TRI CITY BANKSHARES CORPORATION. ANNUAL REPORT Audited Consolidated Financial Statements

Transcription

1 TRI CITY BANKSHARES CORPORATION ANNUAL REPORT Audited Consolidated Financial Statements 2015

2 Dear Shareholder, As we look back on 2015, we are pleased to report that job number one loan growth discussed in last year s shareholder letter, resulted in a $40 million increase to our bank s loan portfolio for the year ended December 31, Directors, management and our lenders continue to focus on acquiring high quality, new business loans to grow the portfolio. It should be noted that $40 million is net loan growth, which required closing over $200 million in new loans during the year. Loan payments and loan payoffs reduce our outstanding loan balances significantly each month, with some reduction driven by our management team to eliminate problem credits. We are pleased to report continued success in that area as well, as loans past due 30 days or more declined to less than $8 million at year end, compared to $19 million at year end As a reference for you as a shareholder, please recognize that this is every past due loan over 30 days late, not just the 90+ day past due category typically measured. Even more significantly, the total is less than year-end 2008, which was prior to our acquisition of a failed bank from the FDIC. The selected financial data in this annual report shows other positive results as well. Total assets stood at a record of $1.33 billion as of December 31, 2015, funded through continued deposit growth at a record high total of $1.2 billion and the largest equity ever held by the Corporation at $134 million. Dividends were resumed in 2015 with the Board of Directors mindful of our continuing philosophy of maintaining a strong capital base. So I am pleased to announce that the future is bright for a company that looks quite a bit different than the bank I joined in From three locations and less than $20 million in total assets, we have come a long way indeed since then. Your support of Tri City Bankshares has made this possible along with the efforts of the hundreds of Tri City bankers I have been privileged to work with. I will be retiring following the annual shareholder meeting in June. I am fortunate to have had your support and thank you for over forty-four years of opportunity and growth. The Board of Director s has honored me with an on-going role as Chairman Emeritus and I will be pleased to provide my experience and insight to management and the Board in the future. The Board has selected my successor, Mr. Brian T. McGarry, to become Chairman and Chief Executive Officer of both Tri City Bankshares and the subsidiary bank. His election will become official at the July board meetings. Mr. McGarry is already known to shareholders as a former Vice President, current Director and as a member of the family of our founder, David A. Ulrich. He will lead our executive team to continued success for the benefit of all shareholders as we continue to enhance our profitability and your investment for years to come. Very truly yours, TRI CITY BANKSHARES CORPORATION Ronald K. Puetz Chairman of the Board Chief Executive Officer

3 Management s Discussion and Analysis of Financial Condition and Results of Operations The following discussion provides management s analysis of the audited consolidated financial statements of Tri City Bankshares Corporation (the Corporation ) and should be read in conjunction with those financial statements. This discussion focuses on significant factors that affected the Corporation s financial performance in 2015, with comparisons to 2014 and to 2013 where applicable. For all periods presented, the operations of Tri City National Bank (the Bank ) contributed substantially all of the Corporation s revenues and expenses. Included in the operations of the Bank are the activities of its wholly-owned subsidiaries, Tri City Capital Corporation and Title Service of Southeast Wisconsin, Inc. This report contains statements that may constitute forward-looking statements that speak of the Corporation s plans, goals, beliefs or expectations, refer to estimates or use similar terms. Forward-looking statements are subject to significant risks and uncertainties. The Corporation s actual results may differ materially from the results discussed in such forward-looking statements. Performance Summary The Corporation posted net income of $10.6 million during 2015, an increase of $1.9 million, or 21.3%, from Earnings per share were $1.19 during 2015 compared to $0.98 in The increase in earnings was due to a $4.2 million increase in non-interest income which was partially offset by a $0.1 million decrease in net interest income and a $0.7 million increase in operating expenses. The provision for loan losses was unchanged. The $0.1 million decrease in net interest income was due to a decrease in interest income on investments which was partially offset by an increase on interest income on loans and a decrease in interest paid on deposits. The low interest rate environment continued to put downward pressure on our net interest margin which was partially offset by increases interest income on loans due to strong loan growth in The increase in non-interest income was primarily due to a sale of $43.4 million of investments in the second quarter of 2015 which resulted in a gain on sale of investments of $2.9 million. In addition, there was an increase in acquisition-related purchase accounting income compared The increase in non-interest income was partially offset by a death benefit on bank owned life insurance of $0.3 million in 2015 compared to $1.0 million in The increase in operating expenses was primarily due to an increase in salary and benefits as management invested in additional experienced lending and compliance personnel. The increase in salary and benefits was partially offset by a decrease in the expenses related to the operation of other real estate owned. The Corporation s total assets increased $80.4 million, or 6.4%, from $1,251.9 million at December 31, 2014 to $1,332.3 million at December 31, The increase in total assets was due to an increase in investment securities and loans outstanding which was partially offset by a decrease in cash and due from banks. The $40.0 million increase in total loans outstanding is especially important as management has focused on redeploying the Bank s excess liquidity