135       7                   5,135       7  
Collateralized mortgage obligations:
                                               
Federal National Mortgage Association
                2,332       11       2,332       11  
Federal Home Loan Mortgage Corporation
    612       1                   612       1  
Government National Mortgage Association
    17,798       289                   17,798       289  
 
                                   
Total collateralized mortgage obligations
    18,410       290       2,332       11       20,742       301  
 
                                   
Total mortgage-backed securities
    131,029       2,644       2,332       11       133,361       2,655  
Asset-backed securities
    111       61       96       70       207       131  
 
                                   
Total temporarily impaired securities
  $ 217,290     $ 6,088     $ 11,249     $ 135     $ 228,539     $ 6,223  
 
                                   
The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly. When evaluating debt securities for OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intention to sell the debt security or whether it is more likely than not that it will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
At June 30, 2011, the Company had positions in 11 investment securities with an amortized cost of $9.9 million and an unrealized loss of $33 thousand that have been in a continuous unrealized loss position for more than 12 months.
There were a total of 99 securities positions in the Company’s investment portfolio, with an amortized cost of $119.1 million and a total unrealized loss of $1.5 million at June 30, 2011, that have been in a continuous unrealized loss position for less than 12 months. The unrealized loss on these investment securities was predominantly caused by changes in market interest rates, average life or credit spreads subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.
Based on management’s review and evaluation of the Company’s debt securities as of June 30, 2011, the debt securities with unrealized losses were not considered to be OTTI. As of June 30, 2011, the Company does not intend to sell any debt securities which have an unrealized loss, it is unlikely the Company will be required to sell these securities before recovery and the Company expects to recover the entire amortized cost of these impaired securities.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(4.) LOANS
The Company’s loan portfolio consisted of the following as of the dates indicated (in thousands):
                         
            Net Deferred        
            Loan (Fees)        
    Loans, Gross     Costs     Loans, Net  
June 30, 2011
                       
Commercial business
  $ 217,293     $ 137     $ 217,430  
Commercial mortgage
    357,989       (526 )     357,463  
Residential mortgage
    120,766       23       120,789  
Home equity
    212,117       3,520       215,637  
Consumer indirect
    412,332       19,279       431,611  
Other consumer
    24,953       169       25,122  
 
                 
Total
  $ 1,345,450     $ 22,602       1,368,052  
 
                   
Allowance for loan losses
                    (20,632 )
 
                     
Total loans, net
                  $ 1,347,420  
 
                     
 
                       
December 31, 2010
                       
Commercial business
  $ 210,948     $ 83     $ 211,031  
Commercial mortgage
    353,537       (607 )     352,930  
Residential mortgage
    129,553       27       129,580  
Home equity
    205,070       3,257       208,327  
Consumer indirect
    400,221       17,795       418,016  
Other consumer
    25,937       169       26,106  
 
                 
Total
  $ 1,325,266     $ 20,724       1,345,990  
 
                   
Allowance for loan losses
                    (20,466 )
 
                     
Total loans, net
                  $ 1,325,524  
 
                     
Loans held for sale (not included above) totaled $14.5 million as of June 30, 2011, comprised of $935 thousand of residential mortgage loans and $13.6 million of indirect auto loans. During the second quarter of 2011, the Company reclassified $13.6 million of indirect auto loans from portfolio to loans held for sale pursuant to a letter of intent to sell the loans under a 90%/10% participation agreement. The Company will continue to service the loans for a fee in accordance with the participation agreement. The loans were subsequently sold in July 2011. Loans held for sale totaled $3.1 million as of December 31, 2010, all of which were residential mortgage loans.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(4.) LOANS (Continued)
Past Due Loans Aging
The Company’s recorded investment, by loan class, in current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of the dates indicated (in thousands):
                                                         
                    Greater                              
    30-59 Days     60-89 Days     Than 90     Total Past                     Total  
    Past Due     Past Due     Days     Due     Nonaccrual     Current     Loans  
June 30, 2011
                                                       
Commercial business
  $ 11     $     $     $ 11     $ 711     $ 216,571     $ 217,293  
Commercial mortgage
                            2,863       355,126       357,989  
Residential mortgage
    248                   248       2,262       118,256       120,766  
Home equity
    299       97             396       472       211,249       212,117  
Consumer indirect
    349       54             403       667       411,262       412,332  
Other consumer
    101       3       4       108             24,845       24,953  
 
                                         
Total loans, gross
  $ 1,008     $ 154     $ 4     $ 1,166     $ 6,975     $ 1,337,309     $ 1,345,450  
 
                                         
 
                                                       
December 31, 2010
                                                       
Commercial business
  $ 172     $ 92     $     $ 264     $ 947     $ 209,737     $ 210,948  
Commercial mortgage
    163                   163       3,100       350,274       353,537  
Residential mortgage
    492       6             498       2,102       126,953       129,553  
Home equity
    428       47             475       875       203,720       205,070  
Consumer indirect
    656       107             763       514       398,944       400,221  
Other consumer
    82       1       3       86       41       25,810       25,937  
 
                                         
Total loans, gross
  $ 1,993     $ 253     $ 3     $ 2,249     $ 7,579     $ 1,315,438     $ 1,325,266  
 
                                         
There were no loans past due greater than 90 days and still accruing interest as of June 30, 2011 and December 31, 2010. There were $4 thousand and $3 thousand in consumer overdrafts which were past due greater than 90 days as of June 30, 2011 and December 31, 2010, respectively. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans but by their terms do not accrue interest.
Troubled Debt Restructurings
Troubled debt restructurings (“TDRs”) are loans where the Company, for economic or legal reasons related to the borrower’s financial condition, has granted a significant concession to the borrower that it would not otherwise consider. TDRs can be classified as either accrual or nonaccrual loans. The Company had no TDRs on which it continued to accrue interest at June 30, 2011 or December 31, 2010. Included in nonaccrual loans are commercial TDRs of $760 thousand and $534 thousand at June 30, 2011 and December 31, 2010, respectively. The Company assigned $85 thousand and $137 thousand of specific reserves to loans classified as TDRs as of June 30, 2011 and December 31, 2010, respectively. TDRs typically migrate from the Company’s criticized and classified watch list and are assigned specific reserves in accordance with the Company’s standard allowance for loan loss methodology.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(4.) LOANS (Continued)
Impaired Loans
Management has determined that specific commercial loans on nonaccrual status and all loans that have had their terms restructured in a troubled debt restructuring are impaired loans. The following table presents data on impaired loans as of the dates indicated (in thousands):
                                                         
                            Quarter-to-Date     Year- to-Date  
            Unpaid             Average     Interest     Average     Interest  
    Recorded     Principal     Related     Recorded     Income     Recorded     Income  
    Investment     Balance     Allowance     Investment     Recognized     Investment     Recognized  
June 30, 2011
                                                       
With no related allowance recorded:
                                                       
Commercial business
  $ 157     $ 335     $     $ 208     $     $ 283     $  
Commercial mortgage
    703       722             610             527        
 
                                         
 
    860       1,057             818             810        
With an allowance recorded:
                                                       
Commercial business
    555       555       199       681             648        
Commercial mortgage
    2,159       2,159       483       2,188             2,399        
 
                                         
 
    2,714       2,714       682       2,869             3,047        
 
                                         
 
  $ 3,574     $ 3,771     $ 682     $ 3,687             3,857     $  
 
                                         
 
                                                       
December 31, 2010
                                                       
With no related allowance recorded:
                                                       
Commercial business
  $ 372     $ 524     $                     $ 275     $  
Commercial mortgage
    187       187                             481        
 
                                             
 
    559       711                             756        
With an allowance recorded:
                                                       
Commercial business
    576       576       149                       1,828        
Commercial mortgage
    2,913       2,921       883                       1,897        
 
                                             
 
    3,489       3,497       1,032                       3,725        
 
                                             
 
  $ 4,048     $ 4,208     $ 1,032                     $ 4,481     $  
 
                                             
Credit Quality Indicators
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to credit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:
Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.
Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans not meeting the criteria above that are analyzed individually as part of the process described above are considered “Uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(4.) LOANS (Continued)
The following table sets forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of the dates indicated (in thousands):
                 
    Commercial     Commercial  
    Business     Mortgage  
June 30, 2011
               
Uncriticized
  $ 202,200     $ 344,334  
Special mention
    8,940       4,816  
Substandard
    6,153       8,839  
Doubtful
           
 
           
Total
  $ 217,293     $ 357,989  
 
           
 
               
December 31, 2010
               
Uncriticized
  $ 194,510     $ 338,061  
Special mention
    11,479       4,931  
Substandard
    4,959       10,545  
Doubtful
           
 
           
Total
  $ 210,948     $ 353,537  
 
           
The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following table sets forth the Company’s retail loan portfolio, categorized by payment status, as of the dates indicated (in thousands):
                                 
    Residential     Home     Consumer     Other  
    Mortgage     Equity     Indirect     Consumer  
June 30, 2011
                               
Performing
  $ 118,504     $ 211,645     $ 411,665     $ 24,953  
Non-performing
    2,262       472       667        
 
                       
Total
  $ 120,766     $ 212,117     $ 412,332     $ 24,953  
 
                       
 
                               
December 31, 2010
                               
Performing
  $ 127,451     $ 204,195     $ 399,707     $ 25,896  
Non-performing
    2,102       875       514       41  
 
                       
Total
  $ 129,553     $ 205,070     $ 400,221     $ 25,937  
 
                       
Allowance for Loan Losses
Loans and the related allowance for loan losses at June 30, 2011, are presented below (in thousands):
                                                         
    Commercial     Commercial     Residential     Home     Consumer     Other        
    Business     Mortgage     Mortgage     Equity     Indirect     Consumer     Total  
 
Loans:
                                                       
Ending balance
  $ 217,293     $ 357,989     $ 120,766     $ 212,117     $ 412,332     $ 24,953     $ 1,345,450  
 
                                         
Evaluated for impairment:
                                                       
Individually
  $ 712     $ 2,862     $     $     $     $     $ 3,574  
 
                                         
Collectively
  $ 216,581     $ 355,127     $ 120,766     $ 212,117     $ 412,332     $ 24,953     $ 1,341,876  
 
                                         
 
                                                       
Allowance for loan losses:
                                                       
Ending balance
  $ 4,011     $ 5,763     $ 957     $ 1,050     $ 8,319     $ 532     $ 20,632  
 
                                         
Evaluated for impairment:
                                                       
Individually
  $ 199     $ 483     $     $     $     $     $ 682  
 
                                         
Collectively
  $ 3,812     $ 5,280     $ 957     $ 1,050       8,319     $ 532     $ 19,950  
 
                                         

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(4.) LOANS (Continued)
The changes in the allowance for loan losses for the three and six months ended June 30, 2011 were as follows (in thousands):
                                                         
    Commercial     Commercial     Residential     Home     Consumer     Other        
    Business     Mortgage     Mortgage     Equity     Indirect     Consumer     Total  
 
