New Hampshire Mutual Bancorp. Creating a Road Map for Successful Expansion

Transcription

1 New Hampshire Mutual Bancorp Creating a Road Map for Successful Expansion Stonier Graduate School of Banking Traditional Capstone Class of 2016 Jason C. Hicks Senior Vice President - Chief Financial Officer/Treasurer

2 Table of Contents Executive Summary... 3 Introduction/Background... 5 History Overview and Competition... 5 Bank Subsidiaries... 5 Wealth Management Subsidiary... 6 Market Share... 6 Table 1: Deposit Market Share for All Banks in NH as of June 30, Table 2: Deposit Market Share for New Hampshire Based Banks as of June 30, Table 3: Residential Loan Market Share by County - Year-to-Date August 31, Table 4: Commercial Loan Market Share by County Year-to-Date August 31, Financial Condition... 8 Table 5: Performance Summary... 9 Overall Strategy... 9 Strategy/Implementation Considerations for Establishing a Road Map for Successful Expansion Why This Project is Important and the CFO s Role Creating a Competitive Advantage Future Opportunities Implementation of a Capital Management Process Financial Impacts Strategic Investment Pro Forma Financial Statements for Meredith Village Savings Bank Balance Sheet Assumptions Portsmouth, NH Branch Pro Forma Balance Sheet Yield Curve Assumptions Loan and Deposit Yields Pro Forma Income Statement Discussion & Analysis Net Interest Income Non-Interest Income Operating Expenses

3 Portsmouth, NH Branch Pro Forma Income Statement Pro Forma Capital Impacts Discussion and Analysis Pro Forma Capital Ratios and Levels Risks Associated with Strategic Branch Expansion Excerpt from MVSB Interest Rate Sensitivity Model as of 9/30/ Financial Conclusion Non-Financial Impacts Hurdles in Establishing a New Bank Branch Overcoming the Hurdles Evaluating Non-Financial Impacts and Long Term Profitability Conclusion Creating a Roadmap for Successful Expansion Bibliography..44 2

4 Executive Summary In January 2013, (NHMB) was created through the affiliation of two mutual savings banks from New Hampshire that had been serving their communities for over 145 years. Both Meredith Village Savings Bank (MVSB), headquartered in Meredith, and Merrimack County Savings Bank (MCSB), headquartered in Concord, have successful franchises with strong customer bases. There is no overlap in their branch network. These two banks decided that they could form a holding company and use a shared internal services model to accommodate the needs of both banks. The goal being to reduce or at least limit the amount of overhead needed to service the combined communities the two banks serve (i.e. gain economies of scale). Obviously, becoming efficient in operational and administrative areas of the banks does not occur overnight. Over the first three years under the affiliation, NHMB has worked to gain these efficiencies. Prior to the affiliation, MCSB had its core banking system outsourced. However, the decision was made to convert from an outsourced banking system to the in-house system run by MVSB s Information Technology department. This decision saved MCSB a substantial amount of annual service costs and created a standardized loan and deposit servicing platform which drives operational efficiencies and standardized processes between the two organizations. To gain further operational efficiencies and standardization, the general ledger, investment securities accounting system, accounts payable and fixed asset systems were also converted to the same platforms that MVSB previously used. In the third year of the affiliation, MVSB s online banking platform was upgraded to match MCSB s online banking system. MVSB customers now enjoy a more functional and modern experience and MCSB was able to garner better pricing on its online service agreement under the combined service agreement for both banks. The pension plan, 401(k) plan and health care benefits were also standardized to provide the same benefits to all employees. MCSB s health care plan now has more options for its employees while saving money under a group plan. The standardization of benefits also allows for employees to transfer between affiliated companies without losing or changing any benefits. This has been a great way to retain valued employees when they want or need to change jobs for advancement opportunities or just an office location that is closer to their home. Another benefit is that the two banks can now collectively double the size of their lending limits prior to the affiliation. This allows the banks to compete for larger loans and participate the loans between the two sister banks and not have to look for other lenders to successfully win a large credit deal. This is a huge competitive advantage over smaller banks in New England. Being able to share a large credit deal and keep the origination fees and interest income within 3

5 the NHMB company structure allows NHMB to grow in a conservative manner under its own underwriting standards. The changes and opportunities noted above are some of the major benefits of the affiliation that make NHMB a stronger organization for the future. In its fourth year of operations, NHMB has refocused on the business of banking and the next steps to growing its franchises. These steps will include strategic initiatives such as adding new branches, bringing in new bank affiliates, growing its wealth management business organically and through acquisition. All of these initiatives will require proper discipline and capital management. The focus of this paper was to create a capital management model and a business valuation model to use in the financial and regulatory capital analysis of new strategic ventures, followed by formally documenting the process needed to evaluate the investment of the company s capital into these strategic opportunities. The formal evaluation process includes not only the financial impacts to NHMB when adding new branches or companies to its corporate structure, but also the non-financial impacts such as culture and succession planning. All of these pieces are a part of creating a road map to the successful expansion of NHMB. To illustrate the use of the capital model and the strategic process utilized for expansion purposes, this paper focused on MVSB s branch expansion into the Portsmouth, New Hampshire market. Portsmouth is a vibrant and growing seacoast town of approximately 21,000 (PortsmouthNH.com, 2016). Based on the financial analysis, MVSB s new branch will reach breakeven status in the fourth year of operations. The drag on earnings by the new branch will be offset by the continued growth of the existing MVSB franchise. By the third year of operations, the growth of MVSB will almost offset the cumulative costs of the new branch. MVSB will be focused on building a core group of branch employees that know the Portsmouth market and will be key to growing MVSB s business in that area. Finding the right people is always important and indoctrinating them into the MVSB culture is just as vital. This may be a bit more challenging since Portsmouth is not contiguous to MVSB s current footprint. However, with the modern technology of video conferencing as well as continued outreach by current MVSB staff, it is expected that the new branch will become a great source of new deposit and loan activity for the bank. NHMB expects to continually utilize this roadmap as it plans to add a new branch in Hooksett, New Hampshire in There will also be future bank and wealth management company alliances to add to the suite of NHMB companies. NHMB should be confident that it is ready for new challenges and will continue to succeed in its mission to provide the framework and organizational structure for enhancing the efficiencies and profitability of the individual affiliated companies by leveraging and integrating the strengths of each subsidiary institution. 4

6 Through this mission each institution will preserve its rich mutual heritage and unique brand. Introduction/Background History Overview and Competition Effective January 2, 2013, Meredith Village Savings Bank and Merrimack County Savings bank decided to pool their banking skills, resources and collective vision to form an alliance to create a mutual bank holding company called. Both institutions have been entrenched in the communities they serve for over 145 years and continue to operate as separate state chartered banks in New Hampshire. There were several goals for the affiliation: (1) to leverage the Company s combined size to create greater lending capacity which will enable the banks, through loan participations, to garner larger commercial loans and deposits; (2) to gain operating efficiencies to help defray the ever increasing costs of compliance and declining net interest income and fee income; and (3) to provide a strong succession plan for the combined organization and create new opportunities for its employees. Bank Subsidiaries Meredith Village Savings Bank (MVSB), founded in 1869, is a stock bank headquartered in Meredith, New Hampshire and a wholly-owned subsidiary of NHMB. MVSB has total assets of $770.7 million, as of December 31, 2015, and eleven offices serving individuals, families, businesses and municipalities in the Lakes Region in central New Hampshire. MVSB s commercial lending market is heavily oriented in the hospitality industry due to its presence around one of New Hampshire s largest lakes, Lake Winnipesaukee, and its close proximity to many ski resorts. MVSB has a significant second home mortgage portfolio due to the recreational amenities the area offers. Competition in the Lakes Region has historically been dominated by MVSB, Bank of New Hampshire and to some degree Citizens and TD Bank. However, due to the relatively rural location of our market there is not a strong presence from national or super-regional banks. However, credit unions and mortgage brokers are an increasing threat in its retail deposit and residential lending market place. Founded in 1867, Merrimack County Savings Bank (MCSB) is a stock bank headquartered in Concord, New Hampshire and a wholly-owned subsidiary of NHMB. MCSB has total assets $727.7 million, as of December 31, 2015, and eight offices in Bow, Concord, Contoocook, Hooksett and Nashua. MCSB serves individuals, families, businesses and municipalities. MCSB s commercial lending market is more heavily oriented in the commercial real estate as 5