into loans. The growth on the asset side of the balance sheet was funded by a $74.6 million increase in core deposits and a $5.9 million increase in total stockholders equity. Asset quality improved as nonperforming loans, excluding purchased credit impaired loans, were $10.4 million as of December 31, 2015 which was down significantly from $20.5 million as of December, At December 31, 2015, the allowance for loan losses was $11.6 million which was 1.59% of total loans and covered 103.3% of nonperforming loans. In addition, the Bank had 7 properties in other real estate owned with a total balance of $3.2 million as of December 21, 2015 compared to 20 properties with a total balance of $4.8 million as of December 31, Dividends of $0.48 per share were paid in 2015 following no dividends paid in 2013 or 2014 as the Corporation paid a special dividend of $1.70 per share in December of A key factor in receiving regulatory approval to pay the special dividend in 2012 was the Board s commitment to return to capital levels which existed before the special dividend was paid. Earnings in 2013 and 2014 accomplished that goal resulting in the reinstatement of regular quarterly dividend payments during The Corporation has a long history of maintaining capital ratios in excess of the levels required to be considered well capitalized. This philosophy is unchanged. However, new capital rules for banks which became effective January 1, 2015 have increased the capital required for this classification and added additional capital buffer requirements to be phased-in through The Board of Directors is confident shareholders agree that maintaining a strong capital base for the Bank is a prime objective of Board oversight. The Board will review earnings, on-going regulatory requirements and other factors when approving dividends, just as they have done every quarter throughout our history. On October 23, 2009, the Bank was the successful bidder for the Bank of Elmwood ( Acquired Bank ) through an FDIC-assisted purchase (the Acquisition ). The Acquisition has positively impacted the earnings performance of the Bank. 2

4 INCOME STATEMENT ANALYSIS Table 1 provides average balances of interest-earning assets and interest-bearing liabilities, the interest income and expense resulting from each, and the calculated interest rates earned and paid. The table further shows net interest income, interest rate spread, and the net interest margin on a tax-equivalent basis for the years ended December 31, 2015, 2014 and Table 1 AVERAGE BALANCES AND INTEREST RATES (Interest rates on a tax-equivalent basis) (Dollars in Thousands) ASSETS Interest earning assets: Average Yield or Average Yield or Average Yield or Balance Interest Cost Balance Interest Cost Balance Interest Cost Loans (1) $ 701,609 $ 32, % $ 678,518 $ 32, % $ 687,577 $ 36, % Taxable investment securities (2) 329,557 6, % 334,105 7, % 290,758 2, % Non taxable investment securities 45,971 1, % 47,378 1, % 44,093 1, % Other money market instruments 96, % 54, % 71, % Fed funds sold 1, % 2, % 9, % Total interest-earning assets 1,174,515 41, % 1,116,618 41, % 1,102,978 40, % Noninterest-earning assets 81,845 77,068 80,374 TOTAL ASSETS $ 1,256,360 $ 1,193,686 $ 1,183,352 LIABILITIES AND EQUITY Interest-bearing liabilities: Transaction accounts $ 324, % $ 309, % $ 292, % Money market 242, % 224, % 224, % Savings deposits 220, % 210, % 206, % Other time deposits 108, % 124, % 154,347 1, % Short-term borrowing % % % Total interest-bearing liabilities 895,145 1, % 869,192 1, % 878,253 1, % Demand deposits 220, , ,613 Other 10,209 8,080 8,962 Stockholders equity 130, , ,524 Total liabilities and stockholders Equity $ 1,256,360 $ 1,193,686 $ 1,183,352 Net interest earnings and interest rate spread (3) $ 40, % $ 40, % $ 38, % Net interest margin (4) 3.43% 3.61% 3.53 % Table 1 1. The average loan balances and rates include non-accrual loans. 2. The interest income on tax exempt securities is computed on a tax-equivalent basis using a tax rate of 34% for all periods presented. 3. Interest rate spread represents the difference between the average yield earned on average interest-earning assets for the period and the average rate accrued on average interest-bearing liabilities for the period and is represented on a tax-equivalent basis. 4. Net interest margin represents net interest income for a period divided by average interest-earning assets for the period and is represented on a tax-equivalent basis. 3

5 The following table sets forth, for the periods indicated, a summary of the changes in interest earned on a fully tax-equivalent basis and interest paid resulting from changes in volume and rates: Table 2 NET INTEREST INCOME AND EXPENSE VOLUME AND RATE CHANGE (Dollars in Thousands) 2015 Compared to 2014 Increase (Decrease) Due to 2014 Compared to 2013 Increase (Decrease) Due to Volume Rate(1) Net Volume Rate(1) Net Interest earned on: Loans $ 1,113 $ (934) $ 179 $ (475) $ (2,839) $ (3,314) Taxable investment securities (96) (370) (466) 439 3,649 4,088 Non-taxable investment (52) 5 (47) 125 (58) 67 Other money market instruments (41) - (41) Fed funds sold (1) - (1) (7) - (7) Total interest-earning assets $ 1,068 $ (1,286) $ (218) $ 41 $ 752 $ 793 Interest paid on: Transaction accounts $ 9 $ (8) $ 1 $ 12 $ (36) $ (24) Money market (128) (128) Savings deposits 3 (10) (7) 2 (18) (16) Time deposits (94) (80) (174) (226) (236) (462) Short-term borrowings Total interest-bearing liabilities $ (59) $ (82) $ (141) $ (212) $ (418) $ (630) Increase (decrease) in net interest income $ 77 $ 1,423 (1) The change in interest due to both rate and volume has been allocated to rate changes. Net Interest Income Total interest income on loans increased $0.2 million, or 0.5% during 2015 compared to the same period in The increase was due to an increase in loan volume that was partially offset by a decrease in rate due to the continued low interest rate environment. Average loans increased $23.1 million, or 3.4%, during 2015 due primarily due to an increase in commercial and commercial real estate loans. Loan yields decreased 13 basis points to 4.69% during 2015 compared to 4.82% in 2014, as new and renewed loans were booked at lower interest rates than the existing portfolio. Interest income on loans was negatively affected by a $0.1 million decrease in purchase accounting income related to the Acquisition from $1.2 million during 2014 to $1.1 million