ITEM 1 - BUSINESS
Business Overview
Harris Bankcorp, Inc. ("Bankcorp") is a Delaware multibank holding company headquartered in Chicago. Bankcorp is a wholly-owned subsidiary of Bankmont Financial Corp. ("Bankmont"), a wholly-owned U.S. subsidiary of Bank of Montreal ("BMO"). On October 1, 1994, Bankmont also became the parent company for Harris Bankmont, Inc. (formerly Suburban Bancorp, Inc.), a Chicago area multibank holding company with assets of $1.5 billion at December 31, 1994. The transaction added 13 banks and 30 locations in Illinois in addition to those owned by Bankcorp.
Bankcorp provides banking, trust and other services domestically and internationally through 14 bank and 17 active nonbank subsidiaries. The bank subsidiaries include Harris Trust and Savings Bank; Harris Bank Barrington, N.A.; Harris Bank Frankfort; Harris Bank Glencoe-Northbrook, N.A.; Harris Bank Hinsdale, N.A.; Harris Bank Libertyville; Harris Bank Naperville; Harris Bank Roselle; Harris Bank Argo; Harris Bank Wilmette, N.A.; Harris Bank Winnetka, N.A.; Harris Bank St. Charles; Harris Bank Batavia, N.A.; and Harris Trust Bank of Arizona. All bank subsidiaries, with the exception of Harris Trust Bank of Arizona, are located in Illinois. Nonbank subsidiaries consist of trust companies and other specialized financial services companies. The trust companies include Harris Trust Company of California, Harris Trust Company of Florida, Harris Trust Company of New York and Bank of Montreal Trust Company. They provide specialized nondeposit services, notably stock transfer and indenture trust. Other principal nonbank subsidiaries, Harris Investors Direct, Inc., a discount brokerage company, and Harris Investment Management, Inc., a registered investment adviser, are headquartered in Chicago. Throughout this Form 10-K ("Report"), the term "Corporation" refers to Harris Bankcorp, Inc. and subsidiaries.
Bankcorp's lead bank subsidiary is Harris Trust and Savings Bank ("HTSB"), an Illinois state-chartered bank with its principal office, three domestic branch offices, an international banking facility and two automatic banking centers located in Chicago. Additionally, HTSB has representative offices in Los Angeles, New York and Tokyo; foreign branch offices in Nassau and London; and an Edge Act subsidiary, Harris Bank International Corporation ("HBIC"), in New York.
HTSB provides a variety of banking and financial services to commercial and industrial companies, financial institutions, governmental units, not-for-profit organizations and individuals throughout the U.S. and abroad. Services rendered and products sold to customers include numerous types of demand, savings and time deposit accounts; negotiable certificates of deposit; various types of loans including term, real estate and those under lines of credit and revolving credit facilities; sales and purchases of foreign currencies; interest rate management products including swaps, forward rate agreements and interest rate guarantees; cash management services including lockbox and controlled disbursement processing; underwriting of municipal bonds; and financial consulting. Additionally, HTSB trades foreign currencies and a variety of debt securities for its own account and utilizes interest rate swaps, financial futures and options both to manage its risk exposure and as trading vehicles. Effective April 3, 1995, HTSB and BMO agreed to combine their U.S. foreign exchange activities ("FX"). Under this arrangement, FX net profit will be shared by HTSB and BMO in accordance with a specific formula set forth in the agreement.
HTSB's overseas activities are conducted through its representative offices, branches, an international banking facility, Bank of Montreal Trust Company (Channel Islands), Ltd., and HBIC. Services include various types of loans and deposits, letters of credit, personal trust services, export and import financing and foreign exchange products.
HTSB's Trust Department furnishes a variety of trust services to individuals, businesses, municipalities and charitable organizations. HTSB acts as trustee of personal, corporate, pension and other employee benefit trusts; serves as executor and administrator of estates; provides global custody and master trust services; and acts as stock and bond registrar and transfer agent, dividend reinvestment agent and paying agent. On January 11, 1996, HTSB announced the sale of its securities custody and related trustee services business for large institutions to Citibank.
Effect of Government Policies
The operations of the Corporation are affected by general economic conditions and the policies of various governmental regulatory authorities. In particular, the Federal Reserve System regulates money and credit conditions and interest rates in order to influence general economic conditions, primarily through open market operations in U.S. Government securities, varying the discount rate on bank borrowings, setting reserve requirements against financial institution deposits and prescribing minimum capital requirements for member banks. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for time, savings and other deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and this is expected to continue. The effect of such policies upon the future business and earnings of the Corporation cannot accurately be predicted.
Regulation and Supervision
Bankcorp is a legal entity separate and distinct from its subsidiaries. There are various legal limitations on the ability of its banking subsidiaries to finance or otherwise supply funds to Bankcorp or various of its other affiliates. Note 13 to Financial Statements on page 53 of this Report provides details with respect to regulatory restrictions on dividends.
In addition, the banking subsidiaries are subject to certain restrictions on any extensions of credit to Bankcorp and (with certain exceptions) other affiliates, on investments in stock or other securities thereof and on the taking of such securities as collateral for loans. As a bank holding company, Bankcorp is subject to the Bank Holding Company Act of 1956, as amended, which generally limits the activities of the holding company and its subsidiaries to those so closely related to banking or managing or controlling banks as to be a proper incident thereto.
Bankcorp and its banking subsidiaries are subject to regulation by various State and Federal authorities. Applicable laws and regulations relate to reserves, deposit insurance, investments, loans, mergers and consolidations, issuance of securities, payment of dividends, capital adequacy and other aspects of their operations. Bankcorp and its nonbank subsidiaries are affiliates of the banking subsidiaries within the meaning of the Federal Reserve Act and the Illinois Banking Act. Certain nonbank subsidiaries including the trust companies; Harris Investment Management, Inc.; Harris Investors Direct, Inc. and others are subject to a variety of Federal and state regulations.
The enactment of the Federal Deposit Insurance Corporation Improvement Act of 1991, and the regulations adopted to implement its various provisions, have had a significant effect on commercial banks. Five capital categories ranging from "well capitalized" to "critically undercapitalized" were defined. Adequate capital is essential if a bank or thrift is to avoid the statute's prompt corrective action provisions. Federal regulators adopted safety and soundness standards covering operations and management, asset quality, earnings and stock valuation, and compensation. Federal regulations require establishment of annual independent audits, management's assessment of internal controls over financial reporting and compliance with designated laws and regulations, independent auditor reports and independent audit committees. A risk-based assessment system was designed for the calculation of deposit insurance premiums. Truth-in-savings regulations, loan-to-value ratios for real estate lending and standards to limit interbank exposures were adopted. The Corporation's subsidiaries are in compliance with the statute and its regulations.
Competition
Active competition exists in all principal geographic and product line areas in which the Corporation is presently engaged. Competitors include other commercial banks, investment banks, savings and loan associations, finance companies, credit unions, insurance companies, mutual funds, mortgage banks, investment managers and advisors, leasing companies, other domestic and foreign financial institutions and various nonfinancial intermediaries.
Employees
The Corporation and HTSB had full-time equivalent employees of 5,749 and 4,256, respectively, at December 31, 1995.
ITEM 2

ITEM 2 - PROPERTIES
The Corporation's headquarters and HTSB's main banking premises are located at 111 West Monroe Street, Chicago, Illinois. This bank and office building complex is comprised of three connected buildings containing a total of approximately 1,590,000 gross square feet. Approximately 56 percent of the rentable space is committed to use by HTSB. Virtually all of the remaining space in the entire building complex has been rented to tenants. HTSB holds title to this property.
HTSB also owns its operations center. This 15-story building contains approximately 415,000 gross square feet and is totally dedicated to bank use. It is located at 311 West Monroe Street, Chicago.
Certain banking subsidiaries, other than HTSB, individually own premises used to conduct banking business. Nonbank subsidiaries, certain divisions of HTSB and certain other subsidiaries conduct activities from leased premises.
In 1990 and 1991, HTSB purchased air rights and a 72,000 square foot parcel of vacant land in Chicago's downtown business district. Construction plans for a new operations and office building complex on this site were deferred. For more information, see Note 5 to Financial Statements on page 43 of this Report.
ITEM 3

ITEM 3 - LEGAL PROCEEDINGS
For information on the Corporation's legal proceedings, see Note 14 to Financial Statements on page 53 of this Report.
ITEM 4

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Stockholder during the fourth quarter of 1995.
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ITEM 5

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Bankmont presently owns all 6,667,490 shares of the voting stock of Bankcorp, which are not listed or traded on any securities exchange. In 1995, Bankcorp declared and paid approximately $262.7 million in cash dividends to Bankmont, including a $205 million special dividend in connection with the capital restructuring described below. Dividends amounting to approximately $34.7 million and $56.6 million were declared and paid to Bankmont in 1994 and 1993, respectively. The 1993 dividend included a $7.2 million dividend-in-kind related to the transfer of Harris Futures Corporation to Bankmont.
Effective December 27, 1995, Bankcorp increased its capital base by $40 million. At the same time, Bankcorp adjusted its capital structure to mirror the capital mix of BMO and more closely resemble its peer group comprising other major U.S. and Chicago bank holding companies. Bankcorp issued $180 million of Series A non-voting, callable, perpetual preferred stock and an additional $65 million of long-term subordinated debt, both purchased by Bankmont. The 180 shares of preferred stock have no par value and a stated value of $1.0 million per share. The dividend rate per annum is 7.25 percent of the stated value per share. No dividends were accrued or paid on the preferred stock in 1995. Concurrently, common equity was reduced by $205 million through the declaration of a special dividend. These actions resulted in a total capital base, including long-term subordinated debt, of approximately $1.5 billion at December 31, 1995, and a reduced overall cost of capital for the Corporation.
ITEM 6

ITEM 6 - -SELECTED FINANCIAL DATA
ITEM 7

ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Summary
1995 Compared to 1994
The Corporation's 1995 net income was $147.6 million, up 52 percent from $97.3 million in 1994. For 1995, the return on average common equity was 13.6 percent and the return on average assets was 0.95 percent, compared to returns of 9.70 percent and 0.68 percent, respectively, a year ago. Year to year earnings comparisons were significantly affected by a one-time $33.4 million after-tax charge in 1994 resulting from management's decision to absorb the impact of higher interest rates on mortgage-backed securities held in certain customer accounts of HTSB's Securities Lending unit. Excluding the effect of the securities lending charge, returns on average common equity and average assets were, respectively, 13.0 percent and 0.92 percent in 1994, compared to 13.6 percent and 0.95 percent in 1995; and 1995 earnings increased by 13 percent compared to 1994. The earnings gain is attributable to strong growth and business momentum broadly across the Corporation--and in particular loan growth in corporate banking, community banking and the credit card business; sustained cost control, overhead reduction and operations consolidation; gains from securities transactions; and reduced FDIC premiums.
Net interest income on a fully taxable equivalent ("FTE") basis was $500.3 million in 1995, up $19.9 million or 4 percent from $480.4 million in 1994. Average earning assets rose 10 percent to $13.33 billion from $12.17 billion in 1994, attributable to an increase of 15 percent or $1.11 billion in average loans. Net interest margin declined to 3.75 percent in 1995 from 3.95 percent the previous year, reflecting rate compression in certain asset categories, a lower mix of noninterest-bearing deposits, and the relationship which existed in the markets between short and longer term rates.
Noninterest income increased $23.8 million or 8 percent in 1995, to $338.3 million. In 1995, net gains from the sale of debt securities amounted to $23.4 million, compared to $5.3 million in the prior year. Most of these 1995 gains were recognized in the second quarter when conditions in the U.S. bond market led to significant price rallies. This enabled the Corporation to sell certain U.S. government agency securities and reinvest the proceeds to reposition its portfolio, taking advantage of profit opportunities not typically available. Money market and bond trading profits increased by $5.5 million in 1995, while charge card fees increased $4.4 million, and trust and investment management revenue rose $1.9 million. Other sources of non-interest income, which include fees for letters of credit, corporate finance income and gains on asset sales, increased $3.7 million year to year. Service charges declined by $4.3 million due to the higher interest rate environment and to customer refunds with respect to FDIC insurance. Foreign exchange revenue decreased by $5.5 million. This revenue is now reported net of expenses under a new profit sharing arrangement with BMO effective April 3, 1995.
Noninterest expenses in 1995 declined to $560.1 million from $604.1 million a year ago, reflecting the one-time $51.3 million (pretax) charge in the securities lending unit in 1994 and lower FDIC insurance premiums in 1995. Excluding the effect of these two events, noninterest expenses increased by 3 percent.
Income taxes increased by $45.6 million in 1995, reflecting substantially higher pretax income and a smaller tax-exempt municipal bond portfolio.
The 1995 provision for credit losses was $43.0 million, down from $45.0 million in 1994. Net loan charge-offs for the current year were $38.5 million, down from $52.0 million a year ago, resulting primarily from lower write-offs in the commercial loan, installment loan and real estate mortgage loan portfolios.
Nonperforming assets at December 31, 1995 totaled $55 million or 0.6 percent of total loans, down from $94.8 million or 1.15 percent of loans a year ago. At December 31, 1995, the allowance for possible credit losses was $129 million or 1.4 percent of total loans outstanding, compared with $125 million or 1.5 percent of loans at the end of 1994. As a result, the ratio of the allowance for possible credit losses to nonperforming assets increased from 132 percent at December 31, 1994 to 235 percent at December 31, 1995. During the first quarter of 1995, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 114--Accounting by Creditors for Impairment of a Loan and SFAS No. 118--Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosures. SFAS No. 114 addresses accounting by creditors for impairment of certain loans. It requires that impaired loans within the scope of the statement (primarily commercial credits) be measured based on the present value of expected future cash flows (discounted at the loan's effective interest rate) or, alternatively, at the loan's observable market price or the fair value of supporting collateral. The Corporation determines loan impairment when assessing the adequacy of the allowance for possible credit losses. SFAS No. 118 permits existing income recognition practices to continue. The adoption of these Statements did not have a material impact on the Corporation's net income or financial position.
At December 31, 1995, the Corporation's consolidated equity capital increased $124.6 million from the prior year-end to $1.15 billion. The increase resulted from the issuance of $180 million of preferred stock, earnings for the prior twelve months and $59.8 million of after-tax unrealized holding gains related to the Corporation's debt and equity securities classified as available for sale. Also, the Corporation paid $262.7 million of dividends. To support continued business growth and expansion, Bankcorp increased its capital base by $40 million, effective December 27, 1995. At the same time, Bankcorp adjusted its capital structure to mirror the capital mix of BMO and more closely resemble the Corporation's peer group comprising other major U.S. and Chicago bank holding companies. Bankcorp issued $180 million of preferred stock and an
additional $65 million of long-term subordinated debt, purchased by Bankmont. Concurrently, common equity was reduced by $205 million through the declaration of a special dividend. These actions resulted in a total capital base, including long-term subordinated debt, of approximately $1.5 billion at December 31, 1995, and a reduced overall cost of capital for the Corporation. On a proforma basis, had these changes to the Corporation's capital mix occurred on January 1, 1995, they would have increased the Corporation's 1995 return on average common equity by approximately 1.4 percent, from 13.6 percent to 15.0 percent.
The Corporation's regulatory capital leverage ratio was 6.77 percent for fourth quarter 1995 compared to 7.03 percent one year earlier. Regulators require most banking institutions to maintain capital leverage ratios of not less than 4.0 percent. At December 31, 1995, the Corporation's Tier 1 and Total Risk-based capital ratios were 8.14 percent and 11.79 percent, respectively, compared to respective ratios of 8.86 percent and 12.49 percent at December 31, 1994. The 1995 year-end ratios substantially exceeded minimum required regulatory ratios of 4.0 percent and 8.0 percent, respectively.
1994 Compared to 1993
The Corporation's 1994 net income was $97.3 million, down 17 percent from $117.6 million in 1993. The earnings decline was primarily caused by the one-time $33.4 million after-tax charge resulting from management's decision in the second quarter of 1994 to absorb the impact of higher interest rates on mortgage-backed securities held in certain customer accounts of HTSB's Securities Lending unit. Excluding the effect of this charge and the favorable benefit in 1993 of a mandatory accounting change for income taxes, 1994 earnings would have increased by approximately 13 percent. Returns on average assets and equity in 1994 were 0.68 percent and 9.70 percent, respectively, compared to 1993 returns of 0.90 percent and 12.31 percent.
FTE net interest income was $480.4 million, up 5 percent from $459.0 million in 1993. Average earning assets, led by loan growth, rose 7 percent from $11.35 billion in 1993 to $12.17 billion in 1994. However, the positive effects of higher earning asset levels were somewhat offset by a narrower net interest margin, which declined to 3.95 percent in 1994 from 4.04 percent in 1993.
Average loans increased $628 million, or 9 percent, led by increases in domestic commercial loans, installment loans and charge card outstandings. Average portfolio securities, which include securities held to maturity and securities available for sale, increased $239 million, or 8 percent to $3.23 billion, primarily reflecting increased holdings of U.S. Treasury securities. Money market assets, consisting of interest-bearing deposits at banks, Federal funds sold and reverse repurchase agreements, were up $23 million compared to 1993. Average levels of trading account assets employed decreased by $70 million year to year.