7 well as commercial and industrial lending. Competition in the Concord area is growing with banks from New Hampshire and Massachusetts building new branches in Concord and towns in the southern half of New Hampshire. Due to Concord being the state capital and the southern region of the state having many Boston commuters, the market there has a strong presence from national and super-regional banks as well as community banks and credit unions. Wealth Management Subsidiary The wealth management industry is very competitive and has many different types of organizational structures. In April of 2015, the MillRiver Trust Company (MillRiver) was founded as a separate wealth management company and wholly-owned subsidiary of NHMB. MillRiver was created as a means to consolidate the wealth management services previously embedded in the banks and enable it to serve a broader market area without ties to either bank s name or current market area. Total assets on the balance sheet as of December 31, 2015 were $4.1 million with off balance sheet assets under management of approximately $400 million. Market Share The banks market areas are complementary with no material overlap. Through its subsidiaries, NHMB offers a wide variety of bank and wealth management products and services including the following: Residential and consumer lending Commercial real estate lending Commercial and Industrial lending Self-directed and managed investment accounts Retirement planning and investment management services Trust management services Mobile deposit capabilities Online and telephone banking Cash management services for commercial customers As of June 30, 2015, the top four bank deposit market share positions in New Hampshire were controlled by Citizens Bank (24.1%), TD Bank (20.0%), Bank of America (15.4%) and People s United Bank (4.74%). NHMB held 3.76% or the fifth highest market share of deposits in New Hampshire (Federal Deposit Insurance Corporation, 2015) as noted in the table below. 6

8 Table 1: Deposit Market Share for All Banks in NH as of June 30, 2015 Bank Name Rank Deposit Dollars ($000s) Market Share % Citizens Bank, N.A. 1 $ 7,498, % TD Bank, N.A. 2 $ 6,104, % Bank of America, N.A. 3 $ 5,724, % People's United Bank 4 $ 1,498, % 5 $ 1,143, % NHMB held the highest bank deposit market share of any New Hampshire based bank as noted in the table below (Federal Deposit Insurance Corporation, 2015). Table 2: Deposit Market Share for New Hampshire Based Banks as of June 30, 2015 New Hampshire Bank Name Rank Deposit Dollars ($000s) Market Share % 1 $ 1,143, % Bank of New Hampshire 2 $ 996, % Lake Sunapee Bank, FSB 3 $ 866, % Mascoma Savings Bank 4 $ 798, % Northway Bank 5 $ 758, % Bank of New England 6 $ 459, % Savings Bank of Walpole 7 $ 316, % Franklin Savings Bank 8 $ 312, % Woodsville Guaranty Savings Bank 9 $ 310, % Optima Bank & Trust Company 10 $ 303, % As of August 31, 2015, NHMB were in the top eleven positions for residential loan market share within the four primary New Hampshire counties the two banks serve (Belknap, Carroll, Hillsborough and Merrimack) as seen in the table below (The Warren Group, 2015). Grafton County is also included as it includes the towns of Holderness and Ashland which are popular tourist destinations in our market area and include many second home mortgages for lake houses. 7

9 Table 3: Residential Loan Market Share by County - Year-to-Date August 31, 2015 Lender County Rank by County Loan Dollar Volume MVSB Belknap 1 $25,753,814 MVSB Carroll 1 $17,574,209 MVSB Grafton 8 $9,734,820 MCSB Hillsborough 11 $29,398,267 MCSB Merrimack 4 $29,164,422 Combined NHMB All Counties 9 $120,621,634 NHMB s market share within the commercial real estate loan market is a bit more challenging. As of August 31, 2015, NHMB has market positions within the top thirty-one lenders in the four primary New Hampshire counties the two banks serve as seen in the table below (The Warren Group, 2015). MCSB has the fifth market position in Belknap County due to loans it has purchased from MVSB to help manage certain MVSB customer concentrations. Grafton County was not included as it has not historically been a strong source of commercial loan volume for MVSB as it does not have a significant retail or commercial presences in that county. Table 4: Commercial Loan Market Share by County Year-to-Date August 31, 2015 Lender County Rank by County Loan Dollar Volume MCSB Belknap 5 $1,585,000 MVSB Belknap 6 $1,321,400 MVSB Carroll 8 $1,373,000 MCSB Hillsborough 31 $2,583,000 MCSB Merrimack 2 $4,969,680 Combined NHMB All Counties 25 $13,236,618 The wealth management market place in the United States encompasses trillions of dollars. MillRiver is clearly a small player with $400 million in assets under management. However, MillRiver will capitalize on its history of strong customer service and leverage the banks clientele to increase its market share. Financial Condition As shown in the following table (Federal Financial Institutions Examination Council (FFIEC), 2013, 2014, 2015), NHMB grew assets in 2014 by 5.92% in its second year of operation and slowed a bit in 2015 due to several large commercial relationships paying down their debt as a result of strong business results. Loan demand is competitive, but the pipelines remain strong. The Company has a healthy trend of strong earnings and capital. The Company continues to be 8

10 well capitalized with a leverage ratio of 10.39% and a total risk based capital ratio of 14.27%, as of June 30, Return on assets is a bit weak. However, management expected the first three years of operations to be lower than past performance due to startup costs and capital outlays to convert the banks onto the same core banking and peripheral systems. Management expects the return on assets to improve in the coming years. Net interest margin is slowly declining which is a problem for the entire industry. Loan rates remain low and there are too many lenders chasing the same customers. This has lead to declines in loan rates while there is beginning to be upward pressure on deposit rates due to the anticipation of the Federal Reserve increasing the Fed Funds rate. Liquidity continues to be adequate with a focus on gathering new deposit relationships, particularly commercial accounts, to help fund loan growth. One metric the Company uses to monitor its liquidity is the net non-core funding dependence ratio which shows the use of wholesale funding. The Company s target range for this ratio is 20% - 25%. Overall, the Company is in a strong position to achieve its strategic goals. Table 5: Performance Summary NHMB Consolidated June 30, 2013 June 30, 2014 June 30, 2015 Avg. Total Assets (000s) $1,343,005 $1,394,909 $1,457,565 Assets Growth % N/A 5.92% 0.31% Net Income (000s) $3,316 $3,263 $3,837 Capital (000s) $136,990 $148,916 $155,245 Tier 1 Leverage Capital 9.67% 10.22% 10.39% Total Risk Based Capital 14.43% 14.85% 14.27% Return On Avg. Assets 0.49% 0.47% 0.53% Net Interest Margin 3.63% 3.61% 3.60% Non-Core Funding Dependence 19.56% 25.34% 22.48% Overall Strategy During the first three years of the affiliation, NHMB worked to improve its technology infrastructure, integrate core banking systems, centralize functions and streamline processes. NHMB is now ready for further expansion. Meredith Village Savings Bank intends to open new branches in the seacoast area of New Hampshire centered on Portsmouth. Merrimack County Savings Bank intends to expand towards southern New Hampshire to close the gap between the Concord area and its satellite office in Nashua. MillRiver plans to grow organically utilizing its new brand to gain new customers in new markets and deepen its customer base in its existing markets, particularly the Lakes Region and southern New Hampshire. MillRiver will also entertain acquisitions of other wealth management businesses when feasible. 9