Three months ended June 30, 2011
                                                       
Beginning balance
  $ 4,021     $ 5,908     $ 1,016     $ 1,030     $ 7,614     $ 530     $ 20,119  
Charge-offs
    225       34       10       155       1,055       268       1,747  
Recoveries
    110       23       3       7       653       136       932  
Provision (credit)
    105       (134 )     (52 )     168       1,107       134       1,328  
 
                                         
Ending balance
  $ 4,011     $ 5,763     $ 957     $ 1,050     $ 8,319     $ 532     $ 20,632  
 
                                         
 
                                                       
Six months ended June 30, 2011
                                                       
Beginning balance
  $ 3,712     $ 6,431     $ 1,013     $ 972     $ 7,754     $ 584     $ 20,466  
Charge-offs
    315       378       12       262       2,345       479       3,791  
Recoveries
    264       39       30       17       1,205       264       1,819  
Provision (credit)
    350       (329 )     (74 )     323       1,705       163       2,138  
 
                                         
Ending balance
  $ 4,011     $ 5,763     $ 957     $ 1,050     $ 8,319     $ 532     $ 20,632  
 
                                         
Activity in the allowance for loan losses during the three and six months ended June 30, 2010 was as follows (in thousands):
                 
    Three months     Six months  
    ended     ended  
    June 30, 2010     June 30, 2010  
Beginning balance
  $ 20,586     $ 20,741  
Charge-offs
    1,476       3,089  
Recoveries
    610       1,650  
Provision
    2,105       2,523  
 
           
Ending balance
  $ 21,825     $ 21,825  
 
           
Risk Characteristics
Commercial business loans primarily consist of loans to small to mid-sized businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.
Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, inferring higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.
Residential mortgage loans and home equities (comprised of home equity loans and home equity lines) are generally made on the basis of the borrower’s ability to make repayment from his or her employment and other income, but are secured by real property whose value tends to be more easily ascertainable. Credit risk for these types of loans is generally influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral.
Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles or boats. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(5.) SHAREHOLDERS’ EQUITY
Common Stock
The changes in shares of common stock were as follows for six months ended June 30, 2011:
                         
    Outstanding     Treasury     Issued  
Shares outstanding at December 31, 2010
    10,937,506       410,616       11,348,122  
Shares issued in common stock offering
    2,813,475             2,813,475  
Restricted stock awards issued
    53,070       (53,070 )      
Stock options exercised
    6,357       (6,357 )      
Treasury stock purchases
    (10,467 )     10,467        
Directors’ retainer
    5,889       (5,889 )      
 
                 
Shares outstanding at June 30, 2011
    13,805,830       355,767       14,161,597  
 
                 
Issuance of Common Stock
On March 15, 2011, the Company completed the sale of 2,813,475 shares of its common stock through an underwritten public offering at a price of $16.35 per share. The net proceeds of the offering, after deducting underwriting discounts and commissions and offering expenses, were $43.1 million. A portion of the proceeds from this offering was used to redeem the Company’s Series A preferred stock as described in greater detail below.
Redemption of Series A Preferred Stock and Warrant
In December 2008, under the U.S. Department of the Treasury’s (the “Treasury”) Troubled Asset Relief Program (“TARP”) Capital Purchase Program, the Company entered into a Securities Purchase Agreement — Standard Terms with the Treasury pursuant to which, among other things, the Company sold to the Treasury for an aggregate purchase price of $37.5 million, 7,503 shares of fixed rate cumulative perpetual preferred stock, Series A (“Series A” preferred stock) and a warrant to purchase up to 378,175 shares of common stock, par value $0.01 per share, at an exercise price of $14.88 per share (the “Warrant”), of the Company.
Pursuant to the terms of the Purchase Agreement, the Company’s ability to declare or pay dividends on any of its shares was limited. Specifically, the Company was prohibited from paying any dividend with respect to shares of common stock, other junior securities or preferred stock ranking pari passu with the Series A preferred stock or repurchasing or redeeming any shares of the Company’s common stock, other junior securities or preferred stock ranking pari passu with the Series A preferred stock in any quarter unless all accrued and unpaid dividends were paid on the Series A preferred stock for all past dividend periods (including the latest completed dividend period), subject to certain limited exceptions.
The $37.5 million in proceeds was allocated to the Series A preferred stock and the Warrant based on their relative fair values at issuance ($35.5 million was allocated to the Series A preferred stock and $2.0 million to the Warrant). The resulting discount for the Series A preferred stock was to be accreted over five years through retained earnings as a preferred stock dividend. The Warrant was to remain in additional paid-in-capital at its initial book value until it was exercised or expired.
On February 23, 2011, the Company redeemed one-third, or $12.5 million, of the Series A preferred stock. On March 30, 2011, the remaining $25.0 million of the Series A preferred stock was redeemed. The unamortized discount related to the Series A preferred stock was charged to retained earnings upon redemption. The complete redemption of the Series A preferred stock removed the TARP restrictions pertaining to the Company’s ability to declare and pay dividends and repurchase its common stock, as well as certain restrictions associated with executive compensation.
On May 11, 2011, the Company repurchased the Warrant issued to the Treasury. The repurchase price of $2.1 million was recorded as a reduction of additional paid-in capital.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(5.) SHAREHOLDERS’ EQUITY (Continued)
Comprehensive Income (Loss)
Presented below is a reconciliation of net income to comprehensive income including the components of other comprehensive income for the periods indicated (in thousands):
                                                 
    Six months ended June 30,  
    2011     2010  
            Tax                     Tax        
    Pre-tax     Expense     Net-of-tax     Pre-tax     Expense     Net-of-tax  
    Amount     (Benefit)     Amount     Amount     (Benefit)     Amount  
Securities available for sale:
                                               
Net unrealized gains arising during the period
  $ 15,921     $ 6,308     $ 9,613     $ 9,046     $ 3,499     $ 5,547  
Reclassification adjustments:
                                               
Realized net gains included in income
    (7 )     (3 )     (4 )     (69 )     (27 )     (42 )
Impairment charges included in income
                      526       204       322  
 
                                   
 
    15,914       6,305       9,609       9,503       3,676       5,827  
Pension and post-retirement benefit liabilities
    290       115       175       211       82       129  
 
                                   
Other comprehensive income
  $ 16,204     $ 6,420       9,784     $ 9,714     $ 3,758       5,956  
 
                                       
Net income
                    11,539                       10,526  
 
                                           
Comprehensive income
                  $ 21,323                     $ 16,482  
 
                                           
The components of accumulated other comprehensive income (loss), net of tax, for the periods indicated were as follows (in thousands):
                 
    June 30,     December 31,  
    2011     2010  
Net actuarial loss and prior service cost on defined benefit pension and post-retirement plans
  $ (6,424 )   $ (6,599 )
Net unrealized gain on securities available for sale
    11,486       1,877  
 
           
Accumulated other comprehensive income (loss)
  $ 5,062     $ (4,722 )
 
           
(6.) SHARE-BASED COMPENSATION PLANS
The Company maintains certain stock-based compensation plans, approved by the Company’s shareholders that are administered by the Board, or the Management Development and Compensation Committee of the Board. The share-based compensation plans were established to allow for the granting of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the success and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.
The Company awarded 45,870 restricted shares of common stock to certain members of management during the six months ended June 30, 2011. The weighted average market price of the restricted stock on the date of grant was $19.25. Either a service requirement or both service and performance requirements must be satisfied before the participant becomes vested in the shares of common stock. Where applicable, the performance period for the awards is the Company’s fiscal year ending on December 31, 2011. The restricted stock awards granted to management in 2011 do not have rights to dividends or dividend equivalents. During the six months ended June 30, 2011, the Company granted 7,200 restricted shares of common stock to directors, of which 3,600 shares vested immediately and 3,600 shares will vest after completion of a one-year service requirement. The market price of the restricted stock on the date of grant was $16.55. The director awards were granted with nonforfeitable rights to dividends.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(6.)  
SHARE-BASED COMPENSATION PLANS (Continued)
The following is a summary of restricted stock award activity for the six months ended June 30, 2011:
                 
            Weighted  
            Average  
            Market  
    Number of     Price at  
    Shares     Grant Date  
Outstanding at beginning of year
    150,796     $ 12.76  
Granted
    53,070       18.88  
Released
    (33,240 )     14.63  
 
             
Outstanding at end of period
    170,626     $ 14.30  
 
             
The Company amortizes the expense related to restricted stock awards over the vesting period. Share-based compensation expense is included in the consolidated statements of income under salaries and employee benefits for awards granted to management and in other noninterest expense for awards granted to directors. The share-based compensation expense included in the consolidated statements of income is as follows for the periods indicated (in thousands):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Stock options:
                               
Management Stock Incentive Plan
  $ 14     $ 24     $ 28     $ 50  
Director Stock Incentive Plan
    4       11       14       22  
 
                       
Total stock options
    18       35       42       72  
Restricted stock awards:
                               
Management Stock Incentive Plan
    253       212       445       382  
Director Stock Incentive Plan
    74       74       89       88  
 
                       
Total restricted stock awards
    327       286       534       470  
 
                       
Total share-based compensation
  $ 345     $ 321     $ 576     $ 542  
 
                       
(7.) EMPLOYEE BENEFIT PLANS
Defined Benefit Pension Plan
The Company participates in The New York State Bankers Retirement System (the “System”), a defined benefit pension plan covering substantially all employees, subject to the limitations related to the plan closure effective December 31, 2006. The benefits are based on years of service and the employee’s highest average compensation during five consecutive years of employment. The defined benefit plan was closed to new participants effective December 31, 2006. Only employees hired on or before December 31, 2006 and who met participation requirements on or before January 1, 2008 are eligible to receive benefits.
The components of the Company’s net periodic benefit expense for its pension plan were as follows (in thousands):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Service cost
  $ 439     $ 408     $ 878     $ 816  
Interest cost on projected benefit obligation
    506       484       1,013       967  
Expected return on plan assets
    (663 )     (611 )     (1,326 )     (1,222 )
Amortization of unrecognized prior service cost
    5       3       9       6  
Amortization of unrecognized loss
    152       114       304       229  
 
                       
Net periodic pension cost
  $ 439     $ 398     $ 878     $ 796  
 
                       
The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of Internal Revenue Code. In December 2010, the Company contributed $4.3 million to the pension plan for fiscal year 2011, which exceeded the minimum required contribution of $1.5 million.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(8.) COMMITMENTS AND CONTINGENCIES
The Company has financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk extending beyond amounts recognized in the financial statements.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.
Off-balance sheet commitments consist of the following (in thousands):
                 
    June 30,     December 31,  
    2011     2010  
Commitments to extend credit
  $ 367,900     $ 357,240  
Standby letters of credit
    17,967       6,524  
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.
The Company also extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements when the Company intends to sell the related loan, once originated, as well as closed residential mortgage loans held for sale, the Company enters into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value. Forward sales commitments totaled $852 thousand and $8.0 million at June 30, 2011 and December 31, 2010, respectively.
(9.) FAIR VALUE MEASUREMENTS
Determination of Fair Value — Assets Measured at Fair Value on a Recurring and Nonrecurring Basis
Valuation Hierarchy
The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
   
Level 1 — Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
   
Level 2 — Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.
   