Incremental funding for the growth in average earning assets came mainly from a $444 million increase in interest-bearing deposits and a $323 million increase in short-term borrowings. Foreign office time deposits grew by $292 million and other interest-bearing time deposits were up $169 million. Average noninterest-bearing supporting funds, primarily demand deposits and stockholder's equity, increased $51 million compared to 1993.
The Corporation's consolidated net interest margin declined by 9 basis points to 3.95 percent. Factors causing this decline were rate compression within certain asset categories, the relative decline in noninterest-bearing funds, and sales and maturities of portfolio securities where proceeds were reinvested at slightly lower yields. Positive factors relative to 1993 included favorable retail spreads, an enrichment in the mixture of earning assets because of overall loan growth and a restructuring of the Corporation's long-term notes issued to Bankmont, converting them to a floating rate structure and extending their maturities by two years.
Total noninterest income in 1994 was $314.4 million, down $22.6 million or 7 percent from 1993. The most significant factor causing this decline resulted from sales of portfolio securities. The Corporation realized a $5.3 million net gain on the sale of certain portfolio securities during 1994, compared to a net gain of $13.0 million in 1993. Bond and financial instrument trading activities reported a $.4 million loss in 1994 compared to a $5.3 million profit in 1993. Foreign exchange income also declined from $24.3 million in 1993 to $19.8 million at year-end 1994. Service fees and charges declined $4.2 million or 5 percent from $77.8 million in 1993 to $73.6 million in 1994.
Noninterest expenses totaled $604.1 million in 1994, up $52.0 million or 9 percent from 1993. Expenses in 1994 contained the one-time $51.3 million (pretax) charge in the Securities Lending unit. Expenses in 1993 benefited from the reversal of $7.2 million of reserves previously recorded for anticipated costs of customer guarantees that were no longer necessary. Excluding both special items, expenses would have decreased by 1 percent.
Income tax expense decreased by $13.6 million in 1994, resulting from lower pretax income. In addition, the Corporation adopted SFAS No. 109--Accounting for Income Taxes in the first quarter of 1993. The cumulative effect of this change, approximately $1.8 million, increased 1993 net income.
The 1994 provision for credit losses of $45.0 million was down from $62.8 million recorded in 1993. Net loan charge-offs were also down from $61.3 million in 1993 to $52.0 million in 1994. At December 31, 1994, the allowance for possible credit losses was $125 million, or 1.5 percent of total loans outstanding, compared to the December 31, 1993 allowance of $132 million, or 1.7 percent of loans. Total nonperforming assets declined to $95 million at December 31, 1994, from $113 million at December 31, 1993.
At December 31, 1994, the Corporation's consolidated equity capital increased $3.5 million to $1.02 billion. The increase resulted from earnings for the prior twelve months less $59.1 million of after-tax unrealized holding losses related to the Corporation's debt and equity securities classified as available for sale, and reduced further by $34.7 million of dividends paid. The Corporation's regulatory capital leverage ratio was 7.03 percent for fourth quarter 1994 compared to 7.33 percent one year earlier. Regulators require most banking institutions to maintain capital leverage ratios of not less than 4.0 percent. At December 31, 1994, the Corporation's Tier 1 and total risk-based capital ratios were 8.86 percent and 12.49 percent, respectively, compared to respective ratios of 9.00 percent and 13.00 percent at December 31, 1993. The 1994 year-end ratios substantially exceed minimum required regulatory ratios of 4.0 percent and 8.0 percent, respectively.
1. Fully taxable equivalent adjustment
Tax-exempt interest income (for Federal purposes) has been restated to a comparable taxable level. The statutory tax rate used for this purpose was 35 percent in 1995, 1994, and 1993.
2. Interest income
The impact of restructured and nonaccrual loans is reflected in all average balance, net interest income and related yield calculations. Average balances include restructured and nonaccrual loans. Interest income and yields on these assets reflect income recorded on a cash basis.
3. Volume and rate variances
The change in interest income/expense attributable to volume is calculated by multiplying the annual change in volume by the prior year's rate. The rate variance is calculated by multiplying the annual change in rate by the prior year's volume. Any variance attributable jointly to volume and rate changes is prorated on a weighted basis between volume and rate.
4. Average rate on portfolio securities
Yields on the portion of average portfolio securities classified as available for sale are based on amortized cost.
Net Interest Income
Net interest income, the difference between interest and fees recognized on earning assets and total interest expense, is the major component of operating income for the Corporation. Since income on certain earning assets may be exempt from Federal and/or State income taxes, the Management's Discussion and Analysis section of this Report is prepared on an FTE basis, which, in effect, restates tax-advantaged income to a comparable level. In 1995, the Corporation's FTE net interest income was $500.3 million, up 4 percent from $480.4 million in 1994.
The year-to-year change in net interest income is typically explained by analyzing its two principal components, average earning assets and net interest margin. Average earning assets represent the average volume of assets employed by the Corporation during the year which generate interest income. Net interest margin is the difference between the overall FTE yield on earning assets and the average cost of supporting liabilities, including noninterest-bearing funds. For 1995, the Corporation's average earning assets grew 10 percent, while net interest margin decreased 20 basis points from 3.95 percent in 1994 to 3.75 percent in 1995.
Average earning assets in 1995 totaled $13.33 billion, up $1.16 billion, or 10 percent, from $12.17 billion in 1994. This growth is primarily the result of an increase in average loans of $1.11 billion, or 15 percent, to $8.79 billion, led by increases in average commercial, charge card, real estate and installment loan outstandings of $608 million (12 percent), $232 million (31 percent), $174 million (14 percent), and $85 million (20 percent), respectively. The growth in average loans is attributable to both a growing demand for credit in the U.S. economy and an aggressive marketing effort by the Corporation. Average portfolio securities increased $349 million, or 11 percent, to $3.58 billion primarily as a result of increased holdings of Federal agency securities of $542 million. Loans and portfolio securities, as a percent of earning assets, were 65.9 percent and 26.9 percent, respectively, compared to 63.1 percent and 26.6 percent, respectively, in 1994. Average federal funds sold and securities purchased under agreement to resell decreased approximately 38 percent, or $206 million, year to year.
Changes in the mix of total supporting funds are a function of loan demand, consumer preferences for maintaining funds in so-called core deposits and wholesale market spreads. The Corporation manages its wholesale funding activity at the margin primarily by using the least expensive products given requirements for matched funding, maturity, ability and expected cost to refund, reserve requirements and deposit insurance costs. Secured borrowings, such as repurchase agreements, may also depend on availability of collateral. Nearly all major categories of supporting liabilities increased year to year. The issuance of new senior notes totaling $512 million accounted for the largest increase in supporting liabilities. Short-term borrowings rose $356 million or 13 percent from 1994 levels. Federal funds purchased and securities sold under agreement to repurchase grew $329 million, representing 93 percent of the growth in short- term borrowings. Domestic interest-bearing deposits increased $56 million, or 1 percent, from one year ago. Average foreign office time deposits totaled $2.4 billion, up 16 percent or $328 million, compared to $2.1 billion in 1994. Noninterest-bearing funds supporting earning assets decreased $90 million, and declined from 20 percent to 18 percent year to year as a percentage of average supporting liabilities.
The Corporation's consolidated net interest margin declined to 3.75 percent from 3.95 percent in the prior year. This decrease reflects rate compression within certain asset categories, the maturity of certain higher-yielding municipal bond holdings, the narrowed relationship which existed in the market between short and longer term rates (i.e. flattened yield curve), the relative decline in noninterest-bearing funds and sales and maturities of portfolio securities where proceeds were reinvested at slightly lower yields. This was somewhat offset by an improved mix of earning assets resulting from the aforementioned loan growth.
Noninterest income for the year was $338.3 million in 1995, up $23.8 million or 8 percent from 1994, primarily due to an $18.1 million increase in net gains from the sale of debt securities. During the second quarter of 1995, conditions in the U.S. bond market led to significant price rallies, enabling the Corporation to sell certain U.S. government agency securities and reinvest the proceeds to reposition its portfolio and take advantage of profit opportunities not typically available.
Trading account gains, primarily from municipal bond trading, totaled $5.1 million up $5.5 million from the prior year when these activities reported losses of $.4 million. Financial results from trading activities will typically exhibit greater fluctuations over time than other business activities. Charge card fees were $41.8 million in 1995, up $4.4 million or 12 percent from the previous year as a result of charge card loan volume increases. Trust and investment management fees were $150.0 million up $1.9 million or 1 percent from the prior year. On January 11, 1996 the Corporation announced the sale of its securities custody and related trustee services business for large institutions to Citibank. After restructuring charges, it is estimated that the net gain on the sale will approximate $4.0 million in 1996. The sale of the custody business for large institutions is not expected to have a material impact on 1996 earnings.
Foreign exchange revenues were $14.2 million, down $5.5 million or 28 percent from 1994. Effective April 3, 1995, the Corporation and BMO agreed to combine their U.S. foreign exchange activities ("FX"). Under this arrangement, FX net profit will be shared by the Corporation and BMO in accordance with a specific formula set forth in the agreement. This agreement expires in April 2002 but may be extended at that time. Either party may terminate the arrangement at its option. Beginning with second quarter 1995, FX revenues were reported net of expenses. This agreement did not have a material impact on the Corporation's 1995 net income or financial position as of December 31, 1995. Service fees and charges were $69.3 million, down $4.3 million or 6 percent from last year due to the higher interest rate environment and customer refunds with respect to FDIC insurance.
Noninterest expenses totaled $560.1 million, down $44.0 million or 7 percent from 1994. In 1994, the Corporation recorded a one-time $51.3 million pretax charge to absorb the impact of higher interest rates on mortgage-backed securities held in certain customer accounts of HTSB's Securities Lending unit. Excluding the effect of this item, 1995 noninterest expenses would have increased $7.3 million or 1 percent from 1994 and 1994 noninterest expenses would have approximated 1993 levels.
The aforementioned charge in the second quarter of 1994 resulted from investments of cash collateral managed by HTSB as agent for certain of its institutional trust customers in its Securities Lending unit. The investments consisted of floating rate mortgage-backed securities with caps on interest ranging from 8.5 percent to 10 percent. HTSB's Securities Lending unit had invested in these types of securities on behalf of customers since 1991, with the total positions growing to $2.3 billion (representing about one-third of total customer positions) by the second quarter of 1994. HTSB management believed that the securities satisfied customer guidelines at the time of their acquisition. All securities were AAA rated and the interest returns were tied to movements in LIBOR. As of March 31, 1994 and December 31, 1993, HTSB had no reason to believe that there were either imbedded customer losses on these securities or that they violated customer guidelines for appropriate investments. Subsequent to March 31, 1994, rising short-term rates substantially extended the average duration of the securities. At that point, customers had an exposure to long-term securities in portfolios that should be kept relatively short. Given customer expectations and a con-
cern that further rate increases could have a disproportionate negative impact on market values, HTSB made a decision to eliminate all the mortgage-backed securities from these customer accounts and absorb the full loss on behalf of customers. Of the approximately $2.3 billion outstanding, one-third was sold into the market place while the remaining two-thirds were sold to the Corporation's ultimate parent, BMO. Sales prices were determined based on available market quotations, which resulted in a loss approximating $51.3 million ($33.4 million after-tax). At June 30, 1994, all mortgage-backed securities that had been included in this portfolio were disposed of, and neither HTSB nor its customers were at risk for subsequent declines in the market value of those securities.
Deposit insurance was $8.1 million, down $7.6 million or 48 percent from 1994, reflecting lower FDIC insurance premiums in 1995, primarily in the latter half of the year. These premiums, assessed at individual bank subsidiaries, were reduced for U.S. banks with favorable risk characteristics.
Employment expenses were $318.3 million, up $5.7 million or 2 percent from the previous year, reflecting normal salary increases, greater incentive payments attributable to substantially stronger earnings performance partially offset by reduced pension and retiree medical expenses. Communication and delivery expenses were $20.3 million, an increase of $2.5 million or 14 percent over 1994 due primarily to postage and printing for promotions and increased use of communications technology. Net occupancy costs were $46.1 million, up $1.0 million or 2 percent from 1994 reflecting increased rental expenses partially offset by lower real estate taxes and building maintenance.
1993 noninterest expenses included the reversal of $7.2 million of reserves previously recorded for anticipated costs of customer guarantees that were no longer necessary.
Income Taxes
The Corporation recorded income tax expense of $70.2 million in 1995, compared to $24.5 million in 1994, primarily due to higher (approximately $89.7 million FTE) pretax earnings and a reduction in the current year's tax-exempt income. The Corporation's effective tax rate increased to 32.2% in 1995 from 20.1% in 1994.
At December 31, 1995, the Corporation's Federal and Illinois net deferred tax assets were $62.4 million and $12.1 million, respectively. The Corporation has fully recognized both its Federal and Illinois deferred tax assets. Current taxable income and taxable income generated in the statutory carryback period is sufficient to support the entire Federal and Illinois deferred tax assets.
The deferred taxes reported on the Corporation's Statement of Condition at December 31, 1995 also include a $17.8 million liability for the tax effect of unrealized gains or losses associated with marking to market certain securities designated as available for sale in accordance with SFAS No. 115.
Impact of New Accounting Standards
In March 1995, the FASB issued SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. This Statement applies to long-lived assets, certain identifiable intangibles and goodwill related to those assets to be held and used and to long-lived assets and certain identifiable intangibles to be disposed of. The Statement requires that long- lived assets to be held and used be reviewed for impairment when events indicate that the carrying value of an asset may not be recoverable and that impairment be measured based on the fair value of the asset. The Statement requires that long-lived assets to be disposed of be reported at the lower of carrying value or fair value less cost to sell, except for assets covered by APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. This Statement is effective for fiscal years beginning after December 15, 1995. The Corporation intends to adopt the Statement in 1996 and does not expect it to have a material effect on the Corporation's financial position or results of operations.
In May 1995, the FASB issued SFAS No. 122, Accounting for Mortgage Servicing Rights. This Statement amends SFAS No. 65, Accounting for Certain Mortgage Banking Activities. The Statement applies to transactions in which a mortgage banking enterprise acquires mortgage servicing rights through the purchase or origination of mortgage loans and then sells or securitizes those loans with servicing rights retained by the seller. The Statement requires that the rights to service mortgage loans for others be recognized as separate assets by allocating the total cost of the mortgage loans to the mortgage servicing rights and the loans (without the mortgage servicing rights) based on their relative fair values. The Statement also requires that the capitalized mortgage servicing rights be periodically evaluated for impairment based on the fair value of those rights. The Statement applies prospectively in fiscal years beginning after December 15, 1995. The Corporation intends to adopt the Statement in 1996 and does not expect it to have a material effect on the Corporation's financial position or results of operations.
In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation. This Statement applies to transactions in which an employer issues shares of its stock or other equity instruments to employees or incurs liabilities to employees based on the price of its stock or other equity instruments. The Statement also applies to transactions in which an entity issues shares of its stock or other equity instruments to nonemployees in exchange for goods or services. The Statement establishes a fair value based method of accounting for stock-based compensation plans and proposes the use of that method rather than an intrinsic value based method as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees. The Statement is effective for fiscal years beginning after December 15, 1995. At 1995 year-end, the Corporation had no stock options outstanding. During the first quarter of 1996, options were issued to certain executives of the Corporation's subsidiaries enabling them to acquire Bank of Montreal shares under specific circumstances. The Corporation is currently evaluating the alternatives available under SFAS No. 123 but does not believe that the impact of adopting the Statement will be material.
On November 15, 1995, the FASB issued a Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities. As described in detail in Question 61 of that report, an enterprise was allowed to conduct a one-time reassessment of the classifications of securities held. Any reclassifications from the held-to-maturity category made in conjunction with that reassessment will not call into question an enterprise's intent to hold other debt securities to maturity in the future and must be accounted for as transfers in accordance with paragraph 15 of Statement 115 and disclosed in accordance with Paragraph 22. The FASB intended that any resulting one-time reclassifications would occur on a single date between November 15, 1995 and December 31, 1995. The Corporation reclassified all held- to-maturity securities to available-for-sale on December 29, 1995. The transaction did not have a material effect on the Corporation's financial position. For additional information, see Note 2 to Financial Statements on page 41 of this Report.
Return on Assets and Common Stockholder's Equity
Return on assets, measured by net income as a percentage of average total assets, was .95 percent in 1995 compared with .68 percent in 1994. The current year's return on assets was higher than the average return on assets of .84 percent for the five-year period ended December 31, 1995. Average common stockholder's equity to average total assets provides a measure of leverage for the Corporation. Return on common stockholder's equity is computed by dividing return on assets by this leverage ratio. The ratio of average common stockholder's equity to average total assets was 6.99 percent in 1995 compared to 7.06 percent in 1994. For 1995, the return on common stockholder's equity was 13.61 percent, up from the 9.70 percent achieved in 1994 and greater than the 12.21 percent five-year average return for the period ended December 31, 1995. Returns on both average assets and common stockholder's equity in 1994 were adversely affected by the one-time $33.4 million after-tax charge related to HTSB's Securities Lending unit. Excluding this charge, in 1994 return on assets would have been approximately .92 percent and return on common equity would have been approximately 13.02 percent.
