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Section 1: 10-K (10-K)

THFF-2013.12.31-10K


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2013
 
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from    _________     to    ___________
 
Commission file number 0-16759
FIRST FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
INDIANA
35-1546989
(State of Incorporation)
(I.R.S. Employer Identification Number)
One First Financial Plaza
Terre Haute, Indiana
 
47807
(Address of Registrant’s Principal Executive Offices)
(Zip Code)
 
(812) 238-6000
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
Name of Exchange on Which Registered
Common Stock, no par value
The NASDAQ Stock Market LLC
(NASDAQ Global Select Market)
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known-seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x    No  ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨
 




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer”, “large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act of 1934.
 
Large accelerated filer ¨       Accelerated filer x       Non-accelerated filer ¨       Smaller reporting company ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x
 
As of June 30, 2013 the aggregate market value of the stock held by non-affiliates of the registrant based on the average bid and ask prices of such stock was $400,280,901. (For purposes of this calculation, the Corporation excluded the stock owned by certain beneficial owners and management and the Corporation’s Employee Stock Ownership Plan.)
 
Shares of Common Stock outstanding as of March 11, 2014—13,355,272 shares.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Definitive Proxy Statement for the First Financial Corporation Annual Meeting of Shareholders to be held April 16, 2014 are incorporated by reference into Part III.
 

 





FIRST FINANCIAL CORPORATION
2013 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
 
PAGE
PART I
 
Item 1.    Business
Item 1A. Risk Factors
Item 1B. Unresolved Staff Comments
Item  2.  Properties
Item  3.   Legal Proceedings
Item  4.   Mine Safety Disclosures
PART II
 
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.    Selected Financial Data
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item  7A. Quantitative and Qualitative Disclosures about Market Risk
Item 8.    Financial Statements and Supplementary Data
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
Item  9A. Controls and Procedures
Item 9B.  Other Information
PART III
 
Item 10.    Directors, Executive Officers and Corporate Governance
Item 11.    Executive Compensation
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
Item 13.   Certain Relationships and Related Transactions and Director Independence
Item 14.   Principal Accountant Fees and Services
PART IV
 
Item 15.   Exhibits and Financial Statement Schedules
Signatures
Exhibit 10.3
 
Exhibit 10.4
 
Exhibit 21
 
Exhibit 31.1
 
Exhibit 31.2
 
Exhibit 32.1
 
Exhibit 32.2
 


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FIRST FINANCIAL CORPORATION
2013 ANNUAL REPORT ON FORM 10-K
 
PART I 
 
ITEM 1.
BUSINESS
 
FORWARD-LOOKING STATEMENTS
 
A cautionary note about forward-looking statements: In its oral and written communication, First Financial Corporation from time to time includes forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements can include statements about estimated cost savings, plans and objectives for future operations and expectations about performance, as well as economic and market conditions and trends. They often can be identified by the use of words such as "expect," "may," "could," "intend," "project," "estimate," "believe" or "anticipate" or words of similar import. By their nature, forward-looking statements are based on assumptions and are subject to risks, uncertainties and other factors. Actual results may differ materially from those contained in the forward-looking statement. First Financial Corporation may include forward-looking statements in filings with the Securities and Exchange Commission, in other written materials such as this Annual Report and in oral statements made by senior management to analysts, investors, representatives of the media and others. It is intended that these forward-looking statements speak only as of the date they are made, and First Financial Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the forward-looking statement is made or to reflect the occurrence of unanticipated events.
 
The discussion in Item 1A (Risk Factors) and Item 7 (Management's Discussion and Analysis of Results of Operations and Financial Condition) of this Annual Report on Form 10-K, lists some of the factors which could cause actual results to vary materially from those in any forward-looking statements. Other uncertainties which could affect First Financial Corporation's future performance include the effects of competition, technological changes and regulatory developments; changes in fiscal, monetary and tax policies; market, economic, operational, liquidity, credit and interest rate risks associated with First Financial Corporation's business; inflation; competition in the financial services industry; changes in general economic conditions, either nationally or regionally, resulting in, among other things, credit quality deterioration; and changes in securities markets. Investors should consider these risks, uncertainties and other factors in addition to those mentioned by First Financial Corporation in its other filings from time to time when considering any forward-looking statement.
 
GENERAL
 
First Financial Corporation (the “Corporation”) is a financial holding company. The Corporation was originally organized as an Indiana corporation in 1984 to operate as a bank holding company.
 
The Corporation, which is headquartered in Terre Haute, Indiana, offers a wide variety of financial services including commercial, mortgage and consumer lending, lease financing, trust account services, depositor services and insurance services through its three subsidiaries. At the close of business in 2013 the Corporation and its subsidiaries had 954 full-time equivalent employees.
 
COMPANY PROFILE
 
First Financial Bank, N.A. (the “Bank”) is the largest bank in Vigo County, Ind. It operates 11 full-service banking branches within the county; four in Clay County, Ind.; one in Daviess County, Ind.; one in Gibson County, Ind.; one in Greene County, Ind.; three in Knox County, Ind.; five in Parke County, Ind.; one in Putnam County, Ind., four in Sullivan County, Ind.; one in Vanderburgh, County.; four in Vermillion County, Ind.; five in Champaign County, Illinois; one in Clark County, Ill.; three in Coles County, Ill.; three in Crawford County, Ill.; two in Franklin County, Ill.; one in Jasper County, Ill.; two in Jefferson County, Ill.; one in Lawrence County, Ill.; three in Livingston County, Illinois; two in Marion County, Ill.; one in Montgomery County, Ill.; three in McLean County, Illinois; two in Richland County, Ill.; seven in Vermilion County, Ill.; and one in Wayne County, Ill. In addition to its branches, it has a main office in downtown Terre Haute and a 50,000-square-foot commercial building on South Third Street in Terre Haute, which serves as the Corporation's operations center and provides additional office space. The Morris Plan Company of Terre Haute, Inc. (“Morris Plan”) has one office and is located in Vigo County. Forrest Sherer Inc. is a regional supplier of insurance, surety and other financial products. Forrest Sherer has more than 58 professionals and over 91 years of service to both businesses and households in their market area. The agency has representation agreements with more than 40 regional and national insurers to market their products of property and casualty insurance, surety bonds, employee benefit plans, life insurance and annuities. FFB Risk Management Co., Inc. located in Las Vegas, Nevada is a captive insurance subsidiary which insures various liability and property damage policies for First Financial Corporation subsidiaries.
 
COMPETITION
 
First Financial Bank and Morris Plan face competition from other financial institutions. These competitors consist of commercial banks, a mutual savings bank and other financial institutions, including consumer finance companies, insurance companies, brokerage firms and credit unions.

The Corporation's business activities are centered in west-central Indiana and east-central Illinois. The Corporation has no foreign activities other than periodically investing available funds in time deposits held in foreign branches of domestic banks.

REGULATION AND SUPERVISION
 
The Corporation and its subsidiaries operate in highly regulated environments and are subject to supervision and regulation by several governmental regulatory agencies, including the Board of Governors of the Federal Reserve System (the "Federal Reserve"), the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (the “FDIC”), and the Indiana Department of Financial Institutions (the “DFI”). The laws and regulations established by these agencies are generally intended to protect depositors, not shareholders. Changes in applicable laws, regulations, governmental policies, income tax laws and accounting principles may have a material effect on the Corporation’s business and prospects. The following summary is qualified by reference to the statutory and regulatory provisions discussed.

The Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Dodd-Frank”), which was enacted in July 2010, significantly restructures the financial regulatory regime in the United States. Although the Dodd-Frank Act’s provisions that have received the most public attention generally have been those applying to or more likely to affect larger institutions such as bank holding companies with total consolidated assets of $50 billion or more, it contains numerous other provisions that affect all bank holding companies and banks, including the Corporation, the Bank, and Morris Plan, some of which are described in more detail below.

Because full implementation of the Dodd-Frank Act will occur over several years, it is difficult to anticipate the overall financial impact on the Corporation, its customers or the financial industry generally. However, the impact is expected to be substantial and may have an adverse impact on the Corporation’s financial performance and growth opportunities

The Volcker Rule

The Dodd-Frank Act requires the federal financial regulatory agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (defined as hedge funds and private equity funds). The statutory provision is commonly called the “Volcker Rule”. The Federal Reserve adopted final rules implementing the Volcker Rule on December 10, 2013. The Volcker Rule became effective on July 21, 2012 and the final rules are effective April 1, 2014, but the Federal Reserve issued an order extending the period during which institutions have to conform their activities and investments to the requirements of the Volcker Rule to July 21, 2015. Although the Corporation is continuing to evaluate the impact of the Volcker Rule and the final rules adopted thereunder, the Corporation does not currently anticipate that the Volcker Rule will have a material effect on the operations of the Bank, Morris Plan, or their respective subsidiaries, as the Corporation does not engage in the businesses prohibited by the Volcker Rule. The Corporation may incur costs to adopt additional policies and systems to ensure compliance with the Volcker Rule, but any such costs are not expected to be material.

Consumer Financial Protection Bureau

The Consumer Financial Protection Bureau (the “CFPB”), created by the Dodd-Frank Act, is responsible for administering federal consumer financial protection laws. The CFPB, which began operations on July 21, 2011, is an independent bureau within the Federal Reserve and has broad rule-making, supervisory and examination authority to set and enforce rules in the consumer protection area over financial institutions that have assets of $10.0 billion or more. The CFPB also has data collecting powers for fair lending purposes for both small business and mortgage loans, as well as authority to prevent unfair, deceptive and abusive practices.


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BASEL III

In July 2013, the federal banking agencies published the Basel III Capital Rules establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Corporation and its subsidiary financial institutions, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules. The Basel III Capital Rules are effective on January 1, 2015 (subject to a phase-in period).

The Basel III Capital Rules, among other things:

introduce a new capital measure called “Common Equity Tier 1” (“CET1”);
specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements;
define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital; and
expand the scope of the deductions/adjustments as compared to existing regulations.

When fully phased in on January 1, 2019, the Basel III Capital Rules will require the Corporation and its banking subsidiaries to maintain:

a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation);
a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation);
a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and
a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets (as compared to a current minimum leverage ratio of 3% for banking organizations that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk).

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

Under the Basel III Capital Rules, the initial minimum capital ratios as of January 1, 2015 will be as follows:

4.5% CET1 to risk-weighted assets;
6.0% Tier 1 capital to risk-weighted assets;
8.0% Total capital to risk-weighted assets.

The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets arising from temporary differences that could not be realized through net operating loss carrybacks and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however, non-advanced approaches banking organizations, including the Corporation, may make a one-time permanent election to continue to exclude these items. The Corporation, the Bank and Morris Plan expect to make this election in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s available-for-sale securities portfolio. The Basel III Capital Rules also preclude certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies, subject to phase-out. As

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of December 31, 2013 the Corporation had no trust preferred securities.

Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2015 and will be phased-in over a four-year period (beginning at 40% on January 1, 2015 and an additional 20% per year thereafter). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specifics changes to current rules impacting the Corporation’s determination of risk-weighted assets include, among other things:
    
Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans;
    
Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due;
    
Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (currently set at 0%); and
    
Providing for a risk weight, generally not less than 20% with certain exceptions, for securities lending transactions based on the risk weight category of the underlying collateral securing the transaction.

Management believes that, as of December 31, 2013, the Corporation, the Bank, and Morris Plan would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect.

The Corporation

The Bank Holding Company Act. Because the Corporation owns all of the outstanding capital stock of the Bank, it is registered as a bank holding company under the federal Bank Holding Company Act of 1956 (“Act”) and is subject to periodic examination by the Federal Reserve and required to file periodic reports of its operations and any additional information that the Federal Reserve may require.

Investments, Control, and Activities. With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before acquiring another bank holding company or acquiring more than five percent of the voting shares of a bank (unless it already owns or controls the majority of such shares).

Bank holding companies are prohibited, with certain limited exceptions, from engaging in activities other than those of banking or of managing or controlling banks. They are also prohibited from acquiring or retaining direct or indirect ownership or control of voting shares or assets of any company which is not a bank or bank holding company, other than subsidiary companies furnishing services to or performing services for their subsidiaries, and other subsidiaries engaged in activities which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be incidental to these operations. The Bank Holding Company Act does not place territorial restrictions on the activities of such nonbanking-related activities.

Bank holding companies which meet certain management, capital, and Community Reinvestment Act of 1977 (“CRA”) standards may elect to become a financial holding company, which would allow them to engage in a substantially broader range of nonbanking activities than is permitted for a bank holding company, including insurance underwriting and making merchant banking investments in commercial and financial companies.

The Corporation does not currently plan to engage in any activity other than owning the stock of the Bank.

The Corporation is a financial holding company (“FHC”) within the meaning of the Gramm-Leach-Bliley Financial Modernization Act of 1999 (“GLB Act”). The GLB Act restricts the business of FHC’s to financial and related activities, and provides the following:


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·
 
it allows bank holding companies that qualify as “financial holding companies” to engage in a broad range of financial and related activities;
 
 
·
 
it allows insurers and other financial services companies to acquire banks;
 
 
·
 
it removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and
 
 
·
 
it establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.

As a qualified FHC, the Corporation is eligible to engage in, or acquire companies engaged in, the broader range of activities that are permitted by the GLB Act. These activities include those that are determined to be “financial in nature,” including insurance underwriting, securities underwriting and dealing, and making merchant banking investments in commercial and financial companies. If any of the Corporation’s banking subsidiaries ceases to be “well capitalized” or “well managed” under applicable regulatory standards, the Federal Reserve Board may, among other things, place limitations on the Corporation’s ability to conduct these broader financial activities or, if the deficiencies persist, require the divestiture of the banking subsidiary. In addition, if any of the Corporation’s banking subsidiaries receives a rating of less than satisfactory under the Community Reinvestment Act of 1977 (“CRA”), the Corporation would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies. The Corporation’s banking subsidiaries currently meet these capital, management and CRA requirements.

Capital Adequacy Guidelines for Bank Holding Companies. The Federal Reserve, as the regulatory authority for bank holding companies, has adopted capital adequacy guidelines for bank holding companies. Bank holding companies with assets in excess of $500 million must comply with the Federal Reserve's risk-based capital guidelines which require a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities such as standby letters of credit) of 8%. At least half of the total required capital must be "Tier 1 capital", consisting principally of common stockholders' equity, non-cumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder ("Tier 2 capital") may consist of a limited amount of subordinated debt and intermediate-term preferred stock, certain hybrid capital instruments and other debt securities, cumulative perpetual preferred stock, and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a Tier 1 (leverage) capital ratio under which the bank holding company must maintain a minimum level of Tier 1 capital to average total consolidated assets of 3% in the case of bank holding companies which have the highest regulatory examination ratings and are not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a ratio of at least 1% to 2% above the stated minimum.
 
Certain regulatory capital ratios for the Corporation as of December 31, 2013, are shown below:
 
Tier 1 Capital to Risk-Weighted Assets
16.22
%
Total Risk Based Capital to Risk-Weighted Asset
17.13
%
Tier 1 Leverage Ratio
11.69
%
 
Dividends. The Federal Reserve's policy is that a bank holding company experiencing earnings weakness should not pay cash dividends exceeding its net income or which could only be funded in ways that weaken the bank holding company's financial health, such as by borrowing. Additionally, the Federal Reserve possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.

Source of Strength. In accordance with Federal Reserve policy, the Corporation is expected to act as a source of financial strength to the Bank and Morris Plan and to commit resources to support the Bank and Morris Plan in circumstances in which the Corporation might not otherwise do so.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. Among other requirements, the Sarbanes-Oxley Act established: (i) requirements for audit committees of public companies, including independence and expertise standards; (ii) additional responsibilities regarding financial statements for the chief executive officers and chief financial officers of reporting companies; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies regarding various matters relating to corporate governance, and (v) new and increased civil and criminal penalties for violation of the securities laws.

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The Bank and Morris Plan

General Regulatory Supervision. The Bank is a national bank organized under the laws of the United States of America and is subject to the supervision of the OCC, whose examiners conduct periodic examinations of the Bank. The Bank must undergo regular on-site examinations by the OCC and must submit quarterly and annual reports to the OCC concerning its activities and financial condition.

Morris Plan is an Indiana-chartered institution and is subject to the supervision of the FDIC and the DFI, whose examiners conduct periodic examinations of Morris Plan. Morris Plan must undergo regular on-site examinations by the FDIC and the DFI and must submit quarterly and annual reports to the FDIC and the DFI concerning its activities and financial condition.

The deposits of the Bank and Morris Plan are insured by the FDIC and are subject to the FDIC's rules and regulations respecting the insurance of deposits. See "Deposit Insurance".

Lending Limits. The total loans and extensions of credit to a borrower outstanding at one time and not fully secured may not exceed 15 percent of the bank's capital and unimpaired surplus. In addition, the total amount of outstanding loans and extensions of credit to any borrower outstanding at one time and fully secured by readily marketable collateral may not exceed 10 percent of the unimpaired capital and unimpaired surplus of the bank (this limitation is separate from and in addition to the above limitation). If a loan is secured by United States obligations, such as treasury bills, it is not subject to this legal lending limit.

Deposit Insurance. The Dodd-Frank Act has permanently increased the maximum amount of deposit insurance for financial institutions per insured depositor to $250,000.

The deposits of the Bank and Morris Plan are insured up to the applicable limits under the DIF. The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC is required to set a DIF reserve ratio of 1.35% of estimated insured deposits and is required to achieve this ratio by September 30, 2020. Also, the Dodd-Frank Act has eliminated the 1.50% ceiling on the reserve ratio and provides that the FDIC is no longer required to refund amounts in the DIF that exceed 1.50% of insured deposits.

In connection with the Dodd-Frank Act’s requirement that insurance assessments be based on assets, the FDIC bases assessments on an institution’s average consolidated assets (less average tangible equity) as opposed to its deposit level. This may shift the burden of deposit premiums toward larger depository institutions which rely on funding sources other than U.S. deposits.

Under the FDIC’s risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. An institution’s risk to the DIF is measured by its regulatory capital levels, supervisory evaluations, and certain other factors. An institution’s assessment rate depends upon the risk category to which it is assigned. As noted above, pursuant to the Dodd-Frank Act, the FDIC will calculate an institution’s assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 capital) as opposed to an institution’s deposit level which was the previous basis for calculating insurance assessments. Pursuant to the Dodd-Frank Act, institutions will be placed into one of four risk categories for purposes of determining the institution’s actual assessment rate. The FDIC will determine the risk category based on the institution’s capital position (well capitalized, adequately capitalized, or undercapitalized) and supervisory condition (based on exam reports and related information provided by the institution’s primary federal regulator). The Bank paid a total FDIC assessment of $2.02 million and Morris Plan paid a total FDIC assessment of $32 thousand in 2013.

In addition to the FDIC insurance premiums, the Bank and the Morris Plan are required to make quarterly payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize a predecessor deposit insurance fund. These assessments will continue until the FICO bonds are repaid.

Transactions with Affiliates and Insiders. Pursuant to Sections 23A and 23B of the Federal Reserve Act and Regulation W, the Bank and Morris Plan are subject to limitations on the amount of loans or extensions of credit to, or investments in, or certain other transactions with, affiliates (including the Corporation) and insiders and on the amount of advances to third parties collateralized by the securities or obligations of affiliates. Furthermore, within the foregoing limitations as to amount, each covered transaction must meet specified collateral requirements. Compliance is also required with certain provisions designed to avoid the taking of low quality assets. The Bank and Morris Plan are also prohibited from engaging in certain transactions with certain affiliates and insiders unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.
        

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Extensions of credit by the Bank or Morris Plan to their executive officers, directors, certain principal shareholders, and their related interests must:

be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties; and
not involve more than the normal risk of repayment or present other unfavorable features.

The Dodd-Frank Act also included specific changes to the law related to the definition of a “covered transaction” in Sections 23A and 23B and limitations on asset purchases from insiders. With respect to the definition of a “covered transaction,” the Dodd-Frank Act now defines that term to include the acceptance of debt obligations issued by an affiliate as collateral for an institution’s loan or extension of credit to another person or company. In addition, a “derivative transaction” with an affiliate is now deemed to be a “covered transaction” to the extent that such a transaction causes an institution or its subsidiary to have a credit exposure to the affiliate. A separate provision of the Dodd-Frank Act states that an insured depository institution may not “purchase an asset from, or sell an asset to” a bank insider (or their related interests) unless (1) the transaction is conducted on market terms between the parties and (2) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the insured institution, it has been approved in advance by a majority of the institution’s non-interested directors.

Dividends. Applicable law provides that a financial institution, such as the Bank or Morris Plan, may pay dividends from its undivided profits in an amount declared by its Board of Directors, subject to prior regulatory approval if the proposed dividend, when added to all prior dividends declared during the current calendar year, would be greater than the current year's net income and retained earnings for the previous two calendar years.

Federal law generally prohibits the Bank or Morris Plan from paying a dividend to the Corporation if it would thereafter be undercapitalized. The FDIC may prevent a financial institution from paying dividends if it is in default of payment of any assessment due to the FDIC. In addition, payment of dividends by a bank may be prevented by the applicable federal regulatory authority if such payment is determined, by reason of the financial condition of such bank, to be an unsafe and unsound banking practice.

