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BENEFICIAL MUTUAL BANCORP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This quarterly report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of the Company. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative or regulatory changes or regulatory actions, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company's market area, changes in real estate market values in the Company's market area, changes in relevant accounting principles and guidelines and the inability of third party service providers to perform. Additional factors that may affect our results are disclosed in the section titled "Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2013 and its other reports filed with the U.S. Securities and Exchange Commission. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events. EXECUTIVE SUMMARY Beneficial Mutual Bancorp Inc. is a federally chartered stock savings and loan holding company and owns 100% of the outstanding common stock of Beneficial Mutual Savings Bank ("the Bank"), a Pennsylvania chartered stock savings bank. The Bank offers a variety of consumer and commercial banking services to individuals, businesses, and nonprofit organizations through 58 offices throughout the Philadelphia and Southern New Jersey area. The Bank is supervised and regulated by the Department and the FDIC. The Company is regulated by the Federal Reserve Board. The Bank's customer deposits are insured up to applicable legal limits by the Deposit Insurance Fund of the FDIC. Insurance services are offered through Beneficial Insurance Services, LLC and wealth management services are offered through Beneficial Advisors, LLC, both wholly owned subsidiaries of the Bank. Our primary source of pre-tax income is net interest income. Net interest income is the difference between the income we earn on our loans and investments and the interest we pay on our deposits and borrowings. Changes in levels of interest rates affect our net interest income. A secondary source of income is non-interest income, which is revenue we receive from providing products and services. Traditionally, the majority of our non-interest income has come from service charges (mostly on deposit accounts), interchange income, mortgage banking, and from fee income from our insurance and wealth management services. The non-interest expense we incur in operating our business consist of salaries and employee benefits expenses, the cost of our equity plans, occupancy expenses, depreciation, amortization and maintenance expenses and other miscellaneous expenses, such as loan and owned real estate expenses, advertising, insurance, professional services and printing and supplies expenses. Our largest non-interest expense is salaries and employee benefits, which consist primarily of salaries and wages paid to our employees, payroll taxes, and expenses for health insurance, retirement plans and other employee benefits. Our business results continue to be impacted by slow economic growth in our markets. To stimulate economic growth, the Federal Reserve Board continues to hold short-term interest rates at historic lows 44 -------------------------------------------------------------------------------- Table of Contents and expects rates to remain low throughout 2015. The low rate environment has impacted the yield on our investment and loan portfolios. Elevated unemployment, slow economic growth and continued economic uncertainty has resulted in a slow recovery and limited consumer consumption. Additionally, capital spending and investing by businesses has remained sluggish given the slow and uneven economic recovery, which has resulted in low loan demand. This has resulted in increased competition among banks to secure new loans often with risky terms and lower pricing. We continue to adhere to our prudent underwriting standards and are committed to originating quality loans. As the economy slowly improves, we have seen reductions in our non-performing assets, past due loans and charge-off levels. As disclosed in our earnings release on January 30, 2014 and in our Form 10-K for the year ended December 31, 2013, in the first quarter of 2013, the Company received notice that it was being investigated by the Department of Justice ("DOJ") for potential violations of the Equal Credit Opportunity Act and Fair Housing Act relating to the Company's home-mortgage lending practices from January 1, 2008 to the present. In late January 2014, the Company received correspondence from the DOJ indicating that the DOJ had completed its review and determined that the matter did not require enforcement action by the DOJ and was being referred back to the FDIC. The Company was not able to determine whether further action will be taken at this point with respect to the ultimate resolution of this matter and the Company is in discussions with the FDIC Staff to clear this matter. Until this matter is resolved, it is unlikely that any regulatory applications will be filed related to strategic expansion or regarding a second step conversion. Net income was $4.6 million and $7.0 million for the three and six months ended June 30, 2014 compared to $2.9 million and $6.1 million for the same periods in 2013. For the three months ended June 30, 2014, net interest income was $29.2 million, a decrease of $2.0 million, or 6.4%, from the three months ended June 30, 2013. The decrease in net interest income was primarily the result of a decline in average assets of $274.4 million with average investments and loans down $194.9 million and $66.0 million, respectively, coupled with a reduction in the average interest rate earned on loans, partially offset by a reduction in the average cost of deposits. The reduction in average assets was part of our ongoing strategy to reduce our municipal deposit portfolio, the average balance of which decreased $194.2 million during the three months ended June 30, 2014 as compared to the same period a year ago. This reduction of municipals deposits, and the corresponding decrease in investments, has improved capital levels and our interest rate risk profile and has also helped to stabilize net interest margin which was 2.81% for the three months ended June 30, 2014 as compared to 2.83% for the same period in 2013. For the six months ended June 30, 2014, net interest income was $58.7 million, a decrease of $4.0 million, or 6.4%, from the six months ended June 30, 2013. The decrease was primarily the result of a decline in the average assets of $280.6 million with average investments and loans down $169.5 million and $91.6 million, respectively, coupled with a reduction in the average interest rate earned on loans, partially offset by a reduction in the average cost of liabilities and a $200.5 million decrease in the average balance of municipal deposits during 2014. We expect that the continued low interest rate environment will put pressure on net interest margin in future periods but are focused on growing our loan portfolio and improving our balance sheet to help stabilize our net interest margin. Asset quality metrics showed continued signs of improvement during the six months ended June 30, 2014. Non-performing loans, excluding government guaranteed student loans, decreased to $27.8 million at June 30, 2014, compared to $51.8 million at December 31, 2013. The $24.0 million, or 46.3%, decrease in non-performing loans since year end, excluding government student loans, was a function of our continued workout of non-performing assets as well as an $11.3 million non-performing loan sale, which resulted in a $913 thousand net recovery. At June 30, 2014, the commercial loan portfolio included approximately $6.3 million of non-performing loans held for sale that are expected to be sold during the third quarter of 2014. These loans are being carried at the lower of cost or market. The improvement in our asset quality metrics is due to stabilization in residential and commercial loan property valuations as 45 -------------------------------------------------------------------------------- Table of Contents well as the continued efforts of our credit officers and loan workout group to identify and manage potential problem loans. As a result of the improvement in our asset quality metrics, we were able to reduce our provision for loan losses for the quarter ended June 30, 2014 to $250 thousand compared to $5.0 million for the quarter ended June 30, 2013. Net charge-offs during the quarter ended June 30, 2014 were $1.7 million compared to $2.7 million during the quarter ended December 31, 2013 and $5.0 million during the quarter ended June 30, 2013. At June 30, 2014, the Bank's allowance for loan losses totaled $52.6 million, or 2.22% of total loans, compared to $55.6 million, or 2.38% of total loans, at December 31, 2013. Over the past few years our loan portfolio has been impacted by high commercial loan repayments and continued weak loan demand, particularly in our residential and consumer lending portfolios. We have been focused on recruiting and hiring lenders for our commercial and small business lending teams to drive future growth and improve our balance sheet mix. Loans increased during the six months