11 Strategy/Implementation Considerations for Establishing a Road Map for Successful Expansion As of June 30, 2015, NHMB is a $1.5 billion mutual bank holding company that owns two sister banks and a wealth management subsidiary. It has no common stock outstanding and the board of directors and executive management do not plan to issue any common stock in the foreseeable future. Access to capital via the trust preferred securities market was eliminated with the Dodd-Frank Act. There is the possibility of the holding company issuing subordinated debt and then pushing down the funding as equity investments in the banks, but it is expensive. Publicly traded banks are currently issuing subordinated debt in the 5 8% coupon range. If NHMB were to issue debt there would be a premium expected by investors due to NHMB being less liquid since it is not publically traded. The best and cheapest source of capital is earnings from operations. Therefore, properly evaluating growth strategies is imperative. Managing capital, ensuring the assets acquired are accurately valued and that the organizational structure and culture supports these strategies are all keys to the future success of NHMB. This project is focused primarily on the financial and regulatory feasibility of NHMB s growth strategies given its capital constraints. Capital management has become even more important subsequent to the increased regulatory capital requirements effective January 1, 2015, per BASEL III regulatory rules. Capital constraints will impact NHMB s ability to achieve its growth strategies. In addition to the financial and regulatory components, these strategies will require the Company to consider its future management structure, organizational structure and culture. The Executive team along with the head of Human Resources will evaluate the management structure of target companies and determine how the members of the target company s management team will be integrated into the current NHMB management team. One of the guiding principles behind creating the alliance between the current two bank subsidiaries was to create operational efficiencies to help both companies spend less time and money on operations. Any new branches, banks or wealth management companies need to be integrated appropriately to continue the efficient use of staff and technology used to service the various subsidiaries. The Executive team will also consider what type of organizational structure will be the most effective for NHMB. These considerations will include buying existing branches, entire banks or wealth management businesses, and whether to rebrand them or retain their original brand. Human Resources will help lead the effort to assess differences in the organizational culture of NHMB and new companies and evaluate the hurdles to ensure as smooth a transition from a new company s culture to NHMB s culture. NHMB has historically used the consulting 10

12 services of Caliper, based in Princeton, New Jersey, to create customized culture surveys to obtain a baseline of employees current opinions on the company s culture and then use the same survey to gauge improvements as management implements changes to address cultural issues. NHMB will continue to use Caliper s services to help integrate new companies under the NHMB umbrella. Why This Project is Important and the CFO s Role Beginning in January of 2015, the banks transferred the departments that provide shared services to the holding company. Shared service departments included Human Resources, Marketing, Finance/Accounting, Loan and Deposit Servicing, Risk/Compliance, Information Technology and Internal Audit. This action essentially moved NHMB from being a nonoperating shell company to a fully functioning holding company. Therefore, it is imperative that the Company begin incorporating capital management and planning into its decision making processes in a holistic manner instead of focusing on the standalone subsidiaries. The CFO is uniquely positioned to champion the development of a capital management program and implement its use in the Company s strategic planning process. The CFO will be able to explore the Company s expansion strategies with regular interaction with the Executive team. The CFO will be able to obtain any necessary information to evaluate these strategies and obtain feedback from the Executive team as needed. Once the CFO has concluded his analysis, he will present the results to the Executive team and help move the Company toward the preferred strategies ultimately chosen. For each strategy chosen, the CFO will ensure that any tactical goals for the Finance department are successfully implemented. The CFO will also be a key leader to help other department heads across the company implement their tactical goals as needed. This project will be a spring board for the CFO. Ensuring the success of this project will provide the CFO with professional growth opportunities to work with Senior Management, Executive Management and the Board of Trustees to evaluate growth strategies and set the future course for the Company. Creating a Competitive Advantage The main thrust of the project is to create a two pronged analytical model (Excel based) to determine what mix of growth strategies would result in the best use of the Banks capital under the constraints of a mutual holding company structure. One part will assess the impacts on the financial performance and resultant regulatory capital levels of the Company. The second part will create a simplistic valuation tool that can be used to help ensure the Company does not overpay for the assets acquired. NHMB is contemplating the following three strategic growth initiatives: 11

13 Branch expansion into new markets using our existing bank brands Increase the wealth management business by acquiring wealth management businesses and/or hire more asset managers to grow the business Add more bank subsidiaries under the NHMB holding company structure (i.e. alliance) This project will produce both a capital allocation model and a simplistic acquisition model that will become significant factors in the due diligence process and enable the Company to build on its prior successes in a comprehensive manner. The capital allocation model will use financial and regulatory capital data sourced from the quarterly uniform bank performance reports (UBPR) as well as any other publically available data. It will use these sources as baseline information and then layer on strategic initiatives to calculate the impacts on NHMB s consolidated and the appropriate subsidiary s standalone earnings and regulatory capital. The valuation model for potential acquisitions will also use publically available information such as the UBPR and Call reports found on the Federal Deposit Insurance Company s website. The model will use a discounted cash flow method to calculate the value of new branches, entire banks or wealth management businesses. There will also be a liquidity premium factored into the model based on the expectation of buying non-public companies. Like many banking companies, NHMB uses industry consultants to provide valuation services on certain acquisition transactions as well as to obtain market data and recommendations for new bank branch locations. Use of such consultants will continue to be an important part of the acquisition process and is not the focus of this project. However, some of the considerations involved in these processes are noted below to evidence that the bank has adequate procedures in place for these aspects of the acquisition process. NHMB has previously used a company called Paramount Partners to assist in bank market research to determine what markets would be best for expansion opportunities (Paramount Partners Financial Institutions Group, August 13, 2014). The process involves demographic and market assessments. Some of the factors utilized in this analysis are: Branch competitor intensity Retail deposit product potential per household Small business per branch Five year household growth forecast Median household income growth patterns Dominant lifestyle profile Five-year deposit trends The bank then conducts trade area assessments which include the following factors: 12

14 Conferring with municipal planning and economic development officials and utility companies Aerial mapping and surveys Scorecard rating of critical location and site features Establishing time frame and complexity for acquiring required public approvals Preparing financial analysis of competing sites Once a trade area has been selected, management will review potential locations for new branches in that area. Once a location is selected, a deal is negotiated and a site is secured. In 2013, NHMB decided that it needed to strategically align the wealth management businesses previously embedded in its two bank subsidiaries. The rationale being that the wealth management business would be more successful and efficient if it was consolidated into a new subsidiary with a new name separate and distinct from either bank. NHMB used a valuation consulting firm, Gordon Associates, Inc., to value the wealth management businesses on a combined basis. Since there were no tangible assets to value (i.e. merely customer relationships) the valuation focused on the revenue earned from the advisory and trust services provided by the business. The valuation was the key piece of information in financially structuring the formation of the new wealth management company, now called MillRiver Wealth Management. In the future, NHMB will look for strategic growth opportunities by either growing this business organically or buying new firms. Finding new businesses to buy and wealth management professionals to hire is relatively easy. Knowing whether they are the best use of capital is more complicated. Particularly as any near-term wealth management business acquisitions will require the banks to fund the transaction via dividends to the parent company, NHMB. NHMB also used valuation consultants, Northeast Capital & Advisory, Inc., to derive the market value of Merrimack County Savings Bank s balance sheet during the formation of the alliance with Meredith Village Savings Bank. This process involved reviewing all of MCSB s assets and liabilities and determining their individual market values. Market values are primarily impacted by current interest rates, credit risk and liquidity risk. The valuation was a cornerstone in accounting for the alliance of MCSB into the NHMB corporate structure. NHMB has a high degree of confidence in the consultants it hires. However, if the Company fails to validate the external valuations of acquisition targets and evaluate the investment s impacts on capital, it could suffer unintended negative consequences for years. For these reasons, no matter which mix of strategies the Company chooses, capital planning and management is an imperative for NHMB and its subsidiaries. As NHMB positions itself for 13