Community Reinvestment Act. The CRA requires that the federal banking regulators evaluate the records of a financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could result in the imposition of additional requirements and limitations on the Bank or on Morris Plan.

Capital Regulations. The OCC has adopted risk-based capital ratio guidelines to which the Bank is subject. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet commitments to four risk weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk.

These guidelines divide a bank's capital into two tiers. The first tier (Tier 1) includes common equity, certain non-cumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts of consolidated subsidiaries, less goodwill and certain other intangible assets (except mortgage servicing rights and purchased credit card relationships, subject to certain limitations). Supplementary (Tier 2) capital includes, among other items, cumulative perpetual and long-term limited-life preferred stock, mandatory convertible securities, certain hybrid capital instruments, term subordinated debt and the allowance for loan and lease losses, subject to certain limitations, less required deductions. Banks are required to maintain a total risk-based capital ratio of 8%, of which 4% must be Tier 1 capital. The OCC may, however, set higher capital requirements when a bank's particular circumstances warrant. Banks experiencing or anticipating significant growth are expected to maintain capital ratios, including tangible capital positions, well above the minimum levels.

In addition, the OCC established guidelines prescribing a minimum Tier 1 leverage ratio (Tier 1 capital to adjusted total assets as specified in the guidelines). These guidelines provide for a minimum Tier 1 leverage ratio of 3% for banks that meet certain specified criteria, including that they have the highest regulatory rating and are not experiencing or anticipating significant growth. All other banks are required to maintain a Tier 1 leverage ratio of 3% plus an additional cushion of at least 1% to 2% basis points.






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Certain actual regulatory capital ratios under the OCC's risk-based capital guidelines for the Bank at December 31, 2013, are shown below:
 
Tier 1 Capital to Risk-Weighted Assets
15.68
%
Total Risk-Based Capital to Risk-Weighted Assets
16.49
%
Tier 1 Leverage Ratio
11.40
%
 
The federal bank regulators also have issued a joint policy statement to provide guidance on sound practices for managing interest rate risk. The statement sets forth the factors the federal regulatory examiners will use to determine the adequacy of a bank's capital for interest rate risk. These qualitative factors include the adequacy and effectiveness of the bank's internal interest rate risk management process and the level of interest rate exposure. Other qualitative factors that will be considered include the size of the bank, the nature and complexity of its activities, the adequacy of its capital and earnings in relation to the bank's overall risk profile, and its earning exposure to interest rate movements. The interagency supervisory policy statement describes the responsibilities of a bank's board of directors in implementing a risk management process and the requirements of the bank's senior management in ensuring the effective management of interest rate risk. Further, the statement specifies the elements that a risk management process must contain.

The federal banking regulators have also issued regulations revising the risk-based capital standards to include a supervisory framework for measuring market risk. The effect of these regulations is that any bank holding company or bank which has significant exposure to market risk must measure such risk using its own internal model, subject to the requirements contained in the regulations, and must maintain adequate capital to support that exposure. These regulations apply to any bank holding company or bank whose trading activity equals 10% or more of its total assets, or whose trading activity equals $1 billion or more. Examiners may require a bank holding company or bank that does not meet the applicability criteria to comply with the capital requirements if necessary for safety and soundness purposes. These regulations contain supplemental rules to determine qualifying and excess capital, calculate risk-weighted assets, calculate market risk-equivalent assets and calculate risk-based capital ratios adjusted for market risk.

Morris Plan is also subject to the capital adequacy guidelines of the FDIC in its examination and regulation of Morris Plan.

Certain actual regulatory capital ratios of Morris Plan under the FDIC's risk-based capital guidelines for the Bank at December 31, 2013, are shown below:

Tier 1 Capital to Risk-Weighted Assets
29.61
%
Total Risk-Based Capital to Risk-Weighted Assets
30.90
%
Tier 1 Leverage Ratio
26.07
%

Prompt Corrective Action. The Federal Deposit Insurance Act, as amended (“FDIA”), requires among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDIA includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.

A bank will be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

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The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The FDIA provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice.

The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.

The Corporation believes that, as of December 31, 2013, the Bank and Morris Plan were each “well capitalized” based on the aforementioned ratios.

The Basel III Capital Rules revise the current prompt corrective action requirements effective January 1, 2015 by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category.

Incentive Compensation. The Dodd-Frank Act requires the federal bank regulatory agencies and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities, such as the Corporation and the Bank, having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal shareholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The agencies proposed such regulations in April 2011, but the regulations have not been finalized. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which the Corporation may structure compensation for its executives.

In June 2010, the Federal Reserve Board, OCC and FDIC issued a comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. These three principles are incorporated into the proposed joint compensation regulations under the Dodd-Frank Act, discussed above.



10



The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Corporation, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

Ability-to-Repay Requirement and Qualified Mortgage Rule. The Dodd-Frank Act contains additional provisions that affect consumer mortgage lending. First, it significantly expands underwriting requirements applicable to loans secured by 1-4 family residential real property and augments federal law combating predatory lending practices. In addition to numerous new disclosure requirements, the Dodd-Frank Act imposes new standards for mortgage loan originations on all lenders, including banks and savings associations, in an effort to encourage lenders to verify a borrower’s ability to repay, while also establishing a presumption of compliance for certain “qualified mortgages.” Most significantly, the new standards limit the total points and fees that the Bank and/or a broker may charge on conforming and jumbo loans to 3% of the total loan amount.

In 2013, the CFPB issued a final rule, effective January 10, 2014, that implements the Dodd-Frank Act’s ability-to-repay requirements, and clarifies the presumption of compliance for “qualified mortgages.”  Further, the final rule also clarifies that qualified mortgages do not include “no-doc” loans and loans with negative amortization, interest-only payments, balloon payments, terms in excess of 30 years, or points and fees paid by the borrower that exceed 3% of the loan amount, subject to certain exceptions. In addition, for qualified mortgages, the monthly payment must be calculated on the highest payment that will occur in the first five years of the loan, and the borrower’s total debt-to-income ratio generally may not be more than 43%. The final rule also provides that certain mortgages that satisfy the general product feature requirements for qualified mortgages and that also satisfy the underwriting requirements of Fannie Mae and Freddie Mac (while they operate under federal conservatorship or receivership) or the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service are also considered to be qualified mortgages. This second category of qualified mortgages will phase out as the aforementioned federal agencies issue their own rules regarding qualified mortgages, the conservatorship of Fannie Mae and Freddie Mac ends, and, in any event, after seven years.

As set forth in the Dodd-Frank Act, subprime (or higher-priced) mortgage loans are subject to the ability-to-repay requirement, and the final rule provides for a rebuttable presumption of lender compliance for those loans. The final rule also applies the ability-to-repay requirement to prime loans, while also providing a conclusive presumption of compliance (i.e., a safe harbor) for prime loans that are also qualified mortgages. Additionally, the final rule generally prohibits prepayment penalties (subject to certain exceptions) and sets forth a 3-year record retention period with respect to documenting and demonstrating the ability-to-repay requirement and other provisions.

USA Patriot Act. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”) is intended to strengthen the ability of U.S. Law Enforcement to combat terrorism on a variety of fronts. The potential impact of the USA Patriot Act on financial institutions is significant and wide-ranging. The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires financial institutions to implement additional policies and procedures with respect to, or additional measures designed to address, any or all of the following matters, among others: money laundering and currency crimes, customer identification verification, cooperation among financial institutions, suspicious activities and currency transaction reporting.

S.A.F.E. Act Requirements. Regulations issued under the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 ( the “S.A.F.E. Act” ) require residential mortgage loan originators who are employees of institutions regulated by the foregoing agencies, including national banks, to meet the registration requirements of the S.A.F.E. Act. The S.A.F.E. Act requires residential mortgage loan originators who are employees of regulated financial institutions to be registered with the Nationwide Mortgage Licensing System and Registry, a database created by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to support the licensing of mortgage loan originators by the states. Employees of regulated financial institutions are generally prohibited from originating residential mortgage loans unless they are registered.

Other Regulations

Federal law extensively regulates other various aspects of the banking business such as reserve requirements. Current federal law also requires banks, among other things to make deposited funds available within specified time periods. In addition, with certain exceptions, a bank and a subsidiary may not extend credit, lease or sell property or furnish any services or fix or vary the consideration for the foregoing on the condition that (i) the customer must obtain or provide some additional credit, property or services from,

11



or to, any of them, or (ii) the customer may not obtain some other credit, property or service from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of credit extended.

Interest and other charges collected or contracted by the Bank or Morris Plan are subject to state usury laws and federal laws concerning interest rates. The loan operations are also subject to federal and state laws applicable to credit transactions, such as the:

Truth-In-Lending Act and state consumer protection laws governing disclosures of credit terms and prohibiting certain practices with regard to consumer borrowers;
Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
Equal Credit Opportunity Act and other fair lending laws, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
Fair Credit Reporting Act of 1978 and Fair and Accurate Credit Transactions Act of 2003, governing the use and provision of information to credit reporting agencies;
Fair Debt Collection Practices Act, governing the manner in which consumer debts may be collected by collection agencies; and rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.

The deposit operations also are subject to the:

Customer Information Security Guidelines. The federal bank regulatory agencies have adopted final guidelines (the "Guidelines") for safeguarding confidential customer information. The Guidelines require each financial institution, under the supervision and ongoing oversight of its Board of Directors, to create a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazards to the security or integrity of such information; protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer; and implement response programs for security breaches.
Electronic Funds Transfer Act and Regulation E. The Electronic Funds Transfer Act, which is implemented by Regulation E, governs automatic deposits to and withdrawals from deposit accounts and customers' rights and liabilities arising from the use of automated teller machines and other electronic banking service.
Gramm-Leach-Bliley Act, Fair and Accurate Credit Transactions Act. The Gramm-Leach-Bliley Act, the Fair and Accurate Credit Transactions Act, and the implementing regulations govern consumer financial privacy, provide disclosure requirements and restrict the sharing of certain consumer financial information with other parties.

The federal banking agencies have established guidelines which prescribe standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, compensation fees and benefits, and management compensation. The agencies may require an institution which fails to meet the standards set forth in the guidelines to submit a compliance plan. Failure to submit an acceptable plan or adhere to an accepted plan may be grounds for further enforcement action.

As noted above, the new Bureau of Consumer Financial Protection will have authority for amending existing consumer compliance regulations and implementing new such regulations. In addition, the Bureau will have the power to examine the compliance of financial institutions with an excess of $10 billion in assets with these consumer protection rules. The Bank’s and Morris Plan’s compliance with consumer protection rules will be examined by the OCC and the FDIC, respectively, since neither the Bank nor Morris Plan meet this $10 billion asset level threshold.