during Loan discount accretion on noncredit impaired loans is realized as the Acquired Bank s loan portfolio continues to amortize, mature, renew or pay off. Interest income on loans during 2015, excluding loan discount accretion, increased by $0.3 million compared to same period in The remaining interest income on earning assets includes tax equivalent interest income on taxable investment securities, nontaxable investment securities, other money market instruments and Fed funds sold. As a group, interest income on a tax-equivalent basis decreased $0.4 million to $8.5 million during 2015 compared to the same period in This change reflects an increase in the volume of those assets that was more than offset by a decrease in yield. Total average investment securities increased $34.8 million to $472.9 million as of December 31, 2015 primarily due to an increase in other money market instruments which is the Bank s excess liquidity invested at the Federal Reserve. The average tax equivalent yield on investments decreased 23 basis points to 1.80% during 2015 compared to 2.03% for the same period in The decrease in the average tax equivalent yield was primarily due to the sale of $43.4 million mortgage backed securities for a gain of $2.9 million. The proceeds from the sale were reinvested at lower yields. In addition, the increased balances held at the Federal Reserve, which earned 0.25% for most of the year until December when the yield increased to 0.50%, also lowered the overall yield on our investments portfolio. Interest expense during 2015 decreased $0.1 million or 10.9%, compared to the same period in The decrease in interest expense was due to a decrease in rates that was partially offset by an increase in volume. The average yield on interest-bearing liabilities decreased 2 basis points to 0.13% during 2015 compared to 0.15% in Average interest-bearing liabilities increased $25.9 million or 3.0% to $895.1 million in 2015 from $869.2 million in The increase was in all interest bearing liabilities with the exception of other time deposits as customers continued to shift into floating rate deposits rather than locking into longer term fixed rate certificate of deposits at very low interest rates. 4

6 Net interest income in the consolidated statements of income (which excludes the tax-equivalent adjustment) was $39.7 million in both 2015 and The tax equivalent adjustments (adjustments needed to bring tax-exempt interest to a level that would yield the same after-tax income had that income been subject to taxation using a 34% tax rate) of $0.6 million for both 2015 and 2014 resulted in a taxequivalent net interest income of $40.3 million for both 2015 and The tax-equivalent net interest margin for 2015 was 3.43% compared to 3.61% during Total interest income on loans decreased $3.3 million, or 9.2%, during 2014 compared to the same period in The decrease was due to both a reduction in average loans and the low interest rate environment. The decrease in interest income on loans was also due to a $1.3 million decrease in purchase accounting income related to the Acquisition from $2.5 million during 2013 to $1.2 million during The remaining interest income on earning assets includes tax equivalent interest income on taxable investment securities, nontaxable investment securities, other money market instruments and Fed funds sold. As a group, interest income on a tax-equivalent basis increased $4.1 million to $8.9 million during 2014 compared to the same period in This change reflects both an increase in volume and an increase in yield. Interest expense during 2014 decreased $0.6 million, or 32.9% compared to the same period in 2013.The decrease in interest expense was due to both a decrease in volume and rate. Net interest income on a tax-equivalent basis was $40.3 million in 2014 compared to $38.9 million in The tax-equivalent net interest margin for 2014 was 3.61% compared to 3.53% during Provision for Loan Losses The provision for loans losses ( PLL ) results from the assessment of qualitative and quantitative factors to determine the required allowance for loan losses ( ALL ). Factors considered are the size of the portfolio, levels of nonperforming loans, historical losses, risk inherent in certain categories of loans, concentrations of loans to certain borrowers or certain industry segments, economic trends, collateral pledged, and other factors that could affect loan losses as discussed in the paragraphs following Table 8. The PLL represents the amount periodically added to the Bank s ALL and charged to earnings in the relevant period. The PLL for both 2015 and 2014 was $3.0 million, a decrease from $6.5 million in The fluctuations in the PLL reflect the charge-off activity, net of recoveries on loans previously charged off as well as the level of non-performing loans. Net charge-offs were $3.5 million in 2015, $3.3 million in 2014 and $6.3 million in 2013 Non-interest Income A summary of non-interest income for the years ended December 31, 2015, 2014 and 2013 appear in Table 3 below: Table 3 NON-INTEREST INCOME (Dollars in Thousands) For the Year Ended December 31, Service charges on deposits $ 9,984 $ 9,699 $ 9,777 Loan servicing income Net gain on sale of loans ,558 Increase in cash surrender value of life insurance 1, ,010 Bank owed life insurance death benefit 251 1,002 - Gain on sale of branches - - 2,153 Non-accretable loan discount ,680 Gain on sale of other real estate owned Gain on sale of securities 2, Other income 1,911 1,673 1,804 Total non-interest income $ 19,019 $ 14,856 $ 21,143 Total non-interest income was $19.0 million for 2015, an increase of $4.2 million or, 28.0% from $14.8 million in The increase was primarily due to three factors. In April of 2015 the Asset Liability Investment Committee and the Board of Directors approved the sale of $43.4 million of mortgage backed securities resulting in a gain of $2.9 million. The sale was done to take advantage of the interest rate environment at the time of the sale and to reposition the investment portfolio into longer duration mortgage related securities. Income from the non-accretable loan discount increased by $0.4 million from $0.5 million in 2014 to $0.9 million in The non-accretable loan discount income is related to the purchase accounting on the loans acquired in the Acquisition that were specifically identified as credit impaired which were paid or charged off during the year. In future years, non-accretable income will be dependent on the difference between future contractual payments expected to be received and the carrying amount of the loans specifically impaired. 5