15 long term success, it must use all of the information provided by the capital management process in conjunction with the establishment of the proper management and operational structure as well as organizational culture. Combining all of these components into a disciplined process will ultimately provide a competitive advantage over other market participants. Future Opportunities NHMB intends to grow its banking businesses through acquisitions in the future. NHMB intends to add banks that are complementary and contiguous to its current market footprint with little or no overlap. Potential targets will probably be other mutual banks with assets of similar size or less than its existing bank subsidiaries. NHMB would prefer a new bank to be roughly a third of the size of NHMB s current asset size, with the current management and board members maintaining a control of membership. As noted above, the accounting impacts to the target bank s capital is a major concern from a financial perspective. NHBM will also grow its banking businesses by building or buying new branches in market areas that are complementary to its current market footprint. The amount and frequency of adding new branches will depend on how quickly the banks can achieve positive operating results from the branches. Current projections are for new branches to break even in 3 to 5 years depending on the market area characteristics. However, this forecasting process needs to become more cohesive and link the initial market analysis provided by our consultants to the forecasting process. NHMB intends to grow its wealth management business organically in the near term and through acquisitions in the future. Since acquisitions will require capital from either MillRiver or its parent, NHMB, any purchases will be constrained by the amount of available capital. NHMB can request additional capital from its banking subsidiaries, but there are regulatory limits to the size of such dividends. Dividends from the banks would reduce the banks capital levels. Bank capital levels are currently the financial constraint for potential acquisitions as NHMB and MillRiver do not currently have sufficient excess capital for acquisitions. By incorporating the use of a capital management program into the Company s decision making process, NHMB will become well aware of its capital available to pursue future opportunities. The Senior Management team of NHMB will be able to focus their attention on opportunities that are appropriate for the Company. NHMB senior managers will be able to proactively discover potential banks and wealth management companies for future alliances as they interact with industry professionals. The Finance department of NHMB will be able to evaluate the balance sheet composition of those potential alliance partners to determine if it is worth the time to develop relationships to help foster future alliances. 14

16 Some of the key factors in reviewing potential wealth management businesses would be the size and sustainability of the revenue stream. These two pieces will ultimately impact the value of the business and the capital required to purchase the business. Key factors in evaluating a potential new bank would be its balance sheet structure, earnings projections and the presence of goodwill or intangible assets. These factors dramatically impact the final valuation of the new bank and drive regulatory accounting. The accounting related to the valuation can negatively impact the bank s future earnings stream and reduce its capital initially and for several years subsequent to the transaction. For these reasons, NHMB needs reliable capital and valuation models to estimate the impact of corporate strategies as it searches for future opportunities. Implementation of a Capital Management Process NHMB is currently working through its three year strategic plan for years The CFO will explore these expansion strategies and confer with the Executive team during September 2015 to determine exactly how many branches should be included in the plan for expansion as well as the wealth management expansion strategy. Once the CFO has these parameters to work within, he will be able to obtain any necessary information to evaluate these strategies and obtain feedback from the executive team as needed. The CFO will conclude his analysis before November 1, 2015, and incorporate strategic expansion costs into the 2016 budget and the three year forecast of the balance sheet and income statement. Once the capital management framework and models are created, NHMB will need to begin using the data provided to help make strategic decisions. Implementation will include the following considerations: 1) October November CFO to create the initial capital allocation and business entity valuation models 2) November - December CFO to share results of the initial capital allocation model with Executive management of NHMB for their review, make any necessary refinements and incorporate any necessary items (i.e. capital or operating expenses) into 2016 budget and strategic plan. 3) May June CFO and Controller to back test the models using the data from the MVSB/MCSB alliance, as well as the creation of the MillRiver Wealth Management Company, to ensure the models are producing relatively similar results to those previously provided by third party valuation consultants. Any significant deviations will be vetted with third part consultants. 15

17 4) June - December CFO to properly train the Corporate Controller and Corporate Reporting Manager to run the new models and produce quarterly and ad hoc reporting. 5) January 2017 & Ongoing - CFO to create and present quarterly capital allocation reports focused on achieving NHMB strategic goals to Executive Management and ultimately the Board of Directors. These reports will provide them with the current capital metrics that are important in evaluating current operations and future strategic initiatives. 6) Ongoing Executive Management and CFO to proactively search for new potential companies for future alliances or acquisitions and evaluate using the new capital models. 7) Ongoing CFO to recommend potential targets for future acquisitions to Executive Management 8) Ongoing Executive Management to present any acquisition recommendations to the Board of Trustees for consideration and decide whether to proceed with due diligence work 9) Ongoing CFO to work with Executive Management and other Senior Staff to further analyze potential targets to determine the full set of risks and opportunities associated with any alliance or acquisition including the following: a. The SVP of Human Resources will review culture assessments provided by the target company and prepare assimilation plans. If the culture is drastically different, the use of a consulting firm may be necessary to help manage the assimilation of the culture. b. The SVP of Marketing will review customer metrics of the target company to gather customer perceptions in order to prepare the appropriate marketing plans. Then she will update senior management with those perceptions and plans. c. The Senior Staff team will review market share data and the geographic footprint of the target company versus NHMB s current positions. If there are any significant overlaps it may suggest the need to consolidate branches. d. The Executive Management team and the head of Human Resources will assess the target company s management team, its current succession plan and develop an integration plan into NHMB s Senior Management Team. This would help determine what positions are duplicative and need further investigation to determine which resources could be repositioned and those that may need to be separated from the company. Separation can cause morale issues as well as 16

18 increase severance costs. Repositioning employees into other internal roles should be the first choice when available. e. The Senior Officers from Commercial Lending, Retail Lending and Consumer Lending within the two banking subsidiaries of NHMB will review credit underwriting policies and the credit risks of loan portfolio of the target company as provided in loan review reports from external auditors/consultants as well as internal management reports. Any significant policy differences or credit concerns could impact the valuation of the target company s balance sheet by increasing the credit reserve needed to appropriately value the target company. f. The CFO will review the target company s current asset and liability management position (i.e. NII sensitivity) based on reports provided by the company. The CFO would then create a plan for any necessary balance sheet changes and discuss them with the Executive Management team. Any significant changes in the balance sheet structure could impact the future earnings of the target company and therefore its initial valuation. g. The SVP of Information Technology will assess the current state of the target company s core and peripheral banking systems for potential integration issues. This is a very critical assessment that could impact the operational feasibility of the target company becoming a subsidiary of NHMB. Major system upgrades or conversions can significantly impact the ongoing performance of the company and impact its earnings and resultant capital. The goal is to keep NHMB as operationally efficiently as possible for a reasonable cost. h. The SVP of Risk and Compliance and other appropriate department heads will review vendor contracts for termination conditions and related penalties. Gaining a complete understanding of any and all termination protocols and related costs is key in determining what the potential costs could be to consolidate third party service providers into the common vendors used by NHMB or vice versa. Knowing these costs up front is another key component in evaluating the feasibility of an affiliation or merger. i. The CFO will update the initial valuation of the target company with any new information gained during due diligence steps as noted above. j. The CFO will review the capital allocation and valuation model results to determine if the acquisition is feasible from the financial and capital perspectives and present the assessment to Executive Management for further consideration. k. Assuming the Executives decide to move forward, then the Executive Team will present the due diligence assessment to the Board of Trustees of NHMB. This 17

19 will include a presentation of their strategy to integrate the target company into NHMB. l. Assuming the Board approves a decision to go forward the Senior Management team will then move forward with the following steps: i. Engage legal counsel to help file the necessary regulatory filings which will include the Federal Reserve Bank of Boston, the Federal Deposit Insurance Company, the Banking Commission of New Hampshire and any other regulatory agencies associated with the target company. 1. Discuss the proposed transaction with these regulatory agencies and determine if there are any initial issues to be resolved. ii. If no perceived regulatory issues, then the CEO of NHMB and the target company will announce the merger to NHMB and the target company. They will discuss the reasons for the merger which are to help NHMB become a premier financial services company in New England by establishing a dominant presence in the communities it serves and creating operational efficiencies. iii. Engage a professional merger and acquisition firm to provide further due diligence information and related valuation of the target company. Final results will be communicated to both the NHMB board and the target companies board of directors and seek approval to move forward. iv. Assuming there is approval by both boards, Executive management will move forward to procure the approval by the Corporators of each bank to move forward with the alliance. v. Assuming the necessary majority of Corporators approve the proposed alliance, the Senior Staff teams from each entity will assemble the Integration Team. This process will include pairing up staff members with similar responsibilities at each company to determine what the relevant process and system conversion issues need to be addressed and resolved. A list of these issues will be presented to Senior Staff. vi. Based on input from the Integration Team, the Senior Staff team will establish an integration timeline and detailed plan. vii. The Integration Team will then execute the plan. Regular updates on the status, including successes and setbacks, will be presented to Senior Staff at regular intervals. Any setbacks will be addressed and the necessary 18

20 resources appropriated to achieve success. The steps detailed above are the significant steps to be taken once a decision has been made to acquire or become affiliated with a target banking company. The process would be somewhat shorter for the acquisition of a wealth management company assuming it was owned and operated as a private company. As noted in the Creating a Competitive Advantage section above, the steps required to determine where MVSB and MCSB could expand their branch networks is also more abbreviated than the process for bringing a whole other bank into the NHMB network. Once the capital allocation program is properly designed and implemented, it will be an integral part of the Company s regular management processes and a corner stone of its merger and acquisition process. Financial Impacts Strategic Investment This project is focused on building a capital allocation model and a valuation model for the company to use as an integral part of its decision making process when considering strategic expansions in one of three ways: branch expansion, wealth management business acquisitions or whole bank alliances. Since the wealth management business was reorganized as a separate subsidiary in April of 2015, that business will be focused on organic growth and ensuring it has the infrastructure to support its current and organic growth needs from 2016 through Based on our company s past experience, creating an alliance with a new bank will probably take two years of cultivation between the CEO of NHMB and the CEO of a prospective alliance partner. The biggest challenge is satisfying the new bank s board that its bank will maintain its support of and prominence in the communities it serves. Since this goal is not guaranteed to be achieved through NHMB s own efforts, it will not be a focus of this project. Further, the valuation and accounting process related to an alliance would require a project all on its own. Therefore, this project will focus on branch expansion for MVSB and MCSB as this is a definite part of the strategic plan for both banks over the next three years starting in The capital allocation model is a necessary piece of the decision making process to build new branches. However, the valuation model is not needed for branch expansion when planning to build new branches. If the banks were contemplating buying branches, then the valuation model would be helpful in determining the purchase prices of such branches. The cost of developing these models is relatively immaterial to NHMB as it is part of the CFO s job duties to create or buy and use such tools to properly evaluate strategic decisions. There are two sets of costs involved in building new branches: the initial start-up costs and the 19

21 operating costs during the breakeven period. The initial start-up costs include land acquisition, building and equipment and staffing costs. The bank will include the start-up costs along with its expectations of new loan and deposit business to create financial projections (i.e. pro forma financial statements) to calculate the number of years required for the new branches to breakeven. The longer the breakeven period lasts the more negative impact there is to the bank s capital position. Therefore, it is important to keep start-up costs to a minimum and reach the required level of business activity to earn a profit as soon as possible. NHMB has historically expected it to take three to five years to breakeven in new markets, especially if the new market is not contiguous to the bank s current market footprint. As most customers and bankers are aware, the continued increase in the use of ATMS, online and mobile banking channels has reduced the need for the historically large 5000 square foot branch offices. Part of the strategy in building new branches rather than buying an existing building is to create a branch that is more modern with the optimal square footage being around 2500 square feet for full service branches. Full service branches typically include driveup teller lanes, inside teller lines, office space for deposit business representatives, office space for residential, commercial and consumer lenders and potentially office or conference room space for wealth management representatives. The plan is to effectively utilize the entire footprint so that customers can quickly find who they need to talk to and ensure there are no unoccupied desks or offices. NHMB estimates the cost of such branches to be between $3.5 and $4 million dollars depending on land costs. MVSB intends to build a new full service branch in the Portsmouth, New Hampshire market area. This market is not contiguous to MVSB s current market area in the central part of New Hampshire. Portsmouth is about 45 minutes southeast of MVSB s nearest branch in Alton, New Hampshire. Portsmouth is a city with a population of roughly 21,000 (PortsmouthNH.com, 2016) on the sea coast of New Hampshire with a vibrant economy on the boarder of southern Maine. It is located less than an hour south of Portland, Maine and about an hour north of Boston, Massachusetts. The economic activity that stretches from Portland to Boston is a major commercial and consumer centric hub. NHMB and many other banks want to establish a significant presence in this area. Portsmouth is MVSB s target with the intention to build its first branch as a hub for future branches in and around Portsmouth. MCSB intends to build a new full service branch in Hooksett, New Hampshire. Most of MCSB s branch footprint is centered on Concord, New Hampshire. Hooksett is about ten miles south of Concord. MCSB already has a micro-branch in the interstate highway service plaza off I-93 north in Hooksett. The micro-branch is about 750 square feet with a teller pod to quickly service deposit customers and two small offices to handle loan and new deposit account business. It also has a night deposit drop box which is convenient for our business customers in 20

22 the area that do not want to drive to a Concord branch. Hooksett is a thriving business area half way between Concord and Manchester, New Hampshire and less than an hour from Boston, Massachusetts. Hooksett is a natural extension of MCSB s market area south towards Boston. The southern part of New Hampshire has much more commerce and a larger consumer population to serve. For the sake of keeping this project to a manageable size, MCSB s new branch pro forma results will not be presented as the assumptions are very similar to those used in MVSB s new branch pro forma analysis. Pro Forma Financial Statements for Meredith Village Savings Bank The following section will present and discuss the pro forma financial statements for the fiscal years of 2016 through 2020 as this is the expected construction and breakeven period for MVSB s new branch in Portsmouth, NH. For the purposes of the pro forma financial statements, the assumption is that the new branch in Portsmouth will be open for business on July 1, Balance Sheet Assumptions The pro forma balance sheet on page 22 shows the expectations for the business growth of the new Portsmouth branch shows a slow start to originating loans and accumulating deposits as it is the branch s first year in the new Portsmouth market and the branch will only be open for six months of the year. The loan loss allowance is estimated based on the bank s historical loan loss model and is targeted at 0.86% of the loan balances for each year. This ratio was based on MVSB s current ratio for the entire bank s loan portfolio shows the first full year of operating results. A residential lender working in the Portsmouth area is expected to produce $5 million in new loan volume each full year with 50% of this production sold to the secondary loan market for a gain as shown on the income statement on page 26. MVSB plans to have one commercial lender in the Portsmouth market with expected loan production of $4 million in 2017 and $8 million per year thereafter. Commercial loan production is split with 72% in commercial real estate and 28% in commercial and industrial loans. MVSB also plans to hire a Business Development Officer for the Portsmouth area to focus on bringing in new commercial and municipal deposit accounts. The loan and deposit product mix is based on MVSB s historical balance sheet mix of banking products. Funding from retail repurchase agreements is expected to grow 50% each year, but will eventually level off after Wholesale borrowings such as Federal Home Loan Bank advances or brokered certificates of deposits are used to balance the loan and deposit growth. The loan and deposit growth assumptions are minimum levels expected for the new branch. If loan production officers are able to obtain higher loan volumes, then the branch has a better ability to breakeven sooner than expected. 21

23 Portsmouth, NH Branch Pro Forma Balance Sheet 2016 * Balances Balances Growth Balances Growth Balances Growth Balances Growth Assets Cash & Due from Banks 125, , % 257,500 3% 265,225 3% 273,182 3% Total Cash & Investments 125, , % 257,500 3% 265,225 3% 273,182 3% Residential Real Estate 1,250,000 3,750, % 6,250,000 67% 8,750,000 40% 11,250,000 29% Home Equity 250, , % 1,000, % 1,250,000 25% 1,500,000 20% Commercial Real Estate 1,440,000 4,320, % 10,080, % 15,840,000 57% 21,600,000 36% Commercial Loans 560,000 1,680, % 3,920, % 6,160,000 57% 8,400,000 36% Consumer Loans 37,500 75, % 150, % 300, % 600, % Total Loans 3,537,500 10,325, % 21,400, % 32,300,000 51% 43,350,000 34% Loan Growth $$ 3,537,500 10,325,000 11,075,000 10,900,000 11,050,000 Allowance as % Total Loans -0.86% -0.86% -0.86% -0.86% -0.86% Allowance for Loan Loss (30,381) (88,679) 192% (183,823) 107% (277,396) 51% (372,097) 34% Net Loans 3,507,119 10,236, % 21,216, % 32,022,604 51% 42,977,903 34% Premises & Equipment, Net 3,948,925 3,805,364-4% 3,661,803-4% 3,518,243-4% 3,518,243 0% Other Assets 98, , % 550, % 870,157 58% % Total Other Assets 4,047,124 4,001,762-1% 4,211,821 5% 4,388,400 4% 3,518,243-20% Total Assets 7,679,243 14,488,083 89% 25,685,499 77% 36,676,229 43% 46,769,328 28% Average Balances 3,839,622 11,083,663 20,086,791 31,180,864 41,722,778 Liabilities Demand Deposits 625,000 1,237,500 98% 2,356,250 90% 3,634,375 54% 5,151,563 42% NOW Accounts 275, ,500 50% 618,750 50% 928,125 50% 1,392,188 50% Money Market Deposits 875,000 1,312,500 50% 1,968,750 50% 2,953,125 50% 4,429,688 50% Savings Accounts 325, ,500 50% 731,250 50% 1,096,875 50% 1,645,313 50% Time Deposits 850,000 1,275,000 50% 1,912,500 50% 2,868,750 50% 4,303,125 50% Total Deposits 2,950,000 4,725,000 60% 7,587,500 61% 11,481,250 51% 16,921,875 47% Deposit Growth $$ 2,950,000 1,775,000 2,862,500 3,893,750 5,440,625 Repurchase Agreements 250, ,000 50% 562,500 50% 843,750 50% 1,265,625 50% Wholesale Borrowings 4,538,203 9,660, % 17,825,746 85% 24,558,816 38% 28,577,804 16% Other Liabilities 42, , % 291, % 410,264 41% 506,667 23% Total Other Liabilities 4,830,702 10,153, % 18,680,012 84% 25,812,830 38% 30,350,095 18% Total Liabilities 7,780,702 14,878,370 91% 26,267,512 77% 37,294,080 42% 47,271,970 27% Equity Accounts Surplus & Capital Stock -00 (101,450) 100% (390,287) -285% (582,013) -49% (617,851) -6% Current Year Profit (101,450) (288,837) -185% (191,727) 34% (35,837) 81% 115, % Total Equity (101,450) (390,287) -285% (582,013) -49% (617,851) -6% (502,643) 19% Total Liabilities & Equity 7,679,252 14,488,083 89% 25,685,499 77% 36,676,229 43% 46,769,327 28% * Assumes branch start up mid

24 Yield Curve Assumptions The interest rate curve for the pro forma analysis is shown in the table below. Based on the ongoing discussions by the Federal Reserve System Chair and its Board of Governors, predictions by capital markets economists and NHMB s management team, the Asset and Liability Management Committee of the company made the decision in November 2015 to use the following interest rate assumptions for NHMB s strategic plan. The assumption for short term interest rates, such as Federal Funds (Fed Funds) and Prime, was to increase them by 100 basis points each year by 25 basis points per quarter using a mid-month convention beginning in 2016 through The Fed Funds and Prime rates are expected to level off after 2018 with no further increases. Deposit product rates are modeled to increase in synch with the Fed Funds rate increases. Interest rates for Federal Home Loan Bank (FHLB) fixed rate advances, which are used as a base rate loan pricing, with maturities of five years will only increase approximately 60 basis points each year. Interest rates for FHLB fixed rate advances with maturities of ten years will only increase approximately 50 basis points each year. Therefore, in years 2016 through 2018, interest income from loans will not grow as fast, on a percentage basis, as interest expense due to a majority of deposit products being priced on short term funding rates which will increase faster than the longer term asset interest rates. As seen on the income statement, interest income growth percentages lag behind interest expense growth percentages until 2019 when interest rates level off. Interest Rate Curve for Pro Forma Financial Statements Interest Rate Index Dec Dec Dec Dec Thereafter Prime 3.25% 4.25% 5.25% 6.25% 6.25% Fed Funds 0.25% 1.25% 2.25% 3.25% 3.25% FHLB - Overnight Advance 0.34% 1.34% 2.34% 3.34% 3.34% FHLB - 1 Month 0.35% 1.35% 2.35% 3.35% 3.35% FHLB - 3 Month 0.38% 1.38% 2.38% 3.38% 3.38% FHLB - 6 Month 0.45% 1.43% 2.42% 3.40% 3.40% FHLB - 1 Year 0.54% 1.50% 2.46% 3.42% 3.42% FHLB - 2 Year 1.01% 1.88% 2.75% 3.62% 3.62% FHLB - 3 Year 1.34% 2.11% 2.88% 3.65% 3.65% FHLB - 4 Year 1.66% 2.36% 3.05% 3.75% 3.75% FHLB - 5 Year 1.86% 2.48% 3.10% 3.72% 3.72% FHLB 7 Year 2.37% 2.91% 3.44% 3.98% 3.98% FHLB 10 Year 2.80% 3.29% 3.79% 4.28% 4.28% FHLB 15 Year 3.40% 3.89% 4.39% 4.88% 4.88% FHLB 20 Year 3.71% 4.20% 4.70% 5.19% 5.19% 23

25 Loan and Deposit Yields The table below shows the loan and deposit yields used in the pro forma analysis. Consistent with the interest rate curve assumptions noted above, the loan and deposit yields increase from 2016 through 2018 and then level off in 2019 and Loan & Deposit Yields for Pro Forma Financial Statements Rates Rates Rates Rates Rates Loan Yields Residential Loans 3.77% 3.94% 4.27% 4.27% 4.27% Home Equity Loan 4.48% 4.89% 5.93% 5.93% 5.93% Commercial Real Estate Loans 4.88% 5.13% 5.75% 5.75% 5.75% Commercial & Industrial Loans 4.83% 5.38% 6.32% 6.32% 6.32% Consumer Loans 7.33% 7.33% 7.52% 7.52% 7.52% Deposit Yields Money Market 0.32% 0.59% 0.95% 0.95% 0.95% NOW 0.39% 0.84% 1.39% 1.39% 1.39% Savings 0.19% 0.30% 0.45% 0.45% 0.45% Certificates of Deposit 1.03% 1.33% 2.08% 2.08% 2.08% Repurchase Agreements (Retail) 0.83% 1.75% 2.91% 2.91% 2.91% FHLB Long Term 1.45% 1.93% 2.58% 2.58% 2.58% FHLB Shrot Term 0.75% 1.75% 2.75% 3.25% 3.25% Pro Forma Income Statement Discussion & Analysis Net Interest Income The pro forma income statement for the Portsmouth branch is shown on page 26. The 2016 results represent only six months of operating results as the branch plans to open in July of The loan volume for commercial loans is expected to produce $2 million new volume in 2016, $4 million new volume in 2017 and $8 million in new loan volume every year thereafter. Therefore, interest income on commercial loans really is not at its full potential until 2019 after a full year s worth of production at the $8 million level is booked in However, please note that loan growth is expected to grow a good bit faster than deposits due to the fact that MVSB already has one loan originator in the Portsmouth area working out of a temporary loan production office. Total loans are expected to be $10.3 million by the end of 2017 versus 24

26 deposits at only $4.7 million. The funding gap is filled with the use of short term advances from the FHLB. Therefore, net interest income is expected to be positive every year even after the deduction for provision expense. Provision expense levels off in 2019 due to the assumption that all loan originators are consistently meeting there minimum goals for new volume. Non-Interest Income Non-interest income projections were based on MVSB s recent experience. Income from loan servicing and other loan underwriting fees will increase consistent with the increase in loan growth. Gains from the sale of residential loans and the related gains from the creation of new loan servicing assets were kept flat due to the expected production of $5 million in new residential volume for the first few years. Operating Expenses Compensation expense is based on a full service staff pool using the bank s historical average costs consisting of the following positions: Branch & Business Development Officer (i.e. Branch Manager) Business Development Officer Branch Services Supervisor Branch Services Representative 2 full time Tellers 2 part time Compensation is expected to increase 3% in 2018 and 5% thereafter to provide for merit increases as well as benefit cost increases. The bank is expecting a 6% increase in medical benefits in 2018, if not sooner. A 3% average merit increase combined with a 6% increase in medical insurance is expected to result in an overall increase of 5%. Occupancy and furniture and equipment costs are expected to remain level for several years as the building will be new with no significant repairs expected. Professional expenses are expected to drop to zero after 2018 to reflect the branch being fully staffed with no need for any personnel recruiting or other professional fees specific to the startup of the branch. Insurance costs are based on the bank s historical experience and expected to increase nominally over the pro forma period. Marketing expense is expected to decline 70% in 2018 after the first two years of initial publicity campaigns are complete. All other operating expense estimates are based on the historical experience of MVSB, are relatively minor and are expected to increase modestly every year. 25

27 The bank s effective tax rate is 32%. The branch is projected to breakeven in However, the branch starts improving its net income and return on average assets in 2018 due to the continued increases in loan revenue while funding costs level off and operating expenses remain relatively constant. Portsmouth, NH Branch Pro Forma Income Statement Balances Balances Growth Balances Growth Balances Growth Balances Growth Interest Income Interest on Residential Loans 23,565 73, % 133,360 81% 186,703 40% 240,047 29% Interest on Home Equity Loans 5,596 12, % 29, % 37,085 25% 44,502 20% Interest on Commercial Real Estate Loans 35, , % 289, % 455,671 57% 621,370 36% Interest on Commercial Loans 13,513 45, % 123, % 194,558 57% 265,306 36% Interest on Consumer Loans 1,375 2, % 5, % 11, % 22, % Total Interest Income 79, , % 582, % 885,294 52% 1,193,778 35% Interest Expense Interest on NOW Accounts 538 1, % 4, % 6,441 50% 9,662 50% Interest on Money Market Deposits 1,396 3, % 9, % 14,022 50% 21,033 50% Interest on Savings Accounts % 1, % 2,471 50% 3,707 50% Interest on Time Deposits 4,392 8,510 94% 19, % 29,866 50% 44,799 50% Interest on Deposits 6,631 14, % 35, % 52,800 50% 79,200 50% Int. on Repurchase Agreements 1,037 3, % 8, % 12,291 50% 18,436 50% Int. on Wholesale Funds 17,018 84, % 245, % 316,967 29% 368,838 16% Total Interest Expense 24, , % 288, % 382,057 32% 466,473 22% Net Interest Income before Provision 54, , % 293, % 503,237 71% 727,305 45% Provision expense (30,381) (58,299) 92% (95,144) 63% (93,573) -2% (94,701) 1% Net Interest Income after Provision 84,863 83,789-1% 198, % 409, % 632,604 54% Tot. Loan Servicing and Other Loan Fees 2,199 4, % 9, % 13,760 51% 18,467 34% Deposit Fees 7,419 14, % 14,910 0% 36, % 53,143 47% Gain/Loss Loans Sold 27,500 55, % 55,000 0% 55,000 0% 55,000 0% Mortgage Servicing Gain 13,750 27, % 27,500 0% 27,500 0% 27,500 0% Total Other Income 50, , % 106,527 5% 132,317 24% 154,110 16% Total Income Subtotal 135, ,526 37% 305,334 65% 541,980 78% 786,714 45% Operating Expenses Total Compensation 169, , % 348,836 3% 366,278 5% 384,592 5% Occupancy Expense 40,280 80, % 80,561 0% 80,561 0% 80,561 0% Furn. & Equip. Expense 31,500 63, % 63,000 0% 63,000 0% 63,000 0% Professional Fees 8,400 16, % 16,800 0% % -00 0% Institution Insurance 5,600 11, % 11,536 3% 12,113 5% 12,718 5% Marketing Expense 25,000 50, % 15,000-70% 15,000 0% 15,000 0% Deposit Expense 2,000 4, % 4,120 3% 4,326 5% 4,542 5% Supplies Expense 6,000 12, % 12,360 3% 12,978 5% 13,627 5% Communications Expense 10,000 20, % 20,600 3% 21,630 5% 22,712 5% Postage Expense % 258 3% 250-3% 250 0% Travel Expense % 515 3% 541 5% 568 5% Dues, Subscriptions & Assessments % 309 3% 324 5% 341 5% Charitable Contribution Expense 2,500 5, % 5,150 3% 5,408 5% 5,678 5% Training & Education Expense 1,000 2, % 2,060 3% 2,163 5% 2,271 5% Correspondent Banking Fees 2,000 4, % 4,120 3% 4,326 5% 4,542 5% Other Operating Exp. 1,000 2, % 2,060 3% 2,163 5% 2,271 5% Total Operating Expenses 305, , % 587,284-4% 594,682 1% 617,291 4% Net Income before Tax (169,412) (424,760) (281,951) (52,702) 169,423 Provision for Taxes (67,962) (135,923) (90,224) (16,865) 54,215 Effective Tax Rate 0 32% 32% 32% 32% Reported Net Income(Loss) (101,450) (288,837) 185% (191,727) -34% (35,837) -81% 115, % Return on Average Assets -2.64% -2.61% -0.95% -0.11% 0.28% 26

28 Pro Forma Capital Impacts Discussion and Analysis The table on page 28 presents the impacts on MVSB s capital ratios and levels due to the construction and operation of the new branch in Portsmouth. The pro forma capital impacts of the new branch were based on the bank s historical balance sheet mix and related risk weighting for regulatory Call Reporting purposes. The table presents four sections of information focused on the following: 1) Changes in capital ratios and levels assuming no bank growth This section isolates the impacts due to the addition of the new branch and holding the bank s balance sheet and income levels constant. During the initial year of construction and startup, the branch reduces the bank s total risk based capital by 24 basis points and capital dollars by $71,000. This is fairly immaterial in dollar terms and not a significant impact on the bank s capital ratios is the first full year of operations and it shows a reduction in the bank s total risk based capital of 16 basis points and capital dollars of $231,000. Again, this is not huge in relative terms. In 2018 the impact is a decrease of 22 basis points and only $95,000 in total risk based capital. The impact on the ratio is larger than the prior year due to the fact that commercial loans increased by $8 million in 2018 up from only $4 million in Meaning, the risk weighted assets increased from 2017 by $4 million. However, the capital dollar level was not impacted as much as it was in 2017 as net interest income increased in 2018 by $152,000 and operating costs leveled off. This becomes a trend through 2019 and By 2020, the branch has its first year of making a profit. In turn, the impact to capital is only 12 basis points and a positive increase of $211,000 to total risk based capital. 2) Changes in capital ratios and levels due to bank growth only This section isolates the impacts due to the expected growth of the bank excluding the addition of the new branch. The bank is forecasting positive capital growth from regular bank operations over all periods. This is based on a relatively steady stable mix of the bank s balance sheet and the assumed yield curve impacts as noted above. Total loans are modeled to grow 3% per year and total deposits are expected to grow 4% per year. 3) Changes in capital ratios and levels with combined bank growth and a new branch This section merely combines the first two sections and presents the net impacts on the bank s capital ratios and level. In 2019, the bank s growth is sufficient to almost completely offset the drag on earnings and capital from the addition of the new branch. This shows that as long as the bank continues to grow it should easily offset the impact of the new branch on its regulatory capital ratios by the end of three years. Further, in dollar terms, the bank s net income is positive every year and continues to increase the capital levels of the bank. 4) Capital ratios and levels of the combined bank and new branch This section shows the combined ratios and capital dollar levels of the bank including 27

29 the impact of the new branch. Tier 1 leverage ratio increases from the base year of 2015 from 11.00% to 11.51% which is well above management s internal target of 9.00%. Common equity tier 1 and tier 1 capital ratios decrease from 14.63% in 2015 to 14.32% in 2020 which is still well above management s internal target of 13.00%. The same is true for the total risk based capital ratio which ends 2020 at 15.25% and is well above the same internal target of 13.00%. Pro Forma Capital Ratios and Levels Changes in Capital Ratios & Levels Cummulative Assuming No Bank Growth % $ % $ % $ % $ % $ % $ Tier 1 Leverage Ratio -0.27% (101) -0.13% (289) -0.14% (190) -0.15% (35) -0.12% % (499) Common Equity Tier 1 Capital -0.23% (101) -0.17% (289) -0.23% (190) -0.19% (35) -0.13% % (499) Tier 1 Risk-based Capital Ratio -0.23% (101) -0.17% (289) -0.23% (190) -0.19% (35) -0.13% % (499) Total Risk-based Capital Ratio -0.24% (71) -0.16% (231) -0.22% (95) -0.19% % % (127) Changes in Capital Ratios & Levels Cummulative Due to Bank Growth ONLY % $ % $ % $ % $ % $ Tier 1 Leverage Ratio 0.44% 5, % 4, % 4, % 6, % 6, % 26,810 Common Equity Tier 1 Capital 0.14% 5, % 4, % 4, % 6, % 6, % 26,810 Tier 1 Risk-based Capital Ratio 0.14% 5, % 4, % 4, % 6, % 6, % 26,810 Total Risk-based Capital Ratio 0.12% 5, % 4, % 5, % 6, % 6, % 27,732 Changes in Capital Ratios & Levels Cummulative Combined Bank Growth + Branch % $ % $ % $ % $ % $ Tier 1 Leverage Ratio 0.17% 4, % 4, % 4, % 5, % 6, % 26,311 Common Equity Tier 1 Capital -0.09% 4, % 4, % 4, % 5, % 6, % 26,311 Tier 1 Risk-based Capital Ratio -0.09% 4, % 4, % 4, % 5, % 6, % 26,311 Total Risk-based Capital Ratio -0.12% 5, % 4, % 5, % 6, % 6, % 27,605 Capital Ratios & Levels Combined Bank Growth + Branch % $ % $ % $ % $ % $ % $ Tier 1 Leverage Ratio 11.00% 84, % 89, % 93, % 98, % 104, % 110,690 Common Equity Tier 1 Capital 14.63% 84, % 89, % 93, % 98, % 104, % 110,690 Tier 1 Risk-based Capital Ratio 14.63% 84, % 89, % 93, % 98, % 104, % 110,690 Total Risk-based Capital Ratio 15.65% 90, % 95, % 100, % 105, % 111, % 117,861 28

30 Risks Associated with Strategic Branch Expansion In business there are always risks associated with strategic plans. Certainly, expanding the bank s service area into the new market of Portsmouth has risks. The primary risks are: The timing and amount of loan volumes are incorrect The timing and amount of deposit volumes are incorrect Interest rate assumptions are incorrect As in any business, management must be aware of the risks, determine the likelihood of their projected results and ensure they have contingency plans if things do not turn out as they expected. As it relates to the timing and amount of loan volume, the bank has the ability to withstand less income if loan volumes are lower than expected due to its strong capital levels. It also has the ability to increase the volume of its existing business by raising growth targets. Further, the bank could buy loans from other banks in New England or the wholesale market to supplement income in the first few years to offset the drag on income levels from adding the new branch. The same is true as it relates to the risks associated with the timing and amount of deposit volumes. The bank has the ability to raise deposit gathering goals by its existing branch network and business development officers. Further, the bank could buy wholesale funding from the Federal Home Loan Bank or the brokered certificate of deposit market. The wholesale market can be cheaper than local markets which would actually improve the operating results of the company and the new branch. The bank can also buy funding directly from other banks. The interest rate scenario that was used to create the pro forma financial statements was viewed by management as a reasonable projection of future interest rates or most likely scenario. It was based on recent comments made during November 2015 by the Federal Reserve System Chair and fellow Board of Governors. Management also incorporated discussions it has had with its asset and liability management consultants to determine what the size and timing of rate increases may be by the Federal Reserve. As with any prediction, it is just one of many possibilities. There are two other possible interest rate forecast scenarios that would change the results of the analysis. One scenario would be for the short term rates to continue to stay low with no increases or a continued delay before any increases. Please see the graph on page 31 from the bank s interest rate risk model and focus on the graph on the right side of the page. This scenario, labeled Base, would actually increase the profitability of the bank in years as short term rates would stay lower than expected in the pro forma analysis. This scenario would help keep deposit and other short term funding costs at the current low levels. 29

31 Long term interest rates would continue to stay in the static range they have been which results in a relatively steep yield curve. While this is a profitable yield curve scenario for the bank as noted by the blue bars in the graph it is not as profitable as the scenario used in the pro forma analysis. The related net interest income is noted in the table below the graph. This scenario could be thought of as the worst case scenario. Capital ratios would not recover from the impact of the new branch as quickly as the pro forma results indicate, but the company would still be well capitalized and can sustain this prolonged static rate environment as long as it continues to grow loans and deposits in a consistent manner. Another interest rate scenario would be that rates rise faster than expected or best case scenario. If this occurred, the bank s income would suffer more in the first two to three years based on projections using the bank s interest rate risk model. Please see page 31 which is an excerpt from the bank s interest rate risk model and focus on the graph on the right side of the page. The Up 400BP 24 month scenario contemplates an increase in interest rates of 400 basis points spread over a 24 month time frame. This scenario would lead to the longer term interest rates rising sooner than expected which would therefore increase the loans rates sooner than expected. As noted in the table of results below the graph, this scenario would result in higher net interest income for the bank starting in year three as compared to the Base or current interest rate environment. Capital ratios would improve much more on a cumulative basis in the best case scenario as net income would be higher than the pro forma results. However, based on comments by the Board of Governors of the Federal Reserve System, short term interest rates are expected to move more slowly than the best case scenario. 30

32 Excerpt from MVSB Interest Rate Sensitivity Model as of 9/30/15 31