Enforcement Powers. Federal regulatory agencies may assess civil and criminal penalties against depository institutions and certain "institution-affiliated parties", including management, employees, and agents of a financial institution, as well as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution's affairs.

In addition, regulators may commence enforcement actions against institutions and institution-affiliated parties. Possible enforcement actions include the termination of deposit insurance. Furthermore, regulators may issue cease-and-desist orders to, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the regulator to be appropriate.


12



Effect of Governmental Monetary Policies. The Corporation's earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Bank's monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies.

Available Information

The Corporation files annual reports on Form 10-K, quarterly reports on Form 10-Q, proxy statements and other information with the Securities and Exchange Commission. Such reports, proxy statements and other information can be read and copied at the public reference facilities maintained by the Securities and Exchange Commission at the Public Reference Room, 100 F Street, NE, Washington, D.C. 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a web site (http://www.sec.gov) that contains reports, proxy statements, and other information. The Corporation’s filings are also accessible at no cost on the Corporation's website at www.first-online.com.


ITEM 1A.
RISK FACTORS

 An investment in the Corporation’s common stock is subject to risks inherent to the Corporation’s business. The material risks and uncertainties that management believes affect the Corporation are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Corporation. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Corporation’s business, financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Corporation’s common stock could decline significantly, and you could lose all or part of your investment.

Risks Related to the Corporation’s Business

Difficult conditions in the capital markets and the economy generally may materially adversely affect the Corporation’s business and results of operations

In recent years, the U.S. economy has faced a severe economic crisis including a major recession from which it is slowly recovering. Business activity across a wide range of industries and regions in the U.S. remains reduced and local governments and many businesses continue to experience financial difficulty. In addition, on-going federal budget negotiations, the implementation of the Patient Protection and Affordable Care Act and the level of U.S. debt may have a destabilizing effect on financial markets.

The Corporation’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services that the Corporation offers, is highly dependent upon the business environment in the markets where the Corporation operates and in the United States as a whole. Overall during recent years, the business environment has been adverse for many households and businesses in the United States and worldwide. While economic conditions in the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions have affected, and could continue to adversely affect, the credit quality of the Corporation’s loans, results of operations and financial condition.


The geographic concentration of the Corporation’s markets makes the Corporation’s business highly susceptible to local economic conditions
Unlike larger banking organizations that are more geographically diversified, the Corporation’s operations are currently concentrated in west central Indiana and east central Illinois. As a result of this geographic concentration, the Corporation’s

13



financial results depend largely upon economic conditions in these market areas. Deterioration in economic conditions in the Corporation’s market could result in one or more of the following:

an increase in loan delinquencies;
an increase in problem assets and foreclosures;
a decrease in the demand for the Corporation’s products and services; and
a decrease in the value of collateral for loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with problem loans and collateral coverage.

The Corporation operates in a highly competitive industry and market area

The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors include banks and many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Corporation's competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can.

The Corporation's ability to compete successfully depends on a number of factors, including, among other things:

the ability to develop, maintain and build upon long-term customer relationships based on top quality service, and safe, sound assets;
the ability to expand the Corporation's market position;
the scope, relevance and pricing of products and services offered to meet customer needs and demands;
the rate at which the Corporation introduces new products and services relative to its competitors;
customer satisfaction with the Corporation's level of service; and
industry and general economic trends.

Failure to perform in any of these areas could significantly weaken the Corporation's competitive position, which could adversely affect the Corporation's growth and profitability, which, in turn, could have a material adverse effect on the Corporation's financial condition and results of operations.

The Corporation is dependent on certain key management and staff

The Corporation relies on key personnel to manage and operate its business. The loss of key staff may adversely affect the Corporation’s ability to maintain and manage these portfolios effectively, which could negatively affect the Corporation’s revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in the Corporation's net income.

Recently enacted and potential further financial regulatory reforms could have a significant impact on our business, financial condition and results of operations

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Corporation. The changes resulting from the Dodd-Frank Act will impose more stringent capital, liquidity and leverage requirements and may impact the profitability of business activities, require changes to certain business practices, or otherwise adversely affect the Corporation’s business.

Further, the Corporation may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements under the Dodd-Frank Act, which may negatively impact results of operations and financial condition.

14



Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non- banks to offer competing financial services and products, among other things.

The Corporation cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may impact the Corporation’s financial condition and results of operations. However, the costs of complying with any additional laws or regulations could have a material adverse effect on the Corporation’s financial condition and results of operations.

The Corporation is subject to extensive government regulation and supervision

The Corporation, primarily through the Bank and Morris Plan, is subject to extensive federal regulation and supervision. Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Corporation's lending practices, capital structure, investment practices, and growth, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation's business, financial condition and results of operations. While the Corporation has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.

The Corporation is subject to lending risk

There are inherent risks associated with the Corporation's lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Corporation operates as well as those across Indiana, Illinois and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans.

The Corporation originates commercial real estate loans, commercial loans, consumer loans and residential real estate loans primarily within its market areas. Commercial real estate, commercial, and consumer loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate. The Corporation is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Corporation.

The Corporation's allowance for loan losses may be insufficient

The Corporation maintains an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management's best estimate of probable incurred losses that are inherent within the existing portfolio of loans. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation's control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review the Corporation's allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge- offs, based on judgments different than those of management. If charge-offs in future periods exceed the allowance for loan losses, the Corporation will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation's financial condition and results of operations.

The Corporation may foreclose on collateral property and would be subject to the increased costs associated with ownership of real property, resulting in reduced revenues and earnings

The Corporation forecloses on collateral property from time to time to protect its investment and thereafter owns and operates such property, in which case it is exposed to the risks inherent in the ownership of real estate. The amount that the Corporation,

15



as a mortgagee, may realize after a default is dependent upon factors outside of its control, including, but not limited to: (i) general or local economic conditions; (ii) neighborhood values; (iii) interest rates; (iv) real estate tax rates; (v) operating expenses of the mortgaged properties; (vi) environmental remediation liabilities; (vii) ability to obtain and maintain adequate occupancy of the properties; (viii) zoning laws; (ix) governmental rules, regulations and fiscal policies; and (x) natural disasters. Certain expenditures associated with the ownership of real estate, principally real estate taxes, insurance, and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the income earned from such property, and the Corporation may have to advance funds in order to protect its investment, or it may be required to dispose of the real property at a loss. These expenditures and costs could adversely affect the Corporation’s ability to generate revenues, resulting in reduced levels of profitability.

The Corporation is subject to environmental liability risk associated with lending activities

A significant portion of the Corporation’s loan portfolio is secured by real property. During the ordinary course of business, the Corporation may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Corporation may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Corporation to incur substantial expenses and may materially reduce the affected property’s value or limit the Corporation’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Corporation’s exposure to environmental liability. Environmental reviews of real property before initiating foreclosure actions may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

The Corporation is subject to interest rate risk

The Corporation’s earnings and cash flows are largely dependent upon the Corporation’s net interest income. Net interest income is the difference between interest income earned on interest earning assets such as loans and securities and interest expense paid on interest bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, could influence not only the interest that is received on loans and securities and the interest that is paid on deposits and borrowings, but such changes could also affect (i) the Corporation’s ability to originate loans and obtain deposits, and (ii) the fair value of the Corporation’s financial assets and liabilities. Currently, the Corporation is in an asset-sensitive position. In a rising interest rate environment, the Corporation may be unable to sell its lower-yielding mortgage loans, thus impacting its ability to generate higher yielding loans which could adversely impact earnings.

The repeal of federal prohibitions on payment of interest on business demand deposits could increase our interest expense and have a material adverse effect on us

All federal prohibitions on the ability of financial institutions to pay interest on business demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, some financial institutions have commenced offering interest on these demand deposits to compete for customers. If competitive pressures require us to pay interest on these demand deposits to attract and retain business customers, our interest expense would increase and our net interest margin would decrease. This could have a material adverse effect on us. Further, the effect of the repeal of the prohibition could be more significant in a higher interest rate environment as business customers would have a greater incentive to seek interest on demand deposits.

The Corporation’s accounting estimates and risk management processes rely on analytical and forecasting models

The processes the Corporation uses to estimate its probable loan losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on the Corporation’s financial condition and results of operations, depends upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are adequate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation. If the models the Corporation uses for interest rate risk and asset-liability management are inadequate, the Corporation may incur increased or unexpected losses upon changes in market interest rates or other market measures. If the models the Corporation uses for determining its probable loan losses are inadequate, the allowance for loan losses may not be sufficient to support future charge-offs. If the models the Corporation uses to measure the fair value financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what the

16



Corporation could realize upon sale or settlement of such financial instruments. Any such failure in the Corporation’s analytical or forecasting models could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

The Corporation continually encounters technological change

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Corporation's future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Corporation's operations. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation's business and, in turn, the Corporation's financial condition and results of operations.

The Corporation’s controls and procedures may fail or be circumvented

The Corporation’s internal operations are subject to certain risks, including but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards. The Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures are based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

The Corporation’s earnings could be adversely impacted by incidences of fraud and compliance failures that are not within our direct control

Financial institutions are inherently exposed to fraud risk. A fraud can be perpetrated by a customer of the Bank, an employee, a vendor, or members of the general public. We are most subject to fraud and compliance risk in connection with the origination of loans, ACH transactions, ATM transactions and checking transactions. Our largest fraud risk, associated with the origination of loans, includes the intentional misstatement of information in property appraisals or other underwriting documentation provided to us by third parties. Compliance risk is the risk that loans are not originated in compliance with applicable laws and regulations and our standards. There can be no assurance that we can prevent or detect acts of fraud or violation of law or our compliance standards by the third parties that we deal with. Repeated incidences of fraud or compliance failures would adversely impact the performance of our loan portfolio.

The Corporation's information systems may experience an interruption or breach in security

The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation's customer relationship management, general ledger, deposit, loan and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Corporation's information systems could damage the Corporation's reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation's financial condition and results of operations.

The Corporation has opened new offices

The Corporation has placed a strategic emphasis on expanding its banking office network. Executing this strategy carries risks of slower than anticipated growth in the new offices, which require a significant investment of both financial and personnel resources. Lower than expected loan and deposit growth in new offices can decrease anticipated revenues and net income

17



generated by those offices, and opening new offices could result in more additional expenses than anticipated and divert resources from current core operations.

Potential acquisitions may disrupt the Corporation’s business and dilute stockholder value

The Corporation generally seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:
    
potential exposure to unknown or contingent liabilities of the target company;
exposure to potential asset quality issues of the target company;
potential disruption to the Corporation’s business;
potential diversion of the Corporation’s management’s time and attention;
the possible loss of key employees and customers of the target company;
difficulty in estimating the value of the target company; and
potential changes in banking or tax laws or regulations that may affect the target company.

Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

New lines of business or new products and services may subject the Corporation to additional risks

From time to time, the Corporation may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Corporation may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Corporation’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

Future growth or operating results may require the Corporation to raise additional capital but that capital may not be available or it may be dilutive

The Corporation is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. To the extent the Corporation’s future operating results erode capital or the Corporation elects to expand through loan growth or acquisition it may be required to raise capital. The Corporation’s ability to raise capital will depend on conditions in the capital markets, which are outside of its control, and on the Corporation’s financial performance. Accordingly, the Corporation cannot be assured of its ability to raise capital when needed or on favorable terms. If the Corporation cannot raise additional capital when needed, it will be subject to increased regulatory supervision and the imposition of restrictions on its growth and business. These could negatively impact the Corporation’s ability to operate or further expand its operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on its financial condition and results of operations.

The Corporation is subject to claims and litigation pertaining to Intellectual Property

Banking and other financial services companies, such as the Corporation, rely on technology companies to provide information technology products and services necessary to support the Corporations’ day-to-day operations. Technology companies frequently enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or otherwise obtained. Competitors of the Corporation’s vendors, or other individuals or companies, have from time to time claimed to hold intellectual property sold to

18



the Corporation by its vendors. Such claims may increase in the future as the financial services sector becomes more reliant on information technology vendors. The plaintiffs in these actions frequently seek injunctions and substantial damages.

Regardless of the scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or actual litigants, the Corporation may have to engage in protracted litigation. Such litigation is often expensive, time-consuming, disruptive to the Corporation’s operations, and distracting to management. If the Corporation is found to infringe upon one or more patents or other intellectual property rights, it may be required to pay substantial damages or royalties to a third-party. In certain cases, the Corporation may consider entering into licensing agreements for disputed intellectual property, although no assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Corporation’s operating expenses. If legal matters related to intellectual property claims were resolved against the Corporation or settled, the Corporation could be required to make payments in amounts that could have a material adverse effect on its business, financial condition and results of operations.

The value of the Corporation’s goodwill and other intangible assets may decline in the future

As of December 31, 2013, the Corporation had $44.4 million of goodwill and other intangible assets. A significant decline in the Corporation’s expected future cash flows, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of the Corporation’s common stock may necessitate taking charges in the future related to the impairment of the Corporation’s goodwill and other intangible assets. If the Corporation were to conclude that a future write-down of goodwill and other intangible assets is necessary, the Corporation would record the appropriate charge, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

The Corporation’s operations rely on certain external vendors

The Corporation relies on certain external vendors to provide products and services necessary to maintain day-to-day operations of the Corporation. Accordingly, the Corporation’s operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. The failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements, because of changes in the vendor’s organizational structure, financial condition, support for existing products and services or strategic focus or for any other reason, could be disruptive to the Corporation’s operations, which could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.

The Corporation may be adversely affected by the soundness of other financial institutions

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. The Corporation has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose the Corporation to credit risk in the event of a default by a counterparty or client. In addition, the Corporation’s credit risk may be exacerbated when the collateral held by the Corporation cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Corporation. Any such losses could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

The Corporation relies on dividends from its subsidiaries for most of its revenue

The Corporation is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on the Corporation’s common stock and interest and principal on the Corporation’s debt. Various federal and state laws and regulations limit the amount of dividends that the Bank and Morris Plan may pay to the Corporation. Also, the Corporation’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event the Bank is unable to pay dividends to the Corporation, the Corporation may not be able to service debt, pay obligations or pay dividends on the Corporation’s common stock. The inability to receive dividends from the Bank could have a material adverse effect on the Corporation’s business, financial condition and results of operations.







19



Risks Related to the Corporation’s Common Stock

The Corporation may not be able to pay dividends in the future in accordance with past practice
The Corporation has historically paid a semi-annual dividend to common stockholders. The payment of dividends is subject to legal and regulatory restrictions. Any payment of dividends in the future will depend, in large part, on the Corporation’s earnings, capital requirements, financial condition and other factors considered relevant by the Corporation’s Board of Directors.

The price of the Corporation’s common stock may be volatile, which may result in losses for investors

General market price declines or market volatility in the future could adversely affect the price of the Corporation’s common stock. In addition, the following factors may cause the market price for shares of the Corporation’s common stock to fluctuate:

announcements of developments related to the Corporation’s business;
fluctuations in the Corporation’s results of operations;
sales or purchases of substantial amounts of the Corporation’s securities in the marketplace;
general conditions in the Corporation’s banking niche or the worldwide economy;
a shortfall or excess in revenues or earnings compared to securities analysts’ expectations;
changes in analysts’ recommendations or projections; and
the Corporation’s announcement of new acquisitions or other projects.

An investment in the Corporation’s common stock is not an insured deposit

The Corporation’s common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity. Investment in the Corporation’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire the Corporation’s common stock, you could lose some or all of your investment.

ITEM 1B.
UNRESOLVED STAFF COMMENTS
 
None.

ITEM 2.
PROPERTIES
 
The Corporation is located in a four-story office building in downtown Terre Haute, Indiana that was first occupied in June 1988. It is leased to the Bank. The Bank also owns two other facilities in downtown Terre Haute. One is available for lease and the other is a 50,000-square-foot building housing operations and administrative staff and equipment. In addition, the Bank holds in fee six other branch buildings. One of the branch buildings is a single-story 36,000-square-foot building which is located in a Terre Haute suburban area. Four other branch bank buildings are leased by the Bank. The expiration dates on the leases are May 31, 2016, February 14, 2016, May 31, 2015, and December 31, 2019.
 
Facilities of the Corporation’s banking center in Daviess County include an office in Washington, Indiana. This building is held in fee.
 
Facilities of the Corporation’s banking centers in Clay County include three offices in Brazil, Indiana and an office in Clay City, Indiana. All four buildings are held in fee.
 
Facilities of the Corporation’s banking centers in Vermillion County include two offices in Clinton, Indiana and offices in Cayuga and Newport, Indiana. All four buildings are held in fee.
 
Facilities of the Corporation’s banking centers in Sullivan County include offices in Sullivan, Dugger, Farmersburg and Hymera, Indiana. All four buildings are held in fee.
 
Facilities of the Corporation’s banking center in Gibson County include an office in Princeton, Indiana. This building is held in fee.
 
Facilities of the Corporation’s banking center in Greene County include an office in Worthington, Indiana. This building is held in fee.

20



 
Facilities of the Corporation’s banking centers in Knox County include offices in Sandborn and two in Vincennes, Indiana. All three buildings are held in fee.
 
Facilities of the Corporation’s banking centers in Parke County include two offices in Rockville, Indiana and offices in Marshall, Montezuma and Rosedale, Indiana. All five buildings are held in fee.
 
Facilities of the Corporation’s banking center in Putnam County include an office in Greencastle, Indiana. This building is held in fee.
 
Facilities of the Corporation’s banking center in Vanderburgh County include an office in Evansville, Indiana. This building is held in fee.
 
Facilities of the Corporation’s banking centers in Crawford County include its main office and a drive-up facility in Robinson, Illinois and a branch facility in Oblong, Illinois. All three of the buildings are held in fee.
 
Facilities of the Corporation’s banking centers in Franklin County include an office in Benton, Illinois and an office in West Frankfort, Illinois. Both buildings are held in fee.

Facilities of the Corporation’s banking centers in Jefferson County include an office and a drive-up facility in Mt. Vernon, Illinois. Both buildings are held in fee.

Facilities of the Corporation’s banking center in Lawrence County include an office in Lawrenceville, Illinois. This building is held in fee.
 
Facilities of the Corporation’s banking centers in Livingston include three offices in Pontiac, Illinois. All of the buildings are held in fee.
 
Facilities of the Corporation’s banking centers in Marion County include an office and a drive-up facility in Salem, Illinois. Both buildings are held in fee.

Facilities of the Corporation’s banking center in McLean County include two offices in Bloomington, Illinois, and an office in Gridley, Illinois. These building are all held in fee.
 
Facilities of the Corporation’s banking center in Montgomery County include an office in Hillsboro, Illinois. This building is held in fee.

Facilities of the Corporation’s banking center in Wayne County include an office in Fairfield, Illinois. This building is held in fee.
 
Facilities of the Corporation’s banking center in Jasper County include an office in Newton, Illinois. This building is held in fee.
 
Facilities of the Corporation’s banking centers in Coles County include two offices in Charleston, Illinois and an office in Matoon, Illinois. These buildings are held in fee.
 
Facilities of the Corporation’s banking center in Clark County include an office in Marshall, Illinois. This building is held in fee.
 
Facilities of the Corporation’s banking center in Champaign County include two offices in Champaign, Illinois, an office in Mohomet, Illinois, and two offices in Urbana, Illinois. One of the banking centers in Champaign is held in fee while the land is leased. The land lease expires September 6, 2036. One of the banking centers in Champaign is leased and the lease expires on December 31, 2017. The banking center in Mohomet is leased and the lease expires on June 30, 2016. One of the banking centers in Urbana is held in fee while the other banking center in Urbana is held in fee while the land is leased and the lease expires on November 30, 2014.

Facilities of the Corporation’s banking center in Vermilion County include five offices in Danville, Illinois, an office in Westville, Illinois, and an office in Ridge Farm, Illinois. One of the buildings in Danville is leased and the lease expires on December 31, 2018 and the other six buildings are held in fee.

21



 
Facilities of the Corporation’s banking centers in Richland County include two offices in Olney, Illinois. One building is held in fee and the other building is leased. The expiration date on the lease is March 1, 2015.
 
The facility of the Corporation’s subsidiary, The Morris Plan Company, includes an office facility in Terre Haute, Indiana. The building is leased by The Morris Plan Company. The expiration date on the lease is October 31, 2020.
 
Facilities of the Corporation’s subsidiary, Forrest Sherer, Inc., include its main office and one satellite office in Terre Haute, Indiana. The buildings are held in fee by Forrest Sherer, Inc.
 
Facilities of the Corporation’s subsidiary, FFB Management Co., Inc., include an office facility in Las Vegas, Nevada. This office facility is leased.
 
ITEM 3.
LEGAL PROCEEDINGS
 
(a) There are no material pending legal proceedings to which the Corporation or its subsidiaries is a party, other than ordinary routine litigation incidental to its business.
(b) Not applicable.
 
ITEM 4.
MINE SAFETY DISCLOSURES
 
Not applicable

PART II
 
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
MARKET AND DIVIDEND INFORMATION
 
(a) As of March 11, 2014 shareholders owned 13,307,498 shares of the Corporation's common stock. The stock is traded on the NASDAQ Global Select Market under the symbol “THFF”. On March 11, 2014, approximately 3,735 shareholders held our common stock.
 