(1) Total average assets and average common equity used in these calculations include average gross and net unrealized gains or losses on available for sale securities, respectively.
(2) Dividends as a percent of net income. 1995 ratio includes the impact of a $205 million special dividend as part of a capital restructuring. Excluding the payment of the special dividend, the dividend payout ratio would have been 39.11 percent.
(3) Earnings retained is defined as net income minus dividends. 1995 includes the impact of a $205 million special dividend as part of a capital restructuring. Excluding the payment of the special dividend, earnings retained as a percentage of common stockholder's equity would have been 8.29 percent.
Capital Position
The Corporation's equity capital of $1.15 billion at December 31, 1995, has increased significantly from five years earlier when equity capital amounted to $805 million. Growth has come primarily from the of earnings and the recent issuance of preferred stock. During 1995, Bankcorp declared and paid $262.7 million of cash dividends, including a $205 million special dividend as part of a capital restructuring. For additional information see the Summary of 1995 Compared to 1994 section of this Report. During 1994 and 1993, dividends declared and paid amounted to $34.7 million and $56.6 million, respectively. Included in 1993 dividends were cash dividends of $49.4 million and a $7.2 million dividend-in-kind related to the transfer of Harris Futures Corporation to Bankmont. During 1995, the Corporation's equity capital was increased by $59.8 million of after-tax unrealized holding gains related to the Corporation's debt and equity securities classified as available for sale. During 1994, equity capital was reduced by $59.1 million of after-tax unrealized holding losses. Average consolidated equity capital for 1995 was $1.1 billion, compared with the 1994 average of $1.0 billion and the 1993 average of $956 million.
Bankcorp's double leverage ratio, which is the Bankcorp parent company-only net equity investment in bank and nonbank subsidiaries and other equity investments as a percentage of its equity capital, was 103 percent at December 31, 1995, up from 101 percent at December 31, 1994. This ratio generally measures the extent to which holding company equity investments are supported, in part, by parent-issued debt instruments. A double leverage ratio greater than 100 percent indicates that parent company equity investments are supported, in part, by parent-issued debt. In the case of Bankcorp, outstanding long-term debt is sufficient to fund equity investments not otherwise covered by equity capital.
Risk-Based Capital
U.S. banking regulators have issued risk-based capital guidelines, based on the international "Basle Committee" agreement, which are applicable to all U.S. banks and bank holding companies. These guidelines serve to: 1) establish a uniform capital framework which is more sensitive to risk factors, including off-balance-sheet exposures; 2) promote the strengthening of capital positions; and 3)diminish a source of competitive inequality arising from differences in supervisory requirements among countries. Bankcorp, as a U.S. bank holding company, and HTSB, as a state-member bank, must each adhere to the guidelines of the Federal Reserve Board (the "Board"), which are not significantly different than those published by other U.S. banking regulators. Effective December 31, 1992, the guidelines specify minimum ratios for Tier 1 capital to risk-weighted assets of 4 percent and total regulatory capital to risk-weighted assets of 8 percent.
Risk-based capital guidelines define total capital to consist of Tier 1 (core) and Tier 2 (supplementary) capital. In general, Tier 1 capital is comprised of stockholder's equity, including certain types of preferred stock, less goodwill and cer-
tain other intangibles. Core capital must comprise at least 50 percent of total capital. Tier 2 capital basically includes subordinated debt (less a discount factor during the five years prior to maturity), other types of preferred stock and the allowance for possible credit losses. At year-end 1995, the portion of the allowance for possible credit losses includable in Tier 2 capital is limited to 1.25 percent of risk-weighted assets. The Corporation's Tier 1 and total risk-based capital ratios were 8.14 percent and 11.79 percent, respectively, at December 31, 1995.
The Board also requires an additional measure of capital adequacy, the Tier 1 leverage ratio, which is evaluated in conjunction with risk-based capital ratios. The Tier 1 leverage ratio is computed by dividing period-end Tier 1 capital by adjusted quarterly average assets. The Board established a minimum ratio of 3 percent applicable only to the strongest banking organizations having, among other things, excellent asset quality, high liquidity, good earnings and no undue interest rate risk exposure. Other institutions, including those experiencing or anticipating significant growth, are expected to maintain a ratio which exceeds the 3 percent minimum by at least 100 to 200 basis points. The Corporation's Tier 1 leverage ratio was 6.77 percent for fourth quarter 1995 and 7.03 percent for fourth quarter 1994.
The Federal Deposit Insurance Corporation Improvement Act of 1991 contains several provisions that established five capital categories for all FDIC-insured institutions ranging from "well capitalized" to "critically undercapitalized." Based on those regulations effective at December 31, 1995, all of the Corporation's subsidiary banks were designated as "well capitalized" at year-end 1995, the highest capital category.
In February 1993, the Board revised the capital adequacy guidelines by further restricting the inclusion of intangible assets in Tier 1 capital. Purchased mortgage servicing rights and the premium on purchased credit card relationships are, in general, included with (i.e., not deducted from) Tier 1 capital provided that, in the aggregate, they do not exceed a limit of 50 percent of Tier 1 capital. In addition, intangibles from purchased credit card relationships may not exceed a sublimit of 25 percent of Tier 1 capital. All other intangibles (including core deposit premiums), along with amounts in excess of the above limits, are deducted from Tier 1 capital for purposes of risk-based and leverage capital ratio calculations. Identifiable intangibles acquired before February 19, 1992 continue to be included with Tier 1 capital. The previous requirement to deduct all goodwill from Tier 1 capital is unchanged. At December 31, 1995, the Corporation's intangible assets totaled $38.4 million, including approximately $1.0 million of intangibles excluded under the new rules and an additional $16.5 million of goodwill excluded under 1992 guidelines. The Corporation's tangible Tier 1 leverage ratio (which excludes all intangibles) was 6.65 percent for the fourth quarter of 1995.
In September 1993, U.S. banking regulators proposed adding an additional element to risk-based capital rules which would essentially require financial institutions with levels of interest-rate risk above a specified threshold amount to maintain higher capital levels. Based on the proposed rules, management does not expect any of the Corporation's banking subsidiaries to be subject to these higher capital requirements.
Effective January 17, 1995, the Board issued amendments to its risk-based capital guidelines for state member banks regarding concentration of credit risk and risks of nontraditional activities. The guidelines now explicitly identify these items, as well as an institution's ability to manage them, as important factors in assessing the institution's overall capital adequacy. The Corporation does not expect this amendment to have a significant effect on its capital adequacy.
The Board further amended risk-based capital guidelines relating to deferred tax assets. Effective April 1, 1995, deferred tax assets included in Tier 1 capital are limited to the amount of taxable income that an institution expects to realize within one year of its quarter-end report date or 10 percent of Tier 1 capital, whichever is less. Deferred tax assets that can be realized from taxes paid in prior carryback years are generally not limited. This amendment did not have a material impact on its risk-based capital ratios.
As of December 31, 1993, the Corporation adopted SFAS No. 115-Accounting for Certain Investments in Debt and Equity Securities. This pronouncement requires an adjustment to stockholder's equity for the tax effected unrealized gain or loss associated with marking to market securities designated as available for sale. Effective December 31, 1994, the Board amended its risk- based capital guidelines to exclude net unrealized holding gains (losses) from Tier 1 capital with the exception of unrealized depreciation of marketable equity securities, which will continue to be deducted from Tier 1 capital. Net unrealized holding gains(losses) excluded for risk-based capital purposes amounted to $27.1 million and $(32.7) million at December 31, 1995 and 1994, respectively.
The following table summarizes the Corporation's risk-based capital ratios and Tier 1 leverage ratio for the past three years.
Liquidity And Sources of Funds
Summary
Effective liquidity management allows a banking institution to accommodate the changing net funds flow requirements of customers who may deposit or withdraw funds, or modify their credit requirements. One of the principal obligations of the banking system, and individual banks, is to provide for the legitimate credit demands of customers. The liquidity of the banking system as a whole may be viewed as the ability of the system to satisfy aggregate credit demand; however, individual banks experience changes in liquidity resulting from interbank transfers of deposits which do not affect the liquidity of the banking system. Therefore, liquidity management within individual banks must deal with the potential for greater volatility of net deposit flows which have little or no impact on the banking system itself.
The Corporation manages its liquidity position through continuous monitoring of profitability trends, asset quality, interest rate sensitivity, maturity schedules of earning assets and supporting liabilities, the composition of managed and other (primarily demand) liabilities, and prospective customer credit demand based upon knowledge of major customers and overall economic conditions. Appropriate responses to changes in these conditions preserve customer confidence in the ability of the Corporation to continually serve their credit and deposit withdrawal requirements.
Some level of liquidity is provided by maintaining assets which mature within a short time-frame or could be sold quickly without significant loss. The Corporation's liquid assets include cash and demand balances due from banks, money market assets, portfolio securities available for sale and trading account assets. Liquid assets represented approximately 36 percent of the Corporation's total assets and amounted to $5.65 billion at December 31, 1995 compared to liquid assets of $5.18 billion or approximately 34 percent of total assets one year earlier. However, the most important source of liquidity is the ability to raise funds, as required, in a variety of markets using multiple instruments. This fund-raising activity involves the identification of broadly distributed sources of funds, typically referred to as managed liabilities, which are varied by type, maturity and geographical location of customers. The Corporation monitors and controls the sources of these funds to avoid unwarranted market activity or customer concentrations.
The principal sources of external funds available to the Corporation are retail and wholesale liabilities. Retail liabilities are comprised of demand deposits, money market accounts, NOW accounts, passbook savings and nonnegotiable certificates of deposit, typically of small denomination. Wholesale funding sources include Eurodollar deposits in foreign offices, Federal funds borrowed, securities sold under agreement to repurchase, negotiable large denomination certificates of deposit and commercial paper. HTSB offers to institutional investors from time to time, unsecured short-term and medium-term bank notes in an aggregate principal amount of up to $1.5 billion outstanding at any time. The term of each note could range from fourteen days to fifteen years. The notes are subordinated to deposits and rank pari passu with all other senior unsecured indebtedness of HTSB. As of December 31, 1995, $478 million of short-term notes were outstanding with maturities and interest rates ranging from 29 to 180 days and 5.50 to 5.79 percent, respectively. There were no outstandings under this program at December 31, 1994.
The Corporation's average volume of core deposits, consisting of demand deposits, interest checking deposits, savings deposits and certificates, and money market accounts remained consistent with 1994. Core deposits represented 51.9 percent of average supporting liabilities in 1995 down from 56.6 percent in 1994. Average money market liabilities increased 13 percent to $3.01 billion from $2.65 billion for 1994, primarily as a result of increases in Federal funds borrowed and securities sold under repurchase agreements slightly offset by a decrease in commercial paper. Average money market assets decreased $326.3 million or 26.7 percent from 1994 mainly as a result of the increase in loans and portfolio securities. These assets represented 7 percent of average earning assets in 1995 compared to 10 percent one year ago.
The Corporation, in connection with the issuance of commercial paper and for other corporate purposes, has a $150 million revolving credit agreement with five nonaffiliated banks and BMO that terminates on December 18, 1999. There were no borrowings under this credit facility in 1995 or 1994.
The maintenance of an appropriate balance of maturity and interest rate sensitivity risks between assets and liabilities is an integral component of overall liquidity management. Mismatches of actual asset and liability maturities, or interest rate sensitivity of assets and liabilities, will increase the potential for profit or loss relative to changes in the general level of interest rates. Asset and liability mismatches result in the normal course of servicing customer credit and deposit requirements. The Corporation uses interest rate swaps and financial futures, as appropriate, to reduce the level of financial risk inherent in asset and liability mismatches. Gross cash flows from the Corporation's derivative positions as an end-user were not material to gross cash flows from financing and investing activities. The Corporation's Asset/Liability Management Committee monitors and adjusts its strategies in response to changing liquidity demands.
Interest Sensitivity
Interest rate sensitivity information, in the form of interest sensitivity gap schedules and simulations reflecting exposure of earnings to future changes in interest rates, is used in conjunction with other data by the Corporation's banking subsidiaries to monitor and manage their individual interest rate exposures. The Corporation uses various derivative products, including interest rate swaps, forward rate agreements, futures, options, and forward commitments to manage interest rate sensitivities corresponding to various balance sheet items, thereby modifying its exposure to changing interest rates.
The schedule above presents the Corporation's consolidated interest sensitivity gap at December 31, 1995. This point-in-time analysis depicts repricing dates for earning assets, supporting funds and related off-balance- sheet activities. Generally, dates for repricing are included on a contractual basis. A negative gap in a given time span indicates an excess of interest- bearing liabilities over interest earning assets which reprice in that period. After including interest rate swaps, derivative products and forward commitments, at December 31, 1995, the Corporation had a cumulative negative one-year interest rate gap of $301 million. This measure, called the "contractual gap" position, is calculated without regard to the existence of nonrepricing items, the behavior of which must be considered in the evaluation of the Corporation's overall interest rate sensitivity.
In addition to gap measurements, the Corporation uses simulation modeling to measure valuation risk, risk to earnings, assets, liabilities and equity, as a result of various interest rate scenarios and balance sheet structures. Shifts in the yield curve and changes in the shape of the yield curve are among the variables considered. Limits are established for valuation risk at the individual bank and consolidated levels and actual exposure is monitored to ensure that these limits are not exceeded. At December 31, 1995, simulations indicate that for an immediate 100 basis point upward movement in interest rates, net interest income would increase by approximately $8 million over the next year compared to what it would otherwise have been, and the change in the value of all gap positions, contractual and non-contractual, would be $55 million lower. Conversely, a decline in rates would have approximately the same absolute impact but in the opposite direction.
Management believes that the Corporation is well positioned with its mix of assets and liabilities to respond to interest rate movements in either direction.
Cash Flows
Cash flow analysis is an essential element for evaluating a company's ability to satisfy its obligations to short- and long-term creditors, bondholders and investors. The Corporation's Consolidated Statement of Cash Flows can be found on page 37 of this Report. This financial statement is based on period-end balances and does not reflect average investment or financing levels.
As a bank holding company, the Corporation regularly receives and disperses large volumes of cash and cash equivalents. Since these gross numbers provide little additional information to financial statement users, the FASB permits bank holding companies to net certain cash receipts and payments in their cash flow statements. The Corporation has adopted this net presentation for loans and deposits.
The Corporation's Consolidated Statement of Cash Flows divides its activities into three main categories: operating, investing and financing. Operating activities consist of those activities not categorized as investing or financing and generally include cash revenues and expenses associated with providing services to customers. Investing cash flows are defined as those arising from the acquisition or disposal of loans, portfolio securities, money market assets, subsidiaries, and fixed assets. Financing cash flows include both infusions from and dividend payments to stockholders, along with borrowings and principal repayments to bondholders or other creditors.
Cash flows from operations are a significant source of operating capital. Since applicable accounting statements require that cash transactions involving assets held for sale and for trading purposes be included with operating cash flows, normal year-end fluctuations in these holdings may not appropriately portray the company's generated cash flows from operations. Excluding net changes in loans held for sale and trading account assets, cash generated from operations amounted to approximately $266 million in 1995 and $133 million in 1994. The change in cash flows from operations, from year to year, was mainly due to increases in net income before provision for credit losses and gains on sales of portfolio securities. Year-end trading account assets increased $63 million year to year, while loans held for sale (primarily residential mortgages) increased $21 million.
In 1995, the Corporation's investing activities utilized a total of $252 million in net cash. Loans, the primary use of new funds, increased $1.31 billion. Interest-bearing deposits at banks decreased $300 million, Federal funds sold and securities purchased under agreement to resell decreased $225 million, and portfolio securities decreased $421 million in 1995.
In 1995, the Corporation's financing activities included accepting customer deposits, purchasing Federal funds and issuing long-term notes, short-term senior notes and preferred stock. Financing activities provided $192 million of net cash to the Corporation in 1995. Deposits increased $309 million. In addition, net new short-term senior notes and preferred stock of $478 million and $180 million, respectively, were issued. Gross cash received and paid resulting from the Corporation's derivative positions as an end-user were not material relative to gross cash flows from financing or investing transactions.
Since 1992, the Corporation has had three significant noncash transactions. On December 29, 1995, all held to maturity securities were reclassified to available for sale. See Portfolio Securities section below for further information. On December 31, 1993, the Corporation adopted SFAS No. 115-- Accounting for Certain Investments in Debt and Equity Securities. In compliance with this Statement, portfolio securities designated as available for sale are marked to market on the Corporation's Consolidated Statement of Condition. On July 1, 1993, the Corporation paid a $7.2 million dividend-in-kind to Bankmont related to the transfer of Harris Futures Corporation. Non-cash portions of these transactions were excluded from the Corporation's Consolidated Statement of Cash Flows.
Selected Loan Maturity Spread
Variable rate loans, excluding consumer loans, accounted for 55 percent of total loans in 1995 compared to 57 percent in 1994. Excluding consumer loans, term loans (those with a remaining contractual maturity in excess of one year) totaled $1.035 billion. Of these loans, $893 million or 86 percent are due within five years. Overall, the average FTE yield on total loans increased to 8.89 percent in 1995 from 7.75 percent in 1994. The Corporation's average prime rate in 1995 was 8.83 percent compared to 7.07 percent in 1994.
Portfolio Securities
On December 31, 1993, the Corporation adopted SFAS No. 115--Accounting for Certain Investments in Debt and Equity Securities, which requires debt and marketable equity securities to be classified into three categories. Trading account securities continue to include those securities purchased for sale in the near term. The remaining securities have been segregated into "Held to Maturity" and "Available for Sale" categories. Held to maturity securities include those debt securities where a company has both the ability and positive intent to hold to maturity. All other securities are classified as available for sale, even if the company has no current intent to dispose of them. Held to maturity securities are carried at amortized historical cost while available for sale securities are carried at fair value, with net unrealized gains and losses (after-tax) reported as a separate component of equity.
Throughout this Report the term "portfolio securities" encompasses both the held to maturity and available for sale categories. At December 31, 1995, available for sale securities included $44.9 million of fair value above amortized cost, and stockholder's equity included $27.1 million of unrealized (after tax effect) holding gains.
Portfolio securities averaged $3.57 billion in 1995. On an FTE basis, interest income from portfolio securities increased $31.6 million to $241 million. The overall FTE yield on the Corporation's portfolio securities averaged 6.72 percent during 1995. Yields on the portion of average portfolio securities classified as available for sale are based on amortized cost.
The Corporation periodically repositions its investment portfolio in response to changes in laws, in order to meet regulatory capital requirements or, as part of asset/liability management, to enhance future net interest income levels while maintaining an appropriate risk/reward relationship. During 1995, the Corporation purchased $7.09 billion of available for sale securities and $445 million of held to maturity securities, sold $2.03 billion of available for sale securities and had $5.22 billion available for sale securities and $714 million held to maturity securities mature. The aforementioned sales of portfolio securities generated a pretax net gain of $23.4 million during 1995 compared to a net gain of $5.3 million during 1994 and $13.0 million in 1993. $16.8 million of net gain was realized in the second quarter of 1995 when conditions in the U.S. bond market led to significant price rallies. These events enabled the Corporation to sell certain U.S. government agency securities and reinvest the proceeds to reposition its portfolio and take advantage of profit opportunities not typically available. On an after-tax basis, the Corporation recorded a net gain from securities sales of $14.3 million in 1995 compared to $3.2 million in 1994 and $7.9 million in 1993. In some cases, security gains are taken in order to realize otherwise unrealized profits in anticipation of near-term increases in interest rates.
On November 15, 1995, the FASB issued a Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities. In accordance with that report, the Corporation conducted a one-time reassessment of the classifications of all securities held. As a result, the Corporation reclassified all held to maturity securities to available for sale on December 29, 1995. The amortized cost of the transferred securities was $839 million and the related unrealized gross holding gain was $20 million.
The estimated market value of held to maturity securities was $1,102 million at December 31, 1994, compared to a carrying value of $1,108 million. See Note 2 to Financial Statements, page 41 of this Report for details on specific types of securities.
Unrealized holding gains for available for sale securities, as of December 31, 1995, amounted to $44.9 million compared to unrealized holding losses of $54.2 million as of December 31, 1994. The change in net unrealized gains and losses of $99.1 million was due to gains in market value as a result of declines in interest rates during the year, a change in the mix of the portfolio and the aforementioned reclassification of all held to maturity securities.
At year-end 1995, the weighted average maturity of the Corporation's portfolio securities was 3 years and 3 months, an increase of 1 year from the average maturity at the end of 1994. The maturity distribution of the investment portfolio at December 31, 1995, together with the approximate taxable equivalent yield of the portfolio, is presented in the following table. The weighted average yields shown are computed by dividing an annualized interest income amount, including the accretion of discounts and the amortization of premiums, by the amortized cost of the securities outstanding at December 31, 1995. Yields on tax-exempt securities have been calculated on an FTE basis.
Other than securities of the U.S. Government and its agencies and corporations, at December 31, 1995, there were no portfolio securities of any one issuer aggregating more than 10 percent of stockholder's equity of the Corporation. In the opinion of management, there were no material investments in securities which would have constituted an unusual risk or uncertainty for the Corporation at December 31, 1995.
Deposits
Total deposits in 1995 averaged $10.04 billion, up $321 million or 3 percent from 1994. Average total deposits in foreign offices experienced the largest growth, up $325 million or 15 percent over 1994 levels. The growth was attributed primarily to foreign office time deposits which increased by $328 million to $2.40 billion, up 16 percent from 1994. The Corporation's core deposits, consisting of demand deposits, interest checking deposits, money market accounts, passbook and statement savings accounts and savings certificates grew $36 million or 1 percent to $6.92 billion. Savings certificates increased by $259 million while money market accounts decreased by $132 million and demand deposits decreased $51 million, accounting for the net increase in core deposits. Other time deposits decreased $40 million or 6% from 1994 levels. Daily averages and year to year comparisons are summarized below.
Interest expense on deposits increased by $109 million or 43 percent in 1995 primarily due to higher effective interest rates. Interest expense on domestic deposits rose 34 percent from 1994, while interest on foreign office deposits increased by 60 percent compared to the prior year. Effective interest rates on both domestic and foreign office interest-bearing deposits are summarized below.
Certificates of deposit in denominations of $100,000 or more issued by domestic offices totaled $1.12 billion at December 31, 1995. These deposits totaled $653 million and $753 million at December 31, 1994 and 1993, respectively. During the past three years, virtually all time deposits in foreign offices were in denominations of $100,000 or more.
The remaining maturity of domestic office certificates of deposit of $100,000 or more is as follows:
Money Market Assets and Liabilities
The Corporation conducts most of its money market activities through HTSB. Average money market assets, consisting primarily of interest-bearing deposits at banks, Federal funds sold and securities purchased under agreement to resell, decreased 27 percent to $897 million in 1995 from $1.22 billion in 1994. The average yield on money market assets increased from 4.27 percent in 1994 to 6.46 percent in 1995. Interest income earned on these assets increased 11 percent to $57.9 million in 1995. At December 31, 1995, interest-bearing deposits at banks, Federal funds sold and reverse repurchase agreements totaled $458 million, $100 million and $79 million, respectively, compared to $757 million, $394 million and $10 million at year-end 1994. The decrease in money market assets was primarily the result of accommodating customers' borrowing requirements at the end of 1995, thereby increasing loan volume.
Money market liabilities, consisting of Federal funds purchased, securities sold under agreement to repurchase, commercial paper and other short-term borrowings, represent a managed source of funds for the Corporation. During 1995, money market liabilities averaged $3.01 billion, an increase of 13 percent from 1994, when money market liabilities averaged $2.65 billion. The average rate paid on these borrowings increased from 4.09 percent in 1994 to 5.61 percent in 1995, reflecting generally higher short-term interest rates experienced by the market during 1995. At December 31, 1995, repurchase agreements totaled $1.18 billion compared to $1.53 billion at year-end 1994. Federal funds purchased and securities sold under agreement to repurchase consist of overnight Federal funds borrowed and securities sold to banks, brokers and corporations under agreement to repurchase. The repurchase agreements are generally outstanding for periods ranging from one day to six months. The following amounts and rates applied during 1995, 1994 and 1993:
Short-term borrowings consist primarily of term borrowings in excess of three days, term Federal funds purchased and short sales of securities. The following amounts and rates applied during 1995, 1994 and 1993:
Commercial paper has been sold directly by Bankcorp to a number of investors, including individuals, partnerships, corporations, banks and other financial institutions in various amounts with initial terms not exceeding 270 days. The following amounts and rates applied during 1995, 1994 and 1993:
Loans
Summary
In 1995, significant year-to-year loan growth occurred among the following loan categories: manufacturing and processing, public and private service industries, other financial institutions, mortgages secured by commercial and residential property, charge card and other installment.
Distribution of Loans by Type of Borrower
Average loans increased by 15 percent during 1995 compared to 1994. Daily average loans over the last five years were as follows:
Lending is diversified into several categories at the Corporation. Concentrations to individual and related customers are monitored and risks within specific industries are tracked in order to reduce overall expense. When lending to specialized industries such as Agribusiness or Futures and Securities, the risks are mitigated by following specifically developed policies and procedures in the underwriting process as well as obtaining security for most of these transactions. Secured and unsecured loans totaled $5.87 billion and $3.65 billion, respectively, of total loans at 1995 year-end.
Risk Management
Summary
In a commercial banking environment, corporate personnel must identify, quantify, monitor, evaluate and manage the risks inherent in its businesses, product lines and other activities. Through its risk management framework which continued to be enhanced during 1995, the Corporation: 1) maintains a clear philosophy, approach and accountabilities towards risk taking activities in well documented policies, directives and procedures; 2) fosters an environment where risks incurred are commensurate with an individual's qualifications, skills and expertise; 3) implements risk measures and limits to contain, diversify, or otherwise mitigate certain risks the Corporation faces; and 4) continuously enhances information flows and reporting to monitor exposures and ensure timely responses to any change in risk profiles. The risk management framework helps to ensure the Corporation employs its capital efficiently and achieves returns commensurate with the risk undertaken.
The Corporation's risk management process includes continuous monitoring and review of the following classes of risk: 1) Credit risk, which is risk of loss of principal, interest or revenues due to the obligor's inability or failure to repay a financial obligation. This includes loan loss risk, replacement risk, and settlement risk. 2) Position risk, which is risk of loss associated with taking a position in an asset and is inclusive of interest rate risk, foreign exchange risk and liquidity risk. 3) Operating risk, which is risk that systems and control environments do not accurately or safely process transactions or assets. Legal and regulatory risks are included in this category. 4) Fiduciary risk, which arises when the Corporation, or its employees acting purportedly on its behalf, take actions which violate the trust and confidence properly placed in the Corporation by the client.
The Corporation applies a comprehensive risk assessment framework to monitor these risks by line of business, customer and product line. The roles and relationships of the Corporation's Management Committees and the Board Oversight Committees are well defined and ensure comprehensive risk management and oversight. The Risk Management and Fiduciary Risk Management Committees are manned by senior managers from various business units of the Corporation who bring specialized expertise to bear on risk management issues. Through this risk management structure, the Corporation evaluates risks, establishes formal policies, sets risk/return parameters and reviews performance versus objectives. Management believes that effective policies, procedures, monitoring and review systems are in place to determine that risk is thoroughly and effectively analyzed, risk is well diversified, any exceptions are dealt with in a timely manner and compensation for risk is appropriately established and meets return objectives.
Although the majority of the Corporation's customers are located in the Midwestern region of the United States, this risk is mitigated by a number of factors (see Note 9 to Financial Statements on page 49 of this Report for a detailed discussion). Further, the Corporation maintains a watch on the economic health of the region, primarily to address risk in its consumer lending business. With the national unemployment rate for the 1995 fourth quarter at 5.6 percent and projected to increase to 5.9 percent in 1996, the unemployment rate in the various states of the Midwestern region is also expected to be equal to, or lower than, the national rate due to a resurgence of traditional manufacturing. Real estate sales of existing housing in Illinois are expected to remain strong relative to many other areas of the country because of the strength of the job market and loan rates on adjustable mortgages.
The level of credit risk inherent in the Corporation's earning assets is evidenced, in part, by nonperforming assets consisting of loans placed on nonaccrual status when collection of interest is doubtful, restructured loans on which interest is being accrued but which have terms that have been renegotiated to provide for a reduction of interest or principal, and real estate or other assets which have been acquired in full or partial settlement of defaulted loans. These assets, as a group, are not earning at rates comparable to other earning assets. Assets received in satisfaction of debt are recorded by the Corporation at lower of cost or fair value less estimated sales costs. Losses of principal on nonperforming assets are charged off when, in management's opinion, the amounts are uncollectible. Interest on nonaccrual loans is recognized as income only at the time cash is received, although such interest may be applied to reduce a loan's carrying value if the collectibility of principal is in doubt. Information is reported monthly to the Board of Directors regarding nonperforming loans and other nonperforming assets owned, primarily real estate. During the first quarter of 1995, the Corporation adopted SFAS No. 114- Accounting by Creditors for Impairment of a Loan and SFAS No. 118-Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures. For additional information see Notes 1 and 4 to Financial Statements on pages 39 and 42 of this Report.
Management places an individual commercial or real estate credit on nonaccrual status when the collection of interest is doubtful or when principal or interest is 90 days past due unless the past due amounts are in process of collection and the loan is adequately collateralized. Consumer loans and charge card receivables are charged off when 180 and 150 days past due, respectively. Accrued interest on charge card loans is reversed against interest income when principal is charged-off. Consumer loans and charge card loans are not normally placed on nonaccrual status. The purpose of this policy is to avoid excessive administrative costs for relatively insignificant balances.
The Corporation extends credit to both commercial and retail customers. Lending activities are centered in those industries in which it has demonstrated expertise and specialized knowledge. All recognized risks are mitigated, to the fullest extent possible, through loan structure and the perfection of a security interest in collateral. The Corporation prescribes, within policy guidelines, specific advance rates to be used in lending against readily marketable collateral. These rates take into consideration the collateral type and the term. Other collateral advances are set to reflect the marketability and liquidation value of the collateral and normal advance rates are set by corporate policy with deviations necessitating specific documentation and approval.
In addition to risks on earning assets, the Corporation has various commitments and contingent liabilities outstanding that are not reflected on its Statement of Condition. Examples of these "off-balance-sheet" items include foreign exchange and interest rate contracts, assets held in trust, loan commitments and letters of credit. Virtually all off-balance-sheet items must conform to the same risk review process as loans and are subject to the Corporation's preset limits on customer and product risk. Various hedging strategies are employed to reduce certain types of exposure. Management reviews the magnitude and quality of outstanding commitments and contingent liabilities.
Nonaccrual, Restructured and Past Due Loans
Management closely monitors nonperforming assets, including assets received in satisfaction of debt. Nonperforming assets were .58 percent of total loans at December 31, 1995, compared with 1.15 percent at year-end 1994. All nonperforming loans are domestic.
Interest shortfall is the difference between the gross amount of interest that would have been recorded if all year-end nonperforming loans had been accruing at their original terms and the cash-basis interest income actually recognized. Interest shortfall was $2.9 million in 1995 compared to $3.9 million a year ago.
Loan Concentrations
Management monitors industry loan concentrations in an effort to maintain a well-diversified loan portfolio. Excluding total residential mortgages and charge card outstandings, at December 31, 1995 the Corporation's loan portfolio did not include any single industry concentration in excess of 10 percent of total consolidated loans.
The largest category of the Corporation's loans was domestic commercial, which totaled $4.53 billion, or 48 percent of total outstandings at year-end 1995. Most of these credits were extended to manufacturing and service-related companies. Outstandings to machinery industries represented 22 percent of all manufacturing loans and 3 percent of total consolidated loans. The largest concentration within service-related industries was consumer wholesalers, which accounted for 38 percent of all service-related credits and 8 percent of total loans.
Foreign loans totaled $203 million at year-end 1995, accounting for 2 percent of the Corporation's total outstandings. Further details on the Corporation's foreign loans can be found in the Foreign Outstandings section on page 26 of this Report.
Real estate loans, including residential mortgages, totaled $2.19 billion at December 31, 1995, or 23 percent of total outstandings. Mortgages collateralized by residential property totaled $1.51 billion, or 16 percent of loans. Commercial real estate mortgages and construction loans totaled $681 million at the end of 1995, representing 7 percent of loans. Further details on the Corporation's commercial real estate outstandings can be found on page 27 of this Report.
Foreign Outstandings
Foreign outstandings consist of loans, acceptances, interest-bearing deposits with other financial institutions and other interest-bearing investments and monetary assets. At December 31, 1995, substantially all foreign outstandings represented U.S.dollar claims. Foreign outstandings of certain countries are net of: a) written guarantees by domestic or other non-local third parties or b) the value of tangible, liquid collateral deemed realizable by the Corporation. A significant portion of the Corporation's foreign outstandings are placed with major financial institutions and governments and their agencies. The Corporation continually monitors its risk related to foreign outstandings and imposes internal limits on its foreign exposure.
Information provided in the table on foreign outstandings is presented in accordance with guidelines of the Securities and Exchange Commission and is not intended to be indicative of prudent lending levels.
At December 31, 1995, the Corporation had no aggregate public and private sector outstandings to any single country experiencing liquidity problems which exceeded one percent of the Corporation's consolidated assets.
Commercial Real Estate
The commercial real estate market in certain areas of the country has historically experienced depressed conditions from time to time. Many banks with loans to borrowers in this industry have reported large increases in nonperforming assets and corresponding increases in their allowances for credit losses resulting from commercial real estate transactions. This phenomenon tends to be cyclical and varies by location.
As of December 31, 1995, the Corporation, primarily through its banking subsidiaries, had outstanding commercial real estate loans of approximately $681 million which included both construction loans and commercial credits collateralized by commercial real estate. The vast majority of these loans are collateralized by real estate located in the Chicago metropolitan area. Of the outstanding commercial real estate loans, approximately $6.4 million were classified as nonperforming assets representing less than 1% of total consolidated loans. There were no material charge-offs related to commercial real estate loans during 1995 or 1994. Other real estate owned and other assets received in satisfaction of debt were $2.5 million at December 31, 1995, compared to $8.1 million at December 31, 1994, and comprised approximately 4% of total nonperforming assets. Management does not currently anticipate the need to increase its allowance for possible credit losses to reflect potential charge- offs in its commercial real estate loan portfolio.
Highly Leveraged Transactions
The Corporation, primarily through HTSB, selectively engages in highly leveraged transactions ("HLTs") by originating and participating in financings for highly leveraged customers. Such financings are generally senior and collateralized. The Corporation controls the HLT portfolio through its normal credit extension process with the goal of not materially changing the risk profile of the Corporation.
The Corporation internally defines and manages its HLT portfolio using a total debt to assets ratio exceeding 75 percent as an initial indicator of high leverage, though other facts and circumstances of a transaction, such as typical leverage ratios in the customer's industry, may affect that judgment. All loans and letters of credit extended to a highly leveraged customer represent HLT exposure, regardless of their purpose. The following discussion of HLTs uses the Corporation's internal definition.
All corporate credit policies are strictly applied to HLT credits. The credit analysis performed on an HLT credit must indicate strong primary debt repayment sources as well as contingency plans providing secondary sources of repayment. The primary source of expected repayment for HLTs is typically cash flow from operations. Most HLT loans are also fully collateralized either by a direct pledge of operating assets or by the stock of operating subsidiaries. Cash flows based on contingent events such as asset sales or substantial operating improvements are not treated as primary repayment sources. If, during the course of the credit review, sensitivity analysis reveals that the borrower's ability to generate future cash flows would be significantly impaired by higher interest rates, the borrower may be required to hedge a meaningful portion of its debt. Pricing guidelines require HLT relationships to earn a premium over existing minimum risk relationship return-on-asset standards.
The Corporation manages its HLT portfolio to obtain proper portfolio quality and diversification and, to this end, all HLT credits are subject to periodic review by senior management. Aggregate commitments (including outstandings) are currently capped at $600 million. Overall, target credit outstandings are not to exceed 10 percent of total Corporation loans. Commitments, including outstandings, represented less than 3 percent of the Corporation's outstanding loans at December 31, 1995.
Provision and Allowance for Possible Credit Losses
The provision for credit losses is based upon management's estimate of potential credit losses and its evaluation of the adequacy of the allowance for possible credit losses. Factors which influence management's judgment in estimating credit losses and the adequacy of the allowance include the impact of anticipated general economic conditions, the nature and volume of the current loan portfolio, historical loss experience, the balance of the allowance in relation to total loans outstanding and the evaluation of risks associated with nonperforming loans.
In 1994, the Corporation adopted the guidelines set forth under the December 1993 "Interagency Policy Statement on the Allowance for Loan and Lease Losses" issued by the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Deposit Insurance Corporation and the Federal Reserve Board. This statement outlines a methodology management should follow in order to properly measure the adequacy of the allowance for possible credit losses. It includes specific quantitative measures as well as certain subjective factors that may cause estimated credit losses to differ from historical loss experience. The quantitative measures basically require a bank to place its loans into "separate pools" with like characteristics and then measure the historical loss experience of these loan pools. In the case of "non-classified loans," it is sufficient to estimate credit losses for the upcoming 12 months. But in the case of "classified loans," the losses must be projected for the remaining effective lives of the loans. The subjective factors that should also be considered and that could potentially modify some of the conclusions reached by only looking at the quantitative measures are: significant changes in the institution's lending policies and procedures; changes in national and local business and economic conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability, and depth of lending management and staff; changes in the trend of the volume and severity of past due and classified loans; changes in the quality of the institution's loan review system; the existence and effect of any concentrations, and changes in the level of such concentrations; and the effect of external factors such as competition or any special legal or regulatory changes.
The Corporation's aggregate allowance for possible credit losses is derived from the combination of allowances at its individual subsidiaries, primarily banks. Each subsidiary has a responsibility to maintain an adequate allowance based on an evaluation of its own loan portfolio and considering the guidelines set forth in the aforementioned interagency credit statement. Although allocations of the Corporation's allowance are made for reporting purposes, each subsidiary's individual allowance for possible credit losses is available for use against its total loan portfolio.
On a regular basis, management identifies portions of specific commercial and real estate credits as "doubtful." These credits include loans where less than full repayment is reasonably possible, the loan is classified as nonaccrual and the borrower is experiencing serious financial problems. Approximately 12 percent, 11 percent, 23 percent, 24 percent and 27 percent of the consolidated allowance for possible credit losses was represented by doubtful portions of loans at December 31, 1995, 1994, 1993, 1992, and 1991, respectively. At December 31, 1995, the Corporation had allocated $14.9 million to loans internally categorized as doubtful, compared to $13.6 million at year-end 1994.
At December 31, 1995, the Corporation designated all of the allocated portion of the allowance to cover total domestic credit exposure, compared to $102.4 million and $3.8 million for domestic and foreign, respectively, at December 31, 1994 due to declining foreign credit exposure.
During 1995, the provision for credit losses decreased to $43.0 million, compared to $45.0 million in 1994. At year-end 1995, the allowance for possible credit losses was $129.3 million, or 1.36 percent of total loans outstanding, compared to $124.7 million or 1.52 percent of total loans one year ago. The provision for credit losses is established and reviewed based on the following criteria: current economic trends, current status of loan portfolio, federal regulatory requirements, expected net charge-offs and peer group analysis. With regard to establishing the provision and as a monitoring tool, the ratio of the allowance for possible credit losses to total loans and the ratio of the allowance for possible credit losses to nonperforming loans are evaluated on a regular basis. At year-end 1995, the ratios of the allowance for possible credit losses to total loans and to nonperforming loans were 1.36% and 246%, respectively. Both ratios are acceptable when compared to peers and are adequate when considered in conjunction with the previously-mentioned criteria. Accordingly, the 1995 provision for credit losses was established, in part, to achieve these ratios.
Net charge-offs in 1995 were $38.5 million, or .44 percent of average loans outstanding as compared to $52.0 million, or .68 percent of average loans outstanding in 1994. Net charge-offs of domestic commercial loans amounted to $9.9 million in 1995, or .17 percent of average domestic commercial loans outstanding, down from $24.7 million, or .48 percent of average domestic commercial loans outstanding in 1994. The charge card portfolio experienced net charge-offs of $27.4 million and $21.3 million in 1995 and 1994, respectively, or 2.82 percent and 2.88 percent, respectively, of average outstandings. Installment loans, including real estate mortgages, had net charge-offs of $1.3 million in 1995, or 0.8 percent of average outstandings, down from $5.9 million, or .40 percent of average outstandings in 1994. Over the five-year period ending December 31, 1995, combined net charge-offs were .81 percent of average total loans outstanding.
The Board of Governors of the Federal Reserve System has established rules requiring banking institutions to establish special reserves against the risks presented in certain international assets, as determined by the Federal Reserve Board. At December 31, 1995 and 1994, the Corporation was not required to maintain any special reserve under the aforementioned regulation.
The following table sets forth the Corporation's allocation of the allowance for possible credit losses. This allocation is based on management's subjective estimates. The amount allocated to a particular category should not be interpreted as the only amount available for future charge-offs that may occur within that category; it may not be indicative of future charge-off trends and it may change from year to year based on management's assessment of the risk characteristics of the loan portfolio.
*Prior to 1992, the Corporation charged off past-due charge card interest to the allowance for possible credit losses. In 1995, 1994, 1993, and 1992, $1.9 million, $2.0 million, $2.6 million and $3.0 million, respectively, of such interest was recorded as a reduction of interest income.
International Banking
Summary
International banking services of the Corporation include extension of foreign credits, foreign exchange trading activities and dealings in Eurocurrencies. These services are conducted through the Chicago headquarters; the London and Nassau branch offices; representative offices in Los Angeles and Tokyo; Bank of Montreal Trust Company (Channel Islands), Ltd.; and Harris Bank International Corporation, a wholly-owned Edge Act subsidiary of HTSB located in New York City.
International banking services contributed $15.3 million, or 10 percent, of the Corporation's 1995 consolidated net income, compared to $18.0 million or 18 percent in 1994. International operating income decreased $4.1 million, or 8 percent, to $49.3 million in 1995 and represented 4 percent of the Corporation's total operating income. In 1994 and 1993, international operating income represented 5 percent of the Corporation's total operating income. Assets and liabilities associated with foreign domiciled customers are summarized as follows:
Geographic Distribution
As of year-end 1995, substantially all international loans, interest-bearing deposits at banks and deposits in foreign offices represented U.S. dollar claims. The geographical distribution of international loans and interest- bearing deposits at banks is presented in the following table:
Vision 2002
The Corporation and its parent company, Bank of Montreal, have developed a joint, long-term strategic plan with the goal of becoming, over a period of 10 years, a North American financial services organization with comprehensive capabilities in both Canada and the United States. This plan, called Vision 2002, envisions Harris as one of four main operating entities within the Bank of Montreal organization, with the responsibility for serving individuals and small to mid-sized businesses in the Midwest while providing trust, cash management, investment management and special industries services nationally.
Vision 2002 will lead to a substantially larger Bank of Montreal presence in the United States, principally focused in the Harris organization and its subsidiaries. The Corporation's services to individuals, small businesses and mid-market corporations will be expanded throughout Chicago, Illinois and neighboring states. Additionally, trust, cash management, investment management and special industries services will continue to grow nationwide.
Over a period of 10 years, Bank of Montreal plans to invest up to $700 million in the Corporation with the purpose of expanding, through acquisition and de novo branching, its distribution network within the City of Chicago, Cook County and surrounding counties. As part of this expansion, in October 1994, Bank of Montreal and Suburban Bancorp, Inc. completed their merger. The merger was effected using Bank of Montreal stock valued at approximately $237 million. Suburban Bancorp, now known as Harris Bankmont, Inc., became a wholly-owned subsidiary of Bankmont Financial Corp. The transaction added 13 banks with 30 locations in Cook and surrounding counties, thereby doubling the number of community banks in the Chicago area and making Harris (the Corporation and Harris Bankmont, Inc.) the area's third largest community bank network with 86 locations opened or announced at year end 1995. The Corporation and its sister company, Harris Bankmont, Inc., plan to open approximately 10 new branches in 1996. The two-to-three year process of building a cost-effective operations and staff support infrastructure, started in 1994, continued in 1995, with over $20 million in infrastructure costs reduced and redeployed into marketing, sales, and service. The goal is to obtain North American scale advantages and reduce fixed costs. Building broad-based centers of competence within corporate services and operations will eliminate duplication, create scale efficiencies and improve quality and responsiveness. Additionally, the use of advanced technology to auto-
mate processing activities at the point of customer contact will lower costs and increase quality. To this end, the consolidation of processing functions for Harris' and Bank of Montreal's U.S.-based foreign currency operations at a single location in Montreal was completed in 1995 as was the consolidation of credit card remittance processing in suburban Chicago. The new community bank operations center, which provides centralized customer support functions, opened at 1994 year-end. Customer support functions include stop payments, overdrafts, application balancing, customer account set-up and maintenance and proofing and encoding. The center consolidated all bookkeeping and proofing functions during 1995. Bank of Montreal and Harris loan administration functions will be consolidated in 1996. Management believes that new and existing customers will have even better access to the wide range of services that the Corporation has built over its 114 years, as well as to the additional services it will provide in the years ahead.
Fourth Quarter 1995 Compared with Fourth Quarter 1994
Net income for the fourth quarter of 1995 was $38.8 million, up 9 percent from fourth quarter 1994 earnings of $35.6 million. The earnings growth is attributable primarily to an improvement in net interest income, securities gains, increased other income and lower FDIC insurance premiums. The Corporation recorded returns on average assets and average common equity of 0.94 percent and 13.7 percent, respectively, in fourth quarter 1995, compared to returns of 0.96 percent and 14.0 percent in last year's fourth quarter.
FTE net interest income was $127.7 million during the 1995 fourth quarter, an increase of 1 percent from $126.8 million for the same quarter one year ago. Net interest margin fell from 4.03% to 3.62%, reflecting rate compression in certain asset categories, a lower mix of noninterest-bearing deposits, and the relationship which existed in the markets between short and longer term rates. Average earning assets rose 12% from $12.5 billion to $14.0 billion and average loans increased by $1.5 billion or 19% with commercial loans, real estate loans and charge card outstandings being the strongest contributors to this growth. Average portfolio securities increased $226 million in fourth quarter 1995 compared to 1994, offset by a $227 million decrease in money market assets and interest bearing deposits at banks.
Funding for the quarter's asset growth came from interest-bearing liabilities, which rose $1.6 billion from last year's fourth quarter. Average interest-bearing deposits increased $334 million, or 5 percent to $7.31 billion, reflecting increased savings and certificates of deposits as well as time deposits in foreign offices. Short-term borrowings were up $503 million or 18 percent and senior notes increased $739 million from the prior year as described in the "Liquidity and Sources of Funds" section of this Report. Noninterest- bearing supporting funds were virtually unchanged, representing 16 percent of supporting liabilities in fourth quarter 1995, down from 19 percent in the 1994 fourth quarter.
The fourth quarter provision for credit losses of $11.6 million was up from $10.5 million provided in the fourth quarter of 1994. Net loan charge-offs during the current quarter were $11.7 million, compared to $12.9 million in the same period last year.
In the fourth quarter of 1995, noninterest revenue increased $9.3 million or 12% to $86.3 million. Net gains from the sale of debt securities amounted to $2.8 million compared to a $0.4 million loss in the fourth quarter of 1994. Money market and bond trading profits rose $1.4 million, while other sources of noninterest income increased $4.9 million.
Noninterest expenses for the fourth quarter of 1995 of $141.7 million were 2% higher than the comparable quarter a year ago, primarily reflecting normal salary increases and higher variable compensation attributable to substantially stronger earnings performance. FDIC insurance premiums declined by $3.1 million while other expense categories approximated last year's levels.
Income tax expense increased $6.0 million or 48 percent, quarter to quarter, attributable to higher pretax income and a smaller tax-exempt municipal bond portfolio.
Rows may not add to annual amounts because of rounding.
FINANCIAL STATEMENTS
Consolidated Statement of Income Harris Bankcorp, Inc. and Subsidiaries
The accompanying notes to financial statements are an integral part of this statement.
The accompanying notes to financial statements are an integral part of this statement.
Notes to Financial Statements
1. Summary Of Significant Accounting Policies
Principles of consolidation and nature of operations
Harris Bankcorp, Inc. ("Bankcorp"), a Delaware corporation, is a wholly-owned subsidiary of Bankmont Financial Corp. ("Bankmont"), a Delaware corporation and a wholly-owned subsidiary of Bank of Montreal ("BMO"). Throughout these Notes to Financial Statements, the term "Corporation" refers to Bankcorp and subsidiaries.
The consolidated financial statements include the accounts of Bankcorp and its wholly-owned subsidiaries including Harris Trust and Savings Bank ("HTSB"). Significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to conform prior years' financial statements to the current year's presentation. See Note 17 for additional information on business combinations and Note 18 for additional information on related party transactions.
The Corporation provides banking, trust and other services domestically and internationally through 14 bank and 17 active nonbank subsidiaries. HTSB and the Corporation's other banking and non-bank subsidiaries provide a variety of banking and financial services to commercial and industrial companies, financial institutions, governmental units, not-for-profit organizations and individuals throughout the U.S., primarily the Midwest, and abroad. Services rendered and products sold to customers include demand and time deposit accounts and certificates; various types of loans; sales and purchases of foreign currencies; interest rate management products; cash management services; underwriting of municipal bonds; and financial consulting.
Basis of accounting
The accompanying financial statements are prepared in accordance with generally accepted accounting principles and conform to practices within the banking industry.
Foreign currency and foreign exchange contracts
Assets and liabilities denominated in foreign currencies have been translated into United States dollars at respective year-end rates of exchange. Monthly translation gains or losses are computed at rates prevailing at month-end. There were no material translation gains or losses during any of the years presented. Foreign exchange trading positions including spot, forward, futures and options contracts are revalued monthly using prevailing market rates. Exchange adjustments are included with foreign exchange income in the Consolidated Statement of Income.
Interest rate futures, forward rate agreements, options and guarantees
Interest rate futures contracts can be used in the management of the Corporation's risk strategy or as part of its dealer and trading activities. Open positions on such contracts not designated as hedges of existing positions or anticipated transactions are marked to market daily and the resulting gains and losses are recognized in noninterest income. Deferred gains and losses on futures contracts used to hedge existing assets and liabilities are included in the basis of the item being hedged. For hedges of anticipated transactions, the Corporation recognizes deferred gains or losses on futures transactions as adjustments to the cash position eventually taken. Interest rate forward rate agreements, options and guarantees, including caps, floors and collars, are marked to market with the resulting gains and losses recorded in trading account profits.
Interest rate swaps
The Corporation engages in interest rate swaps in order to manage its interest rate risk exposure, generate fee income and as a trading vehicle. Gains and losses on swaps designated as hedges are deferred and recognized over the lives of the related hedged positions. Contractual payments under interest rate swaps designated as hedges are recognized in the Statement of Income. Swaps not designated as hedges are marked to market with realized and unrealized gains and losses included with trading account profits.
Securities
In May 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 115-Accounting for Certain Investments in Debt and Equity Securities, which the Corporation elected to adopt as of December 31, 1993. As required by the Statement, securities are classified as either trading account assets, held to maturity or available for sale. Trading account assets include securities acquired as part of trading activities and are typically purchased with the expectation of near-term profit. These assets consist primarily of municipal bonds and U.S. government securities. Securities are classified as held to maturity when the Corporation has both the positive intent and ability to hold them to maturity. All other securities are classified as available for sale, even if the Corporation has no current plans to divest. Trading account assets are reported at fair value with unrealized gains and losses included in trading account results, which also includes realized gains and losses from closing such positions. Held-to-maturity securities are stated at cost, adjusted for amortization of premium and accretion of discount. Available-for-sale securities are reported at fair value with unrealized gains and losses included, on an after-tax basis, in a separate component of stockholder's equity. For comparative purposes (primarily for periods prior to the adoption of SFAS No. 115), the Corporation considers "portfolio securities" to include both held to maturity and available for sale securities.
Application of SFAS No. 115 to prior periods is not permitted and, accordingly, prior-period financial statements have not been restated to reflect the change in accounting principle. There is no cumulative effect on the Corporation's Consolidated Statement of Income as of December 31, 1993, from adopting SFAS No. 115. However, the December 31, 1993 balance of stockholder's equity was increased by $26.4 million (net of $17.4 million in deferred taxes) to reflect the net unrealized holding gains on securities classified as available for sale which were previously carried at amortized cost or lower of cost or market. On December 29, 1995, the Corporation transferred all held-to- maturity securities to available for sale. See Note 2 on page 41 for further information.
Interest income on securities, including amortization of discount or premium, is included in earnings. Realized gains and losses, as a result of portfolio securities sales, are included in securities gains and losses, with the cost of securities sold determined on the specific identification basis.
Loans, loan fees and commitment fees
Loans not held for sale are recorded at the principal amount outstanding, net of unearned income, deferred fees and origination costs. Origination fees collected on commercial loans, loan commitments, mortgage loans and standby letters of credit, which are not held for sale, are generally deferred and amortized over the life of the related facility. Other loan-related fees that are not the equivalent of yield adjustments are recognized as income when received or earned. At December 31, 1995 and 1994, the Corporation's Consolidated Statement of Condition included approximately $13.8 million and $11.0 million, respectively, of deferred loan-related fees net of deferred origination costs.
In conjunction with its mortgage and commercial banking activities, the Corporation will originate loans with the intention of selling them in the secondary market. These loans are carried at the lower of original cost or current market value, on a portfolio basis. Deferred origination fees and costs associated with these loans are not amortized, and are included as part of the basis of the loan at time of sale. Realized gains and unrealized losses are included with other noninterest income.
Commercial and real estate loans are placed on nonaccrual status when the collection of interest is doubtful or when principal or interest is 90 days past due, unless the credit is adequately collateralized and the past due amount is in process of collection. When a loan is placed on nonaccrual status, all interest accrued but not yet collected which is deemed uncollectible is charged against interest income in the current year. Interest on nonaccrual loans is recognized as income only when cash is received and the Corporation expects to collect the entire principal balance of the loan. Interest income on restructured loans is accrued according to the most recently agreed upon contractual terms.
Commercial and real estate loans are charged off when, in management's opinion, the loan is deemed uncollectible. Charge card and consumer installment loans are charged off when 150 and 180 days past due, respectively. Accrued interest on these loans is charged to interest income. Such loans are not normally placed on nonaccrual status.
Loan commitments and letters of credit are executory contracts and are not reflected on the Corporation's Consolidated Statement of Condition. Fees collected are generally deferred and recognized over the life of the facility.
During the first quarter of 1995, the Corporation adopted SFAS No. 114- Accounting by Creditors for Impairment of a Loan and SFAS No. 118-Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures. SFAS No. 114 addresses accounting by creditors for impairment of certain loans. It requires that impaired loans within the scope of the statement (primarily commercial credits) be measured based on the present value of expected future cash flows (discounted at the loan's effective interest rate) or, alternatively, at the loan's observable market price or the fair value of supporting collateral. Impaired loans are defined as those where it is probable that amounts due according to contractual terms, including principal and interest, will not be collected. Both nonaccrual and certain restructured loans meet this definition. Large groups of smaller-balance, homogeneous loans, primarily charge card, residential real estate and consumer installment loans, are excluded from the scope of these Statements. The Corporation determines loan impairment when assessing the adequacy of the allowance for possible credit losses. SFAS No. 118 permits existing income recognition practices to continue. The adoption of these Statements did not have a material impact on the Corporation's net income or financial position.
Allowance for possible credit losses
The allowance for possible credit losses is maintained at a level considered adequate to provide for potential credit losses. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Known losses of principal on impaired loans are charged off. The provision for credit losses is based on past loss experience, management's evaluation of the loan portfolio under current economic conditions and management's estimate of anticipated, but as yet not specifically identified, credit losses. Such estimates are reviewed periodically and adjustments, if necessary, are recorded during the periods in which they become known.
Premises and equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Interest costs associated with long-term construction projects are capitalized and then amortized over the life of the related asset after the project is completed. For financial reporting purposes, the provision for depreciation and amortization is computed on the straight-line basis over the estimated useful lives of the assets.
Other assets
The Corporation records specifically identifiable and unidentifiable (goodwill) intangibles in connection with the acquisition of assets from unrelated parties or the acquisition of new subsidiaries. Original lives range from 3 to 15 years. Goodwill is amortized on the straight-line basis. Identifiable intangibles are amortized on either an accelerated or straight-line basis depending on the character of the acquired asset.
Property or other assets received in satisfaction of debt are included in "Other Assets" on the Corporation's Consolidated Statement of Condition and are recorded at the lower of remaining cost or fair value. Fair values for other real estate owned generally are reduced by estimated costs to sell. Losses arising from subsequent write-downs to fair value are charged directly to expense.
Retirement and other postemployment benefits
The Corporation has noncontributory defined benefit pension plans covering virtually all its employees. For its primary plan, the policy of the Corporation is to, at a minimum, fund annually an amount necessary to satisfy the requirements under the Employee Retirement Income Security Act ("ERISA"), without regard to prior years' contributions in excess of the minimum.
SFAS No. 106-Employers' Accounting for Postretirement Benefits Other Than Pensions, requires that certain retiree benefit plans, including health care plans for retirees and their dependents, be treated as a form of deferred compensation that should be recognized on an accrual basis over the employment period. The Corporation adopted SFAS No. 106 in the first quarter of 1993, and elected to defer its accumulated postretirement benefit obligation of approximately $42 million and amortize it on a straight-line basis over 20 years.
The Corporation adopted SFAS No. 112, Employers' Accounting for Postemployment Benefits, in the first quarter of 1994. As required by the Statement, postemployment benefits provided to former or inactive employees after employment but before retirement are accrued in accordance with SFAS No. 43, Accounting for Compensated Absences, if they meet the conditions for accrual of compensated absences. Otherwise, postemployment benefits are accrued or disclosed in accordance with SFAS No. 5, Accounting for Contingencies. The effect of initially adopting SFAS No. 112 was not material.
Cash flows
On December 29, 1995, the Corporation transferred all held to maturity securities to available for sale. See Note 2 on page 41 for further information. On December 31, 1993, the Corporation adopted SFAS No. 115-Accounting for Certain Investments in Debt and Equity Securities. In compliance with this Statement, portfolio securities designated as available for sale were marked to market on the Corporation's Consolidated Statement of Condition. On July 1, 1993, the Corporation paid a $7.2 million dividend-in-kind to Bankmont related to the transfer of Harris Futures Corporation. Non-cash portions of these transactions were excluded from the Corporation's Consolidated Statement of Cash Flows.
Income taxes
Bankmont, Bankcorp and their wholly-owned subsidiaries file a consolidated Federal income tax return. Accordingly, no Federal income tax is applicable to dividends received by Bankmont from Bankcorp, or to dividends received by Bankcorp from its subsidiaries. Income tax return liabilities for the Corporation are not materially different than they would have been if computed on a separate return basis.
Management's estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The accounts within the consolidated financial statements of the Corporation requiring significant management judgment include: provision and allowance for possible credit losses, income taxes, pension cost, post employment benefits, fair values and temporary - - vs - other than temporary impairment.
2. Portfolio Securities
The amortized cost and estimated market value of "held to maturity" and "available for sale" securities were as follows:
At December 31, 1995 and 1994, portfolio and trading account securities having a par value of $1.7 billion and $2.7 billion, respectively, were pledged as collateral for certain liabilities, securities sold under agreement to repurchase, public and trust deposits, trading account activities and for other purposes where permitted or required by law. Securities carried at approximately $1.1 billion and $1.4 billion were sold under agreement to repurchase at December 31, 1995 and 1994, respectively.
On November 15, 1995, the FASB issued a Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities. In accordance with that report, the Corporation conducted a one-time reassessment of the classifications of securities held. As a result, the Corporation reclassified all held-to-maturity securities to available-for- sale on December 29, 1995. The amortized cost of the transferred securities was $839 million and the related unrealized holding gain was $20 million.
The amortized cost and estimated market value of available-for-sale securities at December 31, 1995, by contractual maturity, are shown below. Expected maturities can differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In 1995 and 1994, proceeds from the sale of securities available for sale amounted to $2,025 million and $146 million. Proceeds from sales of portfolio securities during 1993 were $211 million. Gross gains of $26,284,000 and gross losses of $2,905,000 were realized on these sales in 1995, while gains of $6,032,000 and losses of $778,000 were realized in 1994, and gains of $13,204,000 and losses of $166,000 were realized in 1993. Net unrealized holding gain or loss on trading securities included in earnings during 1995 changed by $833,000 from an unrealized loss of $72,000 at December 31, 1994 to an unrealized gain of $761,000 at December 31, 1995.
3. Loans
The following table summarizes loan balances by category:
The Corporation had approximately $103 million and $82 million of loans classified as held for sale at December 31, 1995 and 1994, respectively. Approximately 80 percent and 58 percent of these respective amounts were real estate mortgages
Nonaccrual loans, restructured loans and other nonperforming assets are summarized below:
At December 31, 1995 and 1994, the Corporation had no aggregate public and private sector outstandings to any single country experiencing liquidity problems which exceeded one percent of the Corporation's consolidated assets. Additional information on foreign outstandings is provided in the Foreign Outstandings section on page 26 of this Report.
4. Allowance For Possible Credit Losses The changes in the allowance for possible credit losses were as follows:
5. Premises And Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. A summary of these accounts is stated below:
The provision for depreciation and amortization was $39,142,000 in 1995, $39,524,000 in 1994, and $41,018,000 in 1993.
In 1990 and 1991, HTSB purchased a 72,000 square foot parcel of vacant land in Chicago's downtown business district. Construction plans for a new operations and office building complex on this site were deferred, pending strategic clarification as to the appropriate size and functional characteristics of this facility.
During the second quarter of 1992, management determined that a writedown was necessary because of the uncertainty of proceeding with this project in the near future. Therefore, all capitalized expenditures associated with this project, totaling $8.8 million were written off. In addition, the land was written down by $3.0 million, leaving the Corporation's December 31, 1995 and 1994 Consolidated Statement of Condition reflecting a value of $8.5 million for this property.
6. Short, Medium and Long-Term Notes and Unused Lines Of Credit
The following table summarizes the Corporation's long-term notes:
On December 27, 1995 in connection with a capital restructuring, Bankcorp issued a $65 million par value 6-1/2% subordinated note to Bankmont that matures on December 27, 2007. All of the Bankcorp notes are unsecured obligations, ranking on a parity with all unsecured and subordinated indebtedness of the Corporation and are not subject to redemption prior to maturity at the election of the debtholders. The interest rate on the floating rate notes reprices semiannually and floats at 50 basis points above 180 day LIBOR. At year-end 1995, 180 day LIBOR stood at 5.51 percent.
In connection with the issuance of commercial paper and for other corporate purposes, Bankcorp has a revolving credit agreement with a group of five nonaffiliated banks and BMO. On December 18, 1995, this revolving credit agreement was amended to increase the credit limit from $130 million to $150 million and to extend the maturity date to December 18, 1999. There were no borrowings under this credit agreement during 1995 or 1994.
HTSB offers to institutional investors from time to time, unsecured short- term and medium-term bank notes in an aggregate principal amount of up to $1.5 billion outstanding at any time. The term of each note could range from fourteen days to fifteen years. The notes are subordinated to deposits and rank pari passu with all other unsecured senior indebtedness of HTSB. As of December 31, 1995, $478 million of short-term notes were outstanding with maturities and interest rates ranging from 29 to 180 days and 5.50 to 5.79 percent, respectively. There were no outstandings under this program at December 31, 1994.
7. Fair Value of Financial Instruments
Generally accepted accounting principles require the disclosure of estimated fair values for both on- and off-balance-sheet financial instruments. The Corporation's fair values are based on quoted market prices when available. For financial instruments not actively traded, such as certain loans, deposits, off- balance-sheet transactions and long term borrowings, fair values have been estimated using various valuation methods and assumptions. Although management used its best judgement in estimating these values, there are inherent limitations in any estimation methodology. In addition, accounting pronouncements require that fair values be estimated on an item-by-item basis, thereby ignoring the impact a large sale would have on a thin market and intangible values imbedded in established lines of business. Therefore, the fair value estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in an actual transaction. The fair value estimation methodologies employed by the Corporation were as follows:
The carrying amounts for cash and demand balances due from banks along with short-term money market assets and liabilities reported on the Corporation's Consolidated Statement of Condition were considered to be the best estimates of fair value for these financial instruments. Fair values of trading account assets and portfolio securities were based on quoted market prices.
A variety of methods were used to estimate the fair value of loans. Changes in estimated fair value of loans reflect changes in credit risk and general interest rates which have occurred since the loans were originated. Fair values of floating rate loans, including commercial, broker dealer, financial institution, construction, charge card, consumer and home equity, were assumed to be the same as book value as the loans' interest rates automatically reprice to market. Fair values of residential mortgages were based on current prices for securities backed by similar loans. For long-term fixed rate loans, including consumer installment and commercial mortgage loans, fair values were estimated based on the present value of future cash flows with current market rates as discount rates. A fair-value discount related to nonperforming loans included in the above categories, along with a discount for future credit risk throughout the portfolio, was based on an analysis of expected and unidentified future losses. Accordingly, the fair value estimate for total loans was reduced by these discounts, which in total approximated the allowance for possible credit losses on the Corporation's Consolidated Statement of Condition. Additionally, management considered appraisal values of collateral when nonperforming loans were secured by real estate.
The fair values of demand deposits, savings accounts, interest checking deposits, and money market accounts were the amounts payable on demand at the reporting date, or the carrying amounts. The fair value of time deposits was estimated using a discounted cash flow calculation with current market rates offered by the Corporation as discount rates.
The fair value of long-term notes was determined using a discounted cash flow calculation with current rates available to the Corporation for similar debt as discount rates.
The estimated fair values of the Corporation's financial instruments at December 31, 1995 and 1994 are presented in the following table. See Note 8 for additional information regarding fair values of off-balance-sheet financial instruments.
8. Financial Instruments With Off-Balance-Sheet Risk
The Corporation utilizes various financial instruments with off-balance-sheet risk in the normal course of business to a) meet its customers' financing and risk management needs, b) reduce its own risk exposure, and c) produce fee income and trading profits. The Corporation's major categories of financial instruments with off-balance-sheet risk include credit facilities, interest rate and foreign exchange contracts, and various securities-related activities. Fair values of off-balance-sheet instruments were based on fees currently charged to enter into similar agreements, market prices of comparable instruments, pricing models using year-end rates and counterparty credit ratings.
Credit facilities
Credit facilities with off-balance-sheet risk include commitments to extend credit, standby letters of credit and commercial letters of credit.
Commitments to extend credit are contractual agreements to lend to a customer as long as contract terms have been met. They generally require payment of a fee and have fixed expiration dates. The Corporation's commitments serve both business and individual customer needs, and include commercial loan commitments, credit card lines, home equity lines, commercial real estate loan commitments and mortgage loan commitments. The Corporation's maximum risk of accounting loss is represented by the total contractual amount of commitments which was $8.20 billion and $7.43 billion at December 31, 1995 and 1994, respectively. Since only a portion of commitments will ultimately be drawn down, the Corporation does not expect to provide funds for the total contractual amount. Risks associated with certain commitments are reduced by participations to third parties, which at December 31, 1995, totaled $244 million and at December 31, 1994, totaled $217 million.
Standby letters of credit are unconditional commitments which guarantee the obligation of a customer to a third party should that customer default. They are issued to support financial and performance-related obligations including brokers' margin maintenance, industrial revenue bond repayment, debt repayment, construction contract performance and trade agreement performance. The Corporation's maximum risk of accounting loss for these items is represented by the total commitments outstanding of $1.59 billion at December 31, 1995 and $1.23 billion at December 31, 1994. Risks associated with standby letters of credit are reduced by participations to third parties which totaled $270 million at December 31, 1995 and $168 million at December 31, 1994.
Commercial letters of credit are commitments to make payments on behalf of customers when letter of credit terms have been met. Maximum risk of accounting loss is represented by total commercial letters of credit outstanding of $131 million at December 31, 1995 and $148 million at December 31, 1994.
Credit risks associated with all of these facilities are mitigated by reviewing customers' creditworthiness on a case-by-case basis, obtaining collateral, limiting loans to individual borrowers, setting restrictions on long-duration maturities and establishing stringent covenant terms outlining performance expectations which, if not met, may cause the Corporation to terminate the contract. Credit risks are further mitigated by monitoring and maintaining portfolios that are well diversified.
Collateral is required to support certain of these credit facilities when they are drawn down and may include equity and debt securities, commodities, inventories, receivables, certificates of deposit, savings instruments, fixed assets, real estate, life insurance policies and seats on national or regional exchanges. Requirements are based upon the risk inherent in the credit and are more stringent for firms and individuals with greater default risks. The Corporation monitors collateral values and appropriately perfects its security interest. Periodic evaluations of collateral adequacy are performed by Corporation personnel.
The fair value of credit facilities (i.e. deferred income) is approximately equal to their carrying value of $13.8 million at December 31, 1995 and $11.0 million at December 31, 1994.
Interest rate contracts
Interest rate contracts include futures, forward rate agreements, option contracts, guarantees (caps, floors and collars) and swaps. The Corporation enters into these contracts for dealer, trading and risk management purposes.
Dealer and trading activity
As dealer, the Corporation serves customers seeking to manage interest rate risk by entering into contracts as a counterparty to their (customer) transactions. In its trading activities, the Corporation uses interest rate contracts to profit from expected future market movements.
These contracts may create exposure to both credit and market risk. Replacement risk, the primary component of credit risk, is the risk of loss should a counterparty default following unfavorable market movements and is measured as the Corporation's cost of replacing contracts at current market rates. The Corporation manages credit risk by establishing credit limits for customers and products through an independent corporate-wide credit review process and continually monitoring exposure against those limits to ensure they are not exceeded. Credit risk is, in many cases, further mitigated by the existence of netting agreements which provide for netting of contractual receivables and payables in the event of default or bankruptcy.
Market risk is the risk of loss as a result of changes in interest rates. The Corporation manages market risk by establishing limits which are based on dollars at risk given a parallel shift in the yield curve. Limits are established by product, maturity and volatility. Limits are approved by management and monitored independently of the traders on a regular basis. Market risk is further diminished by entering into offsetting positions. Senior management oversees all dealer risk-related activities.
Futures and forward contracts are agreements in which the Corporation is obligated to make or take delivery, at a specified future date, of a specified instrument, at a specified price or yield. Futures contracts are exchange traded and, because of exchange requirements that gains and losses be settled daily, create negligible exposure to credit risk.
Forward rate agreements are arrangements between two parties to exchange amounts, at a specified future date, based on the difference between an agreed upon interest rate and reference rate applied to a notional principal amount. These agreements enable purchasers and sellers to fix interest costs and returns.
Options are contracts that provide the buyer the right (but not the obligation) to purchase or sell a financial instrument, at a specified price, either within a specified period of time or on a certain date. Interest rate guarantees (caps, floors and collars) are agreements between two parties that, in general, establish for the purchaser a maximum level of interest expense or a minimum level of interest revenue based on a notional principal amount for a specified term. Options and guarantees written create exposure to market risk. As a writer of interest rate options and guarantees, the Corporation receives a premium at the
outset of the agreement and bears the risk of an unfavorable change in the price of the financial instrument underlying the option or guarantee. Options and guarantees purchased create exposure to credit risk and, to the extent of the premium paid, market risk.
Interest rate swaps are contracts involving the exchange of interest payments based on a notional amount for a specified period. Most of the Corporation's activity in swaps is as intermediary in the exchange of interest payments between customers, although the Corporation also uses swaps to manage its own interest rate exposure (see discussion of risk management activity below).
The following table summarizes the Corporation's dealer/trading interest rate contracts and their related contractual or notional amounts and maximum replacement costs. Contractual or notional amount gives an indication of the volume of activity in the contract. Maximum replacement cost reflects the potential loss resulting from customer defaults and is computed as the cost of replacing, at current market rates, all outstanding contracts with unrealized gains.
The following table summarizes average and end of period fair values of dealer/trading interest rate contracts for the years ended December 31, 1995 and 1994:
Net gains (losses) from dealer/trading activity in interest rate contracts and nonderivative trading account assets for the years ended December 31, 1995, 1994 and 1993 are summarized below:
The following table summarizes the maturities and weighted average interest rates paid and received on dealer/trading interest rate swaps as of December 31, 1995:
Risk management activity
In addition to its dealer activities, the Corporation uses interest rate contracts, primarily swaps, to reduce the level of financial risk inherent in mismatches between the interest rate sensitivities of certain assets and liabilities. During 1995 and 1994, interest rate swaps were primarily used to alter the character of funds supporting the municipal bond portfolio and the senior note program. The Corporation had $281 million notional amount of swap contracts, used for risk management purposes, outstanding at December 31, 1995 with a fair value of $(11.8) million and a replacement cost of zero. At December 31, 1994, the Corporation had $497 million notional amount of swap contracts outstanding with a fair value of $(16.4) million and a replacement cost of $263 thousand. Gross unrealized gains and losses, representing the difference between fair value and carrying value (i.e. accrued interest payable or receivable) on these contracts, totaled zero and $6.3 million, respectively, at December 31, 1995 and $134 thousand and $7.8 million, respectively, at December 31, 1994. Risk management activity, including the related cash positions, had no material effect on the Corporation's net income for the year ended December 31, 1995 or 1994. There were no deferred gains or losses on terminated contracts at December 31, 1995 or 1994.
The following table summarizes swap activity for risk management purposes during 1995 and 1994:
The following table summarizes the maturities and weighted average interest rates paid and received on interest rate swaps used for risk management as of December 31, 1995:
Foreign exchange contracts Dealer activity
The Corporation is also a dealer in foreign exchange, having a significant presence in the marketplace. Foreign exchange contracts may create exposure to market and credit risk, including replacement risk and settlement risk. Credit risk is managed by establishing limits for customers through an independent corporate-wide credit approval process and continually monitoring exposure against those limits. In addition, both settlement and replacement risk are reduced through netting by novation, agreements with counterparties to offset certain related obligations. Market risk is managed through establishing exposure limits by currency and monitoring actual exposure against those limits, entering into offsetting positions, and closely monitoring price behavior. Effective April 3, 1995, the Corporation and BMO agreed to combine their U.S. foreign exchange activities ("FX"). Under this arrangement, FX net profit will be shared by the Corporation and BMO in accordance with a specific formula set forth in the agreement. This agreement expires in April 2002 but may be extended at that time. Either party may terminate the arrangement at its option. Beginning with second quarter 1995, FX revenues were reported net of expenses. This agreement did not have a material impact on the Corporation's 1995 net income or financial position at December 31, 1995.
At December 31, 1995, approximately two-thirds of the Corporation's gross notional positions in foreign currency contracts are represented by five currencies: English pounds, German deutsche marks, Canadian dollars, Japanese yen and French francs.
Foreign exchange contracts include spot, future, forward and option contracts that enable customers to manage their foreign exchange risk. Spot, future and forward contracts are agreements to exchange currencies at a future date, at a specified rate of exchange. Foreign exchange option contracts give the buyer the right and the seller an obligation (if the buyer asserts his right) to exchange currencies during a specified period (or on a certain date in the case of "European" options) at a specified exchange rate.
The following table summarizes the Corporation's dealer/trading foreign exchange contracts and their related contractual or notional amount and maximum replacement cost:
The following table summarizes average and end of period fair values of dealer/trading foreign exchange contracts for the years ended December 31, 1995 and 1994:
Net gains (losses) from dealer/trading foreign exchange contracts, for the years ended December 31, 1995, 1994 and 1993 are summarized below. 1995 net foreign exchange gains include $8.8 million of net profit under the aforementioned agreement with BMO.
Securities activities
The Corporation's securities activities that have off-balance-sheet risk include municipal bond underwriting, short selling and indemnified lending of securities held in trust.
Through its municipal bond underwriting activities, the Corporation commits to buy and offer for resale newly issued bonds. The Corporation is exposed to market risk because it may be unable to resell its inventory of bonds profitably as a result of unfavorable market conditions. In syndicate arrangements, the Corporation is obligated to fulfill syndicate members' commitments should they default. The syndicates of which the Corporation was a member had underwriting commitments totaling $15.5 million at December 31, 1995 and $14.6 million at December 31, 1994.
Security short selling, defined as selling of securities not yet owned, exposes the Corporation to off-balance-sheet market risk because the Corporation may be required to buy securities at higher prevailing market prices to cover its short positions. The Corporation had no short position at December 31, 1995 and a short position of $10 million at December 31, 1994.
Securities lending, a service the Corporation provides to master trust and institutional custody customers, exposes the Corporation to off-balance-sheet credit risk when it indemnifies its customers against the risks of borrower default. Risks are minimized by lending to approved brokers and dealers, up to a lending limit established for each broker, and by obtaining collateral in excess of the value of the loan. Collateral is typically cash, U.S. Government securities or letters of credit from approved banks. The value of the collateral is monitored daily and additional collateral is obtained when deemed necessary. Highly liquid collateral, such as cash and U.S. Government securities, typically represents over 95 percent of the collateral held by the Corporation. The Corporation's maximum risk of accounting loss is represented by the amount of securities lent under indemnification, which totaled $1.04 billion at December 31, 1995 and $2.09 billion at December 31, 1994.
9. Concentrations Of Credit Risk In Financial Instruments
The Corporation had four concentrations of credit risk arising from financial instruments at December 31, 1995 and 1994. These concentrations were the Midwest geographic area, individuals, brokers and dealers, and commercial banks. Each concentration exceeded 10 percent of the Corporation's total credit exposure, which is the total potential accounting loss should all customers fail to perform according to contract terms and all collateral prove to be worthless.
Midwestern geographic area
A majority of the Corporation's customers are located in the Midwestern region of the United States, defined here to include Illinois, Indiana, Iowa, Michigan, Minnesota, Missouri and Wisconsin. The Corporation provides credit to these customers through a broad array of banking and trade financing products including commercial loans, commercial loan commitments, commercial real estate loans, consumer installment loans, charge card loans and lines, mortgage loans, home equity loans and lines, standby and commercial letters of credit and banker's acceptances. The financial viability of customers in the Midwest is, in part, dependent on the region's economy. Corporate customers headquartered in the region and serving a national or international market are not included in this concentration because their business is broad-based and not dependent on the region's economy. The Corporation's maximum risk of accounting loss, should all customers making up the Midwestern concentration fail to perform according to contract terms and all collateral prove to be worthless, was approximately $12.8 billion or 49 percent of the Corporation's total credit exposure at December 31, 1995 and $12.1 billion or 47 percent of the Corporation's total credit exposure at December 31, 1994.
The Corporation manages this exposure by continually reviewing local market conditions and customers, adjusting individual and industry exposure limits within the region and by obtaining or closely monitoring collateral values. See Note 8 for information on collateral supporting credit facilities.
Individuals
The Corporation extends credit to individuals through credit card lines, style lines of credit, installment and single payment loans. Credit card and style lines are unsecured revolving lines of credit, accessed through VISA and MasterCard, special drafts, and/or automated teller machines. The Corporation's credit card lines represent most of its total credit exposure to individuals. Although credit card loans are not collateralized, measures have been implemented to reduce credit loss. These measures include strict credit approval criteria, card use monitoring, automated authorization procedures and aggressive collection procedures. Further, credit card customers are broad-based geographically, although currently about 50 percent are located in the Midwest.
Installment and single payment loans are generally collateralized by personal property and have a fixed maturity. The Corporation ensures that it has sufficient collateral by monitoring its value and perfecting its legal rights to the property upon default.
The Corporation's maximum risk of accounting loss, should all individual customers fail to perform according to contract terms and all available collateral prove to be worthless, was approximately $5.7 billion or 22 percent of the Corporation's total credit exposure at December 31, 1995 and $5.2 billion or 20 percent of the Corporation's total credit exposure at December 31, 1994.
Brokers and dealers
The Corporation has credit exposure to various brokers and dealers in securities and commodities through securities lending, commercial lending and standby letter of credit guarantees. Securities lending represents most of the total credit exposure to this group and consists of loans of securities held by trust customers where the Corporation has provided indemnification against borrower default. Securities are typically used by brokers and dealers to cover their short positions. These loans are generally collateralized by cash, U.S. Government securities and letters of credit with values in excess of loan amounts. Cash collateral is typically held at the Corporation while other collateral is usually held at the depositories through which securities lending transactions are conducted.
Commercial loans are used by brokers and dealers to fund the purchase of securities, while standby letters are used to maintain margins. Collateral is typically equity and debt securities, commodities, futures and option contracts held by the Corporation or other appropriate custodians or depositories. Security interest is obtained to ensure access to collateral.
The Corporation's maximum risk of accounting loss, should brokers and dealers fail to fulfill their contractual obligations and all collateral prove to be worthless, was approximately $1.8 billion or 7 percent of the Corporation's total credit exposure at December 31, 1995 and $3.1 billion or 12 percent of the Corporation's total credit exposure at December 31, 1994.
Commercial banks
The Corporation has credit exposure to the domestic and international banking industry through its participation in check clearing, international banking transactions, foreign exchange transactions, Eurodollar investing and through correspondent banking services including Federal fund loans and standby letter of credit guarantees. Generally, collateral is not held to support credit exposure to banks, although risks are mitigated since durations are short, investments are highly liquid, and counterparties are geographically diverse. The Corporation's maximum risk of accounting loss, should all commercial banks fail to fulfill their contractual obligations, was approximately $2.0 billion or 8 percent of the Corporation's total credit exposure at December 31, 1995 and $2.8 billion or 11 percent of the Corporation's total credit exposure at December 31, 1994.
10. Retirement And Other Postemployment Plans
The Corporation has noncontributory defined benefit pension plans covering virtually all its employees as of December 31, 1995. Most of the employees participating in retirement plans were included in one primary plan ("primary plan") during the three-year period ended December 31, 1995. The benefit formula for this plan is based upon length of service and an employee's highest qualifying compensation during five consecutive years of active employment. The plan is a multiple-employer plan covering the Corporation's employees as well as persons employed by certain affiliated entities. In 1995, the Corporation prospectively expanded the definition of qualifying compensation and reduced the rate used to compute retirement benefits. The estimated net cost savings generated by these changes is $2.28 million in 1995.
The policy for this plan is to have the participating entities, at a minimum, fund annually an amount necessary to satisfy the requirements under ERISA, without regard to prior years' contributions in excess of the minimum. For 1994, the minimum and maximum deductible contribution were both zero as a result of the full funding limitation. For 1995 and 1993, cumulative contributions were greater than the amount recorded as pension expense for financial reporting purposes.
In 1995, the Corporation changed mortality rates from the 1984 Unisex Pensioner Mortality Table to the 1983 Group Annuity Mortality Table in accordance with the Retirement Protection Act of 1994. In addition, the assumption regarding future annual increases were modified as follows: the wage base was decreased from 6% to 5% and the Consumer Price Index was reduced by 1% at each age. These changes had no material effect on 1995 pension expense. In 1994, the Corporation elected to change the measurement date for plan assets and liabilities from December 31 to September 30. The change had no material effect on 1994 or prior years' pension expense.
*Plan assets consist primarily of participating units in collective trust funds administered by HTSB, along with U.S. Government bonds. **Plan assets and obligations measured as of September 30, 1994. ***Plan assets and obligations measured as of September 30, 1995.
Net pension expense included the following components for the primary plan:
Certain employees participating in the primary plan are also covered by a supplemental unfunded retirement plan. The purpose of this plan is to extend full retirement benefits to individuals without regard to statutory limitations for qualified funded plans. The following table sets forth the status of this supplemental plan:
During 1995, 1994 and 1993, the Corporation's lump-sum benefit payments to retirees resulted in settlement losses of approximately $.8 million, $3.1 million and $3.4 million, respectively, reflected above as a portion of net periodic pension expense.
The total consolidated pension expense of the Corporation, including the supplemental plan, for 1995, 1994 and 1993 was $9,770,000, $15,222,000, and $13,830,000, respectively.
In addition to pension benefits, the Corporation provides medical care benefits for retirees (and their dependents) who have attained age 55 and have at least 10 years of service. In 1994, the Corporation expanded the plan to provide medical care benefits for disabled employees and widows of former employees (and their dependents). The Corporation provides these medical care benefits through a self-insured plan. Under the terms of the plan, the Corporation contributes to the cost of coverage based on employees' length of service. Cost sharing with plan participants is accomplished through deductibles, coinsurance and out-of-pocket limits. Funding for the plan largely comes from the general assets of the Corporation, although recently contributions to a trust fund have been made under Internal Revenue Code Section 401(h).
In 1994 the Corporation elected to change the measurement date for plan assets and liabilities from December 31 to September 30; the change had no material effect on 1994 benefit expense. The following table sets forth the postretirement medical care benefit plan's status at December 31, 1995, 1994 and 1993 for the Corporation:
*Plan assets consist primarily of participating units in collective trust funds administered by HTSB. **Plan assets and obligations measured as of September 30, 1994. ***Plan assets and obligations measured as of September 30, 1995. ****For 1993 postretirement medical expense, no assets were assumed to exist. The initial funding occurred in 1993.
Net postretirement benefit expense included the following components:
For 1995, the weighted average annual rate of increase in the per capita cost of covered benefits was assumed to be 9 percent and was assumed to decrease gradually to 6 percent in 2001 and remain level thereafter. For 1994 and 1993, the weighted average annual rate of increase in the per capita cost of covered benefits was assumed to be 12 percent and was assumed to decrease gradually to 7 percent in 2001 and remain level thereafter. This health care cost trend rate assumption had a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point each
year would have increased the accumulated postretirement benefit obligation as of September 30, 1995, September 30, 1994 and December 31, 1993 by $6.3 million, $7.3 million and $6.7 million, respectively, and the aggregate service and interest cost components of net postretirement benefit expense for 1995 by approximately $.7 million.
11. Lease Expense And Obligations
Rental expense for all operating leases was $18,144,000 in 1995, $16,002,000 in 1994, and $16,623,000 in 1993. These amounts include real estate taxes, maintenance, and other rental-related operating costs of $3,992,000, $4,151,000, and $4,712,000 for 1995, 1994, and 1993 respectively, paid under net lease arrangements. Lease commitments are primarily for office space. Minimum rental commitments as of December 31, 1995 for all noncancelable operating leases are as follows:
Occupancy expenses for 1995, 1994 and 1993 have been reduced by $13,200,000, $13,816,000 and $13,300,000, respectively, for rental income from leased premises.
12. Income Taxes
The 1995, 1994 and 1993 applicable income tax expense (benefit) was as follows:
Deferred tax assets (liabilities) are comprised of the following at December 31, 1995, and at December 31, 1994:
At December 31, 1995, the net deferred tax asset of $74.5 million included $62.4 million for Federal tax and $12.1 million for Illinois tax. The Corporation has fully recognized both its Federal and Illinois deferred tax assets. Current taxable income and taxable income generated in the statutory carryback period is sufficient to support the entire deferred tax asset. The deferred taxes reported on the Corporation's Consolidated Statement of Condition at December 31, 1995 also include a $17.8 million deferred tax liability for the tax effect of the net unrealized gains associated with marking to market certain securities designated as available for sale.
Total income tax expense of $70,175,000 for 1995, $24,528,000 for 1994, and $39,879,000 for 1993 reflects effective tax rates of 32.2 percent, 20.1 percent and 25.6 percent, respectively. The reasons for the differences between actual tax expense and the amount determined by applying the U.S. Federal income tax rate of 35 percent to income before income taxes were as follows:
The tax expense from net gains on security sales amounted to $9,094,000, $4,440,000, and $5,166,000 in 1995, 1994, and 1993, respectively.
13. Investments In Subsidiaries And Statutory Restrictions
Bankcorp's investment in the combined net assets of its wholly-owned subsidiaries was $1,175,037,000 and $1,026,515,000 at December 31, 1995 and 1994, respectively.
Provisions of both Illinois and Federal banking laws place restrictions upon the amount of dividends that can be paid to Bankcorp by its bank subsidiaries. Illinois state law requires that no dividends may be paid in an amount greater than the net profits then on hand, reduced by certain loan losses (as defined). In addition to these restrictions, Federal Reserve member banking subsidiaries require prior approval of Federal banking authorities if dividends declared by a subsidiary bank, in any calendar year, will exceed its net profits (as defined in the applicable statute) for that year, combined with its retained net profits, as so defined, for the preceding two years. Based on these and certain other prescribed regulatory limitations, Bankcorp subsidiaries could have declared, without regulatory approval, $235,622,000 of dividends at December 31, 1995. Actual dividends paid, however, would be subject to prudent capital maintenance. Cash dividends paid to Bankcorp by its subsidiaries amounted to $63,265,000 and $49,731,000 in 1995 and 1994, respectively.
The Federal Reserve Act also places restrictions on certain transactions between Bankcorp and its affiliates, including loans from subsidiary banks. Such restrictions include collateralization requirements and quantitative limitations. Essentially, a member bank's aggregate involvement in these restricted transactions may not exceed 20 percent of its capital and surplus, as defined by the Federal Reserve Board. In addition, restricted transactions involving an individual affiliate are limited to 10 percent of its capital and surplus.
The bank subsidiaries of Bankcorp are required by the Federal Reserve Act to maintain reserves against certain of their deposits. Reserves are held either in the form of vault cash or balances maintained with the Federal Reserve Bank. Required reserves are essentially a function of daily average deposit balances and statutory reserve ratios prescribed by type of deposit. During 1995 and 1994, daily average reserve balances of $198 million and $206 million, respectively, were required for those subsidiaries of Bankcorp that must maintain such balances. At year-end 1995 and 1994, balances on deposit at the Federal Reserve Bank totaled $441 million and $219 million, respectively.
14. Contingent Liabilities
Certain subsidiaries of Bankcorp are defendants in various legal proceedings arising in the normal course of business. In the opinion of management, based on the advice of legal counsel, the ultimate resolution of these matters will not have a material adverse effect on the Corporation's financial position.
15. Foreign Activities (By Domicile Of Customer)
Income and expenses identifiable with foreign and domestic operations are summarized in the table below:
Determination of rates for foreign funds generated or used are based on the actual external costs of specific interest-bearing sources or uses of funds for the periods. Internal allocations for certain unidentifiable income and expenses were distributed to foreign operations based on the percentage of identifiable foreign income to total income. As of December 31, 1995, 1994 and 1993, identifiable foreign assets accounted for 5, 7 and 6 percent, respectively, of total consolidated assets.
16. Parent Company Only Condensed Financial Information
Presented below is the statement of income, balance sheet and statement of cash flows for Harris Bankcorp, Inc. (parent company only):
*Eliminated in consolidation.
*Eliminated in consolidation
Statement of Cash Flows
17. Business Combinations/Intangibles
At December 31, 1995 and 1994, intangible assets, including goodwill resulting from business combinations, amounted to $38,407,000 and $47,757,000, respectively. Intangible assets are included in "Other Assets" on the Consolidated Statement of Condition. Amortization of these intangibles amounted to $9,350,000 in 1995, $10,266,000 in 1994, and $11,785,000 in 1993. The impact of purchase accounting adjustments, other than amortization of intangibles, was not material to the Corporation's reported results.
18. Related Party Transactions
Bankcorp is a wholly-owned subsidiary of Bankmont, a Delaware corporation. Bankmont is a wholly-owned subsidiary of BMO. Unamortized goodwill of $16.5 million at December 31, 1995 associated with the acquisition of Bankcorp in 1984 is reflected on the accounting records of Bankmont and has not been "pushed down" to the Corporation.
During 1995, 1994 and 1993, the Corporation engaged in various transactions with BMO and its subsidiaries. These transactions included the payment and receipt of service fees and occupancy expenses, and purchasing and selling Federal funds, repurchase and reverse repurchase agreements, long-term borrowings and interest rate and foreign exchange contracts. The purpose of these transactions was to facilitate a more efficient use of combined resources and to better serve customers. Management fees were determined in accordance with applicable banking regulations. During 1995, 1994 and 1993, the Corporation received from BMO approximately $15.7 million, $12.8 million and $8.0 million respectively, primarily for trust services, data processing and other operations support provided by the Corporation.
Effective April 3, 1995, the Corporation and BMO agreed to combine their U.S. foreign exchange activities. Under this arrangement, FX net profit will be shared by the Corporation and BMO in accordance with a specific formula set forth in the agreement. This agreement expires in April 2002 but may be extended at that time. Either party may terminate the arrangement at its option. Beginning with second quarter 1995, FX revenues were reported net of expenses. 1995 foreign exchange revenues included $8.8 million of net profit under this agreement. This agreement did not have a material impact on the Corporation's 1995 net income or financial position at December 31, 1995.
In October 1991, the Corporation announced that certain U.S. corporate banking units of HTSB and BMO were to be merged into a single organizational unit in order to better accommodate the requirements of certain customers in the large corporate market. The transition was expected to take place over several months. During the 1991 fourth quarter, a total of 38 employees had transferred from HTSB to BMO's payroll, although all related customer business remained with the Corporation at that time. During 1992, 75 customers representing approximately $214 million in outstanding credits and $2.3 billion in unused commitments were transferred to BMO. In 1993, an additional 31 customers representing approximately $22 million in outstanding credits and $533 million in commitments were also transferred. BMO was compensated for expenses incurred on behalf of HTSB's customers through December 31, 1993. No material transfers occurred in 1995 or 1994.
19. Subsequent Event
On January 11, 1996, the Corporation announced the sale of its securities custody and related trustee services business for large institutions to Citibank. After restructuring charges, it is estimated that the net gain on the sale will approximate $4.0 million. The sale of the custody business for large institutions is not expected to have a material impact on 1996 earnings.
Explanation of Joint Independent Auditors' Reports - ------------------------------------------------------------------------------- The Board of Directors of Harris Bankcorp, Inc. engaged the firms of KPMG Peat Marwick LLP and Coopers & Lybrand L.L.P. to serve as joint auditors for the three years ended December 31, 1995, 1994 and 1993.
Bankmont Financial Corp., a wholly-owned subsidiary of Bank of Montreal, owns all outstanding shares of Harris Bankcorp, Inc. Canadian bank shareholders had been required by the Canadian Bank Act to appoint each year two firms of independent public accountants to be auditors of their bank and all significant subsidiaries. In prior years, the change in the Corporation's independent public accountants reflected identical changes made by Bank of Montreal. The Canadian Bank Act was revised during 1992; accordingly, the Corporation no longer expects a planned rotation of independent auditors.
Independent Auditors' Report - -------------------------------------------------------------------------------
To the Stockholder and Board of Directors of Harris Bankcorp, Inc.:
We have audited the accompanying consolidated statements of condition of Harris Bankcorp, Inc. and Subsidiaries as of December 31, 1995 and 1994, and the related consolidated statements of income, changes in stockholder's equity and cash flows for each of the years in the three year period ended December 31, 1995. These consolidated financial statements are the responsibility of Harris Bankcorp, Inc.'s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Harris Bankcorp, Inc. and Subsidiaries as of December 31, 1995 and 1994, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1995 in conformity with generally accepted accounting principles.
KPMG Peat Marwick LLP Coopers & Lybrand L.L.P. Chicago, Illinois January 26, 1996
ITEM 9

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no disagreements between the Corporation and its independent auditors related to accounting matters and/or financial disclosures. There were no changes in independent auditors since December 31, 1993.
- ------------------------------------------------------------------------------- PART III
ITEM 10

ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Bankcorp's Board of Directors consists of seventeen members. Directors are elected annually. Each present director, except Mrs. Congalton and Ms. Decyk (both of whom are attorneys), has been employed in an executive capacity by his or her employer for more than five years. Set forth below is certain biographical information concerning each director, including principal occupation, age, the year first elected a director of Bankcorp and HTSB and other directorships.
Matthew W. Barrett, age 51, Chairman and Chief Executive Officer of Bank of Montreal. Elected in 1988.
F. Anthony Comper, age 50, President and Chief Operating Officer and a Director of Bank of Montreal. Elected in 1990.
Susan T. Congalton, age 49, Managing Director, Lupine Partners (private investments). Elected in 1988.
Roxanne J. Decyk, age 43, Vice President, Planning, Amoco Corp. (petroleum products) and a Director of Material Sciences Corporation and Snap-On Incorporated. Elected in 1990.
Wilbur H. Gantz, age 58, President and Chief Executive Officer of PathoGenesis Corporation (diagnostic health care) and a Director of W.W. Grainger, Gillette Corporation and Bank of Montreal. Elected in 1984.
James J. Glasser, age 61, Chairman of GATX Corporation (capital equipment and services for extracting, processing and distributing dry and liquid bulk commodities) and a Director of The B. F. Goodrich Company, Stone Container Corporation and Bank of Montreal. Elected in 1980.
Daryl F. Grisham, age 69, President and Chief Executive Officer of Parker House Sausage Company (meat processor). Elected in 1983.
Dr. Leo M. Henikoff, age 56, President and Chief Executive Officer of Rush- Presbyterian-St. Luke's Medical Center (health care and related services). Elected in 1986.
Dr. Stanley O. Ikenberry, age 61, Regent Professor and President Emeritus of the University of Illinois and a Director of Franklin Life Insurance Company and Pfizer, Inc. Elected in 1985.
Richard M. Jaffee, age 60, Chairman and Chief Executive Officer, Oil-Dri Corporation of America (a developer, manufacturer and marketer of sorbent products). Elected in 1995.
Edward W. Lyman, Jr., age 53, Vice Chair of the Board of Bankcorp and Harris Trust and Savings Bank. Elected in 1995.
Alan G. McNally, age 50, Chairman of the Board and Chief Executive Officer of Bankcorp and Harris Trust and Savings Bank. Elected in 1993.
Maribeth S. Rahe, age 47, Vice Chair of the Board of Bankcorp and Harris Trust and Savings Bank. Elected in 1995.
Charles H. Shaw, age 63, Chairman, The Charles H. Shaw Company (real estate development). Elected in 1990.
Richard E. Terry, age 58, Chairman and Chief Executive Officer, Peoples Energy Corporation (public utility) and a Director of Amsted Industries. Elected in 1992.
James O. Webb, age 64, President, James O. Webb & Associates, Inc. (consultant in new ventures and business development). Elected in 1995.
William J. Weisz, age 69, Chairman of the Board, Motorola, Inc. (manufacturer of electronic equipment). Elected in 1988.
In addition to Messrs. McNally and Lyman and Ms. Rahe, the Corporation had nine executive officers at December 31, 1995--Richard J. Brown, age 51, Jeffrey D. Butterfield, age 49, Charles H. Davis, age 53, Pierre O. Greffe, age 43, Kenneth R. Keck, age 57, Louis F. Lanwermeyer, age 47, Charles R. Tonge, age 46, Edward J. Williams, age 53 and Nancy B. Wolcott, age 41. Each officer has held executive positions with the Corporation or an affiliate for many years.
ITEM 11

ITEM 11 - OMITTED PURSUANT TO GENERAL INSTRUCTION (J)(2)(c) OF FORM 10-K.
ITEM 12

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Bank of Montreal, through its subsidiary, Bankmont Financial Corp., a U.S. bank holding company chartered in Delaware, owns all 6,667,490 issued and outstanding shares of Bankcorp's common stock.
ITEM 13

ITEM 13 - OMITTED PURSUANT TO GENERAL INSTRUCTION (J)(2)(c) OF FORM 10-K.
Part IV
ITEM 14

ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed with Report:
(l) Financial Statements (See page 1 for a listing of all financial statements included in Item 8)
(2) Financial Statement Schedules
All Schedules normally required by Form 10-K are omitted since they are either not applicable or the required information is shown in the financial statements or the notes thereto.
(3) Exhibits:
3. Articles of Incorporation and By-laws
a) Restated Certificate of Incorporation (filed as an Exhibit to Bankcorp's 1987 Form 10-K and incorporated herein by reference)
b) By-laws of Bankcorp
4. Indenture dated as of June 1, 1989 relating to Bankcorp's 9 3/8% Subordinated Notes Due 2001 (filed as an Exhibit to Bankcorp's May 24, 1989 Registration Statement on Form S-3 and incorporated herein by reference). In addition, Bankcorp has issued three Floating Rate Subordinated Notes and one Fixed Rate Subordinated Note to its parent company, Bankmont. The principal amount of these notes totals $200 million for the floating rate notes and $65 million for the fixed rate note, respectively. The floating rate notes mature in 2004, 2005 and 2006, respectively. The fixed rate note matures in 2007. Bankcorp hereby agrees to file a copy of the agreement relating to any such notes with the Commission upon request.
10. Material Contracts and Compensatory Plans
a) 1995 Managerial Incentive Plan
b) Harris Growth Incentive Plan (filed as an Exhibit to Bankcorp's 1991 Form 10-K and incorporated herein by reference)
c) Employees' Savings and Profit Sharing Plan
d) 1995 Stock Appreciation Rights Plan
e) Harris Retirement Benefit Replacement Plan (filed as an Exhibit to Bank of Montreal's August 3, 1994 Registration Statement on Form, File No. 33-82358, and incorporated herein by reference)
23. Consents of Experts and Counsel (consents of Independent Auditors)
24. Power of Attorney
(b) No reports on Form 8-K were filed during the last quarter of 1995. - ------------------------------------------------------------------------------- *Copies of Exhibits (a)(3) 3, 4, 10, 23 and 24, not contained herein, may be obtained at a cost of 25 cents per page upon written request to the Secretary of Harris Bankcorp, Inc.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Harris Bankcorp, Inc. has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 25th day of March 1996.
Alan G. McNally Chairman of the Board and Chief Executive Officer
Pierre O. Greffe Chief Financial Officer
Paul R. Skubic Chief Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by Alan G. McNally, Chairman of the Board and Chief Executive Officer of the Corporation, as attorney-in-fact for the following Directors on behalf of Harris Bankcorp, Inc. on the 25th day of March 1996.
F. Anthony Comper Daryl F. Grisham Maribeth S. Rahe Susan T. Congalton Leo M. Henikoff Charles H. Shaw Roxanne J. Decyk Stanley O. Ikenberry Richard E. Terry Wilbur H. Gantz Richard M. Jaffee James O. Webb James J. Glasser Edward W. Lyman, Jr. William J. Weisz
Alan G. McNally Attorney-In-Fact
Supplemental Information
No annual report or proxy statement will be sent to security holders in 1996.