Level 3 — Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(9.) FAIR VALUE MEASUREMENTS (Continued)
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
Investment securities available for sale: Pooled trust preferred securities are reported at fair value utilizing Level 3 inputs. Fair values for these securities are determined through the use of internal valuation methodologies appropriate for the specific asset, which may include the use of a discounted expected cash flow analysis or the use of broker quotes. Other securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.
Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.
Collateral dependent impaired loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.
Other real estate owned (Foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Mortgage servicing rights: Mortgage servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of mortgage servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. Significant assumptions in the valuation of mortgage servicing rights include changes in interest rates, estimated loan repayment rates, and the timing of cash flows, among other factors. Mortgage servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(9.) FAIR VALUE MEASUREMENTS (Continued)
Assets Measured at Fair Value
The following table presents for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of June 30, 2011 (in thousands).
                                 
    Level 1     Level 2     Level 3     Total  
    Inputs     Inputs     Inputs     Fair Value  
Measured on a recurring basis:
                               
Securities available for sale:
                               
U.S. Government agencies and government sponsored enterprises
  $     $ 115,116     $     $ 115,116  
State and political subdivisions
          122,366             122,366  
Mortgage-backed securities
          462,452             462,452  
Asset-backed securities:
                               
Trust preferred securities
                6,963       6,963  
Other
          61             61  
 
                       
 
  $     $ 699,995     $ 6,963     $ 706,958  
 
                       
Measured on a nonrecurring basis:
                               
Loans:
                               
Loans held for sale
  $     $ 14,511     $     $ 14,511  
Collateral dependent impaired loans
                2,032       2,032  
Other assets:
                               
Mortgage servicing rights
                1,573       1,573  
Other real estate owned
                599       599  
 
                       
 
  $     $ 14,511     $ 4,204     $ 18,715  
 
                       
The following table presents for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of December 31, 2010 (in thousands).
                                 
    Level 1     Level 2     Level 3     Total  
    Inputs     Inputs     Inputs     Fair Value  
Measured on a recurring basis:
                               
Securities available for sale:
                               
U.S. Government agencies and government sponsored enterprises
  $     $ 140,784     $     $ 140,784  
State and political subdivisions
          105,666             105,666  
Mortgage-backed securities
          419,281             419,281  
Asset-backed securities:
                               
Trust preferred securities
                572       572  
Other
          65             65  
 
                       
 
  $     $ 665,796     $ 572     $ 666,368  
 
                       
Measured on a nonrecurring basis:
                               
Loans:
                               
Loans held for sale
  $     $ 3,138     $     $ 3,138  
Collateral dependent impaired loans
                2,457       2,457  
Other assets:
                               
Mortgage servicing rights
                1,467       1,467  
Other real estate owned
                741       741  
 
                       
 
  $     $ 3,138     $ 4,665     $ 7,803  
 
                       
There were no liabilities measured at fair value on a recurring or nonrecurring basis during the six month periods ended June 30, 2011 and 2010.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(9.) FAIR VALUE MEASUREMENTS (Continued)
Changes in Level 3 Fair Value Measurements
The reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) is as follows for the periods indicated (in thousands):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Securities available for sale (Level 3), beginning of period
  $ 567     $ 661     $ 572     $ 1,015  
Transfers into Level 3
                       
Capitalized interest
    111       114       221       200  
Coupon payments applied to principal
    (16 )     (26 )     (16 )     (61 )
Principal paydowns
    (8 )           (8 )      
Total gains/losses (realized/unrealized):
                               
Included in earnings
                      (526 )
Included in other comprehensive income
    6,309       (103 )     6,194       18  
 
                       
Securities available for sale (Level 3), end of period
  $ 6,963     $ 646     $ 6,963     $ 646  
 
                       
Fair Value of Financial Instruments
The Fair Value of Financial Instruments Subsection of the ASC requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.
The following discussion describes the valuation methodologies used for assets and liabilities measured or disclosed at fair value. The techniques utilized in estimating the fair values of financial instruments are reliant on the assumptions used, including discount rates and estimates of the amount and timing of future cash flows. Care should be exercised in deriving conclusions about our business, its value or financial position based on the fair value information of financial instruments presented below.
Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument.
The estimated fair value approximates carrying value for cash and cash equivalents, FHLB and FRB stock, company owned life insurance, accrued interest receivable, short-term borrowings and accrued interest payable. Fair value estimates for other financial instruments are discussed below.
Loans held for sale. The fair value is based on estimates, quoted market prices and investor commitments.
Loans. For variable rate loans that re-price frequently, fair value approximates carrying amount. The fair value for fixed rate loans is estimated through discounted cash flow analysis using interest rates currently being offered on loans with similar terms and credit quality. For criticized and classified loans, fair value is estimated by discounting expected cash flows at a rate commensurate with the risk associated with the estimated cash flows, or estimates of fair value discounts based on observable market information.
Deposits. The fair values for demand accounts, money market and savings deposits are equal to their carrying amounts. The fair values of certificates of deposit are estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments.
Long-term borrowings and junior subordinated debentures. The fair value for long-term borrowings and junior subordinated debentures are estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
(9.)  
FAIR VALUE MEASUREMENTS (Continued)
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. The accounting guidelines exclude certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented at June 30, 2011 and December 31, 2010 may not necessarily represent the underlying fair value of the Company.
The estimated fair values of financial instruments were as follows (in thousands):
                                 
    June 30, 2011     December 31, 2010  
            Estimated             Estimated  
    Carrying     Fair     Carrying     Fair  
    Amount     Value     Amount     Value  
Financial assets:
                               
Cash and cash equivalents
  $ 46,084     $ 46,084     $ 39,058     $ 39,058  
Securities available for sale
    706,958       706,958       666,368       666,368  
Securities held to maturity
    24,091       24,797       28,162       28,849  
Loans held for sale
    14,511       14,523       3,138       3,138  
Loans
    1,347,420       1,417,663       1,325,524       1,388,787  
Accrued interest receivable
    7,845       7,845       7,613       7,613  
FHLB and FRB stock
    8,298       8,298       6,353       6,353  
 
                               
Financial liabilities:
                               
Demand, savings and money market deposits
    1,173,053       1,173,053       1,143,136       1,143,136  
Certificate of deposit
    699,186       700,234       739,754       740,440  
Short-term borrowings
    132,395       132,395       77,110       77,110  
Long-term borrowings (excluding junior subordinated debentures)
    10,000       10,010       10,065       10,244  
Junior subordinated debentures
    16,702       10,550       16,702       10,564  
Accrued interest payable
    7,299       7,299       7,620       7,620  

 

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ITEM 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
FORWARD LOOKING INFORMATION
This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2010. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.
Statements and financial analysis contained in this document that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (the “Act”). In addition, certain statements may be contained in our future filings with SEC, in press releases, and in oral and written statements made by or with our approval that are not statements of historical fact and constitute forward-looking statement within the meaning of the Act. Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “target,” “plan,” “projects,” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
The Company cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advises readers that various factors, including those identified by the Company under the heading “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2010, could affect the Company’s financial performance and could cause the Company’s actual results or circumstances for future periods to differ materially from those anticipated or projected.
Except as required by law, the Company does not undertake, and specifically disclaims any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
SIGNIFICANT EVENTS
Common Stock Offering
On March 15, 2011, we completed the sale of 2,813,475 shares of our common stock through an underwritten public offering at a price of $16.35 per share. The net proceeds of the offering, after deducting underwriting discounts and commissions and offering expenses, amounted to $43.1 million. A portion of the proceeds from this offering was used to redeem the Company’s Series A preferred stock as described in greater detail below. The Company also plans during the third quarter of 2011 to redeem the $16.7 million of 10.20% junior subordinated debentures related to the trust preferred securities issued by an unconsolidated subsidiary, as discussed in greater detail below. The remaining proceeds of this offering were used for general working capital purposes.
Redemption of Series A Preferred Stock
In the first quarter of 2011, the Company fully redeemed $37.5 million of its fixed rate cumulative perpetual preferred stock, Series A (“Series A” preferred stock) issued in connection with the U.S. Department of the Treasury’s (the “Treasury”) Troubled Asset Relief Program’s (“TARP”) Capital Purchase Program (the “Capital Purchase Program”). The redemption was funded, in part, by the proceeds of the common stock offering discussed above and from excess liquidity at the parent company. The redemption resulted in a one-time, non-cash redemption charge of $1.2 million, reflecting the accelerated accretion of the remaining discount on the preferred stock, which reduced 2011 year-to-date diluted earnings per common share by $0.10.
The complete redemption of the Series A preferred stock removed the TARP restrictions pertaining to the Company’s ability to declare and pay dividends and repurchase its common stock, as well as certain restrictions associated with executive compensation.
During the second quarter of 2011, the Company repurchased the Warrant issued to the Treasury. The repurchase price of $2.1 million was recorded as a reduction of additional paid-in capital.
Redemption of Subordinated Debentures
On July 1, 2011, the Company notified the trustee of FISI Statutory Trust I (the “Trust”), a wholly-owned subsidiary of the Company, that it will redeem all of its 10.20% junior subordinated debentures due 2031 on August 22, 2011 (the “Redemption Date”). The redemption price will be 105.1% of the principal amount redeemed, plus all accrued and unpaid interest as of the Redemption Date. As a result of the redemption, the Company anticipates that it will recognize a pre-tax charge of $1.1 million during the third quarter of 2011.
Consequent to repayment of the junior subordinated debentures, the Trust will redeem all of its fixed rate trust preferred securities (the “Securities”). The Securities are subject to mandatory redemption, in whole or in part, upon repayment of the junior subordinated debentures. See the section titled “Liquidity and Capital Resources” included herein for additional information regarding the impact of this transaction on regulatory capital.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
RESULTS OF OPERATIONS
Summary of Performance
Net income increased $521 thousand or 10% to $5.7 million for the second quarter of 2011 compared to $5.2 million for the second quarter of 2010. The increase during the second quarter of 2011 was primarily the result of an increase of $577 thousand in net interest income and a $777 thousand decrease in the provision for loan losses, offset by increases of $283 thousand in noninterest expense and $558 thousand in income tax expense. Net income available to common shareholders for the second quarter of 2011 was $5.3 million, or $0.39 per diluted share, compared with $4.3 million, or $0.39 per diluted share, for the second quarter of last year. Return on average equity was 10.03% and return on average assets was 1.01% for the second quarter of 2011 compared to 10.04% and 0.97%, respectively, for the second quarter of 2010.
Net income for the six months ended June 30, 2011 totaled $11.5 million, an increase of $1.0 million or 10% from $10.5 million for the same period in 2010. The increase in year-to-date net income for 2011 was driven by a $1.2 million increase in net interest income, a $385 thousand decrease in the provision for loan losses and a $1.1 million increase in noninterest income, offset by increases of $895 thousand in noninterest expense and $713 thousand in income tax expense. For the first six months of 2011 net income available to common shareholders was $9.1 million, or $0.72 per diluted share, compared with $8.7 million, or $0.80 per diluted share, for the first six months of 2010. Return on average equity was 10.43% and return on average assets was 1.04% for the six months ended June 30, 2011 compared to 10.35% and 0.99%, respectively, for the same period in 2010.
The 2011 second quarter and year-to-date earnings per share amounts were impacted by the 2,813,475 additional shares of common stock issued in conjunction with our public stock offering that occurred late in the first quarter of 2011. In addition, year-to-date earnings for 2011 were reduced by $1.2 million, or $0.10 per common share, for the accelerated discount accretion related to the Company’s redemption of the Series A preferred stock issued pursuant to the Capital Purchase Program.
Net Interest Income and Net Interest Margin
Net interest income is the primary source of our revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.
Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and stockholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.
The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis:
                                 