7 Finally, the gain on sale of other real estate owned increased from $0.1 million in 2014 to $0.9 million in 2015 as two properties from participations acquired in the Acquisition were sold for significant gains. These increases in non-interest income were offset by a decrease in one-time income from the death benefit on bank owned life insurance from $1.0 million in 2014 compared to $0.3 million in Total non-interest income was $14.8 million for 2014, a decrease of $6.3 million or, 29.7% from $21.1 million in The decrease was primarily due to three factors. The net gain on sale of loans decreased $1.1 million from $1.6 million in 2013 compared to $0.5 million in The decrease was due to an increase in interest rates in the summer of 2013 which meant that mortgage refinance activity was strong during the first half of 2013 but was weak during the second half of 2013 and all of In addition, non-interest income in 2013 benefited from a one-time gain of $2.2 million on the sale of the Cedarburg and Grafton branches. Finally, income from the nonaccretable loan discount decreased by $3.2 million from $3.7 million in 2013 to $0.5 million in The non-accretable loan discount income is related to the purchase accounting on the loans acquired in the Acquisition that were specifically identified as credit impaired which were paid or charged off during the year. In future years, non-accretable income will be dependent on the difference between future contractual payments expected to be received and the carrying amount of the loans specifically impaired. These decreases in noninterest income in 2014 were offset by one-time income of $1.0 million from the death benefit on bank owned life insurance. Non-interest Expense A summary of non-interest expense for the years ended December 31, 2015, 2014 and 2013 appear in Table 4 below: Table 4 NON-INTEREST EXPENSE (Dollars in Thousands) For the Year Ended December 31, Salaries and employee benefits $ 22,502 $ 21,493 $ 21,406 Occupancy 3,783 4,144 4,093 Furniture and equipment 1,616 1,624 1,740 Data processing expense 3,769 3,449 3,198 Telecommunications expense Advertising and promotional Regulatory agency assessments 1,162 1,140 1,273 Operation of other real estate owned ,658 Office supplies Core deposit intangible amortization Other expenses 4,031 3,911 3,718 Total non-interest expense $ 39,802 $ 39,122 $ 39,651 Total non-interest expense for 2015 was $39.8 million, an increase of $0.7 million or 1.7% over The primary reason for the increase in non-interest expense was an increase in salaries and employee benefits which was $22.5 million in 2015 compared to $21.5 million in The increase was due to additional experienced hires in lending and compliance as well as increases in hourly pay raises and benefits. In addition to salary and benefits, data processing expense increased by $0.3 million due to CPI adjustments built into our data processing contract and additional costs related to the continued strong adoption of our mobile banking product. These increases were offset by a decrease in occupancy expense by $0.4 million due to a decrease in maintenance, snowplowing and utilities as well as a decrease in rent expense and leaseholds amortization due to the closing of two of our grocery store locations. In addition, the cost to operate other real estate owned decreased by $0.4 million due to the continued reduction in the number of properties in other real estate owned from 20 in 2014 to 7 in 2015 as noted in Table 7. Total non-interest expense for 2014 was $39.1 million, a decrease of $0.5 million or 1.3% compared to The Corporations largest non-interest expense is salaries and employee benefits which increased slightly to $21.5 million in 2014 compared to $21.4 million in 2013 due several new hires on the lending staff which was partially offset by several retirements. Occupancy expense remained stable at $4.1 million in both 2013 and 2014 as increased snow plowing costs during 2014 were offset by a decrease in depreciation expense due to the sale of our Cedarburg branch in November of The increase in data processing expense of $0.3 million in 2014 was due to increased data processing costs related to the roll out of our mobile banking product. The primary driver of the decrease in non-interest expense in 2014 was the reduction in the cost to operate other real estate owned which decreased by $0.9 million. As noted in Table 7 there was a significant decrease in the overall actively in other real estate owned in 2014 as only 42 properties were added to other real estate owned and 44 properties were sold compared to 108 and 117, respectively, in

8 Income Taxes Income tax expense was $5.3 million in 2015 compared to $3.8 million in 2014 and $4.4 million in The Corporation s effective tax rate (income tax expense divided by income before income taxes) was 33.5% in 2015 compared to 30.2% in 2014 and 33.3% in The increase in the effective tax rate for 2015 was due to the fact that the one-time death benefit on bank owned life insurance was $0.3 million and $1.0 million in 2015 and 2014, respectively, and is not taxable income. BALANCE SHEET ANALYSIS Investment Securities Portfolio The investment securities portfolio is intended to provide the Bank with liquidity, a source of stable income, and is structured to minimize the Corporation s credit exposure. Table 5 INVESTMENT SECURITIES PORTFOLIO (Dollars in Thousands) For the Year Ended December 31, Carrying Percentage Carrying Percentage Carrying Percentage Value of Total Value of Total Value of Total Obligations of: States and political subdivisions (tax exempt) $ 46, % $ 50, % $ 42, % States and political subdivisions (taxable) 11, % 12, % 12, % U.S. government sponsored entities 29, % 84, % 150, % Collateralized mortgage obligations 236, % 104, % 41, % Mortgage-backed securities 123, % 106, % 84, % Total investment securities $ 446, % $ 357, % $ 331, % Designated as: Available for sale $ 446, % $ 149, % $ 32, % Held to maturity - -% 208, % 298, % Total investment securities $ 446, % $ 357, % $ 331, % In the 4 th quarter of 2013, the Board of Directors amended the Investment Policy to allow the use of a Registered Investment Advisor ( RIA ) who has been