Historically, the Corporation has paid cash dividends semi-annually and currently expects that comparable cash dividends will continue to be paid in the future. The following table gives quarterly high and low trade prices and dividends per share during each quarter for 2013 and 2012.
 
 
 
2013
 
2012
 
 
 
 
 
 
Cash
 
 
 
 
 
Cash
 
 
Trade Price
 
Dividends
 
Trade Price
 
Dividends
Quarter ended
 
High
 
Low
 
Declared
 
High
 
Low
 
Declared
March 31
 
$
31.97

 
$
29.24

 
 

 
$
36.84

 
$
30.31

 
 

June 30
 
$
31.54

 
$
29.02

 
$
0.48

 
$
32.23

 
$
27.09

 
$
0.47

September 30
 
$
34.26

 
$
30.42

 
 

 
$
32.93

 
$
28.25

 
 

December 31
 
$
36.86

 
$
30.47

 
$
0.48

 
$
32.18

 
$
28.07

 
$
0.48

 










22



 
The graph below represents the five-year total return of the Corporation’s stock. The five year total return for our stock during this time was 2.28%. During this same period, the return on The Russell 2000 Index was 149.69% and the SNL Index of Banks $1 - $5 Billion had a return of 32.87%.




 
 
 
 
Period Ending
 
 
Index
 
12/31/2008

 
12/31/2009

 
12/31/2010

 
12/31/2011

 
12/31/2012

 
12/31/2013

First Financial Corporation
 
100.00

 
76.57

 
90.88

 
88.66

 
83.27

 
102.28

Russell 2000
 
100.00

 
127.17

 
161.32

 
154.59

 
179.86

 
249.69

SNL Bank $1B-$5B
 
100.00

 
71.68

 
81.25

 
74.10

 
91.37

 
132.87


(b) Not applicable.
(c) The Corporation periodically acquires shares of its common stock directly from shareholders in individually negotiated transactions. The Corporation has not adopted a formal policy or adopted a formal program for repurchases of shares of its common stock. There were no purchases of common stock by the Corporation during the quarter covered by this report. The Corporation contributed 35,531 shares of treasury stock to the ESOP in November of 2013

23



ITEM 6.
SELECTED FINANCIAL DATA
 
FIVE YEAR COMPARISON OF SELECTED FINANCIAL DATA
(Dollar amounts in thousands, except per share amounts)
 
2013
 
2012
 
2011
 
2010
 
2009
BALANCE SHEET DATA
 
 

 
 

 
 

 
 

 
 

Total assets
 
$
3,018,718

 
$
2,895,408

 
$
2,954,061

 
$
2,451,095

 
$
2,518,722

Securities
 
914,560

 
691,000

 
666,287

 
560,846

 
587,246

Loans, net of unearned fees
 
1,791,428

 
1,851,936

 
1,893,679

 
1,640,146

 
1,631,764

Deposits
 
2,458,791

 
2,276,134

 
2,274,499

 
1,903,043

 
1,789,701

Borrowings
 
117,880

 
160,256

 
246,449

 
159,899

 
363,173

Shareholders’ equity
 
386,195

 
372,122

 
346,961

 
321,717

 
306,483

INCOME STATEMENT DATA
 
 

 
 

 
 

 
 

 
 

Interest income
 
116,221

 
122,305

 
116,341

 
123,582

 
126,255

Interest expense
 
8,961

 
13,393

 
17,147

 
26,966

 
39,261

Net interest income
 
107,260

 
108,912

 
99,194

 
96,616

 
86,994

Provision for loan losses
 
7,860

 
8,773

 
5,755

 
9,200

 
11,870

Other income
 
40,455

 
39,547

 
33,340

 
29,797

 
28,532

Other expenses
 
94,554

 
93,056

 
75,187

 
77,202

 
73,381

Net income
 
31,534

 
32,812

 
37,195

 
28,044

 
22,720

PER SHARE DATA:
 
 

 
 

 
 

 
 

 
 

Net Income
 
2.37

 
2.48

 
2.83

 
2.14

 
1.73

Cash dividends
 
0.96

 
0.95

 
0.94

 
0.92

 
0.90

PERFORMANCE RATIOS:
 
 

 
 

 
 

 
 

 
 

Net income to average assets
 
1.06
%
 
1.13
%
 
1.49
%
 
1.11
%
 
0.95
%
Net income to average shareholders’ equity
 
8.35

 
9.02

 
10.88

 
8.73

 
7.54

Average total capital to average assets
 
13.45

 
13.25

 
14.57

 
13.56

 
13.25

Average shareholders’ equity to average assets
 
12.69

 
12.55

 
13.68

 
12.76

 
12.56

Dividend payout
 
40.58

 
38.40

 
33.29

 
43.08

 
51.99

  
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
The Management's Discussion and Analysis of Financial Condition and Results of Operations, as well as disclosures found elsewhere in this report are based upon First Financial Corporation's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Corporation to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, securities valuation and goodwill. Actual results could differ from those estimates.

Allowance for loan losses. The allowance for loan losses represents management's estimate of probable incurred losses in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. The allowance for loan losses is determined based on management's assessment of several factors: reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, current economic and nonperforming loans. Loans are considered impaired if, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest according to the contractual terms of the loan agreement. When a loan is deemed impaired, impairment is measured by using the fair value of underlying collateral, for loans deemed to be collateral dependent, the present value of the future cash flows discounted at the effective interest rate stipulated in the loan agreement, or the estimated market value of the loan. In measuring the fair value of the collateral, management uses assumptions (e.g., discount rate) and methodologies (e.g., comparison to the recent selling price of similar assets) consistent with those that would be utilized by unrelated third parties.
 
Changes in the financial condition of individual borrowers, economic conditions, historical loss experience, or the condition of the various markets in which collateral may be sold may affect the required level of the allowance for loan losses and the associated provision for loan losses. Should cash flow assumptions or market conditions change, a different amount may be recorded for the allowance for loan losses and the associated provision for loan losses.
 

24



Securities valuation and potential impairment. Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income (loss), net of tax. The Corporation obtains market values from a third party on a monthly basis in order to adjust the securities to fair value. Equity securities that do not have readily determinable fair values are carried at cost. Additionally, all securities are required to be evaluated for other than temporary impairment (OTTI). In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline, the duration of the decline and whether the Corporation intends to sell a security or is more likely than not to be required to sell a security before recovery of its amortized cost. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, the OTTI shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings.
 
Changes in credit ratings, financial condition of underlying debtors, default experience and market liquidity affect the conclusions on whether securities are other-than-temporarily impaired. Additional losses may be recorded through earnings for other than temporary impairment, should there be an adverse change in the expected cash flows for these investments.
 
Goodwill. The carrying value of goodwill requires management to use estimates and assumptions about the fair value of the reporting unit compared to its book value. An impairment analysis is prepared on an annual basis. Fair values of the reporting units are determined by an analysis which considers cash flows streams, profitability and estimated market values of the reporting unit. The majority of the Corporation's goodwill is recorded at First Financial Bank, N. A.
 
Management believes the accounting estimates related to the allowance for loan losses, valuation of investment securities and the valuation of goodwill are "critical accounting estimates" because: (1) the estimates are highly susceptible to change from period to period because they require management to make assumptions concerning, among other factors, the changes in the types and volumes of the portfolios, valuation assumptions, and economic conditions, and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Corporation's assets reported on the balance sheet as well as net income.
 

RESULTS OF OPERATIONS - SUMMARY FOR 2013

 
COMPARISON OF 2013 TO 2012
 
Net income for 2013 was $31.5 million, or $2.37 per share. This represents a 3.9% decrease in net income and a 4.4% decrease in earnings per share, compared to 2012. Return on assets at December 31, 2013 decreased 6.2% to 1.06% compared to 1.13% at December 31, 2012.
 
The primary components of income and expense affecting net income are discussed in the following analysis.
 
NET INTEREST INCOME
 
The principal source of the Corporation's earnings is net interest income, which represents the difference between interest earned on loans and investments and the interest cost associated with deposits and other sources of funding .Net interest income decreased in 2013 to $107.3 million compared to $108.9 million in 2012. Total average interest earning assets increased to $2.73 billion in 2013 from $2.67 billion in 2012. The tax-equivalent yield on these assets decreased to 4.46% in 2013 from 4.80% in 2012. Total average interest-bearing liabilities increased to $2.04 billion in 2013 from $2.02 billion in 2012. The average cost of these interest-bearing liabilities decreased to 0.44% in 2013 from 0.66% in 2012.
 
The net interest margin decreased from 4.30% in 2012 to 4.13% in 2013. This decrease is primarily the result of the decreased income provided by earning assets. Earning asset yields decreased 34 basis points while the rate on interest-bearing liabilities decreased by 22 basis points.







25



CONSOLIDATED BALANCE SHEET - AVERAGE BALANCES AND INTEREST RATES
 
 
December 31,
 
 
2013
 
2012
 
2011
(Dollar amounts in thousands)
 
Average
Balance
 
Interest
 
Yield/
Rate
 
Average
Balance
 
Interest
 
Yield/
Rate
 
Average
Balance
 
Interest
 
Yield/
Rate
ASSETS
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest-earning assets:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Loans (1) (2)
 
$
1,807,599

 
92,207

 
5.10
%
 
$
1,863,014

 
100,083

 
5.37
%
 
$
1,637,471

 
92,167

 
5.63
%
Taxable investment securities
 
641,383

 
16,157

 
2.52
%
 
498,509

 
13,541

 
2.72
%
 
460,811

 
16,161

 
3.51
%
Tax-exempt investments (2)
 
242,484

 
13,523

 
5.58
%
 
243,070

 
14,651

 
6.03
%
 
204,921

 
13,465

 
6.57
%
Federal funds sold
 
42,460

 
32

 
0.08
%
 
67,240

 
44

 
0.07
%
 
25,117

 
36

 
0.14
%
Total interest-earning assets
 
2,733,926

 
121,919

 
4.46
%
 
2,671,833

 
128,319

 
4.80
%
 
2,328,320

 
121,829

 
5.23
%
Non-interest earning assets:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Cash and due from banks
 
75,945

 
 

 
 

 
65,445

 
 

 
 

 
58,030

 
 

 
 

Premises and equipment, net
 
48,625

 
 

 
 

 
43,594

 
 

 
 

 
34,054

 
 

 
 

Other assets
 
140,227

 
 

 
 

 
138,462

 
 

 
 

 
99,861

 
 

 
 

Less allowance for loan losses
 
(22,623
)
 
 

 
 

 
(20,134
)
 
 

 
 

 
(22,154
)
 
 

 
 

TOTALS
 
$
2,976,100

 
 

 
 

 
$
2,899,200

 
 

 
 

 
$
2,498,111

 
 

 
 

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest-bearing liabilities:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Transaction accounts
 