    Three months ended June 30,     Six months ended June 30,  
    2011     2010     2011     2010  
Interest income per consolidated statements of income
  $ 23,830     $ 24,202     $ 47,469     $ 48,026  
Adjustment to fully taxable equivalent basis
    534       465       1,048       972  
 
                       
Interest income adjusted to a fully taxable equivalent basis
    24,364       24,667       48,517       48,998  
Interest expense per consolidated statements of income
    3,577       4,526       7,378       9,098  
 
                       
Net interest income on a taxable equivalent basis
  $ 20,787     $ 20,141     $ 41,139     $ 39,900  
 
                       
Analysis of Net Interest Income for the Three Months ended June 30, 2011 and June 30, 2010
Net interest income on a taxable equivalent basis for the three months ended June 30, 2011, was $20.8 million, an increase of $646 thousand or 3% versus the comparable quarter last year. The increase in taxable equivalent net interest income was primarily attributable to favorable volume variances (as changes in the balances and mix of earning assets and interest-bearing liabilities added $1.9 million to taxable equivalent net interest income), partly offset by unfavorable rate variances (as the impact of changes in the interest rate environment and product pricing reduced taxable equivalent net interest income by $1.3 million).

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
The net interest margin for the second quarter of 2011 was 4.00%, 9 basis points lower than 4.09% for the same period in 2010. This comparable period decrease was a function of a 5 basis point decrease in interest rate spread, combined with a 4 basis point lower contribution from net free funds (due principally to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The lower interest rate spread was a net result of a 32 basis point decrease in the yield on earning assets and a 27 basis point decrease in the cost of interest-bearing liabilities.
The yield on earning assets was 4.69% for the second quarter of 2011, 32 basis points lower than the second quarter of 2010. Loan yields decreased 28 basis points to 5.60%, also impacted by the lower interest rate environment. Commercial mortgage and consumer indirect loans in particular, down 37 and 59 basis points, respectively, experienced lower yields given the competitive pricing pressures in a low interest rate environment. The yield on investment securities dropped 48 basis points to 2.96%, also impacted by the lower interest rate environment and prepayments of mortgage-related investment securities. Overall, earning asset rate changes reduced interest income by $1.9 million.
The cost of average interest-bearing liabilities of 0.86% in the second quarter of 2011 was 27 basis points lower than the second quarter of 2010. The average cost of interest-bearing deposits was 0.75% in 2011, 23 basis points lower than 2010, reflecting the lower rate environment, mitigated by a focus on product pricing to retain balances. The cost of short-term funding decreased 17 basis points to 0.62%, while the cost of long-term borrowings increased by 189 basis points to 7.98%. The cost of long-term borrowings has increased as the Company has repaid lower priced debt, leaving the higher fixed rate 10.20% junior subordinated debentures as a larger percentage of total outstanding long-term debt. As previously discussed, the Company intends to repay the junior subordinated debentures in full during the third quarter of 2011. The interest-bearing liability rate changes resulted in $635 thousand of lower interest expense.
Average interest-earning assets were $2.080 billion for the second quarter of 2011, an increase of $108.4 million or 5% from the comparable quarter last year, with average loans up $90.4 million and average securities up $22.3 million. The growth in average loans was comprised of increases in consumer loans (up $77.2 million, primarily indirect loans) and commercial loans (up $30.9 million), while residential mortgages declined (down $17.7 million).
Average interest-bearing liabilities of $1.665 billion in the second quarter of 2011 were $53.0 million or 3% higher than the second quarter of 2010. On average, interest-bearing deposits grew $45.0 million (primarily attributable to $33.0 million higher municipal deposits), while noninterest-bearing demand deposits (a principal component of net free funds) were up $33.6 million. Average borrowings increased $8.0 million between the second quarter periods, with short-term borrowings higher by $28.1 million and long-term funding lower by $20.1 million.
Analysis of Net Interest Income for the Six Months ended June 30, 2011 and June 30, 2010
Net interest income on a taxable equivalent basis for the first six months of 2011 was $41.1 million, an increase of $1.2 million or 3% versus the same period last year. The increase in taxable equivalent net interest income was primarily attributable to a favorable volume variance (as changes in the balances and mix of earning assets and interest-bearing liabilities added $3.6 million to taxable equivalent net interest income), partially offset by an unfavorable rate variance (as the impact of changes in the interest rate environment and product pricing decreased taxable equivalent net interest income by $2.4 million).
The net interest margin for the first six months of 2011 was 4.02%, 9 basis points lower than 4.11% for the same period last year. This comparable period decrease was a function of a 4 basis point decrease in interest rate spread, combined with a 5 basis point lower contribution from net free funds. The decline in the interest rate spread was a net result of a 29 basis point decrease in the yield on earning assets, largely offset by a 25 basis point reduction in the cost of interest-bearing liabilities.
The yield on earning assets was 4.75% for the first six months of 2011, 29 basis points lower than the same period last year, attributable to decreases in the yields on the investment security portfolio (down 47 basis points, to 2.98%) and loan portfolio (down 27 basis points to 5.66%).
The rate on interest-bearing liabilities of 0.90% for the first six months of 2011 was 25 basis points lower than the same period in 2010. Rates on interest-bearing deposits were down 22 basis points to 0.79%. The cost of short-term borrowings decreased 12 basis points to 0.60%, while the cost of long-term funding increased by 189 basis points. As previously discussed, the cost of long-term borrowings has increased due to a change in the mix of outstanding long-term debt.
Average interest-earning assets were $2.056 billion for the first six months of 2011, an increase of $101.9 million or 5% from the comparable period last year, with average loans up $88.3 million and average securities up $22.9 million. The growth in average loans was comprised of increases in consumer loans (up $74.0 million, primarily indirect loans) and commercial loans (up $30.7 million), while residential mortgages declined (down $16.4 million).
Average interest-bearing liabilities of $1.653 billion in the first six months of 2011 were $57.7 million or 4% higher than the first six months of 2010. On average, interest-bearing deposits grew $62.1 million (primarily attributable to $42.8 million higher retail deposits), while noninterest-bearing demand deposits were up $35.2 million. Average borrowings decreased $4.4 million between the first six months of 2011 and the same period in 2010 due to repayment of long-term borrowings upon maturity.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
The following tables sets forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (in thousands).
                                                 
    Three months ended June 30,  
    2011     2010  
    Average             Average     Average             Average  
    Balance     Interest     Rate     Balance     Interest     Rate  
Interest-earning assets:
                                               
Federal funds sold and interest-earning deposits
  $ 116     $       0.22 %   $ 4,479     $ 3       0.20 %
Investment securities (1):
                                               
Taxable
    570,945       3,767       2.64       585,300       4,584       3.13  
Tax-exempt (2)
    143,545       1,526       4.25       106,862       1,366       5.11  
 
                                   
Total investment securities
    714,490       5,293       2.96       692,162       5,950       3.44  
Loans:
                                               
Commercial business
    212,260       2,553       4.82       208,327       2,500       4.81  
Commercial mortgage
    361,265       5,216       5.79       334,253       5,137       6.16  
Residential mortgage
    123,293       1,737       5.63       140,946       2,032       5.77  
Home equity
    212,439       2,376       4.49       199,865       2,277       4.57  
Consumer indirect
    431,728       6,544       6.08       364,801       6,069       6.67  
Other consumer
    24,717       645       10.46       27,060       699       10.37  
 
                                   
Total loans
    1,365,702       19,071       5.60       1,275,252       18,714       5.88  
 
                                   
Total interest-earning assets
    2,080,308       24,364       4.69       1,971,893       24,667       5.01  
 
                                       
Allowance for loan losses
    (20,739 )                     (21,052 )                
Other noninterest-earning assets
    208,790                       208,071                  
 
                                           
Total assets
  $ 2,268,359                     $ 2,158,912                  
 
                                           
 
                                               
Interest-bearing liabilities:
                                               
Deposits:
                                               
Interest-bearing demand
  $ 391,899     $ 161       0.16 %   $ 386,703     $ 179       0.19 %
Savings and money market
    468,130       275       0.24       420,774       294       0.28  
Certificates of deposit
    707,608       2,498       1.42       715,168       3,257       1.83  
 
                                   
Total interest-bearing deposits
    1,567,637       2,934       0.75       1,522,645       3,730       0.98  
Short-term borrowings
    71,092       110       0.62       42,946       85       0.79  
Long-term borrowings
    26,702       533       7.98       46,807       711       6.09  
 
                                   
Total borrowings
    97,794       643       2.63       89,753       796       3.55  
 
                                   
Total interest-bearing liabilities
    1,665,431       3,577       0.86       1,612,398       4,526       1.13  
 
                                       
Noninterest-bearing demand deposits
    358,349                       324,790                  
Other noninterest-bearing liabilities
    15,970                       14,053                  
Shareholders’ equity
    228,609                       207,671                  
 
                                           
Total liabilities and shareholders’ equity
  $ 2,268,359                     $ 2,158,912                  
 
                                           
Net interest income (tax-equivalent)
          $ 20,787                     $ 20,141          
 
                                           
Interest rate spread
                    3.83 %                     3.88 %
 
                                           
Net earning assets
  $ 414,877                     $ 359,495                  
 
                                           
Net interest margin (tax-equivalent)
                    4.00 %                     4.09 %
 
                                           
Ratio of average interest-earning assets to average interest-bearing liabilities
                    124.91 %                     122.30 %
 
                                           
 
     
(1)  
Investment securities are shown at amortized cost and include non-performing securities.
 
(2)  
The interest on tax-exempt securities is calculated on a tax equivalent basis assuming a Federal tax rate of 35% and 34% for the three months ended June 30, 2011 and 2010, respectively.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
                                                 
    Six months ended June 30,  
    2011     2010  
    Average             Average     Average             Average  
    Balance     Interest     Rate     Balance     Interest     Rate  
Interest-earning assets:
                                               
Federal funds sold and interest-earning deposits
  $ 186     $       0.22 %   $ 9,395     $ 10       0.20 %
Investment securities (1):
                                               
Taxable
    558,084       7,416       2.66       563,723       8,797       3.12  
Tax-exempt (2)
    140,054       2,995       4.28       111,542       2,859       5.13  
 
                                   
Total investment securities
    698,138       10,411       2.98       675,265       11,656       3.45  
Loans:
                                               
Commercial business
    209,977       5,027       4.83       206,626       4,964       4.84  
Commercial mortgage
    361,247       10,447       5.83       333,918       10,113       6.11  
Residential mortgage
    125,915       3,572       5.67       142,355       4,254       5.98  
Home equity
    210,558       4,699       4.50       199,884       4,554       4.59  
Consumer indirect
    424,818       13,069       6.20       358,823       12,035       6.76  
Other consumer
    24,971       1,292       10.44       27,599       1,412       10.32  
 
                                   
Total loans
    1,357,486       38,106       5.66       1,269,205       37,332       5.93  
 
                                   
Total interest-earning assets
    2,055,810       48,517       4.75       1,953,865       48,998       5.04  
 
                                       
Allowance for loan losses
    (20,807 )                     (21,036 )                
Other noninterest-earning assets
    210,194                       202,852                  
 
                                           
Total assets
  $ 2,245,197                     $ 2,135,681                  
 
                                           
 
                                               
Interest-bearing liabilities:
                                               
Deposits:
                                               
Interest-bearing demand
  $ 393,842     $ 323       0.17 %   $ 389,783     $ 368       0.19 %
Savings and money market
    451,447       537       0.24       411,088       570       0.28  
Certificates of deposit
    719,943       5,271       1.48       702,297       6,576       1.89  
 
                                   
Total interest-bearing deposits
    1,565,232       6,131       0.79       1,503,168       7,514       1.01  
Short-term borrowings
    61,165       182       0.60       45,441       163       0.72  
Long-term borrowings
    26,723       1,065       7.98       46,827       1,421       6.09  
 
                                   
Total borrowings
    87,888       1,247       2.85       92,268       1,584       3.45  
 
                                   
Total interest-bearing liabilities
    1,653,120       7,378       0.90       1,595,436       9,098       1.15  
 
                                       
Noninterest-bearing demand deposits
    354,213                       319,040                  
Other noninterest-bearing liabilities
    14,765                       16,090                  
Shareholders’ equity
    223,099                       205,115                  
 
                                           
Total liabilities and shareholders’ equity
  $ 2,245,197                     $ 2,135,681                  
 
                                           
Net interest income (tax-equivalent)
          $ 41,139                     $ 39,900          
 
                                           
Interest rate spread
                    3.85 %                     3.89 %
 
                                           
Net earning assets
  $ 402,690                     $ 358,429                  
 
                                           
Net interest margin (tax-equivalent)
                    4.02 %                     4.11 %
 
                                           
Ratio of average interest-earning assets to average interest-bearing liabilities
                    124.36 %                     122.47 %
 
                                           
 
     
(1)  
Investment securities are shown at amortized cost and include non-performing securities.
 
(2)  
The interest on tax-exempt securities is calculated on a tax equivalent basis assuming a Federal tax rate of 35% and 34% for the six months ended June 30, 2011 and 2010, respectively.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
The following table presents, on a tax equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):
                                                 
    Three months ended     Six months ended          
    June 30, 2011 vs. 2010     June 30, 2011 vs. 2010  
Increase (decrease) in:   Volume     Rate     Total     Volume     Rate     Total  
Interest income:
                                               
Federal funds sold and interest-earning deposits
  $ (3 )   $     $ (3 )   $ (10 )   $     $ (10 )
Investment securities:
                                               
Taxable
    (110 )     (707 )     (817 )     (87 )     (1,294 )     (1,381 )
Tax-exempt
    416       (256 )     160       658       (522 )     136  
 
                                   
Total investment securities
    306       (963 )     (657 )     571       (1,816 )     (1,245 )
Loans:
                                               
Commercial business
    47       6       53       80       (17 )     63  
Commercial mortgage
    401       (322 )     79       803       (469 )     334  
Residential mortgage
    (250 )     (45 )     (295 )     (474 )     (208 )     (682 )
Home equity
    141       (42 )     99       239       (94 )     145  
Consumer indirect
    1,046       (571 )     475       2,087       (1,053 )     1,034  
Other consumer
    (61 )     7       (54 )     (136 )     16       (120 )
 
                                   
Total loans
    1,324       (967 )     357       2,599       (1,825 )     774  
 
                                   
Total interest income
    1,627       (1,930 )     (303 )     3,160       (3,641 )     (481 )
 
                                   
Interest expense:
                                               
Deposits:
                                               
Interest-bearing demand
    2       (20 )     (18 )     4       (49 )     (45 )
Savings and money market
    31       (50 )     (19 )     53       (86 )     (33 )
Certificates of deposit
    (34 )     (725 )     (759 )     161       (1,466 )     (1,305 )
 
                                   
Total interest-bearing deposits
    (1 )     (795 )     (796 )     218       (1,601 )     (1,383 )
Short-term borrowings
    47       (22 )     25       50       (31 )     19  
Long-term borrowings
    (360 )     182       (178 )     (720 )     364       (356 )
 
                                   
Total borrowings
    (313 )     160       (153 )     (670 )     333       (337 )
 
                                   
Total interest expense
    (314 )     (635 )     (949 )     (452 )     (1,268 )     (1,720 )
 
                                   
Net interest income
  $ 1,941     $ (1,295 )   $ 646     $ 3,612     $ (2,373 )   $ 1,239  
 
                                   
Provision for Loan Losses
The provision for loan losses is based upon credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimate of losses inherent in the current loan portfolio. There were provisions for loan losses of $1.3 million and $2.1 million for the three and six month periods ended June 30, 2011, compared with provisions of $2.1 million and $2.5 million for the corresponding periods in 2010, respectively. See “Allowance for Loan Losses” under the section titled “Lending Activities” included herein for additional information.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Noninterest Income
The following table details the major categories of noninterest income for the periods presented (in thousands):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Service charges on deposits
  $ 2,243     $ 2,502     $ 4,348     $ 4,732  
ATM and debit card
    1,123       1,054       2,139       1,988  
Broker-dealer fees and commissions
    402       359       788       739  
Loan servicing
    249       140       598       420  
Company owned life insurance
    279       282       545       551  
Net gain on sale of loans held for sale
    117       115       341       177  
Net gain on disposal of investment securities
    4       63       7       69  
Impairment charges on investment securities
                      (526 )
Net (loss) gain on sale and disposal of other assets
    (8 )           37       2  
Other
    565       451       1,319       897  
 
                       
Total noninterest income
  $ 4,974     $ 4,966     $ 10,122     $ 9,049  
 
                       
The components of noninterest income fluctuated as discussed below.
Service charges on deposit accounts were down $259 thousand or 10% in the second quarter of 2011 and $384 thousand or 8% for the six months ended June 30, 2011, compared to the same periods a year earlier. Substantially the entire decline was due to a reduction in non-sufficient funds transactions.
ATM and debit card income was up $69 thousand or 7% and $151 thousand or 8%, respectively, in the three and six months ended June 30, 2011, compared to the same periods of 2010. The increased popularity of electronic banking and transaction processing has resulted in higher ATM and debit card point-of-sale usage income.
Broker-dealer fees and commissions were up $43 thousand or 12% and $151 thousand or 7%, respectively, in the three and six months ended June 30, 2011, compared to the same periods of 2010, mainly due to increased sales volume.
Loan servicing income was up $109 thousand or 78% in the second quarterof 2011 and $178 thousand or 42% for the six months ended June 30, 2011, compared to the same periods a year ago, mainly due to a decrease in the mortgage servicing asset valuation allowance.
Net gain in loans held for sale increased $164 thousand or 93% for the six months ended June 30,2011, compared to the same period a year ago, primarily due to a decrease in the valuation allowance for loans held for sale.
Other noninterest income increased $114 thousand or 25% in the second quarter of 2011 and $422 thousand or 47% for the six months ended June 30, 2011, compared to the same periods a year earlier. Income from the Company’s capital investment in several limited partnerships accounted for the majority of the 2011 increases.

 

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Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS
Noninterest Expense
The following table details the major categories of noninterest expense for the periods presented (in thousands):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Salaries and employee benefits
  $ 8,854     $ 8,044     $ 17,255     $ 16,291  
Occupancy and equipment
    2,644       2,670       5,487       5,441  
Professional services
    571       478       1,253       1,084  
Computer and data processing
    648       615       1,251       1,186  
Supplies and postage
    424       431       876       876  
FDIC assessments
    168       634       775       1,236  
Advertising and promotions
    253       352       418       539  
Other
    1,591       1,646       3,188       2,955  
 
                       
Total noninterest expense
  $ 15,153     $ 14,870     $ 30,503     $ 29,608  
 
                       
The components of noninterest expense fluctuated as discussed below.
The largest noninterest expense increase in the three and six month periods ended June 30, 2011 was in salaries and employee benefits, which increased by $810 thousand or 10% and $964 thousand or 6%, respectively, over the same periods one year earlier. The increases reflect higher employee benefit costs and increased accruals for incentive compensation, which were previously limited under the Capital Purchase Program. In addition, the Company has increased its staffing levels modestly as full time equivalent employees totaled 581 and 573 at June 30, 2011 and 2010, respectively.
Professional services expenses increased $93 thousand or 19% and $169 thousand or 16%, respectively, in the three and six months ended June 30, 2011, compared to the same periods of 2010. Professional fees increased primarily due to legal and shareholder expenses related to the transactions identified earlier as significant events.
FDIC assessments for the second quarter and first six months of 2011 are down considerably compared to the same periods of 2010, primarily a result of changes made by the FDIC in the method of calculating assessment rates.
Advertising and promotions costs were down $99 thousand or 28% in the second quarter of 2011 and $121 thousand or 22% for the six months ended June 30, 2011, compared to the same periods a year earlier due to fewer marketing campaigns and promotions.
The efficiency ratio for the second quarter of 2011 was 58.68% compared with 59.16% for the second quarter of 2010, and 59.32% for the six months ended June 30, 2011, compared to 59.73% for the same period a year ago. The efficiency ratio equals noninterest expense less other real estate expense as a percentage of net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains and impairment charges on investment securities.
Income Taxes
The Company recorded income tax expense of $3.0 million in the second quarter of 2011, compared to income tax expense of $2.5 million in the second quarter of 2010. For the six month period ended June 30, 2011, income tax expense totaled $6.0 million compared to $5.3 million in the same period of 2010. These changes were due in part to increases of $1.1 million and $1.7 million in pre-tax income for the three and six month periods of 2011, respectively, compared to the prior year. The effective tax rates recorded for 2011 on a quarter-to-date and year-to-date basis were 34.6% and 34.3%, respectively, in comparison to the June 30, 2010 quarter-to-date and year-to-date effective tax rates of 32.2% and 33.6%, respectively. Effective tax rates are impacted by items of income and expense that are not subject to federal or state taxation. The Company’s effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities and earnings on company owned life insurance.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
ANALYSIS OF FINANCIAL CONDITION
INVESTING ACTIVITIES
The following table sets forth selected information regarding the composition of the Company’s investment securities portfolio as of the dates indicated (in thousands):
                                 
    Investment Securities Portfolio Composition  
    June 30, 2011     December 31, 2010  
    Amortized     Fair     Amortized     Fair  
    Cost     Value     Cost     Value  
Securities available for sale:
                               
U.S. Government agency and government-sponsored enterprise securities
  $ 115,032     $ 115,116     $ 141,591     $ 140,784  
State and political subdivisions
    120,350       122,366       105,622       105,666  
Mortgage-backed securities:
                               
Agency mortgage-backed securities
    451,380       460,328       414,502       417,709  
Non-Agency mortgage-backed securities
    633       2,124       981       1,572  
Asset-backed securities
    541       7,024       564       637  
 
                       
Total available for sale securities
    687,936       706,958       663,260       666,368  
Securities held to maturity:
                               
State and political subdivisions
    24,091       24,797       28,162       28,849  
 
                       
Total investment securities
  $ 712,027     $ 731,755     $ 691,422     $ 695,217  
 
                       
Impairment Assessment
The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly. When evaluating debt securities for OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intention to sell the debt security or whether it is more likely than not that it will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
The table below summarizes unrealized losses in each category of the securities portfolio at the end of the periods indicated (in thousands).
                                 
    Unrealized Losses on Investment Securities  
    June 30, 2011     December 31, 2010  
    Unrealized     % of     Unrealized     % of  
    Losses     Total     Losses     Total  
Securities available for sale:
                               
U.S. Government agencies and government sponsored enterprises
  $ 1,006       63.8 %   $ 1,965       31.6 %
State and political subdivisions
    346       22.0       1,472       23.6  
Mortgage-backed securities:
                               
Agency mortgage-backed securities
    224       14.2       2,655       42.7  
Non-Agency mortgage-backed securities
                       
Asset-backed securities
                131       2.1  
 
                       
Total available for sale securities
  $ 1,576       100.0     $ 6,223       100.0  
Securities held to maturity:
                               
State and political subdivisions
                       
 
                       
Total investment securities
  $ 1,576       100.0 %   $ 6,223       100.0 %
 
                       
U.S. Government Agencies and Government Sponsored Enterprises (“GSE”). As of June 30, 2011, there were 14 securities in the U.S. Government agencies and GSE portfolio that were in an unrealized loss position. Of these, 7 were in an unrealized loss position for 12 months or longer and had an aggregate amortized cost of $7.8 million and unrealized losses of $22 thousand. Because the decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at June 30, 2011.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
State and Political Subdivisions. As of June 30, 2011, the state and political subdivisions portfolio (“municipals”) totaled $146.5 million, of which $122.4 million was classified as available for sale. As of that date, $24.1 million was classified as held to maturity with a fair value of $24.8 million. As of June 30, 2011, there were 81 municipals in an unrealized loss position, all of which were available for sale. These securities had an aggregate amortized cost of $31.3 million and unrealized losses of $346 thousand.
Although there has been a considerable amount of negative information regarding municipal bond insurers, and several of the municipal bond insurers have been downgraded, there is no indication to date that the underlying credit issuers (counties, towns, villages, cities, schools, etc.) are likely to default on their debt. There have also been some highly publicized concerns over the New York State budget problems as well as reductions in the amounts and delays in funding by New York State to its municipalities and political subdivisions. At this time, management does not believe that the New York State budget problems will culminate in local municipalities defaulting on debt obligations. Additionally, most of the available for sale bonds are General Obligation issues which require the taxing authority to increase taxes as needed to repay the bond holders.
Because the decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at June 30, 2011.
Agency Mortgage-backed Securities. With the exception of the non-Agency mortgage-backed securities (“non-Agency MBS”) discussed below, all of the mortgage-backed securities held by us as of June 30, 2011, were issued by U.S. Government sponsored entities and agencies (“Agency MBS”), primarily GNMA. The contractual cash flows of our Agency MBS are guaranteed by FNMA, FHLMC or GNMA. The GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
As of June 30, 2011, there were 15 securities in the Agency MBS portfolio that were in an unrealized loss position. Of these, only four securities with an aggregate amortized cost of $2.1 million and unrealized losses of $11 thousand were in an unrealized loss position for 12 months or longer. Given the high credit quality inherent in Agency MBS, we do not consider any of the unrealized losses on such MBS to be credit related or other-than-temporary as of June 30, 2011. Furthermore, as of June 30, 2011, we did not intend to sell any of Agency MBS that were in an unrealized loss position, all of which were performing in accordance with their terms.
Non-Agency Mortgage-backed Securities. Our non-Agency MBS portfolio consists of positions in three privately issued whole loan collateralized mortgage obligations with a fair value of $2.1 million and net unrealized gains of $1.5 million as of June 30, 2011. As of that date, each of the three non-Agency MBS were rated below investment grade. None of these securities were in an unrealized loss position. To date, we have recognized aggregate OTTI charges of $6.0 million due to reasons of credit quality against these securities, all of which was recorded prior to 2010.
Asset-backed Securities (“ABS”). As of June 30, 2011, the fair value of the ABS portfolio totaled $7.0 million and consisted of positions in 15 securities, the majority of which are pooled trust preferred securities (“TPS”) issued primarily by financial institutions and, to a lesser extent, insurance companies located throughout the United States. As a result of some issuers defaulting and others electing to defer interest payments, we considered all but one of the ABS securities to be non-performing and stopped accruing interest on the investments during 2009.
Since the second quarter of 2008, we have written down each of the securities in the ABS portfolio, resulting in aggregate OTTI charges of $32.9 million through December 31, 2010. We expect to recover the remaining amortized cost of $541 thousand on the securities. As of June 30, 2011, each of the securities in the ABS portfolio was rated below investment grade. None of these securities were in an unrealized loss position.
The market for these securities greatly improved during the second quarter of 2011, resulting in the $6.4 million increase in fair value from December 31, 2010. During that time, there were no additions to the portfolio as the increase relates solely to an increase in the fair value of each of the 15 securities in the portfolio. During July 2011, the Company sold one of the ABS securities and will recognize a gain of approximately $1 million during the third quarter. The security had a fair value of $752 thousand at June 30, 2011. The Company continues to monitor the market for these securities and evaluate the potential for future dispositions.
Other Investments. As a member of the FHLB the Bank is required to hold FHLB stock. The amount of required FHLB stock is based on the Bank’s asset size and the amount of borrowings from the FHLB. We have assessed the ultimate recoverability of our FHLB stock and believe that no impairment currently exists. As a member of the FRB system, we are required to maintain a specified investment in FRB stock based on a ratio relative to our capital. The FHLB stock and FRB stock are recorded at cost and included in other assets. Our ownership of FHLB stock totaled $4.4 million and $2.5 million at June 30, 2011 and December 31, 2010, respectively. The increase in FHLB stock was required due to an increased level of borrowings.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
LENDING ACTIVITIES
The following table sets forth selected information regarding the composition of the Company’s loan portfolio as of the dates indicated (in thousands).
                                 
    Loan Portfolio Composition  
    June 30, 2011     December 31, 2010  
            % of             % of  
    Amount     Total     Amount     Total  
Commercial business
  $ 217,430       15.9 %   $ 211,031       15.7 %
Commercial mortgage
    357,463       26.1       352,930       26.2  
 
                       
Total commercial
    574,893       42.0       563,961       41.9  
 
                               
Residential mortgage
    120,789       8.8       129,580       9.6  
 
                               
Home equity
    215,637       15.8       208,327       15.5  
Consumer indirect
    431,611       31.6       418,016       31.1  
Other consumer
    25,122       1.8       26,106       1.9  
 
                       
Total consumer
    672,370       49.2       652,449       48.5  
 
                       
Total loans
    1,368,052       100.0 %     1,345,990       100.0 %
 
                           
Allowance for loan losses
    20,632               20,466          
 
                           
Total loans, net
  $ 1,347,420             $ 1,325,524          
 
                           
Total loans increased by 2% to $1.368 billion as of June 30, 2011 from $1.346 billion as of December 31, 2010.
Commercial loans increased $10.9 million from December 31, 2010 and represented 42.0% of total loans as of June 30, 2011, a result of the Company’s continued focus on commercial business development programs.
Residential mortgage loans decreased $8.8 million to $120.8 million as of June 30, 2011 in comparison to $129.6 million as of December 31, 2010. This category of loans decreased as the majority of newly originated and refinanced residential mortgages were sold in the secondary market rather than being added to the portfolio. The Company does not engage in sub-prime or other high-risk residential mortgage lending as a line-of-business.
Consumer loans totaled $672.4 million as of June 30, 2011, an increase of $19.9 million or 3% from December 31, 2010. The consumer indirect portfolio increased $13.6 million to $431.6 million as of June 30, 2011, from $418.0 million as of December 31, 2010. During the first half of 2011, the Company originated $111.6 million in indirect auto loans with a mix of approximately 44% new auto and 56% used auto. During the second quarter of 2011, the Company reclassified $13.6 million of auto loans from the consumer indirect portfolio to loans held for sale.
Loans Held for Sale and Mortgage Servicing Rights. Loans held for sale (not included above) totaled $14.5 million as of June 30, 2011, comprised of $935 thousand of residential mortgage loans and $13.6 million of indirect auto loans. During the second quarter of 2011, the Company reclassified $13.6 million of indirect auto loans from portfolio to loans held for sale pursuant to a letter of intent to sell the loans under a 90%/10% participation agreement. The Company will continue to service the loans for a fee in accordance with the participation agreement. The loans were subsequently sold in July 2011 and we expect to recognize a gain on the sale of $153 thousand during the third quarter. Loans held for sale totaled $3.1 million as of December 31, 2010, all of which were residential mortgage loans.
We sell certain qualifying newly originated and refinanced residential real estate mortgages in the secondary market. The sold and serviced residential real estate loan portfolio decreased to $314.6 million as of June 30, 2011 from $328.9 million as of December 31, 2010. The decrease in the sold and serviced portfolio resulted from payments and payoffs on existing loans outpacing new loan origination and refinancing volumes.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Allowance for Loan Losses
The following table sets forth an analysis of the activity in the allowance for loan losses for the periods indicated (in thousands).
                                 
    Loan Loss Analysis  
    Three months ended June 30,     Six months ended June 30,  
    2011     2010     2011     2010  
Balance as of beginning of period
  $ 20,119     $ 20,586     $ 20,466     $ 20,741  
Charge-offs:
                               
Commercial business
    225       121       315       190  
Commercial mortgage
    34       164       378       209  
Residential mortgage
    10       42       12       54  
Home equity
    155       41       262       88  
Consumer indirect
    1,055       932       2,345       2,160  
Other consumer
    268       176       479       388  
 
                       
Total charge-offs
    1,747       1,476       3,791       3,089  
Recoveries:
                               
Commercial business
    110       92       264       184  
Commercial mortgage
    23       18       39       450  
Residential mortgage
    3       12       30       16  
Home equity
    7       25       17       27  
Consumer indirect
    653       359       1,205       699  
Other consumer
    136       104       264       274  
 
                       
Total recoveries
    932       610       1,819       1,650  
 
                       
Net charge-offs
    815       866       1,972       1,439  
Provision for loan losses
    1,328       2,105       2,138       2,523  
 
                       
Balance at end of period
  $ 20,632     $ 21,825     $ 20,632     $ 21,825  
 
                       
 
                               
Net loan charge-offs to average loans (annualized)
    0.24 %     0.27 %     0.29 %     0.23 %
Allowance for loan losses to total loans
    1.51 %     1.69 %     1.51 %     1.69 %
Allowance for loan losses to non-performing loans
    296 %     192 %     296 %     192 %
The allowance for loan losses represents the estimated amount of probable credit losses inherent in the Company’s loan portfolio. The Company performs periodic, systematic reviews of the loan portfolio to estimate probable losses in the respective loan portfolios. In addition, the Company regularly evaluates prevailing economic and business conditions, industry concentrations, changes in the size and characteristics of the portfolio and other pertinent factors. The process used by the Company to determine the overall allowance for loan losses is based on this analysis. Based on this analysis the Company believes the allowance for loan losses is adequate as of June 30, 2011.
Assessing the adequacy of the allowance for loan losses involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing a variety of factors, including the risk-profile of the Company’s loan products and customers. The Company does not engage in sub-prime or other high-risk residential mortgage lending as a line-of-business. The Company primarily originates fixed and variable rate one-to-four family residential mortgages collateralized by owner-occupied properties located within its central and western New York marketplace, which has been relatively stable in recent years. Residential mortgages collateralized by one-to-four family residential real estate generally have been originated in amounts of no more than 85% of appraised value or have mortgage insurance.
The adequacy of the allowance for loan losses is subject to ongoing management review. While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for loan losses. Such agencies may require the financial institution to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
The provision for loan losses for the three and six months ended June 30, 2011 was $1.3 million and $2.1 million, respectively, compared to a provision for loan losses of $2.1 million and $2.5 million for the three and six months ended June 30, 2010, respectively. Net charge-offs of $815 thousand were recorded for the second quarter of 2011, compared to $866 thousand for the same quarter a year ago. Year-to-date net charge-offs of $2.0 million have been recorded in 2011, compared to $1.4 million through June 30, 2010. The provision for loan losses and net charge-offs for the first six months of 2010 were favorably impacted by a $354 thousand recovery in the first quarter of 2010 on one commercial real estate relationship that was charged-off during 2008 and 2009.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Non-Performing Assets and Potential Problem Loans
The table below sets forth the amounts and categories of the Company’s non-performing assets at the dates indicated (in thousands).
                         
    Delinquent and Non-Performing Assets  
    June 30,     December 31,     June 30,  
    2011     2010     2010  
Nonaccrual loans:
                       
Commercial business
  $ 712     $ 947     $ 5,889  
Commercial mortgage
    2,862       3,100       1,380  
Residential mortgage
    2,262       2,102       2,480  
Home equity
    472       875       1,072  
Consumer indirect
    667       514       464  
Other consumer
          41       19  
 
                 
Total nonaccrual loans
    6,975       7,579       11,304  
Accruing loans 90 days or more delinquent
    4       3       61  
 
                 
Total non-performing loans
    6,979       7,582       11,365  
Foreclosed assets
    599       741       500  
Non-performing investment securities
    6,963       572       646  
 
                 
Total non-performing assets
  $ 14,541     $ 8,895     $ 12,511  
 
                 
 
                       
Non-performing loans to total loans
    0.51 %     0.56 %     0.88 %
Non-performing assets to total assets
    0.64 %     0.40 %     0.58 %
Activity in nonaccrual loans for periods indicated was as follows (in thousands).
                 
    Three months     Six months  
    ended     ended  
    June 30, 2011     June 30, 2011  
Nonaccrual loans, beginning of period
  $ 7,315     $ 7,579  
Additions
    2,846       6,011  
Payments
    (1,260 )     (2,684 )
Charge-offs
    (1,603 )     (3,519 )
Returned to accruing status
    (218 )     (307 )
Transferred to other real estate or repossessed assets
    (105 )     (105 )
 
           
Nonaccrual loans, end of period
  $ 6,975     $ 6,975  
 
           
Non-performing assets include non-performing loans, foreclosed assets and non-performing investment securities. Non-performing assets at June 30, 2011 were $14.5 million or 0.64% of total assets, an increase of $5.6 million from the $8.9 million or 0.40% of total assets at December 31, 2010.
Non-performing investment securities are included in non-performing assets at fair value and represent securities on which the Company has stopped accruing interest. These non-performing investment securities totaled $7.0 million at June 30, 2011, compared to $572 thousand at December 31, 2010. There were no new securities transferred to non-performing status during the quarter. The increase relates solely to an increase in the fair value of each of the 14 securities classified as non-performing. The market for these securities improved dramatically during the second quarter of 2011, resulting in the $6.4 million increase in fair value from December 31, 2010.
During July 2011, the Company sold one of the 14 securities classified as non-performing and will recognize a gain of approximately $1 million during the third quarter. The security had a fair value of $752 thousand at June 30, 2011. The Company continues to monitor the market for these securities and evaluate the potential for future dispositions.
Non-performing loans totaled $7.0 million or 0.51% of total loans at June 30, 2011, a decrease of $603 thousand from the $7.6 million or 0.56% of total loans at December 31, 2010. The ratio of non-performing loans to total loans continues to compare favorably to the average of our peer group, which was 3.43% of total loans at March 31, 2011, the most recent period for which information is available (Source: Federal Financial Institutions Examination Council — Bank Holding Company Performance Report as of March 31, 2011 — Top-tier bank holding companies having consolidated assets between $1 billion and $3 billion). Included in nonaccrual loans are troubled debt restructurings (“TDRs”) of $760 thousand and $534 thousand at June 30, 2011 and December 31, 2010, respectively.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Foreclosed assets consist of real property formerly pledged as collateral to loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. Foreclosed asset holdings consisted of 10 properties (2 commercial properties and 8 residential properties) totaling $599 thousand at June 30, 2011 and 13 properties (5 commercial properties and 8 residential properties) totaling $741 thousand at December 31, 2010.
Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes management to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. Management considers loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $11.4 million and $11.5 million in loans that continued to accrue interest which were classified as substandard as of June 30, 2011 and December 31, 2010, respectively.
FUNDING ACTIVITIES
Deposits
The Company offers a broad array of deposit products including noninterest-bearing demand, interest-bearing demand, savings and money market accounts and certificates of deposit. We rely primarily on providing excellent customer service and long-standing relationships with customers to attract and retain deposits. We continuously evaluate our branch network to determine how to best serve our customers efficiently and to improve our profitability. In July 2011, we upgraded our presence in the Rochester market by relocating a branch from North Chili to Chili Center. We intend to continue to pursue expansion in our market area by growing and enhancing our branch network and anticipate additional expansion in the coming years.
The following table summarizes the composition of our deposits at the dates indicated (dollars in thousands).
                                 
    Deposit Composition  
    June 30, 2011     December 31, 2010  
            % of             % of  
    Amount     Total     Amount     Total  
Noninterest-bearing demand
  $ 358,574       19.2 %   $ 350,877       18.6 %
Interest-bearing demand
    376,306       20.1       374,900       19.9  
Savings and money market
    438,173       23.4       417,359       22.2  
Certificates of deposit less than $100,000
    500,123       26.7       555,840       29.5  
Certificates of deposit of $100,000 or more
    199,063       10.6       183,914       9.8  
 
                       
Total deposits
  $ 1,872,239       100.0 %   $ 1,882,890       100.0 %
 
                       
Nonpublic deposits represent the largest component of the Company’s funding. Total nonpublic deposits were $1.469 billion and $1.501 billion as of June 30, 2011 and December 31, 2010, respectively. The Company continues to manage this segment of funding through a strategy of competitive pricing and relationship-based sales and marketing that minimizes the number of customer relationships that have only a single high-cost deposit account.
The Company offers a variety of public deposit products to the many towns, villages, counties, school districts and other public entities within our market. Public deposits generally range from 20 to 25% of the Company’s total deposits. As of June 30, 2011, total public deposits were $403.2 million in comparison to $382.2 million as of December 31, 2010. There is a high degree of seasonality in this component of funding, as the level of deposits varies with the seasonal cash flows for these public customers. The Company maintains the necessary levels of short-term liquid assets and alternative liquidity sources to accommodate the seasonality associated with public deposits.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Borrowings
The following table summarizes the Company’s borrowings as of the dates indicated (in thousands).
                 
    June 30,     December 31,  
    2011     2010  
Customer repurchase agreements
  $ 45,015     $ 38,910  
Federal funds purchased
    47,380       38,200  
FHLB borrowings
    50,000       10,065  
Junior subordinated debentures
    16,702       16,702  
 
           
Total borrowings
  $ 159,097     $ 103,877  
 
           
The Company has credit capacity with the FHLB and can borrow through facilities that include amortizing and term advances. The Company had approximately $108 million of immediate credit capacity with FHLB as of June 30, 2011. The Company had approximately $359 million in secured borrowing capacity at the Federal Reserve Bank (“FRB”) Discount Window, none of which was outstanding at June 30, 2011. The FHLB and FRB credit capacity are collateralized by securities from the Company’s investment portfolio and certain qualifying loans. FHLB borrowings increased by approximately $40 million during 2011 due primarily to the purchase of municipal and agency mortgage-backed securities as part of a leverage strategy implemented during the second quarter of 2011 to take advantage of a steep yield curve.
Funds are borrowed on an overnight basis through retail repurchase agreements with bank customers and federal funds purchased from other financial institutions. Retail repurchase agreement borrowings are collateralized by securities of the U.S. Treasury and U.S. Government agencies and corporations. The Company had approximately $52 million of credit available under unsecured federal funds purchased lines with various banks as of June 30, 2011.
Equity Activities
Total shareholders’ equity was $233.7 million at June 30, 2011, an increase of $21.6 million from $212.1 million at December 31, 2010. During February 2011, the Company redeemed $12.5 million of Series A preferred stock issued to the U.S. Treasury. During March 2011, the Company successfully completed a follow-on common equity offering, issuing 2,813,475 shares of common stock at a price of $16.35 per share before associated offering expenses. After deducting underwriting and other offering costs, the Company received net proceeds of approximately $43.1 million. Prior to the end of the first quarter of 2011, the Company utilized a portion of the net proceeds to redeem the remaining $25.0 million in Series A preferred stock. During the second quarter of 2011, the Company repurchased the Warrant issued to the Treasury. The repurchase price of $2.1 million was recorded as a reduction of additional paid-in capital.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
The objective of maintaining adequate liquidity is to assure the ability of the Company to meet its financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the servicing and repayment of debt and preferred equity obligations, the ability to fund new and existing loan commitments, to take advantage of new business opportunities and to satisfy other operating requirements. The Company achieves liquidity by maintaining a strong base of core customer funds, maturing short-term assets, its ability to sell securities, lines of credit, and access to the financial and capital markets.
Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, core deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with the other banking institutions, the FHLB and the FRB.
The primary sources of liquidity for FII are dividends from the Bank and access to financial and capital markets. Dividends from the Bank are limited by various regulatory requirements related to capital adequacy and earnings trends. The Bank relies on cash flows from operations, core deposits, borrowings and short-term liquid assets. Five Star Investment Services relies on cash flows from operations and funds from FII when necessary.
The Company’s cash and cash equivalents were $46.1 million as of June 30, 2011, an increase of $7.0 million from $39.1 million as of December 31, 2010. The Company’s net cash provided by operating activities totaled $24.0 million. Net cash used in investing activities totaled $61.5 million, which included cash outflows of $37.7 million for net loan originations and $22.5 million from investment securities transactions. Net cash provided by financing activities of $44.5 million was attributed to a $55.2 million increase in net borrowings and $43.1 million in net proceeds from the issuance of common stock, partly offset by the $37.5 million payment to redeem the Series A preferred stock, a $10.7 million decrease in deposits and $3.5 million in dividend payments.
Capital Resources
Banks and financial holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material impact on the Company’s consolidated financial statements. 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 regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets (all as defined in the regulations). These minimum amounts and ratios are included in the table below.
The Company’s and the Bank’s Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on securities available for sale (except for unrealized losses which have been determined to be other than temporary and recognized as expense in the consolidated statements of income), goodwill and other intangible assets and disallowed portions of deferred tax assets. Tier 1 capital for the Company includes, subject to limitation, $16.2 million of trust preferred securities issued by FISI Statutory Trust I and $17.5 million of preferred stock. The Company and the Bank’s total capital are comprised of Tier 1 capital for each entity plus a permissible portion of the allowance for loan losses.
As previously discussed, on July 1, 2011, the Company notified the trustee of FISI Statutory Trust I that the Company will be redeeming all of its 10.20% junior subordinated debentures on August 22, 2011. Consequent to repayment of the junior subordinated debentures, the Trust will redeem its $16.2 million of trust preferred securities. The trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the junior subordinated debentures. Under applicable regulatory capital guidelines issued by bank regulatory agencies, upon notice of redemption, the trust preferred securities will no longer qualify as Tier 1 capital for the Company. Had the trust preferred securities not qualified as Tier 1 capital as of June 30, 2011, the Company’s Tier 1 capital would have been reduced by $16.2 million and resulted in a Tier 1 leverage ratio of 8.57%, Tier 1 capital ratio of 12.64% and Total risk-based capital ratio of 13.89%. The redemption of the trust preferred securities will not have a significant impact on the Bank’s capital.
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 and disallowed portions of deferred tax assets, allocated by risk weight category and certain off-balance-sheet items (primarily loan commitments and securities more than one level below investment grade that are subject to the low level exposure rules). The leverage ratio is calculated by dividing Tier 1 capital by adjusted quarterly average total assets, which exclude goodwill and other intangible assets and disallowed portions of deferred tax assets.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS
The following table reflects the ratios and their components (dollars in thousands).
                 
    June 30,     December 31,  
    2011     2010  
Total shareholders’ equity
  $ 233,733     $ 212,144  
Less: Unrealized gain on securities available for sale, net of tax
    11,486       1,877  
Unrecognized net periodic pension & postretirement benefits (costs), net of tax
    (6,424 )     (6,599 )
Disallowed goodwill and other intangible assets
    37,369       37,369  
Disallowed deferred tax assets
          14,608  
Plus: Qualifying trust preferred securities
    16,200       16,200  
 
           
Tier 1 capital
  $ 207,502     $ 181,089  
 
           
Adjusted average total assets (for leverage capital purposes)
  $ 2,231,185     $ 2,177,911  
 
           
 
               
Tier 1 leverage ratio (Tier 1 capital to adjusted average total assets)
    9.30 %     8.31 %
 
               
Total Tier 1 capital
  $ 207,502     $ 181,089  
Plus: Qualifying allowance for loan losses
    18,947       18,363  
 
           
Total risk-based capital
  $ 226,449     $ 199,452  
 
           
Net risk-weighted assets
  $ 1,514,057     $ 1,466,957  
 
           
 
               
Tier 1 capital ratio (Tier 1 capital to net risk-weighted assets)
    13.71 %     12.34 %
 
               
Total risk-based capital ratio (Total risk-based capital to net risk-weighted assets)
    14.96 %     13.60 %
The Company’s and the Bank’s actual and required regulatory capital ratios were as follows (in thousands):
                                                     
                        For Capital        
        Actual     Adequacy Purposes     Well Capitalized  
        Amount     Ratio     Amount     Ratio     Amount     Ratio  
June 30, 2011:
                                                   
Tier 1 leverage:
  Company   $ 207,502       9.30 %   $ 89,247       4.00 %   $ 111,559       5.00 %
 
  Bank     174,411       7.84       88,986       4.00       111,233       5.00  
 
                                                   
Tier 1 capital:
  Company     207,502       13.71       60,562       4.00       90,843       6.00  
 
  Bank     174,411       11.55       60,376       4.00       90,564       6.00  
 
                                                   
Total risk-based capital:
  Company     226,449       14.96       121,125       8.00       151,406       10.00  
 
  Bank     193,300       12.81       120,752       8.00       150,940       10.00  
 
                                                   
December 31, 2010:
                                                   
Tier 1 leverage:
  Company   $ 181,089       8.31 %   $ 87,116       4.00 %   $ 108,896       5.00 %
 
  Bank     156,957       7.22       86,958       4.00       108,697       5.00  
 
                                                   
Tier 1 capital:
  Company     181,089       12.34       58,678       4.00       88,017       6.00  
 
  Bank     156,957       10.74       58,450       4.00       87,674       6.00  
 
                                                   
Total risk-based capital:
  Company     199,452       13.60       117,357       8.00       146,696       10.00  
 
  Bank     175,250       11.99       116,899       8.00       146,124       10.00  
Dividend Restrictions
In the ordinary course of business, the Company is dependent upon dividends from Five Star Bank to provide funds for the payment of interest expense on the junior subordinated debentures, 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 the 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.

 

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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
The principal objective of the Company’s interest rate risk management is to evaluate the interest rate risk inherent in certain assets and liabilities, determine the appropriate level of risk to the Company given its business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the guidelines approved by the Company’s Board of Directors. The Company’s management is responsible for reviewing with the Board its activities and strategies, the effect of those strategies on the net interest margin, the fair value of the portfolio and the effect that changes in interest rates will have on the portfolio and exposure limits. Management develops an Asset-Liability Policy that meets strategic objectives and regularly reviews the activities of the Bank.
The primary tool the Company uses to manage interest rate risk is a “rate shock” simulation to measure the rate sensitivity of the balance sheet. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income and economic value of equity. The Company measures net interest income at risk by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of twelve months. This simulation is based on management’s assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of the future results and is based on many assumptions that, if changed, could cause a different outcome.
In addition to the changes in interest rate scenarios listed above, the Company typically runs other scenarios to measure interest rate risk, which vary depending on the economic and interest rate environments.
The Company has experienced no material changes in market risk due to changes in interest rates since the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, dated March 7, 2011, as filed with the Securities and Exchange Commission.
ITEM 4.  
Controls and Procedures
Evaluation of disclosure controls and procedures
As of June 30, 2011, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b), as adopted by the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 (“Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits to the SEC under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in internal control over financial reporting
There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II. OTHER INFORMATION
ITEM 1.  
Legal Proceedings
The Company has experienced no material developments in its legal proceedings from the disclosure included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, dated March 7, 2011, as filed with the Securities and Exchange Commission.
ITEM 1A.  
Risk Factors
In addition to the other information set forth in this report, you should carefully consider the factors discussed under Part I, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, as supplemented and updated by the discussion below. These factors could materially adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in this report.
Implications of U.S. Government Credit Downgrade
We have significant exposure to U.S. Government agency and instrumentality debt in our investment securities portfolio. These investments are backed by the explicit or implied guarantee of the U.S. Government. If the credit rating of U.S. Government debt obligations is downgraded, we would expect there would be a similar impact on the ratings for U.S. Government agency and instrumentality debt backed by these guarantees. Additionally, we hold other assets that rely, to varying degrees, on direct U.S. Government guarantees, insurance, or defeasance to enhance credit levels. A downgrade in the U.S. Government debt rating would likely have a negative impact on the rating of these assets as well. Such downgrades could adversely affect the value of our investment securities and other assets, which could result in a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.
Liquidity Implications of Selective Payments by the U.S. Government on its Debt
In the event that the U.S. Government has to prioritize which debt payments it is able to pay and not pay (selective defaults), the possibility of a short-term liquidity crisis may arise. We believe we have access to sufficient amounts and a variety of types of liquidity sources to withstand interruption in normal liquidity patterns, however, in the event of a catastrophic liquidity crisis, we may not be able to immediately access sufficient liquidity to satisfy our obligations.

 

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ITEM 6.  
Exhibits
  (a)  
The following is a list of all exhibits filed or incorporated by reference as part of this Report.
             
Exhibit        
Number   Description   Location
       
 
   
  11.1    
Statement of Computation of Per Share Earnings
  Incorporated by reference to Note 2 of the Registrant’s unaudited consolidated financial statements under Item 1 filed herewith.
       
 
   
  31.1    
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Principal Executive Officer
  Filed Herewith
       
 
   
  31.2    
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Principal Financial Officer
  Filed Herewith
       
 
   
  32    
Certification pursuant to18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
  Filed Herewith
       
 
   
*101.INS    
XBRL Instance Document
   
       
 
   
*101.SCH    
XBRL Taxonomy Extension Schema Document
   
       
 
   
*101.CAL    
XBRL Taxonomy Extension Calculation Linkbase Document
   
       
 
   
*101.LAB    
XBRL Taxonomy Extension Label Linkbase Document
   
       
 
   
*101.PRE    
XBRL Taxonomy Extension Presentation Linkbase Document
   
       
 
   
*101.DEF    
XBRL Taxonomy Extension Definition Linkbase Document
   
 
     
*  
Pursuant to Rule 406T of Regulation S-T, the information in this exhibit shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that section, and shall not be incorporated by reference into any registration statement, prospectus or other document filed under the Securities Act of 1933, or the Securities Exchange Act of 1934, except as shall be expressly set forth by specific reference in such filings.

 

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
 
  FINANCIAL INSTITUTIONS, INC.    
 
       
 
  /s/ Peter G. Humphrey   , August 2, 2011
 
 
 
Peter G. Humphrey
   
 
  President and Chief Executive Officer    
 
  (Principal Executive Officer)    
 
       
 
  /s/ Karl F. Krebs   , August 2, 2011
 
 
 
Karl F. Krebs
   
 
  Executive Vice President and Chief Financial Officer    
 
  (Principal Financial and Principal Accounting Officer)    

 

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