responsible for all of the investment activity since December of All of the purchases made by the RIA are governed by the guidelines set forth in the Investment Policy which is approved by the Board of Directors. In addition, the RIA s reports at Asset Liability Investment Committee ( ALICO ) meetings and all of the investment activity is reviewed by ALICO to ensure compliance with the Investment Policy. During 2015, the ALICO consisted of the CEO and CFO of the Bank and three outside members of the Board of Directors. The CFO reports to the Board of Directors on compliance with the Investment Policy on a quarterly basis. The carrying value of the investment portfolio increased from $357.7 million as of December 31, 2014 to $446.8 million as of December 31, 2015, an increase of $89.2 million or 24.9%. The significant increase during 2015 was due to two factors. Cash and due from banks decreased by $48.5 million as excess liquidity held at the Federal Reserve was invested in higher yielding investment securities. In addition, deposit growth of $74.6 million exceeded loan growth of $40.0 million which resulted in additional liquidity to be invested into securities. The mix of investment types also changed significantly during While the carrying value of investments in state and political subdivisions has remained relatively stable, there continues to be a significant decrease in U.S government sponsored entities ( GSE ) and significant increases in both collateralized mortgage obligations ( CMO ) and mortgage-backed securities ( MBS ). GSE securities decreased $54.1 million to $30.0 million at December 31, 2015 compared to $84.1 million at year end The decrease was due to call activity as there were no new purchases in this investment category during The RIA continued to focus on reinvesting the excess liquidity and the proceeds from the called GSE securities into securities with more stable cash flows. As a result, investments in CMO and MBS securities increased $148.2 million from $211.4 million at December 31, 2014 to $359.6 million at December 31, 2015 representing 80.5% of the investment securities portfolio. Going forward, management will make efforts to reinvest the cash flows from the investment securities portfolio in prudent loan growth in order to enhance net interest margin and overall profitability. 7

9 Prior to 2013, all of the investment securities were classified as held to maturity. In conjunction with the hiring of the RIA the 4th quarter of 2013, management classified new purchases as available for sale. Securities classified as available for sale are those securities which the Bank has determined might be sold to meet potential liquidity needs, reposition holdings to increase returns or modify durations, or in response to changes in interest rates or other economic factors. During 2015, on the advice from our RIA and approved by both ALICO and the Board of Directors, the investment portfolio was restructured and $43.4 million of MBS were sold for a gain of $2.9 million. The proceeds from the sale were reinvested in longer average life mortgage related securities. Prior to the sale, all of the remaining held to maturity securities were transferred to available for sale resulting in the entire investment portfolio being classified as available for sale as of December 31, Loans Total loans were $728.7 million at December 31, 2015, an increase of $40.1 million, or 5.8%, from $688.6 million at December 31, The increase in the loan portfolio during 2015 was attributable to an increase in new loan production which was offset by portfolio amortization, payoffs and the continued reduction of the Acquired Bank s loans. An increase of $26.3 million in commercial and commercial real estate lending is the result of a reorganization of the Bank s commercial loan group and hiring of new marketing officers over the last three years. This aggressive step was necessary because despite increased loan demand with an improving economy every competitor is seeking to expand its loan portfolio as well. Loans originated by the Bank are generally loans to small businesses and individuals in the communities served in the Southeastern Wisconsin market. While most borrowers credit relationships total less than $1.0 million, the focus on loan growth has resulted in an increase in larger loan relationships. At December 31, 2015, there were six relationships in excess of $10.0 million with aggregate exposure totaling $76.0 million, fourteen relationships between $5.0 and $10.0 million with aggregate exposure totaling $93.8 million and forty-three relationships between $2.0 and $5.0 million with aggregate exposure totaling $136.7 million. Of these sixty-three relationships with $306.5 million committed, the balance outstanding at December 31, 2015 was $272.1 million. The remaining $34.4 million represented unfunded availability on lines of credit to these borrowers. This compares to fifty-five relationships with more than $2.0 million committed totaling $268.2 million with a total outstanding of $229.3 million at December 31, Total loan amounts outstanding to large borrowers increased $42.8 million which was the primary driver of loan growth during As of October 23, 2009 (the Acquisition Date ), the Acquired Bank s loan portfolio of $279.2 million was discounted $85.1 million to reflect the estimated fair value of the acquired loans. Between the Acquisition Date and December 31, 2015, both the Acquired Bank s loan portfolio and the associated discount have been significantly reduced as a result of activity in the Acquired Bank s loan portfolio including renewals, amortization, pay-offs, charge-offs and collateral liquidations. Thus, as of December 31, 2015 the remaining Acquired Bank s loan portfolio was $53.1 million with a discount of $12.8 million reflecting the difference between cash flows expected to be received and contractually required payments on the acquired loans. In addition, $33.1 million of the Acquired Bank s loan portfolio has been restructured or renewed into the Bank s portfolio and does not have any remaining discount. Management continues to pursue improvement in the credit quality of the acquired loans as they are renewed and integrated into the Bank s portfolio. Management believes the remaining discount will be sufficient to cover the remaining credit losses related to the acquired loans that have not yet been paid off, renewed or restructured. The following table presents information concerning the composition of the loans held for investment by the Bank at the dates indicated. Table 6 LOAN PORTFOLIO COMPOSITION (Dollars in Thousands) For the Year Ended December 31, % of % of % of Amount Total Amount Total Amount Total Commercial $ 39, % $ 31, % $ 20, % Real estate Construction 32, % 26, % 29, % Commercial 383, % 365, % 346, % Residential 213, % 214, % 229, % Multifamily 50, % 41, % 45, % Installment and other 8, % 9, % 10, % Total loans $ 728, % $ 688, % $ 683, % 8

10 As Table 6 indicates, commercial loans were $39.1 million at December 31, 2015, an increase of $7.8 million, or 24.9% from December 31, 2014 and comprised 5.4% of the total loan portfolio compared to $31.3 million comprising 4.5% of the loan portfolio at December 31, While commercial lending has historically been a small part of the Bank s portfolio there has been more emphasis on this segment over the last two years as the Bank is building a commercial loan team in order to compete more effectively for these loans. Commercial loans are collateralized by general business assets such as accounts receivable, inventory and equipment and have no real estate component. Real estate construction loans increased $6.7 million, or 25.9% to $32.7 million, representing 4.5% of the total loan portfolio at December 31, 2015, compared to $26.0 million or 3.8% of the total loan portfolio at December 31, The increase in 2015 was due to growth in both commercial and residential real estate construction loans. Construction financing by definition is classified as such only during the development phase. When the project is complete, the outstanding balance is paid in one of several ways. In the case of residential real estate development, the sale of the spec home or lot results in payment. In the case of a commercial project, the completed building is refinanced to term debt for the developer or in some cases a new buyer. Historically, real estate construction loans have been made to developers who are well known to the Bank, have prior successful project experience and are well capitalized. Loans are made to customers in the Bank s Southeastern Wisconsin market with experience and knowledge of the local economy. Commercial real estate loans increased $18.5 million, or 5.1% to $383.5 million at December 31, 2015, compared to $365.0 million at December 31, This increase marks four years of growth in commercial real estate loans. The increase is due to new business exceeding the portfolio amortization, pay-offs and elimination of nonperforming commercial real estate loans from the Acquisition. This category of loans made up the largest component of the total loan portfolio at 52.6% at December 31, 2015 and 53.0% at December 31, The increase is attributable to new relationships as well as new projects with current customers which outpaced run-off from the Acquired loan portfolio. The Bank s commercial real estate lending efforts are focused on owner occupied, improved property such as office buildings, warehouses, small manufacturing operations and retail facilities. The most significant risk factor is occupancy. The fact that the Bank prefers owner occupied commercial real estate reduces that risk, provided of course, the owner s business remains viable. The Bank s $21.4 million per-borrower legal lending limit would permit it to compete for activity in the middle market, but management prefers small businesses as its target borrowers. Loans to such businesses are approved based on the creditworthiness, economic feasibility and cash flow abilities of the borrower. During 2015 residential real estate loans which include single family, 2-4 family dwellings and home equity lines of credit or HELOCs secured by real estate decreased $1.1 million, or 0.5% to $213.8 million comprising 29.3% of the Bank s total loan portfolio at December 31, 2015 compared to $214.9 million comprising 31.2% of the Bank s total loan portfolio at December 31, In 2014, changes mandated by the Consumer Financial Protection Bureau ( CFPB ) limited the Bank s traditional residential real estate products with QM or Qualified Mortgage Rules all but eliminating balloon notes. Despite regulatory changes, the Bank has invested in online mortgage software, additional retail lenders during 2014 and 2015 and new product types in order to grow the residential real estate portfolio. While the commercial and commercial real estate loans have grown over the last several of years, management believes the investments made in our residential real estate capabilities began to take hold in 2015 and expects growth in this segment in Mortgage customers seeking long term rate locks choose the secondary market products offered by the Bank where rates can be fixed for 15, 20 or 30 years. These loans are then sold by the Bank and as a result, do not impact the portfolio yields nor are they a factor in interest rate risk. Portfolio mortgage loans are renewable into either one-, two- or three-year balloons which pre date QM regulations or Adjustable Rate Mortgages ( ARMs ). While ARMs were not the Bank s vehicle of choice for rate management prior to the creation of the CFPB, they serve the purpose of providing annual rate adjustments after an initial fixed rate period of three, five or seven years. As such, they are acceptable loans to hold on the balance sheet. A typical ARM index is the one year U.S. Treasury note rate. The one year U.S. Treasury note rate stayed near historic lows for most of 2015 until the end of the year when the Federal Reserve increased rates in December. While the increase in the one year U.S. Treasury rate will positively impact the yield on the ARM portfolio, the yield on these loans adjust on an annual basis after the initial fixed rate period of time. As a result, the yield on the total ARM portfolio decreased 6 basis points to 3.72% at December 31, 2015 from 3.78% at December 31, Multi-family real estate loans increased $9.1 million, or 22.1%, to $50.6 million, representing 7.0% of the total loan portfolio at December 31, 2015 compared to $41.5 million comprising 6.0% of the total loan portfolio at December 31, The loans in this category are collateralized by properties with more than four family dwelling units. The Bank has always been conservative in requiring borrowers to be well-qualified and to provide their personal guaranty, as well as insisting on proper debt service coverage ratios and equity sufficient to sustain reasonable debt service in the event of interest rate pressure. Loans in this category typically have maturities of 3, 4 or 5 years and are amortized over 15 to 20 years. Installment loans decreased $1.1 million, or 10.7%, to $8.9 million at December 31, 2015 compared to $10.0 million at December 31, 2014 due to the elimination of acquired loans outpacing new business. These loans consist of auto loans, mobile home loans and unsecured consumer loans which have been decreasing at the Bank for several years. Auto loan volume decreased despite improved new car sales because dealer incentive financing makes our products non-competitive. The Bank has historically limited its exposure to mobile home loans and unsecured consumer loans. 9

11 Other Real Estate Owned Real estate acquired by foreclosure or by deed in lieu of foreclosure is held for sale and is initially recorded as OREO at fair value at the date of foreclosure less estimated selling expenses, establishing a new cost basis. At the date of acquisition, any write down to fair value less estimated selling costs is charged to the allowance for loan losses. Subsequent to foreclosure, an analysis of the valuation is performed and a valuation allowance is established as needed. Costs relating to the development and improvement of the property may be capitalized while holding period costs and subsequent changes to the valuation allowance are charged to expense. A summary of the activity in OREO is as follows: Table 7 OTHER REAL ESTATE OWNED (Dollars in Thousands) For the Year Ended December 31, Dollar Number of Dollar Number of Dollar Number of Balance Properties Balance Properties Balance Properties Beginning Balance $ 4, $ 5, $ 8, Additions 2, , , Valuation Adjustment (27) - (107) Sales (4,456) (31) (3,750) (44) (12,843) (117) Ending Balance $ 3,191 7 $ 4, $ 5, Both the number of properties and the total balance of OREO declined in 2015 compared to As of December 31, 2015, the Bank had 7 properties in OREO with a total balance of $3.2 million compared to 20 properties with a total balance of $4.8 million as of December 31, As of December 31, 2015 one property in Arizona accounted for $1.5 million of the total $3.2 million in OREO outstanding. After lengthy legal proceedings, this property will likely be sold during 2016, Allowance for Loan Losses The loan portfolio is the primary asset subject to credit risk. Credit risk is controlled and monitored through the use of lending standards, management s strict underwriting of potential borrowers and on-going review of loan payment performance. Managing credit risk and minimizing loan losses is a high priority for management. Active asset quality administration, including early problem loan identification and timely resolution, aids in the management of credit risk and minimization of loan losses. The ALL represents management s estimate of an amount adequate to provide for probable and inherent credit losses in the loan portfolio. To assess the adequacy of the ALL, management uses significant judgment focusing on specific reserves applied to loans that are identified for evaluation on an individual loan basis. In addition, loans are analyzed on a group basis using risk characteristics that are common to groups of similar loans. The factors that are considered include changes in the size and character of the loan portfolio, changes in the levels of impaired and nonperforming loans, historical losses in each category, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, and the fair value of underlying collateral as well as changes to the fair value of underlying collateral. Table 8 on the following page summarizes the ALL balances at the beginning and end of each year from 2013 through 2015, changes in the ALL arising from loans charged-off and recoveries on loans previously charged-off, additions to the allowance that have been charged to expense and selected performance ratios. 10

12 Table 8 SUMMARY OF ALLOWANCE FOR LOAN LOSSES (Dollars in Thousands) For the Year Ended December 31, ALL at the beginning of the year $ 12,103 $ 12,371 $ 12,197 Total loans charged-off (3,836) (3,674) (7,015) Total recoveries Net loans charged-off (3,512) (3,268) (6,308) Additions to allowance charged to expense 3,000 3,000 6,482 ALL at the end of the year $ 11,591 $ 12,103 $ 12,371 Total loans $ 728,697 $ 688,645 $ 683,010 Total nonperforming loans (1) $ 10,414 $ 20,461 $ 19,065 Ratio of ALL to total nonperforming loans % % 64.89% Ratio of nonperforming loans to total loans 1.43% 2.97 % 2.79% Ratio of nonperforming assets to total assets 1.02% 2.14 % 2.10% Ratio of net loans charged-off during the period to average loans outstanding 0.50% 0.48 % 0.92% Ratio of ALL at end of year to total loans 1.59% 1.76 % 1.81% (1) This amount excludes purchased credit-impaired loans. Purchased credit-impaired loans have evidence of pre-acquisition deterioration in credit quality. Fair value of these loans as of the Acquisition Date includes estimates of credit losses. At December 31, 2015, the ALL was $11.6 million, compared to $12.1 million at December 31, As of December 31, 2015, the ratio of the ALL to total loans was 1.59% and covered 111.3% of nonperforming loans, compared to a ratio of 1.76% covering 59.2% of nonperforming loans at December 31, The decrease in the ratio of ALL to total loans during 2015 was due to both an increase in loans and a decrease in the ALL as net charge-offs exceeded the allowance charged to expense. Nonperforming loans, not including the acquired credit impaired nonperforming loans, improved significantly and were $10.4 million, or 1.43% of total loans as of December 31, 2015 compared to $20.5 million, or 2.97% of total loans at December 31, Net charge-offs were $3.5 million and $3.3 million for 2015 and 2014, respectively. Loans charged-off are subject to continuous review and specific efforts are taken to achieve maximum recovery of principal, accrued interest and related expenses. Potential Problem Loans Management uses an internal asset classification system to identify and report problem and potential problem assets. At their quarterly meetings, the Board of Directors of the Bank review trends for loans classified as Special Mention, Substandard and Doubtful for the previous thirteen months both as a total dollar volume in each classified category and as the percent of capital each classified category represents. A Special Mention loan has potential weaknesses that deserves management s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date. An asset is classified Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged. Substandard assets include those characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of current existing facts, conditions and values, highly questionable and improbable. Assets classified as Loss are those considered uncollectible and viewed as non-bankable assets, worthy of charge-off. Assets that do not currently expose the Bank to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses that may or may not be within the control of the customer are classified as Watch. The determination of the classification of assets and the amount of valuation allowance is subject to review by the Bank s regulator, the Office of the Comptroller of the Currency (the OCC ), which can order the establishment of additional general or specific loss allowances. There can be no assurance that regulators, in reviewing the Bank s loan portfolio, will not request the Bank to materially adjust its allowance for loan losses. The OCC, in conjunction with the other Federal banking agencies, has adopted an interagency policy statement on the ALL. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines. Generally, the policy statement recommends that (1) institutions have effective systems and controls to identify, monitor and address asset quality problems; (2) management has analyzed all significant factors that affect the collectability of the portfolio in a reasonable manner; and (3) management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. Management believes it has established an adequate ALL. The Bank analyzes its process regularly, with modifications made if needed, and reports those results at quarterly meetings of the Board of Directors. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific and general loan loss allowances may become necessary. 11

13 Deposits Deposits are the Bank s largest source of funds. The Bank competes in Southeastern Wisconsin with other financial institutions such as banks, thrifts and credit unions, as well as non-bank institutions, for retail and commercial deposits. The Bank continues to market its checking accounts and had continued success in 2015 with completely free checking (non-interest-bearing), several options for interestbearing checking and for Investor Checking, a tiered product. The interest-bearing checking options offered are desirable to the Bank as low cost core deposit growth. Depositors earn interest, but the yields paid on these products are low compared to other funding costs. The following table presents the average daily balance of deposits and average rate paid on deposits for the years ended December 31, 2015, 2014 and Table 9 AVERAGE DAILY BALANCE OF DEPOSITS AND AVERAGE RATE PAID ON DEPOSITS (Dollars in Thousands) Amount Rate Amount Rate Amount Rate Noninterest-bearing demand deposits $ 220,509 -% $ 195,311 -% $ 184,613 -% Transaction Accounts 324, % 309, % 292, % Money Market Accounts 242, % 224, % 224, % Savings 220, % 210, % 206, % Time deposits (excluding time certificates of deposit of $100,000 or more) 65, % 77, % 99, % Time deposits ($100,000 or more) 42, % 47, % 55, % $ 1,115,648 $ 1,064,481 $ 1,062,851 For the year ended December 31, 2015, average daily deposits were $1,115.6 million, an increase of $51.1 million or 4.8% over $1,064.5 million at December 31, The Bank continued to have substantial organic deposit growth across most of the branches due to a strong product line, convenient hours and locations, online and mobile banking options, and successful marketing campaigns. Average deposits increased during 2015 in all deposit types with the exception of time deposits which continued to decline as customers preferred to keep their money in more liquid products. Average non-interest-bearing demand deposits increased $25.2 million, or 12.9%, to $220.5 million at December 31, 2015 compared to $195.3 million at December 31, The strong growth in demand deposits was primarily due to significant increases in commercial demand deposits which was due to commercial loan growth with new customers. These core deposits are very valuable to the Bank given their non-interest bearing status. Transaction accounts consist of interest-bearing checking held by individuals, municipalities, non-profit organizations and sole proprietorships. Average transaction accounts increased $15.1 million, or 4.9%, to $324.2 million at December 31, 2015 compared to $309.1 million on December 31, The blended yield for all transaction accounts was 0.06% for both 2014 and The daily average balance of money market deposit accounts increased $17.2 million, or 7.7%, to $242.0 million for 2015 compared to $224.8 million in The increase in money market accounts during 2015 is due to the relatively attractive interest rates paid on this product compared to certain transaction accounts and longer term certificates of deposits. The yield on money market deposits increased 1 bp to 0.14% for 2015 from 0.13% in 2014 due to an increase in accounts with higher balances which earn higher rates. The daily average balance of savings accounts increased $10.0 million, or 4.7%, to $220.5 million for the year ended December 31, 2015 from $210.5 million at December 31, The yield on basic savings was 0.02% in 2015 and 0.03% in Savings include savings sweep accounts for businesses in the amount of $8.2 million with rates that are tied to the Fed funds rate and vary as that index moves. The daily average balance of time deposits decreased by $16.3 million, or 13.1%, to $108.4 million at December 31, 2015, from $124.7 million at December 31, The decline was primarily due to deposits moving from fixed rate products with longer terms into floating interest rate products, such as money market accounts given the very low rates available in Within that total, time deposits less than $100,000 decreased $11.7 million, or 15.1%, to $65.9 million at year-end 2015 from $77.6 million at December 31, The yield on time deposits less than $100,000 was 0.49% in 2015, down from 0.50% in Time deposits $100,000 or more decreased by $4.6 million, or 9.7%, to $42.5 million at year-end 2015 from $47.1 million at December 31, The yield on time deposits $100,000 or more was 0.52% in 2015, down from 0.70% in