$
1,321,848

 
1,374

 
0.10
%
 
$
1,176,403

 
1,736

 
0.15
%
 
$
974,275

 
1,501

 
0.15
%
Time deposits
 
579,815

 
4,512

 
0.78
%
 
653,089

 
6,784

 
1.04
%
 
616,164

 
10,626

 
1.72
%
Short-term borrowings
 
37,968

 
78

 
0.21
%
 
50,451

 
140

 
0.28
%
 
43,040

 
187

 
0.43
%
Other borrowings
 
105,161

 
2,997

 
2.85
%
 
136,281

 
4,733

 
3.47
%
 
125,102

 
4,833

 
3.86
%
Total interest-bearing liabilities:
 
2,044,792

 
8,961

 
0.44
%
 
2,016,224

 
13,393

 
0.66
%
 
1,758,581

 
17,147

 
0.98
%
Non interest-bearing liabilities:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Demand deposits
 
479,659

 
 

 
 

 
439,206

 
 

 
 

 
336,038

 
 

 
 

Other
 
73,963

 
 

 
 

 
79,894

 
 

 
 

 
61,693

 
 

 
 

 
 
2,598,414

 
 

 
 

 
2,535,324

 
 

 
 

 
2,156,312

 
 

 
 

Shareholders' equity
 
377,686

 
 

 
 

 
363,876

 
 

 
 

 
341,799

 
 

 
 

TOTALS
 
$
2,976,100

 
 

 
 

 
$
2,899,200

 
 

 
 

 
$
2,498,111

 
 

 
 

Net interest earnings
 
 

 
$
112,958

 
 

 
 

 
$
114,926

 
 

 
 

 
$
104,682

 
 

Net yield on interest- earning assets
 
 

 
 

 
4.13
%
 
 

 
 

 
4.30
%
 
 

 
 

 
4.50
%
 
(1)For purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
(2)Interest income includes the effect of tax equivalent adjustments using a federal tax rate of 35%.



















26



The following table sets forth the components of net interest income due to changes in volume and rate. The table information compares 2013 to 2012 and 2012 to 2011.
 
 
 
2013 Compared to 2012 Increase
(Decrease) Due to
 
2012 Compared to 2011 Increase
(Decrease) Due to
(Dollar amounts in thousands)
 
Volume
 
Rate
 
Volume/
Rate
 
Total
 
Volume
 
Rate
 
Volume/
Rate
 
Total
Interest earned on interest-earning assets:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Loans (1) (2)
 
$
(2,977
)
 
$
(5,049
)
 
$
150

 
$
(7,876
)
 
$
12,695

 
$
(4,201
)
 
$
(579
)
 
$
7,915

Taxable investment securities
 
3,881

 
(983
)
 
(282
)
 
2,616

 
1,322

 
(3,644
)
 
(298
)
 
(2,620
)
Tax-exempt investment securities (2)
 
(35
)
 
(1,096
)
 
3

 
(1,128
)
 
2,507

 
(1,113
)
 
(207
)
 
1,187

Federal funds sold
 
(17
)
 
7

 
(2
)
 
(12
)
 
60

 
(20
)
 
(33
)
 
7

Total interest income
 
$
852

 
$
(7,121
)
 
$
(131
)
 
$
(6,400
)
 
$
16,584

 
$
(8,978
)
 
$
(1,117
)
 
$
6,489

Interest paid on interest-bearing liabilities:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Transaction accounts
 
215

 
(514
)
 
(63
)
 
(362
)
 
311

 
(63
)
 
(13
)
 
235

Time deposits
 
(761
)
 
(1,702
)
 
191

 
(2,272
)
 
637

 
(4,227
)
 
(253
)
 
(3,843
)
Short-term borrowings
 
(35
)
 
(36
)
 
9

 
(62
)
 
32

 
(68
)
 
(12
)
 
(48
)
Other borrowings
 
(1,081
)
 
(849
)
 
194

 
(1,736
)
 
432

 
(488
)
 
(44
)
 
(100
)
Total interest expense
 
(1,662
)
 
(3,101
)
 
331

 
(4,432
)
 
1,412

 
(4,846
)
 
(322
)
 
(3,756
)
Net interest income
 
$
2,514

 
$
(4,020
)
 
$
(462
)
 
$
(1,968
)
 
$
15,172

 
$
(4,132
)
 
$
(795
)
 
$
10,245

 
(1)For purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
(2)Interest income includes the effect of tax equivalent adjustments using a federal tax rate of 35%.
 
PROVISION FOR LOAN LOSSES
 
The provision for loan losses charged to expense is based upon credit loss experience and the results of a detailed analysis estimating an appropriate and adequate allowance for loan losses. The analysis includes the evaluation of impaired loans as prescribed under Accounting Standards Codification (ASC-310), pooled loans as prescribed under ASC 450-10, and economic and other risk factors as outlined in various Joint Interagency Statements issued by the bank regulatory agencies. For the year ended December 31, 2013, the provision for loan losses was $7.9 million net, a decrease of $913 thousand, or 10.4%, compared to 2012. The 2013 provision includes $1.4 million related to a decrease in the FDIC indemnification asset. Pursuant to its accounting policy, the Corporation reflects changes in the FDIC indemnification asset related to actual or expected losses in indemnified loans as offsets or additions to the provision for loan losses.
 
Net charge-offs for 2013 were $8.4 million as compared to $8.3 million for 2012 and $9.0 million for 2011. Non-accrual loans decreased to $19.8 million at December 31, 2013 from $36.8 million at December 31, 2012. Loans past due 90 days and still on accrual decreased to $2.1 million compared to $3.4 million at December 31, 2012.
 
NON-INTEREST INCOME
 
Non-interest income of $40.5 million increased $1.0 million from the $39.5 million earned in 2012. Increases in electronic banking fees, trust fees, deposit fees and insurance income offset reduced income from the sale of mortgage loans.
 
NON-INTEREST EXPENSES
 
Non-interest expenses increased to $94.6 million for 2013 from $93.1 million for 2012. Much of the increase in expenses was related to the increase in occupancy and equipment expenses as the Corporation added 5 locations to banking business. Salaries increased $945 thousand while benefits decreased $2.1 million. The benefits expense decrease of $2.1 million was primarily driven by a decrease in pension expense of $3.3 million. The pension plan was frozen for most employees at the end of 2012. Increased costs of the 401K plan reduced the benefit of the freezing of the pension plan benefit.

INCOME TAXES
 
The Corporation's federal income tax provision was $13.8 million in 2013 and 2012. The overall effective tax rate in 2013 of 30.4% increased as compared to a 2012 effective rate of 29.6%.
 


27



COMPARISON OF 2012 TO 2011
 
Net income for 2012 was $32.8 million or $2.48 per share compared to $37.2 million in 2011 or $2.83 per share. This decrease in net income was driven by the increased non-interest expense from the acquisition of Freestar combined with reduced net interest margin of 20 basis points from 4.50% to 4.30%.
 
Net interest income increased $9.7 million in 2012 compared to 2011 as total average interest-earning assets increased. This increase was primarily the result of increasing the earning assets with the acquisition of the Freestar bank at the end of 2011. The provision for loan losses increased $3.0 million from $5.8 million in 2011 to $8.8 million in 2012. Net non-interest income and expense increased $11.7 million from 2011 to 2012. Non-interest expenses increased $17.9 million while non-interest income increased $6.2 million. The increase in non-interest income resulted primarily from electronic banking fees and gain on sale of mortgage loans. The increase in non-interest expense was primarily salaries and benefits associated with the acquisition of the Freestar bank at the end of 2011and an increase in pension expense.
The provision for income taxes decreased $0.6 million from 2011 to 2012 and the effective tax rate increased 1.7% in 2012 from 2011.
 
COMPARISON AND DISCUSSION OF 2013 BALANCE SHEET TO 2012
 
The Corporation's total assets increased 4.3% or $123.3 million at December 31, 2013, from a year earlier. Available-for-sale securities increased $223.6 million at December 31, 2013, from the previous year. Loans, net of unearned income, decreased by $60.2 million to $1.79 billion. Deposits increased by $182.7 million while borrowings decreased by $42.4 million. In August 2013, the Corporation acquired a number of branch facilities in central and southern Illinois and assumed approximately $189 million in customer deposits. Total shareholders' equity increased $14.1 million to $386.2 million at December 31, 2013. Net income was partially offset by higher dividends. There were also 35,531 shares from the treasury with a value of $1.22 million that were contributed to the ESOP plan in 2013 compared to 49,825 shares with a value of $1.44 million in 2012.
Following is an analysis of the components of the Corporation's balance sheet.
 
SECURITIES
 
The Corporation's investment strategy seeks to maximize income from the investment portfolio while using it as a risk management tool and ensuring safety of principal and capital. During 2013 the portfolio's balance increased by 32.4%. The average life of the portfolio increased from 4.2 years in 2012 to 4.7 years in 2013. The portfolio structure will continue to provide cash flows to be reinvested during 2014.
 
 
 
1 year and less
 
1 to 5 years
 
5 to 10 years
 
Over 10 Years
 
2013
(Dollar amounts in thousands)
 
Balance
 
Rate
 
Balance
 
Rate
 
Balance
 
Rate
 
Balance
 
Rate
 
Total
U.S. government sponsored entity mortgage-backed securities and agencies (1)
 
$
127

 
5.29
%
 
$
14,149

 
5.28
%
 
$
38,461

 
4.93
%
 
$
151,051

 
5.58
%
 
$
203,788

Collateralized mortgage obligations (1)
 

 
%
 
3,475

 
4.48
%
 
5,780

 
4.58
%
 
497,486

 
2.49
%
 
506,741

States and political subdivisions
 
10,612

 
4.25
%
 
33,389

 
3.84
%
 
83,995

 
3.59
%
 
66,991

 
3.71
%
 
194,987

Corporate obligations
 

 
%
 

 
%
 

 
%
 
9,044

 
%
 
9,044

TOTAL
 
$
10,739

 
 

 
$
51,013

 
 

 
$
128,236

 
 

 
$
724,572

 
 

 
$
914,560

 
(1) Distribution of maturities is based on the estimated life of the asset.
 