ended June 30, 2014 by $27.5 million, or 1.2%, to $2.4 billion at June 30, 2014 from $2.3 billion at December 31, 2013. The growth was primarily driven by a $54.6 million increase in our commercial loan portfolio due to strong commercial real estate growth. Commercial business loans include shared national credits, which are participations in loans or loan commitments of at least $20.0 million that are shared by three or more banks. Included in our shared national credit portfolio are purchased participations and assignments in leveraged lending transactions. Leveraged lending transactions are generally used to support a merger- or acquisition-related transaction, to back a recapitalization of a company's balance sheet or to refinance debt. When considering a participation in the leveraged lending market, we will participate only in first lien senior secured term loans that are highly rated (investment grade) by the rating agencies and that trade in active secondary markets. We actively monitor the secondary market for these types of loans to ensure that we maintain flexibility to sell such loans in the event of deteriorating credit quality. To further minimize risk and based on our current capital levels and loan portfolio, we have limited the total amount of leveraged loans to $150.0 million with no single obligor exceeding $15.0 million while maintaining single industry concentrations below 30%. We may reevaluate these limits in future periods. The shared national credit loans are typically variable rate with terms ranging from one to seven years. At June 30, 2014, shared national credits totaled $93.1 million, which included $54.8 million of leveraged lending transactions. All of these loans were classified as pass rated as June 30, 2014 as all payments are current and the loans are performing in accordance with their contractual terms. A weak housing market in the Philadelphia Metropolitan area contributed to lower mortgage loan originations resulting in an $8.8 million decrease in our residential loan portfolio. Our consumer loan categories continue to be impacted by weak demand and decreased $18.3 million during the year. During the first quarter of 2014, we moved our headquarters to 1818 Beneficial Bank Place in Philadelphia, Pennsylvania. The new location affirms our commitment to remaining the oldest and largest bank in Philadelphia. During the first quarter, we incurred approximately $1.3 million of one-time costs associated with the headquarters move including duplicate rent for the old and new headquarters space as the old headquarters lease did not expire until March 31, 2014, moving costs, de-commissioning our old headquarters space, and miscellaneous other costs. During 2014, we repurchased 1,722,500 shares of common stock at an average price of $12.81 under our share repurchase program. Capital levels improved and continue to remain strong. We believe that our strong capital profile positions us to advance our growth strategy by working with our customers to help them save and use credit wisely. It also allows us to continue to dedicate financial and human capital to support organizations that share our sense of responsibility to do what's right for the communities we serve. We remain committed to the financial responsibility we have practiced throughout our 161 year history, and we are dedicated to providing financial education opportunities to our customers by providing the tools necessary to make wise financial decisions. In order to further improve our operating returns, we continue to leverage our position as one of the largest and oldest banks headquartered in the Philadelphia metropolitan area. We are focused on 46 -------------------------------------------------------------------------------- Table of Contents acquiring and retaining customers, and then educating them by aligning our products and services to their financial needs. We also intend to deploy some of our excess capital to grow the Bank in our markets. RECENT INDUSTRY CONSOLIDATION The banking industry has experienced consolidation in recent years, which may continue in future periods. Consolidation may affect the markets in which we operate as competitors integrate newly acquired businesses, adopt new business and risk management practices or change products and pricing as they attempt to maintain or grow market share and maximize profitability. Merger activity involving national, regional and community banks and specialty finance companies in the Philadelphia metropolitan area has and will continue to impact the competitive landscape in the markets we serve. We believe that there are opportunities to continue to grow via acquisition in our markets and expect that acquisitions will continue to be a key part of our future growth strategy. Management continually monitors our primary market area and assesses the impact of industry consolidation, as well as the practices and strategies of our competitors, including loan and deposit pricing and customer behavior. CURRENT REGULATORY ENVIRONMENT In December 2010 and January 2011, the International Basel Committee on Banking Supervision, a committee of central banks and bank supervisors, published the final texts of reforms on capital and liquidity, which is referred to as "Basel III." On July 2, 2013, the Federal Reserve Board approved the final Basel III capital rules, establishing unique standards for all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (such as the Company). The effective date of the implementation of Basel III is January 1, 2015 for the Bank. When fully phased-in on January 1, 2019, Basel III will require banks to maintain: (i) 4.5% Common Equity Tier 1 to risk-weighted assets; (ii) 6.0% Tier 1 capital to risk-weighted assets; and (iii) 8.0% Total capital to risk-weighted assets. Each of these ratios will also require an additional 2.5% of common equity Tier 1 capital to risk-weighted assets "capital conservation buffer" on top of the minimum requirements. As of June 30, 2014, our current capital levels exceed the required capital amounts to be considered "well capitalized" and they also meet the fully-phased in minimum capital requirements, including the related capital conservation buffers, as required by the Basel III capital rules. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). In addition to eliminating the Office of Thrift Supervision and creating the Consumer Financial Protection Bureau, the Dodd-Frank Act, among other things, repealed non-payment of interest on commercial demand deposits, requires changes in the way that institutions are assessed for deposit insurance, mandates the imposition of consolidated capital requirements on savings and loan holding companies, forces originators of securitized loans to retain a percentage of the risk for the transferred loans, requires regulatory rate-setting for certain debit card interchange fees and contains a number of reforms related to mortgage origination. Many of the provisions of the Dodd-Frank Act are subject to delayed effective dates and require the issuance of implementing regulations. It is therefore difficult to determine at this time their impact on the Bank, Company and the MHC. However, there is a significant possibility that the Dodd-Frank Act will, at a minimum, result in increased regulatory burden, compliance costs and interest expense as well as potential reduced fee income for the Bank, the Company and the MHC. As mandated by the Dodd-Frank Act, in December 2013, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, FDIC, U.S. Securities and Exchange Commission and Commodity Futures Trading Commission issued final rulings (the "Final Rules") implementing certain prohibitions and restrictions on the ability of a banking entity and non-bank financial company supervised by the FRB to engage in proprietary trading and have certain ownership interests in, or relationships with, a "covered fund" (the so-called "Volcker Rule"). The Final Rules also require regulated entities to establish an internal compliance program that is consistent with the extent to which it engages in activities covered by the Volcker Rule, which must include making regular reports about those activities to 47 -------------------------------------------------------------------------------- Table of Contents regulators. Although the Final Rules provide some tiering of compliance and reporting obligations based on size, the fundamental prohibitions of the Volcker Rule apply to banking entities of any size. Banking entities have until July 21, 2015 to conform their activities and investments to the requirements of the Final Rules. During the quarter ended December 31, 2013, the Company sold its holdings in pooled trust preferred securities due to the uncertainty regarding banking institutions being allowed to hold pooled trust preferred securities under the Volcker Rule. Based on our evaluation to date, we do not currently expect the Final Rules will have a material effect in future periods on our business, financial condition or results of operations. CRITICAL ACCOUNTING POLICIES In the preparation of our condensed consolidated financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and to general practices within the banking industry. Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies, which are discussed below, to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Actual results could differ from these judgments and estimates under different conditions, resulting in a change that could have a material impact on the carrying values of our assets and liabilities and our results of operations. Allowance for Loan Losses. We consider the allowance for loan losses to be a critical accounting policy. The allowance for loan losses is determined by management based upon portfolio segment, past experience, evaluation of estimated loss and impairment in the loan portfolio, current economic conditions and other pertinent factors. Management also considers risk characteristics by portfolio segments including, but not limited to, renewals and real estate valuations. The allowance for loan losses is maintained at a level that management considers appropriate to provide for estimated losses and impairment based upon an evaluation of known and inherent risk in the loan portfolio. Loan impairment is evaluated based on the fair value of collateral or estimated net realizable value. While management uses the best information available to make such evaluations, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. The allowance for loan losses is established through a provision for loan losses charged to expense, which is based upon past loan loss experience and an evaluation of estimated losses in the current loan portfolio, including the evaluation of impaired loans. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: overall economic conditions; value of collateral; strength of guarantors; loss exposure at default; the amount and timing of future cash flows on impaired loans; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management regularly reviews the level of loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, the FDIC and the Department, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize adjustments to the allowance based on judgments about information available to them at the time of their examination. Our financial results are affected by the changes in and the level of the allowance for loan losses. This process involves our analysis of complex internal and external variables, and it requires that we exercise judgment to estimate an appropriate allowance for loan losses. As a result of the uncertainty associated with this subjectivity, we cannot assure the precision of the amount reserved, should we experience sizeable loan or lease losses in any particular period. For example, changes in the financial condition of individual borrowers, economic conditions, or the condition of various markets in which collateral may be sold could require us to significantly decrease or increase the level of the allowance for loan losses. Such 48 -------------------------------------------------------------------------------- Table of Contents an adjustment could materially affect net income as a result of the change in provision for credit losses. For example, a change in the estimate resulting in a 10% to 20% difference in the allowance would have resulted in an additional provision for credit losses of $5.3 million to $10.6 million for the six months ended June 30, 2014. We also have approximately $46.6 million in non-performing assets consisting of non-performing loans and other real estate owned. Most of these assets are collateral dependent loans where we have incurred significant credit losses to write the assets down to their current appraised value less selling costs. We continue to assess the realizability of these loans and update our appraisals on these loans each year. To the extent the property values continue to decline, there could be additional losses on these non-performing assets which may be material. For example, a 10% decrease in the collateral value supporting the non-performing assets could result in additional credit losses of $4.7 million. During 2013 and, in particular, the six months ended June 30, 2014, we began to experience a decline in levels of delinquencies, net charge-offs and non-performing assets. Management considered these market conditions in deriving the estimated allowance for loan losses; however, given the continued economic difficulties, the ultimate amount of loss could vary from that estimate. Goodwill and Intangible Assets. The acquisition method of accounting for business combinations requires us to record assets acquired, liabilities assumed and consideration paid at their estimated fair values as of the acquisition date. The excess of consideration paid over the fair value of net assets acquired represents goodwill. Goodwill totaled $122.0 million at both June 30, 2014 and December 31, 2013, respectively. Goodwill and other indefinite lived intangible assets are not amortized on a recurring basis, but rather are subject to periodic impairment testing. We have adopted the amendments included in Accounting Standards Update ("ASU") 2011-08, which allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. During 2013, management reviewed qualitative factors for the Bank, which represents $112.7 million of our goodwill balance, including financial performance, market changes and general economic conditions and noted there was not a significant change in any of these factors as compared to 2012. Accordingly, it was determined that it was more likely than not that the fair value of the banking unit continued to be in excess of its carrying amount as of December 31, 2013. Additionally during 2013, we assessed the qualitative factors related to Beneficial Insurance Services, LLC, which represents $9.3 million of our goodwill balance and determined that the two-step quantitative goodwill impairment test was warranted. We performed a two-step quantitative goodwill impairment for Beneficial Insurance Services, LLC based on estimates of the fair value of equity using discounted cash flow analyses as well as guideline company and guideline transaction information. The inputs and assumptions are incorporated in the valuations including projections of future cash flows, discount rates, the fair value of tangible and intangible assets and liabilities, and applicable valuation multiples based on the guideline information. Based on our latest annual impairment assessment of Beneficial Insurance Services, LLC and their current and projected financial results, we believe that the fair value is in excess of the carrying amount. As a result, management concluded that there was no impairment of goodwill as of December 31, 2013. Although, we concluded that no impairment of goodwill existed for Beneficial Insurance Services, LLC for 2013, Beneficial Insurance Services, LLC has experienced declining revenues and profitability over the past few years and any further declines in financial performance for Beneficial Insurance Services, LLC could result in potential goodwill impairment in future periods. We did not note any negative trends in financial performance, or general market or economic conditions, for Beneficial Insurance Services, LLC for the six months ending June 30, 2014 that would indicate potential goodwill impairment. Other intangible assets subject to amortization are evaluated for impairment in accordance with authoritative guidance. An impairment loss will be recognized if the carrying amount of the intangible asset is not recoverable and exceeds fair value. The carrying amount of the intangible is not considered recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use of the 49 -------------------------------------------------------------------------------- Table of Contents asset. During 2013, management reviewed qualitative factors for its intangible assets and determined that it was more likely than not that the fair value of the intangible assets was greater than their carrying amount. During the six months ended June 30, 2014, the Company noted no indicators of impairment as it relates to goodwill and other intangibles. Income Taxes. We are subject to the income tax laws of the various jurisdictions where we conduct business and estimate income tax expense based on amounts expected to be owed to these various tax jurisdictions. The estimated income tax expense (benefit) is reported in the Consolidated Statements of Income. The evaluation pertaining to the tax expense and related tax asset and liability balances involves a high degree of judgment and subjectivity around the ultimate measurement and resolution of these matters. Accrued taxes represent the net estimated amount due to or to be received from tax jurisdictions either currently or in the future and are reported in other assets on the Company's consolidated statements of financial condition. We assess the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintain tax accruals consistent with our evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, status of examinations by the tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, when they occur, impact accrued taxes and can materially affect our operating results. We regularly evaluate our uncertain tax positions and estimate the appropriate level of reserves related to each of these positions. As of June 30, 2014, the Bank had net deferred tax assets totaling $41.4 million. These deferred tax assets can only be realized if the Bank generates taxable income in the future. The Bank regularly evaluates the realizability of deferred tax asset positions. In determining whether a valuation allowance is necessary, the Bank considers the level of taxable income in prior years to the extent that carrybacks are permitted under current tax laws, as well as estimates of future pre-tax and taxable income and tax planning strategies that would, if necessary, be implemented. The Bank currently maintains a valuation allowance for certain state net operating losses, other-than-temporary impairments, and a charitable contribution carryover that, if not fully utilized, will expire in 2015, that management believes it is more likely than not that such deferred tax assets will not be realized. The Bank expects to realize the remaining deferred tax assets over the allowable carryback and/or carryforward periods. Therefore, no valuation allowance is deemed necessary against its remaining federal or state deferred tax assets as of June 30, 2014. However, if an unanticipated event occurred that materially changed pre-tax book income and taxable income in future periods, an increase in the valuation allowance may become necessary and it could be material to the Company's financial statements. Postretirement Benefits. Several variables affect the annual cost for our defined benefit retirement programs. The main variables are: (1) size and characteristics of the employee population, (2) discount rate, (3) expected long-term rate of return on plan assets, (4) recognition of actual asset returns and (5) other actuarial assumptions. Below is a brief description of these variables and the effect they have on our pension costs. Size and Characteristics of the Employee Population. Pension cost is directly related to the number of employees covered by the plans, and other factors including salary, age, years of employment and benefit terms. Effective June 30, 2008, plan participants ceased to accrue additional benefits under the existing pension benefit formula and their accrued benefits were frozen. Discount Rate. The discount rate is used to determine the present value of future benefit obligations. The discount rate for each plan is determined by matching the expected cash flows of each plan to a yield curve based on long-term, high-quality fixed income debt instruments available as of the measurement date. The discount rate for each plan is reset annually or upon occurrence of a triggering event on the measurement date to reflect current market conditions. 50 -------------------------------------------------------------------------------- Table of Contents Expected Long-term Rate of Return on Plan Assets. Based on historical experience, market projections, and the target asset allocation set forth in the investment policy for the retirement plans, the pre-tax expected rate of return on plan assets was 7.45% for 2013 compared to 8.0% for 2012. This expected rate of return is dependent upon the asset allocation decisions made with respect to plan assets. Annual differences, if any, between expected and actual returns are included in the unrecognized net actuarial gain or loss amount. We generally amortize any unrecognized net actuarial gain or loss in excess of 10% in net periodic pension expense over the average future service of active employees, which is approximately seven years, or the average future lifetime for plans with no active participants that are frozen. Recognition of Actual Asset Returns. Accounting guidance allows for the use of an asset value that "smoothes" investment gains and losses over a period up to five years. However, we have elected to use an alternative method in determining pension cost that uses the actual market value of the plan assets. Therefore, we will experience more variability in the annual pension cost, as the asset values will be more volatile than companies who elected to smooth their investment experience. Other Actuarial Assumptions. To estimate the projected benefit obligation, actuarial assumptions are required with respect to factors such as mortality rate, turnover rate, retirement rate and disability rate. These factors do not tend to change significantly over time, so the range of assumptions, and their impact on pension cost, is generally limited. We annually review the assumptions used based on historical and expected future experience. In addition to our defined benefit programs, we offer a defined contribution plan ("the 401(k) Plan") covering substantially all of our employees. During 2008, in conjunction with freezing benefit accruals under the defined benefit program, we enhanced our 401(k) Plan and combined it with the Employee Stock Ownership Plan ("the ESOP") to form the Beneficial Bank Employee Savings and Stock Ownership Plan ("the KSOP"). While the KSOP is one plan, the two separate components of the 401(k) Plan and ESOP remain. Under the KSOP we make basic and matching contributions as well as additional contributions for certain employees based on age and years of service. We may also make discretionary contributions. Each participant's account is credited with shares of the Company's stock or cash based on compensation earned during the year. Comparison of Financial Condition at June 30, 2014 and December 31, 2013 Total assets decreased $157.7 million, or 3.4%, to $4.4 billion at June 30, 2014 from $4.6 billion at December 31, 2013. Cash and cash equivalents decreased $101.7 million to $254.0 million at June 30, 2014 from $355.7 million at December 31, 2013. The decrease in cash and cash equivalents was primarily driven by a planned $155.2 million run-off of municipal deposits. The run-off of the municipal deposits and the related decrease in our cash balances have helped stabilize our net interest margin for the quarter and the year to date. Investments decreased $80.2 million, or 5.1%, to $1.5 billion at June 30, 2014 from $1.6 billion at December 31, 2013. The decrease in investments during the six months ended June 30, 2014 was primarily driven by investment prepayments, which were used to fund the municipal deposit run-off and the growth in our loan portfolio. We continue to focus on maintaining a high quality investment portfolio that provides a steady stream of cash flows both in the current and in rising interest rate environments. Additionally, improving our balance sheet mix by reducing cash and investments and growing loans remains one of our priorities to help us grow net interest income and improve profitability. Loans increased $27.5 million, or 1.2%, to $2.4 billion at June 30, 2014 from $2.3 billion at December 31, 2013. Commercial loans increased $54.6 million due to strong commercial real estate growth. Commercial loans include shared national credits, which increased to $93.1 million during the year from $39.9 million at December 31, 2013. A weak housing market in the Philadelphia Metropolitan area contributed to lower mortgage loan originations resulting in an $8.8 million decrease in our residential 51 -------------------------------------------------------------------------------- Table of Contents loan portfolio. Our consumer loan categories continue to be impacted by weak demand and decreased $18.3 million during the year. Bank premises and equipment, net, increased $7.3 million to $79.1 million at June 30, 2014 from $71.8 million at December 31, 2013, primarily due to the move into our new headquarters location at 1818 Market Street and the opening of our new Maple Glen, Broomall and Rosemore campus locations during the year. Other assets decreased $12.7 million to $91.3 million at June 30, 2014 from $104.0 million at December 31, 2013 primarily due to a $7.3 million decline in the deferred tax asset and a $4.0 million decrease in other real estate owned during the year. Deposits decreased $154.6 million, or 4.2%, to $3.5 billion at June 30, 2014 from $3.7 billion at December 31, 2013. The decrease in deposits was primarily the result of a $155.2 million decrease in municipal deposits, which was consistent with the planned run-off associated with our re-pricing of higher-cost, non-relationship-based municipal accounts. At June 30, 2014, stockholders' equity decreased to $612.7 million, or 13.8% of total assets, compared to $615.1 million, or 13.4% of total assets, at December 31, 2013. This decrease was due to the repurchase of 1,748,090 shares of common stock during the period at a cost of $22.5 million, partially offset by a $7.0 million increase in retained earnings and an $8.5 million increase in other comprehensive income during the period. Comparison of Operating Results for the Three Months Ended June 30, 2014 and June 30, 2013 General - For the three months ended June 30, 2014, Net income was $4.6 million, or $0.06 per diluted share, compared to $2.9 million, or $0.04 per diluted share, for the three months ended June 30, 2013. Net Interest Income - For the three months ended June 30, 2014, net interest income was $29.2 million, a decrease of $2.0 million, or 6.4%, from the three months ended June 30, 2013. The decrease in net interest income was primarily the result of a decline in the average balance of investments and loans, coupled with a reduction in the average interest rate earned on loans, partially offset by a reduction in the average cost of deposits and average balance of municipal deposits. Net interest margin was relatively stable at 2.81% for the three months ended June 30, 2014 as compared to 2.83% for the same period in 2013. We expect that the continued low interest rate environment will put pressure on net interest margin in future periods but are focused on growing our loan portfolio and improving our balance sheet to help stabilize our net interest margin. Provision for Loan Losses - The provision for loan losses was $250 thousand for the three months ended June 30, 2014 compared to a provision of $5.0 million for the same period in 2013. The decrease in the provision for loan losses was the result of continued improvement in our asset quality including a $75.0 million decrease in criticized and classified loans, a $19.4 million decrease in delinquencies and a $3.3 million decrease in net charge-offs as of and for the three months ended June 30, 2014 compared to the same period in 2013. Net charge-offs totaled $1.7 million during the three months ended June 30, 2014 as compared to $5.0 million during the same period in 2013. Additionally non-performing assets decreased $41.1 million to $46.6 million at June 30, 2014 compared to $87.7 million at June 30, 2013. At June 30, 2014, our allowance for loan losses totaled $52.6 million, or 2.22% of total loans, compared to an allowance for loan losses of $55.6 million, or 2.38% of total loans, at December 31, 2013. Non-interest Income - For the three months ended June 30, 2014, non-interest income totaled $6.3 million, a decrease of $1.0 million, or 13.7%, from the three months ended June 30, 2013. The decrease was primarily due to a $710 thousand decrease in the gain on the sale of investment securities, a $396 thousand decrease in mortgage banking income due to our decision to retain some of our residential mortgage production, and a $278 thousand decrease in return check charges. These decreases to non- 52 -------------------------------------------------------------------------------- Table of Contents interest income were partially offset by a $743 thousand gain associated with a limited partnership investment. Non-interest Expense - For the three months ended June 30, 2014, non-interest expense totaled $29.2 million, a decrease of $1.1 million, or 3.5%, from the three months ended June 30, 2013. The decrease in non-interest expense was primarily due to a $1.3 million decrease in classified loan and other real estate owned expenses and a $377 thousand decrease in marketing expense, partially offset by a $436 thousand increase in salaries and employee benefits reflecting investments in our lending teams and risk and compliance functions. The decrease in classified loan and other real estate owned expenses was consistent with the reduction in the balance of non-performing assets and our improving asset quality metrics. Income Taxes - For the three months ended June 30, 2014, we recorded a provision for income taxes of $1.5 million, reflecting an effective tax rate of 24.7% compared to a provision for income taxes of $374 thousand, reflecting an effective tax rate of 11.4% for the three months ended June 30, 2013. The increase in income tax expense for the three months ended June 30, 2014 compared to the three months ended June 30, 2013 was due to higher profitability levels for the three months ended June 30, 2014. The tax rates differ from the statutory rate of 35% principally because of tax-exempt investments, non-taxable income related to bank-owned life insurance and tax credits received on affordable housing partnerships. These tax credits relate to investments maintained by the Bank as a limited partner in partnerships that sponsor affordable housing projects utilizing low-income housing credits pursuant to Section 42 of the Internal Revenue Code. 53 -------------------------------------------------------------------------------- Table of Contents The following table summarizes average balances and average yields and costs for the three months ended June 30, 2014 and June 30, 2013. Yields are not presented on a tax-equivalent basis. Any adjustments necessary to present yields on a tax-equivalent basis are insignificant. Average Balance Tables Three Months Ended June 30, Three Months Ended June 30, 2014 2013 Average Interest & Yield / Average Interest & Yield / (Dollars in thousands) Balance Dividends Cost Balance Dividends Cost Interest Earning Assets: Investment Securities: Overnight Investments $ 301,195 $ 190 0.25 % $ 322,787 $ 203 0.25 % Stock 15,902 219 5.45 % 18,519 12 0.27 % Other Investment securities 1,509,566 8,175 2.17 % 1,680,301 8,431 2.01 % Total Investment securities 1,826,663 8,584 1.88 % 2,021,607 8,646 1.71 % Loans: Real estate loans Residential 673,668 7,522 4.47 % 681,339 7,918 4.65 % Non-residential 584,285 7,307 4.96 % 598,151 7,713 5.16 % Total real estate 1,257,953 14,829 4.70 % 1,279,490 15,631 4.89 % Business loans 320,817 2,971 3.68 % 295,702 3,803 5.16 % Small Business loans 102,930 1,430 5.51 % 124,131 1,824 5.88 % Total Business & Small Business loans 423,747 4,401 4.12 % 419,833 5,632 5.37 % Total Business loans 1,008,032 11,708 4.61 % 1,017,984 13,345 5.25 % Personal loans 640,460 6,972 4.37 % 688,867 7,789 4.54 % Total loans, net of discount 2,322,160 26,202 4.50 % 2,388,190 29,052 4.87 % Total interest earning assets 4,148,823 34,786 3.35 % 4,409,797 37,698 3.42 % Non-interest earning assets 342,182 355,651 Total assets $ 4,491,005 $ 4,765,448 Interest Bearing Liabilities: Interest bearing savings and demand deposits: Savings and club accounts $ 1,155,229 $ 998 0.35 % $ 1,080,095 $ 1,171 0.43 % Money market accounts 440,830 350 0.32 % 482,617 471 0.39 % Demand deposits 677,371 346 0.20 % 671,938 415 0.25 % Demand deposits - Municipals 272,803 77 0.11 % 467,041 304 0.26 % Certificates of deposit 714,301 1,988 1.12 % 765,727 2,057 1.08 % Total interest-bearing deposits 3,260,534 3,759 0.46 % 3,467,418 4,418 0.51 % Borrowings 250,376 5,569 2.90 % 275,360 2,052 2.99 % Total interest-bearing liabilities 3,510,910 0.64 % 3,742,778 6,470 0.69 % Non-interest-bearing deposits 314,569 312,339 Other non-interest-bearing liabilities 53,387 79,219 Total liabilities 3,878,866 4,134,336 Total stockholders' equity 612,139 631,112 Total liabilities and stockholders' equity $ 4,491,005 $ 4,765,448 Net interest income $ 29,217 $ 31,228 Interest rate spread 2.71 % 2.73 % Net interest margin 2.81 % 2.83 % Average interest-earning assets to average interest-bearing liabilities 118.17 % 117.82 % 54 -------------------------------------------------------------------------------- Table of Contents Comparison of Operating Results for the Six Months Ended June 30, 2014 and June 30, 2013 General - For the six months ended June 30, 2014, Net income was $7.0 million, or $0.09 per diluted share, compared to net income of $6.1 million, or $0.08 per diluted share, for the six months ended June 30, 2013. Net Interest Income - For the six months ended June 30, 2014, net interest income was $58.7 million, a decrease of $4.0 million, or 6.4%, from the six months ended June 30, 2013. The decrease was primarily the result of a decline in the average balance of investments and loans, coupled with a reduction in the average interest rate earned on loans, partially offset by a reduction in the average cost of liabilities and a $200.5 million decrease in the average balance of municipal deposits during 2014. Our net interest margin decreased to 2.81% for the six months ended June 30, 2014 from 2.83% for the same period in 2013. Provision for Loan Losses - Provision for loan losses was $1.8 million for the six months ended June 30, 2014 compared to a provision of $10.0 million for the same period in 2013. The decrease in the provision for loan losses was the result of continued improvement in our asset quality including a $75.0 million decrease in criticized and classified loans, a $19.4 million decrease in delinquencies and a $4.2 million decrease in net charge-offs as of and for the six months ended June 30, 2014 compared to the same period in 2013. Net charge-offs totaled $4.8 million during the six months ended June 30, 2014 as compared to $9.0 million during the same period in 2013. Additionally non-performing assets decreased $41.1 million to $46.6 million at June 30, 2014 compared to $87.7 million at June 30, 2013. At June 30, 2014, our allowance for loan losses totaled $52.6 million, or 2.22% of total loans, compared to an allowance for loan losses of $55.6 million, or 2.38% of total loans, at December 31, 2013. Non-interest Income - For the six months ended June 30, 2014, non-interest income totaled $11.9 million, a decrease of $2.3 million, or 16.3%, from the six months ended June 30, 2013. The decrease was primarily due to a $1.3 million decrease in the gain on the sale of investment securities and a $512 thousand decrease in mortgage banking income due to our decision to retain some of our residential mortgage production. Non-interest Expense - For the six months ended June 30, 2014, non-interest expense totaled $60.4 million, an increase of $455 thousand, or 0.8%, from the six months ended June 30, 2013. The increase in non-interest expense was primarily driven by a $1.5 million increase in salaries and employee benefits, reflecting investments in our lending teams and risk and compliance functions, a $1.0 million increase in occupancy expenses, which were driven by snow removal expenses and duplicate rent costs for our headquarters during the first quarter related to the move, and a $1.1 million increase in other expenses related to one time headquarter moving costs, partially offset by a $2.1 million decrease in classified loan and other real estate owned expenses and a $493 thousand decrease in professional fees. Income Taxes - For the six months ended June 30, 2014, the provision for income taxes was $1.4 million, reflecting an effective tax rate of 16.9% compared to a provision for income taxes of $949 thousand reflecting an effective tax rate of 13.4% for the six months ended June 30, 2013. The increase in income tax expense and the effective tax rate was due to higher profitability levels for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. The tax rates differ from the statutory rate of 35% principally because of tax-exempt investments, non-taxable income related to bank-owned life insurance and tax credits received on affordable housing partnerships. These tax credits relate to investments maintained by the Company as a limited partner in partnerships that sponsor affordable housing projects utilizing low-income housing credits pursuant to Section 42 of the Internal Revenue Code. 55 -------------------------------------------------------------------------------- Table of Contents The following table summarizes average balances and average yields and costs for the six months ended June 30, 2014 and June 30, 2013. Yields are not presented on a tax-equivalent basis. Any adjustments necessary to present yields on a tax-equivalent basis are insignificant. Average Balance Tables Six Months Ended June 30, Six Months Ended June 30, 2014 2013 Average Interest & Yield / Average Interest & Yield / (Dollars in thousands) Balance Dividends Cost Balance Dividends Cost Interest Earning Assets: Investment Securities: Overnight Investments $ 302,731 $ 379 0.25 % $ 307,022 $ 384 0.25 % Stock 16,653 372 4.44 % 17,623 38 0.44 % Other Investment securities 1,529,659 16,479 2.15 % 1,693,897 16,530 1.95 % Total Investment securities 1,849,043 17,230 1.86 % 2,018,542 16,952 1.68 % Loans: Real estate loans Residential 676,014 15,247 4.51 % 676,404 15,865 4.69 % Non-residential 566,769 13,890 4.88 % 621,638 15,793 5.09 % Total real estate 1,242,783 29,137 4.68 % 1,298,042 31,658 4.88 % Business loans 328,189 6,476 3.93 % 292,731 7,611 5.21 % Small Business loans 104,811 2,998 5.70 % 127,440 3,754 5.91 % Total Business & Small Business loans 433,000 9,474 4.36 % 420,171 11,365 5.42 % Total Business loans 999,769 23,364 4.66 % 1,041,809 27,158 5.23 % Personal loans 645,104 14,049 4.39 % 694,272 15,685 4.56 % Total loans, net of discount 2,320,887 52,660 4.54 % 2,412,485 58,708 4.88 % Total interest earning assets 4,169,930 69,890 3.35 % 4,431,027 75,660 3.42 % Non-interest earning assets 345,648 365,191 Total assets $ 4,515,578 $ 4,796,218 Interest Bearing Liabilities: Interest bearing savings and demand deposits: Savings and club accounts $ 1,143,677 $ 1,979 0.35 % $ 1,065,806 $ 2,311 0.44 % Money market accounts 443,381 699 0.32 % 489,213 952 0.39 % Demand deposits 676,264 687 0.20 % 664,563 852 0.26 % Demand deposits - Municipals 305,171 178 0.12 % 505,644 667 0.27 % Certificates of deposit 721,359 3,989 1.12 % 772,945 4,180 1.09 % Total interest-bearing deposits 3,289,852 7,532 0.46 % 3,498,171 8,962 0.52 % Borrowings 250,408 3,611 2.91 % 266,440 3,905 2.96 % Total interest-bearing liabilities 3,540,260 11,143 0.63 % 3,764,611 12,867 0.69 % Non-interest-bearing deposits 309,452 309,610 Other non-interest-bearing liabilities 52,032 90,061 Total liabilities 3,901,744 4,164,282 Total stockholders' equity 613,834 631,936 Total liabilities and stockholders' equity $ 4,515,578 $ 4,796,218 Net interest income $ 58,747 $ 62,793 Interest rate spread 2.72 % 2.73 % Net interest margin 2.81 % 2.83 % Average interest-earning assets to average interest-bearing liabilities 117.79 % 117.70 % 56 -------------------------------------------------------------------------------- Table of Contents Asset Quality At June 30, 2014, non-performing assets decreased $35.4 million to $46.6 million from $82.0 million at December 31, 2013. The ratio of non-performing assets to total assets decreased to 1.05% at June 30, 2014 from 1.79% at December 31, 2013. ASSET QUALITY INDICATORS (Unaudited) June 30, March 31, December 31, June 30, (Dollars in thousands) 2014 2014 2013 2013 Non-performing assets: Non-accruing loans* $ 27,782 $ 48,127 $ 51,765 $ 57,937 Accruing government guaranteed student loans past due 90 days or more 16,819 20,236 24,410 22,516 Total non-performing loans 44,601 68,363 76,175 80,453 Real estate owned 2,008 4,039 5,861 7,197 Total non-performing assets $ 46,609 $ 72,402 $ 82,036 $ 87,650 Non-performing loans to total loans 1.88 % 2.94 % 3.25 % 3.37 % Non-performing assets to total assets 1.05 % 1.60 % 1.79 % 1.86 % Non-performing assets, excluding government guaranteed student loans, to total assets 0.67 % 1.15 % 1.26 % 1.39 % ALLL to total loans 2.22 % 2.32 % 2.38 % 2.46 % ALLL to non-performing loans 117.99 % 79.08 % 73.05 % 72.91 % ALLL to non-performing loans, excluding government guaranteed student loans 189.42 % 112.33 % 107.50 % 101.25 % -------------------------------------------------------------------------------- * Non-accruing loans include $6.0 million, $15.8 million, $18.3 million, and $20.1 million of troubled debt restructured loans (TDRs) as of June 30, 2014, March 31, 2014, December 31, 2013, and June 30, 2013, respectively. During the second quarter of 2014, the Company sold $11.3 million of non-performing commercial loans and recorded a $913 thousand net recovery. At June 30, 2014, the commercial loan portfolio included approximately $6.3 million of non-performing loans held for sale as of June 30, 2014 that are expected to be sold during the third quarter of 2014. These loans are being carried at the lower of cost or market. With the exception of government guaranteed student loans, we place loans on non-performing status at 90 days delinquent or sooner if management believes the loan has become impaired (unless return to current status is expected imminently). The accrual of interest is discontinued and reversed once an account becomes past due 90 days or more. The uncollectible portion including any cash flow or collateral deficiency of all loans is charged-off at 90 days past due or when we have confirmed there is a loss. Non-performing consumer loans include $16.8 million and $24.4 million in government guaranteed student loans as of June 30, 2014 and December 31, 2013, respectively. Non-performing loans are evaluated under authoritative guidance in FASB ASC Topic 310 for Receivables and Topic 450 for Contingencies and are included in the determination of the allowance for loan losses. The Company charges-off the collateral or discounted cash flow deficiency on all loans at 90 days past due, as a result, no specific valuation allowance was maintained at June 30, 2014 or December 31, 2013 for non-performing loans. If necessary, specific reserves are established for estimated losses in determination of the allowance for loan loss. During the six months ended June 30, 2014, real estate owned decreased $3.9 million to $2.0 million at June 30, 2014 from $5.9 million at December 31, 2013 as we continue to manage and sell these properties. 57 -------------------------------------------------------------------------------- Table of Contents Allowance for Loan Losses The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated: June 30, 2014 December 31, 2013 (Dollars in thousands) Loan Balance ALLL Coverage LoanBalance ALLL Coverage Commercial $ 1,055,431 $ 42,300 4.01 % $ 1,000,863 $ 44,578 4.45 % Residential 675,228 1,986 0.29 % 683,977 2,200 0.32 % Consumer 638,676 7,788 1.22 % 656,967 8,321 1.27 % Unallocated - 550 - % - 550 - % Total $ 2,369,335 $ 52,624 2.22 % $ 2,341,807 $ 55,649 2.38 % The allowance for loan losses is a valuation allowance for probable losses inherent in the loan portfolio. We evaluate the appropriateness of the allowance for loan losses balance on loans on a quarterly basis. When additional allowances are necessary, a provision for loan losses is charged to earnings. Our methodology for assessing the appropriateness of the allowance for loan losses consists of: (1) a specific valuation allowance on identified problem loans; (2) a general valuation allowance on the remainder of the loan portfolio; and (3) an unallocated component. Management established an unallocated reserve to cover uncertainties that the Company believes have resulted in losses that have not yet been allocated to specific elements of the general component. Such factors include uncertainties in economic conditions and in identifying triggering events that directly correlate to subsequent loss rates, changes in the appraised value of underlying collateral, risk factors that have not yet manifested themselves in loss allocation factors and historical loss experience data that may not precisely correspond to the current portfolio or economic conditions. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodology for estimating general losses in the portfolio. The appropriate allowance level is estimated based upon factors and trends identified by the Company at the time the consolidated financial statements are prepared. Management regularly monitors the condition of borrowers and assesses both internal and external factors in determining whether any relationships have deteriorated considering factors such as historical loss experience, trends in net charge-offs, delinquent and criticized and classified loans, changes in risk composition and underwriting standards, experience and ability of staff and regional and national economic conditions and trends. Our credit officers and workout group identify and manage potential problem loans for our loan portfolio. Changes in management, financial and operating performance, company behavior, industry factors and external events and circumstances are evaluated on an ongoing basis to determine whether potential impairment is evident and additional analysis is needed. For our commercial loan portfolio, risk ratings are assigned to each individual loan to differentiate risk within the portfolio and are reviewed on an ongoing basis by credit risk management and revised, if needed, to reflect the borrowers' current risk profiles and the related collateral positions. The risk ratings consider factors such as financial condition, debt capacity and coverage ratios, market presence and quality of management. When a credit's risk rating is downgraded to a certain level, the relationship must be reviewed and detailed reports completed that document risk management strategies for the credit going forward, and the appropriate accounting actions to take in accordance with GAAP. When credits are downgraded beyond a certain level, our workout department becomes responsible for managing the credit risk. Risk rating actions are generally reviewed formally by one or more Credit Committees depending on the size of the loan and the type of risk rating action being taken. Our commercial, consumer and residential loans are monitored for credit risk and deterioration considering factors such as delinquency, loan to value, and credit scores. When problem loans are identified that are secured with collateral, management examines the loan files to evaluate the nature and type of collateral supporting the loans. Management documents the collateral type, date of the most recent valuation, and whether any liens exist, to determine the value to compare 58 -------------------------------------------------------------------------------- Table of Contents against the committed loan amount. If a loan is identified as impaired and is collateral dependent, an updated appraisal is obtained to provide a baseline in determining the property's fair market value, a key input into the calculation to measure the level of impairment, and to establish a specific reserve or charge-off the collateral deficiency. If the collateral value is subject to significant volatility (due to location of asset, obsolescence, etc.) an appraisal is obtained more frequently. In-house evaluations are typically performed on at least a quarterly basis and updated appraisals are obtained annually, if determined necessary. When we determine that the value of an impaired loan is less than its carrying amount, we recognize impairment through a charge-off to the allowance. We perform these assessments on at least a quarterly basis. For commercial loans, a charge-off is recorded when management determines we will not collect 100% of a loan based on the fair value of the collateral, less costs to sell the property, or the net present value of expected future cash flows. Charge-offs are recorded on a monthly basis and partially charged-off loans continue to be evaluated on a monthly basis. The collateral deficiency on consumer loans and residential loans are generally charged-off when deemed to be uncollectible or delinquent 90 days or more, whichever comes first, unless it can be clearly demonstrated that repayment will occur regardless of the delinquency status. Examples that would demonstrate repayment include a loan that is secured by adequate collateral and is in the process of collection, a loan supported by a valid guarantee or insurance, or a loan supported by a valid claim against a solvent estate. Consumer loan delinquency includes $16.8 million and $24.4 million in government guaranteed student loans at June 30, 2014 and December 31, 2013, respectively. Additionally, we reserve for certain inherent, but undetected, losses that are probable within the loan portfolio. This is due to several factors, including, but not limited to, inherent delays in obtaining information regarding a customer's financial condition or changes in their unique business conditions and the interpretation of economic trends. While this analysis is conducted at least quarterly, we have the ability to revise the allowance factors whenever necessary in order to address improving or deteriorating credit quality trends or specific risks associated with a given loan pool classification. Regardless of the extent of our analysis of customer performance, portfolio evaluations, trends or risk management processes established, a level of imprecision will always exist due to the judgmental nature of loan portfolio and/or individual loan evaluations. We maintain an unallocated allowance to recognize the existence of these exposures. These risk factors are continuously reviewed and revised by management where conditions indicate that the estimates initially applied are different from actual results. We perform a comprehensive analysis of the allowance for loan losses on a quarterly basis. In addition, a review of allowance levels based on nationally published statistics is conducted quarterly. The factors supporting the allowance for loan losses do not diminish the fact that the entire allowance for loan losses is available to absorb losses in the loan portfolio and related commitment portfolio, respectively. Our principal focus, therefore, is on the adequacy of the total allowance for loan losses. The allowance for loan losses is subject to review by banking regulators. Our primary bank regulators regularly conduct examinations of the allowance for loan losses and make assessments regarding their appropriateness and the methodology employed in their determination. Our regulators may require the allowance for loan losses to be increased based on their review of information at the time of their examination. Commercial Portfolio. The portion of the allowance for loan losses related to the commercial portfolio totaled $42.3 million or 4.0% of commercial loans at June 30, 2014, which decreased from $44.6 million or 4.5% of commercial loans at December 31, 2013. We experienced a $49.9 million decrease in criticized and classified commercial loans to $82.6 million at June 30, 2014 compared to $132.5 million at December 31, 2013. We have also seen stabilization in commercial delinquencies and net charge-offs over the past twelve months with net charge-offs decreasing to $4.3 million for the six month ending June 30, 2014 compared to $9.0 million for the six months ending June 30, 2013. We continue to charge-off any cash flow or collateral deficiency for non-performing loans once a loan is 90 days past due. We believe the decrease in the commercial reserve was appropriate given the decrease in criticized and classified loans since year end and the decrease in delinquencies and net charge-offs year over year. 59 -------------------------------------------------------------------------------- Table of Contents Residential Loans. The allowance for the residential loan portfolio was $2.0 million, or 0.29% of residential loans, at June 30, 2014 down from $2.2 million, or 0.32% of residential loans, at December 31, 2013. Our residential loan delinquencies decreased $773 thousand, or 11.8%, to $5.8 million at June 30, 2014 from $6.5 million at December 31, 2013 and net charge-offs remain low at $315 thousand for the six months ending June 30, 2014 compared to $188 thousand for the six months ending June 30, 2013. We believe the balance of residential reserves was appropriate given the decrease in delinquencies and continued low charge-off levels. Consumer Loans. The allowance for the consumer loan portfolio decreased $533 thousand to $7.8 million, or 1.2% of consumer loans, at June 30, 2014 compared to $8.3 million, or 1.3% of consumer loans, at December 31, 2013. Net charge-offs remain low for this portfolio at $575 thousand for the six months ending June 30, 2014 compared to $639 thousand for the six months ending June 30, 2013 and delinquencies have been stable year over year. We believe the decrease in the consumer reserve was appropriate based on the overall decrease in consumer loan delinquencies during the year and the decrease in net charge-offs year over year. The allowance for loan losses is maintained at levels that management considers appropriate to provide for losses based upon an evaluation of known and inherent risks in the loan portfolio. Management's evaluation takes into consideration the risks inherent in the loan portfolio, past loan loss experience, specific loans with loss potential, geographic and industry concentrations, delinquency trends, economic conditions, the level of originations and other relevant factors. While management uses the best information available to make such evaluations, future adjustments to the allowance for credit losses may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses will not be necessary should the quality of loans deteriorate as a result of the factors described above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations. Liquidity, Contractual Obligations, Capital and Credit Management Liquidity Management - Liquidity is the ability to meet current and future financial obligations of a short-term nature. The Bank's primary investing activities are the origination and purchase of loans and the purchase of securities. The Bank's primary sources of funds consist of deposits, loan repayments, maturities of and payments on investment securities and borrowings from the Federal Home Loan Bank of Pittsburgh and the Federal Reserve Bank of Philadelphia. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposits and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. We generally manage the pricing of our deposits to be competitive. Occasionally, we offer promotional rates on certain deposit products to attract deposits. The Bank regularly adjusts its investments in liquid assets based upon its assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities and (4) the objectives of its asset/liability management policy. The Bank's most liquid assets are cash and cash equivalents. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At June 30, 2014, cash and cash equivalents totaled $254.0 million. In addition, at June 30 2014, the Bank had the ability to borrow up to $1.2 billion combined from the FHLB of Pittsburgh and the Federal Reserve Bank of Philadelphia. At June 30, 2014, the Bank had $195.0 million of advances outstanding with the FHLB. A significant use of the Bank's liquidity is the funding of loan originations. At June 30, 2014, the Bank had $242.5 million in loan commitments outstanding, which consisted of $32.2 million and $6.6 million in commercial and consumer commitments to fund loans, respectively, $191.8 million in commercial and consumer unused lines of credit, and $11.9 million in standby letters of credit. Another significant use of the Bank's liquidity is the funding of deposit withdrawals. Certificates of deposit due within one year of 60 -------------------------------------------------------------------------------- Table of Contents June 30, 2014 totaled $391.7 million, or 55.7% of certificates of deposit and 11.7% of total deposits. The large percentage of certificates of deposit that mature within one year reflects customers' hesitancy to invest their funds for long periods in the current low interest rate environment. If these maturing deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit, brokered deposits and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due on or before June 30, 2015. We have the ability to attract and retain deposits by adjusting the interest rates offered. The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company has not paid any dividends to shareholders in the past. The Company has repurchased shares of its common stock. The amount of dividends that the Bank may declare and pay to the Company is generally restricted under Pennsylvania law to the retained earnings of the Bank. At June 30, 2014, the Company (stand-alone) had liquid assets of $18.7 million. Contractual Obligations - The following table presents certain of our contractual obligations at June 30, 2014: Payments due by period Less than One to Three to More than (Dollars in thousands) Total One Year Three Years Five Years Five Years Borrowed Funds $ 250,379 $ 60,000 $ 145,000 $ 20,000 $ 25,379 Commitments to fund loans 38,799 38,799 - - - Unused lines of credit 191,770 124,374 8,530 29,593 29,273 Standby letters of credit 11,930 10,208 702 20 1,000 Operating lease obligations 58,768 5,382 9,689 8,263 35,434 Total $ 551,646 $ 238,763 $ 163,921 $ 57,876 $ 91,086 The Bank's primary investing activities are the origination and purchase of loans and the purchase of securities. The Bank's primary financing activities consist of activity in deposit accounts, repurchase agreements and FHLB advances. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our competitors and other factors. We generally manage the pricing of our deposits to be competitive. Occasionally, we offer promotional rates on certain deposit products to attract deposits. Capital Management - The Bank is subject to various regulatory capital requirements administered by the Federal Deposit Insurance Corporation, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At June 30, 2014, the Bank exceeded all of our regulatory capital requirements and was considered "well capitalized" under the regulatory guidelines. Credit Risk Management. The objective of our credit risk management strategy is to quantify and manage credit risk, as well as to limit the risk of loss resulting from an individual customer default. Our credit risk management strategy focuses on conservatism, diversification within the loan portfolio and monitoring. Our lending practices include conservative exposure limits and underwriting, documentation, and collection standards. Our credit risk management strategy also emphasizes diversification on an industry and customer level as well as regular credit examinations and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. The Board of Directors has granted loan approval authority to certain officers or groups of officers up to prescribed limits, based on an officer's experience and tenure. Generally, all individual commercial loans and lending relationships between $3.0 million and $15.0 million must be approved by the Loan Committee, which is comprised of personnel from the Credit, Finance and Lending departments. Individual loans or lending relationships with aggregate exposure in excess of $15.0 million must be approved by the Director Risk Committee of the Company's 61 -------------------------------------------------------------------------------- Table of Contents Board, which is comprised of senior Bank officers and five non-employee directors. Underwriting activities are centralized. Our credit risk review function provides objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, non-accrual and reserve analysis process. Our credit review process and overall assessment of required allowances is based on quarterly assessments of the probable estimated losses inherent in the loan portfolio. We use these assessments to identify potential problem loans within the portfolio, maintain an adequate reserve and take any necessary charge-offs. We charge off the collateral or cash flow deficiency on all loans once they become 90 days delinquent. Generally, all consumer loans are charged-off once they become 90 days delinquent except for education loans as they are guaranteed by the government and there is little risk of loss. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of an enhanced risk grading system. This risk grading system is consistent with Basel II expectations and allows for precision in the analysis of commercial credit risk. Historical portfolio performance metrics, current economic conditions and delinquency monitoring are factors used to assess the credit risk in our homogenous commercial, residential and consumer loan portfolios. In order to mitigate the credit risk related to the Company's held-to-maturity and available-for-sale portfolios, the Company monitors the ratings of its securities. As of June 30, 2014, approximately 94.5% of the Company's portfolio consisted of direct government obligations, government sponsored enterprise obligations or securities rated AAA by Moody's and/or S&P. In addition, at June 30, 2014, approximately 4.2% of the investment portfolio was non-agency securities, rated below AAA but rated investment grade by Moody's and/or S&P and approximately 1.3% of the investment portfolio was not rated. Securities not rated consist primarily of short-term municipal anticipation notes, private placement municipal bonds, equity securities, mutual funds and bank certificates of deposit. Off-Balance Sheet Arrangements In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our consolidated financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers' requests for funding and take the form of loan commitments and lines of credit. See "Liquidity Management" for further discussion regarding loan commitments and unused lines of credit. For the six months ended June 30, 2014, we did not engage in any off-balance sheet transactions reasonably likely to have a material effect on our financial condition, results of operations or cash flows. |