28



 
 
1 year and less
 
1 to 5 years
 
5 to 10 years
 
Over 10 Years
 
2012
(Dollar amounts in thousands)
 
Balance
 
Rate
 
Balance
 
Rate
 
Balance
 
Rate
 
Balance
 
Rate
 
Total
U.S. government sponsored entity mortgage-backed securities and agencies (1)
 
$
1,382

 
4.78
%
 
$
3,261

 
6.06
%
 
$
62,178

 
4.60
%
 
$
184,872

 
5.75
%
 
$
251,693

Collateralized mortgage obligations (1)
 
40

 
3.70
%
 
1,096

 
4.87
%
 
11,789

 
3.94
%
 
220,395

 
2.92
%
 
233,320

States and political subdivisions
 
11,165

 
4.13
%
 
37,782

 
3.92
%
 
81,539

 
3.61
%
 
68,999

 
3.87
%
 
199,485

Corporate obligations
 

 
%
 

 
%
 

 
%
 
6,122

 
%
 
6,122

Total
 
12,587

 
4.20
%
 
42,139

 
4.11
%
 
155,506

 
4.03
%
 
480,388

 
4.11
%
 
690,620

Equities
 
 

 
%
 
 

 
%
 
 

 
%
 
380

 
%
 
380

TOTAL
 
$
12,587

 
 

 
$
42,139

 
 

 
$
155,506

 
 

 
$
480,768

 
 

 
$
691,000

 
(1) Distribution of maturities is based on the estimated life of the asset.

LOAN PORTFOLIO
 
Loans outstanding by major category as of December 31 for each of the last five years and the maturities at year end 2013 are set forth in the following analyses. 
 
(Dollar amounts in thousands)
 
2013
 
2012
 
2011
 
2010
 
2009
Loan Category
 
 

 
 

 
 

 
 

 
 

Commercial
 
$
1,042,138

 
$
1,088,144

 
$
1,099,324

 
$
896,107

 
$
870,977

Residential
 
482,377

 
496,237

 
505,600

 
437,576

 
447,379

Consumer
 
268,033

 
268,507

 
289,717

 
307,403

 
314,561

TOTAL
 
$
1,792,548

 
$
1,852,888

 
$
1,894,641

 
$
1,641,086

 
$
1,632,917

 
 
 
Within
 
After  One
But Within
 
After Five
 
 
(Dollar amounts in thousands)
 
One Year
 
Five Years
 
Years
 
Total
MATURITY DISTRIBUTION
 
 

 
 

 
 

 
 

Commercial, financial and agricultural
 
$
358,025

 
$
534,143

 
$
149,970

 
$
1,042,138

TOTAL
 
 

 
 

 
 

 
 

Residential
 
 

 
 

 
 

 
482,377

Consumer
 
 

 
 

 
 

 
268,033

TOTAL
 
 

 
 

 
 

 
$
1,792,548

Loans maturing after one year with:
 
 

 
 

 
 

 
 

Fixed interest rates
 
 

 
$
172,419

 
$
137,976

 
 

Variable interest rates
 
 

 
361,724

 
11,994

 
 

TOTAL
 
 

 
$
534,143

 
$
149,970

 
 

 













29



ALLOWANCE FOR LOAN LOSSES
 
The activity in the Corporation's allowance for loan losses is shown in the following analysis:
 
(Dollar amounts in thousands)
 
2013
 
2012
 
2011
 
2010
 
2009
Amount of loans outstanding at December 31,
 
$
1,792,548

 
$
1,852,888

 
$
1,894,641

 
$
1,641,086

 
$
1,632,917

Average amount of loans by year
 
$
1,807,599

 
$
1,863,014

 
$
1,637,471

 
$
1,636,254

 
$
1,563,274

Allowance for loan losses at beginning of year
 
$
21,958

 
$
19,241

 
$
22,336

 
$
19,437

 
$
16,280

Loans charged off:
 
 

 
 

 
 

 
 

 
 

Commercial
 
4,830

 
4,176

 
5,336

 
7,099

 
2,997

Residential
 
4,942

 
2,598

 
2,811

 
872

 
1,881

Consumer
 
3,615

 
3,640

 
2,969

 
4,503

 
6,783

Total loans charged off
 
13,387

 
10,414

 
11,116

 
12,474

 
11,661

Recoveries of loans previously charged off:
 
 

 
 

 
 

 
 

 
 

Commercial
 
3,149

 
644

 
938

 
2,319

 
574

Residential
 
472

 
100

 
95

 
258

 
523

Consumer
 
1,401

 
1,387

 
1,108

 
1,934

 
1,851

Total recoveries
 
5,022

 
2,131

 
2,141

 
4,511

 
2,948

Net loans charged off
 
8,365

 
8,283

 
8,975

 
7,963

 
8,713

Provision charged to expense *
 
6,475

 
11,000

 
5,880

 
10,862

 
11,870

Balance at end of year
 
$
20,068

 
$
21,958

 
$
19,241

 
$
22,336

 
$
19,437

Ratio of net charge-offs during period to average loans outstanding
 
0.46
%
 
0.44
%
 
0.55
%
 
0.49
%
 
0.56
%
 
* In 2013 the provision charged to expense was increased by $1.4 million for the decrease to the FDIC
indemnification asset. In 2012 and 2011 the provision was reduced with a corresponding increase in the FDIC indemnification asset by $2.2 million and $125 thousand, respectively.
 
The allowance is maintained at an amount management believes sufficient to absorb probable incurred losses in the loan portfolio. Monitoring loan quality and maintaining an adequate allowance is an ongoing process overseen by senior management and the loan review function. On at least a quarterly basis, a formal analysis of the adequacy of the allowance is prepared and reviewed by management and the Board of Directors. This analysis serves as a point in time assessment of the level of the allowance and serves as a basis for provisions for loan losses. The loan quality monitoring process includes assigning loan grades and the use of a watch list to identify loans of concern.
 
Included in the $1.8 billion of loans outstanding at December 31, 2013 are $19.4 million of covered loans, those loans acquired with the purchase of the First National Bank of Danville from the FDIC that are covered by the loss sharing agreement.
 
Also included are loans acquired on December 30, 2011 in the Freestar acquisition. The acquired portfolio includes purchased credit impaired loans with a contractual balance due of $10.8 million and a fair value of $9.2 million.
 
The analysis of the allowance for loan losses includes the allocation of specific amounts of the allowance to individual impaired loans, generally based on an analysis of the collateral securing those loans. Portions of the allowance are also allocated to loan portfolios, based upon a variety of factors including historical loss experience, trends in the type and volume of the loan portfolios, trends in delinquent and non-performing loans, and economic trends affecting our market. These components are added together and compared to the balance of our allowance at the evaluation date. The allowance for loan losses as a percentage of total loans declined to 1.12% at year end 2013 compared to 1.19% at year end 2012. The Corporation’s unallocated allowance position of $2.4 million at December 31, 2013 has increased from $1.7 million at December 31, 2012 and $505 thousand at December 31, 2011. The calculation of historical losses used in the allowance computation weights the most recent year's net charge off activity more heavily, and the increase in the unallocated portion of the allowance reflects management's uncertainty about whether the more modest levels of net charge offs in the recent years, particularly in the commercial segment of the portfolio, are sustainable and representative of the risk in the loan portfolio. As a result, the unallocated portion of the allowance has increased as compared to prior years. Non-performing loans of $37.3 million at December 31, 2013 decreased significantly from $59.8 million at December

30



31, 2012 due in large part to the resolution of certain larger commercial credits while aggregate net charge-offs remained stable totaling $8.4 million in 2013 compared to $8.3 million if 2012. Management believes the allowance for loan losses balance at year end 2013, including the unallocated portion, is reasonable based on their analysis of specific loans and the credit trends reflected within the loan portfolio. The table below presents the allocation of the allowance to the loan portfolios at year-end.
 
 
 
Years Ended December 31,
(Dollar amounts in thousands)
 
2013
 
2012
 
2011
 
2010
 
2009
Commercial
 
$
12,450

 
$
10,987

 
$
12,119

 
$
12,809

 
$
12,218

Residential
 
1,585

 
5,426

 
2,728

 
2,873

 
1,546

Consumer
 
3,650

 
3,879

 
3,889

 
4,551

 
5,032

Unallocated
 
2,383

 
1,666

 
505

 
2,103

 
641

TOTAL ALLOWANCE FOR LOAN LOSSES
 
$
20,068

 
$
21,958

 
$
19,241

 
$
22,336

 
$
19,437


NONPERFORMING LOANS
 
Management monitors the components and status of nonperforming loans as a part of the evaluation procedures used in determining the adequacy of the allowance for loan losses. It is the Corporation's policy to discontinue the accrual of interest on loans where, in management's opinion, serious doubt exists as to collectability. The amounts shown below represent non-accrual loans, loans which have been restructured to provide for a reduction or deferral of interest or principal because of deterioration in the financial condition of the borrower and those loans which are past due more than 90 days where the Corporation continues to accrue interest. In 2013 restructured loans decreased primarily due to the sale of one large commercial credit. Additional information regarding restructured loans is available in the footnotes to the financial statements. Some restructured loans are also on non-accrual and are only included in the total of restructured loans.
 
(Dollar amounts in thousands)
 
2013
 
2012
 
2011
 
2010
 
2009
Non-accrual loans
 
$
19,779

 
$
36,794

 
$
38,102

 
$
38,517

 
$
35,953

Restructured loans
 
17,301

 
21,285

 
17,337

 
17,094

 
90

Accruing loans past due over 90 days
 
2,073

 
3,362

 
2,047

 
3,185

 
8,218

 
 
$
39,153

 
$
61,441

 
$
57,486

 
$
58,796

 
$
44,261

 
The ratio of the allowance for loan losses as a percentage of nonperforming loans was 51% at December 31, 2013, compared to 36% in 2012. The ratio of nonperforming loans excluding covered loans was 56% at December 31, 2013 and 42% at December 31, 2012. There were no covered loans included in restructured loans in 2013 and $2.4 million of covered loans included in restructured loans in 2012. The following loan categories comprise significant components of the nonperforming loans at December 31, 2013 and 2012:
 
(Dollar amounts in thousands)
 
2013
 
2012
Non-accrual loans:
 
 

 
 

 
 

 
 

Commercial loans
 
$
13,424

 
68
%
 
$
21,900

 
60
%
Residential loans
 
5,195

 
26
%
 
13,201

 
36
%
Consumer loans
 
1,160

 
6
%
 
1,693

 
4
%
 
 
$
19,779

 
100
%
 
$
36,794

 
100
%
Past due 90 days or more:
 
 

 
 

 
 

 
 

Commercial loans
 
$
712

 
34
%
 
$
1,481

 
44
%
Residential loans
 
1,181

 
57
%
 
1,750

 
52
%
Consumer loans
 
180

 
9
%
 
131

 
4
%
 
 
$
2,073

 
100
%
 
$
3,362

 
100
%
 

31



 
 
Covered Loans  (also included above)
(Dollar amounts in thousands)
 
2013
 
2012
Non-accrual loans:
 
 

 
 

 
 

 
 

Commercial loans
 
$
799

 
74
%
 
$
4,114

 
95
%
Residential loans
 
275

 
26
%
 
217

 
5
%
Consumer loans
 

 
%
 

 
%
 
 
$
1,074

 
100
%
 
$
4,331

 
100
%
Past due 90 days or more: