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Section 1: 10-K (FORM 10-K)

Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2017

Commission File Number 1-15817

 

 

OLD NATIONAL BANCORP

(Exact name of the Registrant as specified in its charter)

 

 

 

INDIANA   35-1539838

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Main Street

Evansville, Indiana

 

47708

(Address of principal executive offices)

 

(Zip Code)

(812) 464-1294

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act

 

Title of Each Class

  

Name of each exchange on which registered

Common Stock, No Par Value

   The NASDAQ Stock Market LLC

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  ☐

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  ☑

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  ☑    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 (s232.405 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  ☑    No  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (s229.405 of this chapter) is not contained herein, and will not be contained, to the best of the 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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer     Accelerated filer  
Non-accelerated filer   ☐ (Do not check if a smaller reporting company)   Smaller reporting company  
Emerging growth company      

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ☐    No  ☑

The aggregate market value of the registrant’s voting common stock held by non-affiliates on June 30, 2017, was $2,295,172,245 (based on the closing price on that date of $17.25). In calculating the market value of securities held by non-affiliates of the registrant, the registrant has treated as securities held by affiliates as of June 30, 2017, voting stock owned of record by its directors and principal executive officers, and voting stock held by the registrant’s trust department in a fiduciary capacity for benefit of its directors and principal executive officers. This calculation does not reflect a determination that persons are affiliates for any other purposes.

The number of shares outstanding of the registrant’s common stock, as of January 31, 2018, was 152,061,000.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held April 26, 2018 are incorporated by reference into Part III of this Form 10-K.

 

 

 


Table of Contents

OLD NATIONAL BANCORP

2017 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

         Page
PART I   
Item 1.   Business    5
Item 1A.   Risk Factors    17
Item 1B.   Unresolved Staff Comments    24
Item 2.   Properties    24
Item 3.   Legal Proceedings    24
Item 4.   Mine Safety Disclosures    25
PART II   
Item 5.  

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   26
Item 6.   Selected Financial Data    29
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    30
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk    63
Item 8.   Financial Statements and Supplementary Data    63
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    137
Item 9A.   Controls and Procedures    137
Item 9B.   Other Information    138
PART III   
Item 10.   Directors, Executive Officers and Corporate Governance of the Registrant    139
Item 11.   Executive Compensation    139
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    139
Item 13.   Certain Relationships and Related Transactions, and Director Independence    139
Item 14.   Principal Accounting Fees and Services    139
PART IV   
Item 15.   Exhibits and Financial Statement Schedules    140
SIGNATURES    143

 

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GLOSSARY OF ABBREVIATIONS AND ACRONYMS

As used in this report, references to “Old National,” “we,” “our,” “us,” and similar terms refer to the consolidated entity consisting of Old National Bancorp and its wholly-owned affiliates. Old National Bancorp refers solely to the parent holding company, and Old National Bank refers to Old National’s bank subsidiary.

The acronyms and abbreviations identified below are used throughout this report, including the Notes to Consolidated Financial Statements. You may find it helpful to refer to this page as you read this report.

ACH: Automated Clearing House

Anchor (MN): Anchor Bancorp, Inc.

Anchor Bank (MN): Anchor Bank, N.A.

Anchor (WI): Anchor BanCorp Wisconsin Inc.

AnchorBank (WI): AnchorBank, fsb

AOCI: accumulated other comprehensive income (loss)

AQR: asset quality rating

ASC: Accounting Standards Codification

ASU: Accounting Standards Update

ATM: automated teller machine

CDO: collateralized debt obligation

Common Stock: Old National Bancorp common stock, without par value

CReED: Indiana Community Revitalization Enhancement District Tax Credit

DTI: debt-to-income

EITF: Emerging Issues Task Force

FASB: Financial Accounting Standards Board

FDIC: Federal Deposit Insurance Corporation

FHLB: Federal Home Loan Bank

FHLBI: Federal Home Loan Bank of Indianapolis

FHTC: Federal Historic Tax Credit

FICO: Fair Isaac Corporation

Founders: Founders Financial Corporation

GAAP: generally accepted accounting principles

Integra: Integra Bank N.A.

LGD: loss given default

LIBOR: London Interbank Offered Rate

LIHTC: Low Income Housing Tax Credit

LTV: loan-to-value

N/A: not applicable

N/M: not meaningful

NASDAQ: The NASDAQ Stock Market LLC

NMTC: Federal New Market Tax Credits

NOW: negotiable order of withdrawal

OCC: Office of the Comptroller of the Currency

ONI: ONB Insurance Group, Inc.

OTTI: other-than-temporary impairment

PCI: purchased credit impaired

PD: probability of default

Renewable Energy: investment tax credits for solar projects

SEC: Securities and Exchange Commission

TBA: to be announced

TDR: troubled debt restructuring

 

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OLD NATIONAL BANCORP

2017 ANNUAL REPORT ON FORM 10-K

FORWARD-LOOKING STATEMENTS

In this report, we have made various statements regarding current expectations or forecasts of future events, which speak only as of the date the statements are made. These statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are also made from time-to-time in press releases and in oral statements made by the officers of Old National Bancorp (“Old National” or the “Company”). Forward-looking statements can be identified by the use of the words “expect,” “may,” “could,” “intend,” “project,” “estimate,” “believe,” “anticipate,” and other words of similar meaning. Forward-looking statements also include, but are not limited to, statements regarding estimated cost savings, plans and objectives for future operations, the Company’s business and growth strategies, including future acquisitions of banks, regulatory developments, and expectations about performance as well as economic and market conditions and trends.

Such forward-looking statements are based on assumptions and estimates, which although believed to be reasonable, may turn out to be incorrect. Therefore, undue reliance should not be placed upon these estimates and statements. We cannot assure that any of these statements, estimates, or beliefs will be realized and actual results may differ from those contemplated in these “forward-looking statements.” We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise. You are advised to consult further disclosures we may make on related subjects in our filings with the SEC. In addition to other factors discussed in this report, some of the important factors that could cause actual results to differ materially from those discussed in the forward-looking statements include the following:

 

    economic, market, operational, liquidity, credit, and interest rate risks associated with our business;

 

    economic conditions generally and in the financial services industry;

 

    expected cost savings in connection with the consolidation of recent acquisitions may not be fully realized or realized within the expected time frames, and deposit attrition, customer loss, and revenue loss following completed acquisitions may be greater than expected;

 

    failure to properly understand risk characteristics of newly entered markets;

 

    increased competition in the financial services industry either nationally or regionally, resulting in, among other things, credit quality deterioration;

 

    our ability to achieve loan and deposit growth;

 

    volatility and direction of market interest rates;

 

    governmental legislation and regulation, including changes in accounting regulation or standards;

 

    our ability to execute our business plan;

 

    a weakening of the economy which could materially impact credit quality trends and the ability to generate loans;

 

    changes in the securities markets; and

 

    changes in fiscal, monetary, and tax policies.

Investors should consider these risks, uncertainties, and other factors in addition to risk factors included in our other filings with the SEC.

 

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PART I

 

ITEM 1. BUSINESS

GENERAL

Old National is a financial holding company incorporated in the state of Indiana and maintains its principal executive office in Evansville, Indiana. We, through our wholly-owned banking subsidiary, provide a wide range of services, including commercial and consumer loan and depository services, private banking, brokerage, trust, investment advisory, and other traditional banking services. At December 31, 2017, we employed 2,801 full-time equivalent associates.

COMPANY PROFILE

Old National Bank, our wholly-owned banking subsidiary (“Old National Bank”), was founded in 1834 and is the oldest company in Evansville, Indiana. In 1982, Old National Bancorp was formed; in 2001 we became a financial holding company and we are currently the largest financial holding company headquartered in the state of Indiana with consolidated assets of $17.5 billion at December 31, 2017. At December 31, 2017, Old National Bank operated 191 banking centers located primarily in Indiana, Kentucky, Michigan, Wisconsin, and Minnesota.

OPERATING SEGMENTS

Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Old National Bank is the only significant subsidiary for which management makes decisions regarding how to allocate resources and assess performance. Each of the branches of Old National Bank provide a group of similar community banking services, including such products and services as commercial, real estate and consumer loans, time deposits, checking and savings accounts, cash management, brokerage, trust, and investment advisory services. The individual bank branches located throughout our Midwest footprint have similar operating and economic characteristics. While the chief decision maker monitors the revenue streams of the various products, services, and regional locations, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the community banking services and branch locations are considered by management to be aggregated into one reportable operating segment, community banking.

Lending Activities

We earn interest income on loans as well as fee income from the origination of loans. Lending activities include loans to individuals, which primarily consist of home equity lines of credit, residential real estate loans and consumer loans, and loans to commercial clients, which include commercial loans, commercial real estate loans, letters of credit, and lease financing. Residential real estate loans are either kept in our loan portfolio or sold to secondary investors, with gains or losses from the sales being recognized.

Depository Activities

We strive to serve individuals and commercial clients by providing depository services that fit their needs at competitive rates. We pay interest on the interest-bearing deposits and receive service fee revenue on various accounts. Deposit accounts include products such as noninterest-bearing demand, NOW, savings and money market, and time deposits. Debit and ATM cards provide clients with access to their accounts 24 hours a day at any ATM location. We also provide 24-hour telephone access and online banking as well as other electronic and mobile banking services.

MARKET AREA

We own the largest Indiana-based bank headquartered in Indiana. Operating from a home base in Evansville, Indiana, we have continued to grow our footprint in Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. Since the beginning of 2011, Old National has transformed its franchise by reducing low-return businesses and low-growth markets and investing in higher-growth markets.

 

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The following table reflects information on the top markets we currently serve, demonstrating that our largest metropolitan statistical areas compare favorably to the national average.

 

Metropolitan Statistical Area

   Percent of
Old
National
Bank
Franchise
(%)
     Deposits
Per
Branch
($M)
     2010-2018
Population
Change
(%)
    2018-2023
Projected
Population
Change
(%)
    2018
Median
Household
Income
($)
     2018-2023
Projected
Household
Income
Change
(%)
 

Evansville, IN-KY

     15.7        131.3        1.6       1.4       49,987        4.2  

Minneapolis-St. Paul-Bloomington, MN-WI (1)

     13.4        98.7        7.5       4.2       76,791        9.7  

Indianapolis-Carmel-Anderson, IN

     8.2        42.7        7.6       3.7       58,682        7.6  

Madison, WI (1)

     7.4        42.1        9.0       4.2       70,042        11.0  

Bloomington, IN (1)

     5.3        132.1        5.2       3.0       48,147        8.4  

Fort Wayne, IN (1)

     3.9        97.9        4.6       2.8       54,542        9.1  

Jasper, IN

     3.2        79.0        0.6       1.1       57,432        5.9  

Terre Haute, IN

     3.0        75.0        (1.3     0.1       43,017        0.3  

Adrian, MI (1)

     2.5        63.4        (1.5     (0.3     52,388        9.6  

Ann Arbor, MI (1)

     2.1        53.1        7.2       3.3       69,221        8.9  

National average

           5.8       3.5       61,045        8.9  

Weighted average or sum total Old National

               

Bank top 5

     50.0        75.4        7.3       3.9       60,730        8.5  

Weighted average or sum total Old National

               

Bank top 10

     64.7        75.0        6.8       3.6       58,025        7.8  

(1) Expansion markets weighted average

     34.6        73.5        7.2       3.9       61,855        9.5  

Weighted average total Old National Bank

           3.5       2.1       57,541        7.7  

Source: SNL

               

ACQUISITION AND DIVESTITURE STRATEGY

Since the formation of Old National in 1982, we have acquired over 50 financial institutions and other financial services businesses. Future acquisitions and divestitures will be driven by a disciplined financial process and will be consistent with the existing focus on community banking, client relationships and consistent quality earnings. Targeted geographic markets for acquisitions include mid-size markets with average to above average growth rates.

We anticipate that, as with previous acquisitions, the consideration paid by us in future acquisitions may be in the form of cash, debt, or Old National stock, or a combination thereof. The amount and structure of such consideration is based on reasonable growth and cost savings assumptions and a thorough analysis of the impact on both long- and short-term financial results.

Effective November 1, 2017, Old National acquired St. Paul, Minnesota-based Anchor (MN) through a stock and cash merger. Anchor (MN) was a bank holding company with Anchor Bank (MN) as its wholly-owned subsidiary. Founded in 1967 and with 17 total branches, Anchor Bank (MN) was one of the largest community banks headquartered in the Twin Cities, and also served Mankato, Minnesota. Anchor Bank (MN) has no affiliation with the former AnchorBank (WI) in Madison, Wisconsin, which Old National acquired in 2016. Pursuant to the merger agreement, each holder of Anchor (MN) common stock received $2.625 in cash and 1.350 shares of Old National Common Stock per share of Anchor (MN) common stock such holder owned. The total fair value of consideration for Anchor (MN) was $332.8 million, consisting of $31.9 million of cash and the issuance of 16.5 million shares of Old National Common Stock valued at $300.8 million. See Note 2 to the consolidated financial statements for further details on the Anchor (MN) acquisition.

 

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Prior to 2017, our most recent acquisitions included the following:

 

    24 bank branches from Bank of America in a cash transaction on July 12, 2013 that doubled Old National’s presence in the South Bend/Elkhart, Indiana area and provided an entry into southwest Michigan;

 

    Indiana bank holding company Tower Financial Corporation through a stock and cash merger on April 25, 2014 that added seven full-service branches in the Fort Wayne, Indiana market and strengthened Old National’s position as one of the largest deposit holders in Indiana;

 

    Michigan bank holding company United Bancorp, Inc. through a stock and cash merger on July 31, 2014 that added 18 branches in Ann Arbor, Michigan and the surrounding area, doubling our presence in Michigan;

 

    LSB Financial Corp. through a stock and cash merger on November 1, 2014 that added five branches in Lafayette, Indiana;

 

    Michigan-based Founders Financial Corporation through a stock and cash merger on January 1, 2015 that added four branches in the Grand Rapids, Michigan market; and

 

    Anchor BanCorp Wisconsin Inc. through a stock and cash merger on May 1, 2016 that added 46 branches in the Madison, Milwaukee, and Fox Valley triangle markets.

Over the past decade, we have transitioned our footprint into higher growth markets and opportunistically will continue to do so. We believe we have the right people and the right products in the right markets, with strong leadership in place.

Divestitures

On August 14, 2015, Old National divested its southern Illinois region (twelve branches) along with four branches in eastern Indiana and one in Ohio. At closing, the purchasers assumed loans of $193.6 million and deposits of $555.8 million. Old National recorded a net pre-tax gain of $15.6 million in connection with the divestitures, which included a deposit premium of $19.3 million, goodwill allocation of $3.8 million, and $0.9 million of other transaction expenses.

On May 31, 2016, the Company sold its insurance operations, ONI. The Company received approximately $91.8 million in cash resulting in a pre-tax gain of $41.9 million and an after-tax gain of $17.6 million. See Note 16 to the consolidated financial statements for further details on the income tax impact of this sale. Goodwill and intangible assets of approximately $47.5 million were eliminated as part of this transaction. ONI was an ancillary business and did not meet the criteria to be treated as a discontinued operation as defined in Accounting Standards Update 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity.”

We continue to focus our efforts to optimize our branch network. Since the beginning of 2011, we have consolidated 148 banking centers (including 29 banking centers in 2017). Over the same period, we have more than doubled our assets and have increased our average total deposits per branch from $34 million to approximately $66 million, while only increasing our number of branches by 30. We will continue to review our branch system as we adapt to client behavior changes, continue to make technology improvements, and delivery model changes. Accordingly, as a result of our ongoing branch analysis, we expect a continued reduction in our branch network in 2018.

COMPETITION

The banking industry and related financial service providers operate in a highly competitive market. Old National competes with financial service providers such as other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds, and other financial intermediaries. In addition, Financial Technology, or FinTech, start-ups are emerging in key areas of banking.

Many of our nonfinancial institution competitors have fewer regulatory constraints, broader geographic service areas, greater capital, and, in some cases, lower cost structures. In addition, competition for quality customers has intensified as a result of changes in regulation, mergers and acquisitions, advances in technology and product delivery systems, consolidation among financial service providers, bank failures, and the conversion of certain former investment banks to bank holding companies.

 

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SUPERVISION AND REGULATION

Old National is subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds, and the banking system as a whole and not for the protection of shareholders and creditors.

Significant elements of the laws and regulations applicable to Old National and its subsidiaries are described below. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations, or regulatory policies applicable to Old National and its subsidiaries, for which Old National cannot predict, could have a material effect on the business of the Company.

The Dodd-Frank Act. On July 21, 2010, financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act significantly restructured the financial regulatory environment in the United States. The Dodd-Frank Act contains numerous provisions that affect all bank holding companies and banks, including Old National and Old National Bank, some of which are described in more detail below. The scope and impact of many of the Dodd-Frank Act provisions were determined and issued over time. The impact of the Dodd-Frank Act on Old National has been substantial. Provisions in the legislation that affect the payment of interest on demand deposits and collection of interchange fees increased the costs associated with certain deposits and placed limitations on certain revenues those deposits generate.

The Volcker Rule. Section 619 of the Dodd-Frank Act contains provisions prohibiting proprietary trading and restricting the activities involving private equity and hedge funds (the “Volcker Rule”). Rules implementing the Volcker Rule were adopted in December 2013. Proprietary trading is defined as the trading of securities, derivatives, or futures (or options on any of the foregoing) as principal, where such trading is principally for the purpose of short-term resale, benefiting from actual or expected short-term price movements and realizing short-term arbitrage profits. The rule’s definition of proprietary trading specifically excludes market-making-related activity, certain government issued securities trading and certain risk management activities. Old National and Old National Bank do not engage in any prohibited proprietary trading activities.

The final text of the Volcker Rule contained provisions to the effect that CDOs, including pooled trust preferred securities, would have to be sold prior to July 15, 2015. The practical implication of this rule provision, which was not expected by the industry, was that those instruments could no longer be accorded “held-to-maturity” accounting treatment but would have to be switched to “available-for-sale” accounting, and that all covered CDOs, regardless of the accounting classification, would need to be adjusted to fair value through an other-than-temporary impairment non-cash charge to earnings. On January 14, 2014, federal banking agencies released an interim final rule regarding the Volcker Rule’s impact on trust preferred CDOs, which included a nonexclusive list of CDOs backed by trust preferred securities that depository institutions will be permitted to continue to hold. All of the trust preferred securities owned by Old National are on this list and held as “available-for-sale”. Any unrealized losses associated with these instruments have already impacted our capital. As of December 31, 2017, Old National does not have any securities that will have to be divested as a result of the Volcker Rule.

The Durbin Amendment. The Dodd-Frank Act included provisions (the “Durbin Amendment”) which capped interchange fees for debit card transactions at $0.21 plus five basis points for safe harbor eligibility, provided they were determined to be reasonable and proportionate. The Durbin Amendment began to negatively impact debit card and ATM fees beginning in the second half of 2015.

Bank Holding Company Regulation. Old National is registered as a bank holding company and has elected to be a financial holding company. It is subject to the supervision of, and regulation by, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Federal Reserve has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the policy of the Federal Reserve that, pursuant to this requirement, a bank holding company should stand ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity. Under this requirement, Old National is expected to commit resources to support Old National Bank, including at times when Old National may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such

 

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subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

The BHC Act requires the prior approval of the Federal Reserve to acquire more than a 5% voting interest of any bank or bank holding company. Additionally, the BHC Act restricts Old National’s non-banking activities to those which are determined by the Federal Reserve to be closely related to banking and a proper incident thereto.

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” (as defined in FDICIA) with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal bank regulatory agency.

Capital and Liquidity Requirements. Bank holding companies are required to comply with the Federal Reserve’s risk-based capital guidelines. The FDIC and the OCC have adopted risk-based capital ratio guidelines to which depository institutions under their respective supervision, including Old National Bank, are 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. Old National Bank exceeded all risk-based minimum capital requirements of the FDIC and OCC as of December 31, 2017 and 2016. For Old National’s regulatory capital ratios and regulatory requirements as of December 31, 2017 and 2016, see Note 24 to the consolidated financial statements.

The federal regulatory authorities’ current risk-based capital guidelines are based upon the Basel Committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of international central banks and bank regulators responsible for establishing international supervisory guidelines for use in member jurisdictions to enhance and align bank regulation on a global scale and promote financial stability. In December 2010 and January 2011, the Basel Committee published the final revisions to the international regulatory capital framework generally referred to as “Basel III,” as a response to deficiencies in the international regulatory standards identified during the global financial crisis.

Effective July 2, 2013, the Federal Reserve and the OCC approved final rules known as the “Basel III Capital Rules” substantially revising the risk-based capital and leverage capital requirements applicable to bank holding companies and depository institutions, including Old National and Old National Bank. The Basel III Capital Rules address the components of capital and other issues affecting the numerator 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. Certain of the Basel III Capital Rules came into effect for Old National and Old National Bank on January 1, 2015; subject to a phase-in period ending on December 31, 2018.

The Basel III Capital Rules introduced a new capital measure “Common Equity Tier 1” (“CET1”). The rules specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements. CET1 capital consists of common stock instruments that meet the eligibility criteria in the final rules, retained earnings, accumulated other comprehensive income, and common equity Tier 1 minority interest. The rules also define CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1, and not to the other components of capital. They also expand the scope of the adjustments as compared to existing regulations.

 

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When fully phased-in on January 1, 2019, the Basel III Capital Rules will require banking organizations 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 7.0% upon full implementation);

 

    a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% 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 capital) to risk-weighted assets of at least 8.0%, plus the 2.5% 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 4.0%, calculated as the ratio of Tier 1 capital to adjusted average consolidated assets.

The 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 will face limitations on the payment of dividends, common stock repurchases and discretionary cash payments to executive officers based on the amount of the shortfall.

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 dependent upon future taxable income 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, Old National and Old National Bank are given a one-time election (the “Opt-out Election”) to filter certain AOCI components, comparable to the treatment under the current general risk-based capital rule. The Company chose the Opt-out Election on the March 31, 2015 Call Report and FR Y-9C for Old National Bank and Old National, respectively.

Implementation of the deductions and other adjustments to CET1 began on January 1, 2015 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will 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 also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and is not expected to have any current applicability to Old National or Old National Bank.

In addition, the Basel III Capital Rules revise the rules for calculating risk-weighted assets to enhance their risk sensitivity. They establish a new framework under which mortgage-backed securities and other securitization exposures will be subject to risk-weights ranging from 20% to 1,250%. The rules also establish adjusted risk-weights for credit exposures, including multi-family and commercial real estate exposures that are 90 days or more past due or on non-accrual, which will be subject to a 150% risk-weight, except in situations where qualifying collateral and/or guarantees are in place. The existing treatment of residential mortgage exposures will remain subject to either a 50% risk-weight (for prudently underwritten owner-occupied first liens that are current or less than 90 days past due) or a 100% risk-weight (for all other residential mortgage exposures including 90 days or more past due exposures).

Management believes that, as of December 31, 2017, Old National and Old National Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis if such requirements were currently effective. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s net income.

The Basel III Capital Rules permit banks with less than $15 billion in assets to continue to treat trust preferred securities as Tier 1 capital. This treatment is permanently grandfathered as Tier 1 capital for organic growth but not as a result of a merger or acquisition. On November 1, 2017, Old National acquired Anchor (MN) and exceeded $15 billion in assets. As the result of this acquisition, Tier 1 treatment of trust preferred securities is prohibited and those securities can only be treated as Tier 2 capital. The Basel III Capital Rules also permit banks with less than $250 billion in assets to choose to continue excluding unrealized gains and losses on certain securities holdings for purposes of calculating regulatory capital. As previously reported, the Old National chose the Opt-out Election in its

 

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March 31, 2015 Call Report. Additionally, the Basel III Capital Rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of CET1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.

The Basel III liquidity framework applies a balance sheet perspective to establish quantitative standards designed to ensure that a banking organization is appropriately positioned to satisfy its short- and long-term funding needs. One test to address short-term liquidity risk is referred to as the liquidity coverage ratio (“LCR”), designed to calculate the ratio of a banking entities’ ratio of high-quality liquid assets to its total net cashflows over a 30-day time horizon. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term asset funding by incenting banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt, as well as increase the use of long-term debt as a funding source. The Basel III liquidity framework was implemented as a minimum standard on January 1, 2015, with a phase-in period ending January 1, 2019. However, the federal banking agencies have not proposed rules implementing the Basel III liquidity framework and have not determined to what extent they will apply to U.S. banks that are not large, internationally active banks.

Management believes that, as of December 31, 2017, Old National Bank would meet the LCR requirement under the Basel III liquidity framework on a fully phased-in basis if such requirements were currently effective. Management’s evaluation of the impact of the NSFR requirement is ongoing as of December 31, 2017. Requirements to maintain higher levels of liquid assets could adversely impact the Company’s net income.

Stress Tests. The Dodd-Frank Act mandates company-run stress test requirements for U.S. bank holding companies with total consolidated assets of $10 billion to $50 billion. The objective of the stress test is to ensure that the financial institution has capital planning processes that account for its unique risks, and to help ensure that the institution has sufficient capital to continue operations throughout times of economic and financial stress. The stress tests are conducted with baseline, adverse and severely adverse economic scenarios. The final stress test rule defines total consolidated assets as the average of the institution’s total consolidated assets over the four most recent consecutive quarters as reported in the institution’s Call Report. Old National completed its annual stress test that covered a nine-quarter planning horizon beginning January 1, 2017 and ending on March 31, 2019 and publicly disclosed a summary of the stress test results on October 24, 2017. The stress test showed that Old National would maintain capital levels well above the regulatory guideline minimum levels for all periods and under all stress test scenarios.

Prompt Corrective Action Regulations. The Federal Deposit Insurance Act (the “FDIA”) requires, among other things, federal bank regulatory authorities to take “prompt corrective action” with respect to banks which do not meet minimum capital requirements. Under current prompt corrective action regulations, 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 8.0% 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 Basel III Capital Rules revised the “prompt corrective action” regulations pursuant to Section 38 of the FDIA, by:

 

    introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status;

 

    increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 risk-based capital ratio for well-capitalized status being 8.0% (as compared to the previous 6.0%); and

 

    eliminating the provision that provides that a bank with a composite supervisory rating of 1 may have a 3.0% leverage ratio and still be well-capitalized.

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.

Management believes that, as of December 31, 2017, Old National Bank was “well capitalized” based on the existing ratios and the ratios as modified by the Basel III Capital Rules.

Deposit Insurance. Substantially all of the deposits of Old National Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and Old National Bank is subject to deposit insurance assessments to maintain the DIF. Deposit insurance assessments are based on average consolidated total assets minus average tangible equity. Under the FDIC’s risk-based assessment system, insured institutions with at least $10 billion in assets, such as Old National Bank, are assessed on the basis of a scoring system that combines the institution’s regulatory ratings and certain financial measures. The scoring system assesses risk measures to produce two scores, a performance score and a loss severity score, that will be combined and converted to an initial assessment rate.

The performance score measures an institution’s financial performance and its ability to withstand stress. The loss severity score quantifies the relative magnitude of potential losses to the FDIC in the event of an institution’s failure. Once the performance and loss severity scores are calculated, these scores will be converted to a total score. An institution with a total score of 30 or less will pay the minimum base assessment rate, and an institution with a total score of 90 or more will pay the maximum initial base assessment rate. For total scores between 30 and 90, initial base assessment rates will rise at an increasing rate as the total score increases. The FDIC has the authority to raise or lower assessment rates, subject to limits, and to impose special additional assessments.

In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the DIF reserve ratio reaches 1.35%, as required by the Dodd-Frank Act. The FDIC approved a final rule in March 2016 to meet this requirement by 2018. To meet the 1.35% DIF reserve ratio by 2018, the FDIC will assess banks with consolidated assets of more than $10 billion a surcharge assessment of 0.045% once the DIF reserve ratio reaches 1.15%. The reserve ratio reached 1.15% in the second half of 2016.

Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

 

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Safety and Soundness Regulations. In accordance with the FDIA, the federal banking agencies adopted guidelines establishing general standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, regulations adopted by the federal banking agencies authorize the agencies to require that an institution that has been given notice that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, the institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the agency must issue an order directing corrective actions and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. If the institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

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 having at least $1 billion in total assets, such as Old National and Old National Bank, 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 Old National may structure compensation for its executives.

In June 2010, the Federal Reserve, OCC, and FDIC issued 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 who 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.

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as Old National, 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.

Loans to One Borrower. Old National Bank generally may not make loans or extend credit to a single or related group of borrowers in excess of 15% of unimpaired capital and surplus. An additional amount may be loaned, up to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, which generally does not include real estate. As of December 31, 2017, Old National Bank was in compliance with the loans-to-one-borrower limitations.

Depositor Preference. The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States and the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.

 

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Community Reinvestment Act. The Community Reinvestment Act of 1977 (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings that must be publicly disclosed. In order for a financial holding company to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of certain applications. Old National Bank received a rating of “outstanding” in its latest CRA examination for the period ended December 31, 2012.

Financial Privacy. The federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. These regulations affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

Old National Bank is also subject to regulatory guidelines establishing standards for safeguarding customer information. These guidelines describe the federal banking agencies’ expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer.

Anti-Money Laundering and the USA Patriot Act. A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA Patriot Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.

On May 11, 2016, the Financial Crimes Enforcement Network (the “FinCEN”) issued new anti-money laundering (“AML”) rules governing corporate entities doing business with banks and other financial institutions that are subject to the requirements of the USA Patriot Act. The AML rules impose significant due diligence obligations on financial institutions with respect to opening of new accounts and the monitoring of existing accounts. Under the AML rules, a financial institution must identify persons owning or controlling 25% or more of a “legal entity,” whenever the legal entity opens a new account at the bank. The financial institution must also identify an individual who has substantial management authority at the legal entity, such as a CEO, CFO, or managing partner.

The AML rules codify within the FinCEN regulations the “pillars” that must be included in a financial institutions AML compliance program. Regulators previously communicated their expectations with respect to four of these pillars: (1) the development of internal policies, procedures, and control; (2) the designation of a compliance officer; (3) the establishment of an ongoing employee training program; and (4) the implementation of an independent audit function to test programs. The new beneficial ownership requirement establishes a fifth pillar. Among other things, this new pillar includes the necessity to monitor and update the beneficial ownership of a legal entity, including the need to subject corporate borrowers to due diligence requests from financial institutions for certifications with respect to their beneficial owners. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

 

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Office of Foreign Assets Control Regulation. The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others which are administered by the U.S. Treasury Department Office of Foreign Assets Control. Failure to comply with these sanctions could have serious legal and reputational consequences, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

Transactions with Affiliates. Transactions between Old National Bank and its affiliates are regulated by the Federal Reserve under sections 23A and 23B of the Federal Reserve Act and related regulations. These regulations limit the types and amounts of covered transactions engaged in by Old National Bank and generally require those transactions to be on an arm’s-length basis. The term “affiliate” is defined to mean any company that controls or is under common control with Old National Bank and includes Old National and its non-bank subsidiaries. “Covered transactions” include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve) from the affiliate, certain derivative transactions that create a credit exposure to an affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. In general, these regulations require that any such transaction by Old National Bank (or its subsidiaries) with an affiliate must be secured by designated amounts of specified collateral and must be limited to certain thresholds on an individual and aggregate basis.

Federal law also limits Old National Bank’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. Also, the terms of such extensions of credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Old National Bank’s capital.

Federal Home Loan Bank System. Old National Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions. As a member of the FHLBI, Old National Bank is required to acquire and hold shares of capital stock of the FHLBI in an amount at least equal to the sum of the membership stock purchase requirement, determined on an annual basis at the end of each calendar year, and the activity-based stock purchase requirement, determined on a daily basis. For Old National Bank, the membership stock purchase requirement is 1.0% of the Mortgage-Related Assets, as defined by the FHLBI, which consists principally of residential mortgage loans and mortgage-backed securities, held by Old National Bank. The activity-based stock purchase requirement is equal to the sum of: (1) a specified percentage ranging from 2.0% to 5.0%, which for Old National Bank is 5.0%, of outstanding borrowings from the FHLBI; (2) a specified percentage ranging from 0.0% to 5.0%, which for Old National Bank is 3.0%, of the outstanding principal balance of Acquired Member Assets, as defined by the FHLBI, and delivery commitments for Acquired Member Assets; (3) a specified dollar amount related to certain off-balance sheet items, which for Old National Bank is inapplicable; and (4) a specified percentage ranging from 0.0% to 5.0% of the carrying value on the FHLBI’s balance sheet of derivative contracts between the FHLBI and Old National Bank, which for Old National Bank is inapplicable. The FHLBI can adjust the specified percentages and dollar amount from time to time within the ranges established by the FHLBI capital plan. As of December 31, 2017, Old National Bank was in compliance with the minimum stock ownership requirement.

Federal Reserve System. Federal Reserve regulations require depository institutions to maintain cash reserves against their transaction accounts (primarily NOW and demand deposit accounts). A reserve of 3% is to be maintained against aggregate transaction accounts between $12.4 million and $79.5 million (subject to adjustment by the Federal Reserve) plus a reserve of 10% (subject to adjustment by the Federal Reserve between 8% and 14%) against that portion of total transaction accounts in excess of $79.5 million. The first $12.4 million of otherwise reservable balances (subject to adjustment by the Federal Reserve) is exempt from the reserve requirements. Old National Bank is in compliance with the foregoing requirements.

 

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Other Regulations. Old National Bank is subject to federal consumer protection statutes and regulations promulgated under those laws, including, but not limited to, the:

 

    Truth-In-Lending Act and Regulation Z, governing disclosures of credit terms to consumer borrowers;

 

    Home Mortgage Disclosure Act and Regulation C, requiring financial institutions to provide certain information about home mortgage and refinanced loans;

 

    Fair Credit Reporting Act and Regulation V, governing the provision of consumer information to credit reporting agencies and the use of consumer information;

 

    Equal Credit Opportunity Act and Regulation B, prohibiting discrimination on the basis of race, religion or other prohibited factors in the extension of credit;

 

    Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

    Truth in Savings Act and Regulation DD, which requires disclosure of deposit terms to consumers;

 

    Regulation CC, which relates to the availability of deposit funds to consumers;

 

    Right to Financial Privacy Act, which imposes a duty to maintain the confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and

 

    Electronic Funds Transfer Act, governing 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 services.

The Dodd-Frank Act also significantly impacts the various consumer protection laws, rules and regulations applicable to financial institutions. The statute rolls back the federal preemption of state consumer protection laws that was enjoyed by national banks by (1) requiring that a state consumer financial law prevent or significantly interfere with the exercise of a national bank’s powers before it can be preempted, (2) mandating that any preemption decision be made on a case by case basis rather than a blanket rule, and (3) ending the applicability of preemption to subsidiaries and affiliates of national banks. As a result, we may now be subject to state consumer protection laws in each state where we do business, and those laws may be interpreted and enforced differently in each state.

The Dodd-Frank Act also created the Consumer Financial Protection Bureau (the “CFPB”), a consumer financial services regulator with supervisory authority over banks and their affiliates with assets of more than $10 billion, like Old National, to carry out federal consumer protection laws. The CFPB also regulates financial products and services sold to consumers and has rulemaking authority with respect to federal consumer financial laws. Any new regulatory requirements promulgated by the CFPB or modifications in the interpretations of existing regulations could require changes to Old National’s consumer-facing businesses. The Dodd-Frank Act also gives the CFPB broad data collecting powers for fair lending for both small business and mortgage loans, as well as extensive authority to prevent unfair, deceptive, and abusive practices.

The rules issued by the CFPB have impacted our mortgage loan origination and servicing activities. Compliance with these rules will likely continue to increase our overall regulatory compliance costs.

Dividend Limitation. Old National Bank is subject to the provisions of the National Bank Act, is supervised, regulated and examined by the OCC, and is subject to the rules and regulations of the OCC, Federal Reserve and the FDIC. A substantial portion of Old National’s cash revenue is derived from dividends paid to it by Old National Bank. These dividends are subject to various legal and regulatory restrictions as summarized in Note 24 to the consolidated financial statements.

Legislative and Regulatory Initiatives. From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of Old National in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. Old National cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of Old National. A change in statutes, regulations or regulatory policies applicable to Old National or any of its subsidiaries could have a material effect on Old National’s business, financial condition and results of operations.

 

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AVAILABLE INFORMATION

All reports filed electronically by Old National with the SEC, including the annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements, other information and amendments to those reports filed or furnished (if applicable), are accessible at no cost on Old National’s web site at www.oldnational.com as soon as reasonably practicable after electronically submitting such materials to the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, and Old National’s filings are accessible on the SEC’s web site at www.sec.gov. The public may read and copy any materials filed by Old National with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

ITEM 1A. RISK FACTORS

Old National’s business could be harmed by any of the risks noted below. In analyzing whether to make or to continue an investment in Old National, investors should consider, among other factors, the following:

Risks Related to the Banking Industry

Old National operates in a highly regulated environment, and changes in laws and regulations to which Old National is subject may adversely affect Old National’s results of operations.

Old National operates in a highly regulated environment and is subject to extensive regulation, supervision, and examination by, among others, the OCC, the FDIC, the CFPB, the Federal Reserve, and the State of Indiana. Such regulation and supervision of the activities in which an institution may engage is primarily intended for the protection of the depositors and federal deposit insurance funds. In addition, the Treasury has certain supervisory and oversight duties and responsibilities under EESA and the CPP. See “Business – Supervision and Regulation” herein. Applicable laws and regulations may change, and such changes may adversely affect Old National’s business. The Dodd-Frank Act, enacted in July 2010, mandated the most wide-ranging overhaul of financial industry regulation in decades. This legislation, among other things, weakened federal preemption of state consumer protection laws and established the CFPB with broad authority to administer and enforce a new federal regulatory framework of consumer financial regulation, including consumer mortgage banking. The scope and impact of many of the Dodd-Frank Act provisions were determined and issued over time. The impact of the Dodd-Frank Act on Old National has been substantial. Provisions in the legislation that affect the payment of interest on demand deposits and collection of interchange fees increased the costs associated with certain deposits and placed limitations on certain revenues those deposits generate. In addition, the Dodd-Frank Act required Old National to change certain of its business practices, intensified the regulatory supervision of Old National and the financial services industry, increased Old National’s capital requirements, and imposed additional assessments and costs on Old National. In addition, certain provisions in the legislation that had not previously applied to Old National became effective as Old National and its consolidated assets increased to over $10 billion in June 2014. This includes oversight by the CFPB and a requirement to submit our first stress test report in 2016. Requirements to maintain higher levels of capital or liquidity to address potential adverse stress scenarios could adversely impact the Company’s net income.

Regulatory authorities also have extensive discretion in connection with their supervisory and enforcement activities, including but not limited to the imposition of restrictions on the operation of an institution, the classification of assets by the institution, the adequacy of an institution’s Bank Secrecy Act/Anti Money Laundering program management, and the adequacy of an institution’s allowance for loan losses. Any change in such regulation and oversight, whether in the form of restrictions on activities, regulatory policy, regulations, or legislation, including but not limited to changes in the regulations governing institutions, could have a material impact on Old National and its operations.

If Old National fails to meet regulatory capital requirements which may require heightened capital, we may be forced to raise capital or sell assets.

Old National is subject to regulations that require us to satisfy certain capital ratios, such as the ratio of our Tier 1 capital to our risk-based assets. Both the Dodd-Frank Act, which reformed the regulation of financial institutions in a comprehensive manner, and the Basel III regulatory capital reforms, which increase both the amount and quality of capital that financial institutions must hold, will impact our capital requirements. Specifically, in July 2013, the U.S.

 

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federal banking authorities approved the implementation of the Basel III Capital Rules. The Basel III Capital Rules are applicable to all U.S. banks that are subject to minimum capital requirements as well as to bank and saving and loan holding companies, other than “small bank holding companies” (generally bank holding companies with consolidated assets of less than $500 million). The Basel III Capital Rules not only increase most of the required minimum regulatory capital ratios, they introduce a new Common Equity Tier 1 Capital ratio and the concept of a capital conservation buffer. The Basel III Capital Rules also expand the current definition of capital by establishing additional criteria that capital instruments must meet to be considered Additional Tier 1 Capital (i.e., Tier 1 Capital in addition to Common Equity) and Tier 2 Capital. A number of instruments that now generally qualify as Tier 1 Capital will not qualify or their qualifications will change when the Basel III Capital Rules are fully implemented. The Basel III Capital Rules have maintained the general structure of the current prompt corrective action thresholds while incorporating the increased requirements, including the Common Equity Tier 1 Capital ratio. In order to be a “well-capitalized” depository institution under the new regime, an institution must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more, a Tier 1 Capital ratio of 8% or more, a Total Capital ratio of 10% or more, and a leverage ratio of 5% or more. Institutions must also maintain a capital conservation buffer consisting of Common Equity Tier 1 Capital. Financial institutions became subject to the Basel III Capital Rules on January 1, 2015 with a phase-in period through 2019 for many of the changes. If we are unable to satisfy these heightened regulatory capital requirements, due to a decline in the value of our loan portfolio or otherwise, we will be required to improve such capital ratios by either raising additional capital or by disposing of assets. If we choose to dispose of assets, we cannot be certain that we will be able to do so at prices that we believe to be appropriate, and our future operating results could be negatively affected. If we choose to raise additional capital, we may accomplish this by selling additional shares of Common Stock, or securities convertible into or exchangeable for Common Stock, which could significantly dilute the ownership percentage of holders of our Common Stock and cause the market price of our Common Stock to decline. Additionally, events or circumstances in the capital markets generally may increase our capital costs and impair our ability to raise capital at any given time.

A reduction in our credit rating could adversely affect our business and/or the holders of our securities.

The credit rating agencies rating our indebtedness regularly evaluate Old National and Old National Bank, and credit ratings are based on a number of factors, including our financial strength and ability to generate earnings, as well as factors not entirely within our control, including conditions affecting the financial services industry and the economy and changes in rating methodologies. There can be no assurance that we will maintain our current credit ratings. A downgrade of the credit ratings of Old National or Old National Bank could adversely affect our access to liquidity and capital, and could significantly increase our cost of funds, and decrease the number of investors and counterparties willing to lend to us or purchase our securities. This could affect our growth, profitability, and financial condition, including liquidity.

Changes in interest rates could adversely affect Old National’s results of operations and financial condition.

Old National’s earnings depend substantially on Old National’s interest rate spread, which is the difference between (i) the rates Old National earns on loans, securities and other earning assets and (ii) the interest rates Old National pays on deposits and other borrowings. These rates are highly sensitive to many factors beyond Old National’s control, including general economic conditions and the policies of various governmental and regulatory authorities. If market interest rates rise, Old National will have competitive pressures to increase the rates that Old National pays on deposits, which could result in a decrease of Old National’s net interest income. If market interest rates decline, Old National could experience fixed-rate loan prepayments and higher investment portfolio cash flows, resulting in a lower yield on earnings assets.

A failure or breach, including cyber-attacks, of our operational or security systems, could disrupt our business, result in the disclosure of confidential information, damage our reputation, and create significant financial and legal exposure.

Although we devote significant resources to maintain and regularly upgrade our systems and processes that are designed to protect the security of our computer systems, software, networks, and other technology assets and the confidentiality, integrity, and availability of information belonging to us and our customers, there is no assurance that our security measures will provide absolute security. Further, to access our products and services our customers may use computers and mobile devices that are beyond our security control systems. In fact, many other financial services institutions and companies engaged in data processing have reported breaches in the security of their websites or other systems, some of which have involved sophisticated and targeted attacks intended to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage systems, often

 

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through the introduction of computer viruses or malware, cyberattacks, and other means. Certain financial institutions in the United States have also experienced attacks from technically sophisticated and well-resourced third parties that were intended to disrupt normal business activities by making internet banking systems inaccessible to customers for extended periods. These “denial-of-service” attacks have not breached our data security systems, but require substantial resources to defend, and may affect customer satisfaction and behavior.

Despite our efforts to ensure the integrity of our systems, it is possible that we may not be able to anticipate or to implement effective preventive measures against all security breaches of these types, especially because the techniques used change frequently or are not recognized until launched, and because security attacks can originate from a wide variety of sources, including persons who are involved with organized crime or associated with external service providers or who may be linked to terrorist organizations or hostile foreign governments. Those parties may also attempt to fraudulently induce employees, customers or other users of our systems to disclose sensitive information in order to gain access to our data or that of our customers or clients. We have implemented employee and customer awareness training around phishing, malware, and other cyber risks. These risks may increase in the future as we continue to increase our mobile payments and other internet-based product offerings and expand our internal usage of web-based products and applications.

If our security systems were penetrated or circumvented, it could cause serious negative consequences for us, including significant disruption of our operations, misappropriation of our confidential information or that of our customers, or damage our computers or systems and those of our customers and counterparties, and could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, significant litigation exposure, and harm to our reputation, all of which could have a material adverse effect on us.

We rely on third party vendors, which could expose Old National to additional cybersecurity risks.

Third party vendors provide key components of our business infrastructure, including certain data processing and information services. On our behalf, third parties may transmit confidential, propriety information. Although we require third party providers to maintain certain levels of information security, such providers may remain vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious attacks that could ultimately compromise sensitive information. While we may contractually limit our liability in connection with attacks against third party providers, Old National remains exposed to the risk of loss associated with such vendors. In addition, a number of our vendors are large national entities with dominant market presence in their respective fields. Their services could prove difficult to replace in a timely manner if a failure or other service interruption were to occur. Failures of certain vendors to provide contracted services could adversely affect our ability to deliver products and services to our customers and cause us to incur significant expense.

Changes in economic or political conditions could adversely affect Old National’s earnings, as the ability of Old National’s borrowers to repay loans, and the value of the collateral securing such loans, decline.

Old National’s success depends, to a certain extent, upon economic or political conditions, local and national, as well as governmental monetary policies. Conditions such as recession, unemployment, changes in interest rates, inflation, money supply, and other factors beyond Old National’s control may adversely affect its asset quality, deposit levels, and loan demand and, therefore, Old National’s earnings. Because Old National has a significant amount of commercial real estate loans, decreases in real estate values could adversely affect the value of property used as collateral. Adverse changes in the economy may also have a negative effect on the ability of Old National’s borrowers to make timely repayments of their loans, which would have an adverse impact on Old National’s earnings. In addition, substantially all of Old National’s loans are to individuals and businesses in Old National’s market area. Consequently, any economic decline in Old National’s primary market areas, which include Indiana, Kentucky, Michigan, Wisconsin, and Minnesota could have an adverse impact on Old National’s earnings.

Failure to keep pace with technological change could adversely affect Old National’s results of operations and financial condition.

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. Old National’s future success depends, in part, upon its ability to address customer needs by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in Old National’s operations. Old National may not

 

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be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could negatively affect Old National’s growth, revenue, and profit.

Changes in consumer use of banks and changes in consumer spending and savings habits could adversely affect Old National’s financial results.

Technology and other changes now allow many customers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and savings habits could adversely affect Old National’s operations, and Old National may be unable to timely develop competitive new products and services in response to these changes.

Our earnings could be adversely impacted by incidences of fraud and compliance failure.

Financial institutions are inherently exposed to fraud risk. A fraud can be perpetrated by a customer of Old National, 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, wire 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.

Risks Related to Old National’s Business

Acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration difficulties and dilution to existing shareholder value.

We have acquired, and expect to continue to acquire, other financial institutions or parts of those institutions in the future, and we may engage in de novo branch expansion. We may also consider and enter into new lines of business or offer new products or services.

We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance that integration efforts for any mergers or acquisitions will be successful. Also, we may issue equity securities in connection with acquisitions, which could cause ownership and economic dilution to our current shareholders. There is no assurance that, following any mergers or acquisitions, our integration efforts will be successful or that, after giving effect to the acquisition, we will achieve profits comparable to, or better than, our historical experience.

 

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Acquisitions and mergers involve a number of expenses and risks, including:

 

    the time and costs associated with identifying potential new markets, as well as acquisition and merger targets;

 

    the accuracy of the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution;

 

    the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

 

    our ability to finance an acquisition and possible dilution to our existing shareholders;

 

    the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combined businesses;

 

    entry into new markets where we lack experience;

 

    the introduction of new products and services into our business;

 

    the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations;

 

    closing delays and increased expenses related to the resolution of lawsuits filed by shareholders of targets; and

 

    the risk of loss of key employees and customers.

Old National must generally receive federal regulatory approval before it can acquire a bank or bank holding company. Old National cannot be certain when or if, or on what terms and conditions, any required regulatory approvals will be granted. Old National may be required to sell banks or branches as a condition to receiving regulatory approval.

Future acquisitions could be material to Old National and it may issue additional shares of stock to pay for those acquisitions, which would dilute current shareholder’s ownership interests.

Economic conditions have affected and could continue to adversely affect our revenues and profits.

Old National’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 Old National offers, is highly dependent upon the business environment in the markets where Old National operates and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, terrorist acts, or a combination of these or other factors.

The U.S. economy experienced growth during 2017, with increasing exports, jobs, and manufacturing production. Real GDP has increased, and unemployment is in line with a full-employment economy. However, if tighter financial conditions emerge, along with additional rate hikes by the Federal Reserve, there can be no assurance that the economy will not enter into another recession, whether in the near term or long term. An economic downturn or sustained, high unemployment levels, and stock market volatility may negatively impact our operating results and have a negative effect on the ability of our borrowers to make timely repayments of their loans increasing the risk of loan defaults and losses.

If Old National’s actual loan losses exceed Old National’s allowance for loan losses, Old National’s net income will decrease.

Old National makes various assumptions and judgments about the collectibility of Old National’s loan portfolio, including the creditworthiness of Old National’s borrowers and the value of the real estate and other assets serving as collateral for the repayment of Old National’s loans. Despite Old National’s underwriting and monitoring practices, the effect of a declining economy could negatively impact the ability of Old National’s borrowers to repay loans in a timely manner and could also negatively impact collateral values. As a result, Old National may experience significant loan losses that could have a material adverse effect on Old National’s operating results. Since Old National must use assumptions regarding individual loans and the economy, Old National’s current

 

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allowance for loan losses may not be sufficient to cover actual loan losses. Old National’s assumptions may not anticipate the severity or duration of the current credit cycle; and Old National may need to significantly increase Old National’s provision for losses on loans if one or more of Old National’s larger loans or credit relationships becomes delinquent or if Old National expands its commercial real estate and commercial lending. In addition, federal and state regulators periodically review Old National’s allowance for loan losses and may require Old National to increase the provision for loan losses or recognize loan charge-offs. Material additions to Old National’s allowance would materially decrease Old National’s net income. There can be no assurance that Old National’s monitoring procedures and policies will reduce certain lending risks or that Old National’s allowance for loan losses will be adequate to cover actual losses.

Old National’s loan portfolio includes loans with a higher risk of loss.

Old National Bank originates commercial real estate loans, commercial loans, agricultural real estate loans, agricultural loans, consumer loans, and residential real estate loans primarily within Old National’s market areas. Commercial real estate, commercial, consumer, and agricultural real estate and operating 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. These loans also have greater credit risk than residential real estate for the following reasons:

 

    Commercial Real Estate Loans. Repayment is dependent upon income being generated in amounts sufficient to cover operating expenses and debt service.

 

    Commercial Loans. Repayment is dependent upon the successful operation of the borrower’s business.

 

    Consumer Loans. Consumer loans (such as personal lines of credit) are collateralized, if at all, with assets that may not provide an adequate source of payment of the loan due to depreciation, damage, or loss.

 

    Agricultural Loans. Repayment is dependent upon the successful operation of the business, which is greatly dependent on many things outside the control of either Old National Bank or the borrowers. These factors include weather, input costs, commodity and land prices, and interest rates.

Our wholesale funding sources may prove insufficient to replace deposits or support our future growth.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. These sources include brokered certificates of deposit, repurchase agreements, and federal funds purchased. Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our results of operations and financial condition would be negatively affected.

Our accounting estimates and risk management processes rely on analytical and forecasting models.

The processes that we use to estimate 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 our financial condition and results of operations, depend 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 our models for determining interest rate risk and asset-liability management are inadequate, we may incur increased or unexpected losses upon changes in market interest rates or other market measures. If our models for determining probable loan losses are inadequate, the allowance for loan losses may not be sufficient to support future charge-offs. If our models to measure the fair value of financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what we could realize upon sale or settlement of such financial instruments. Any such failure in our analytical or forecasting models could have a material adverse effect on our business, financial condition, and results of operations.

 

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If Old National forecloses on collateral property, Old National may be subject to the increased costs associated with the ownership of real property, resulting in reduced revenues.

Old National may have to foreclose on collateral property to protect Old National’s investment and may thereafter own and operate such property, in which case Old National will be exposed to the risks inherent in the ownership of real estate. The amount that Old National, as a mortgagee, may realize after a default is dependent upon factors outside of Old National’s 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) acts of God. 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 Old National may have to advance funds in order to protect Old National’s investment, or Old National may be required to dispose of the real property at a loss. The foregoing expenditures and costs could adversely affect Old National’s ability to generate revenues, resulting in reduced levels of profitability.

Old National operates in an extremely competitive market, and Old National’s business will suffer if Old National is unable to compete effectively.

In our market area, Old National encounters significant competition from other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds, and other financial intermediaries. In addition, FinTech start-ups are emerging in key areas of banking. Our competitors may have substantially greater resources and lending limits than Old National does and may offer services that Old National does not or cannot provide. Many of our nonfinancial institution competitors have fewer regulatory constraints, broader geographic service areas, and, in some cases, lower cost structures. Old National’s profitability depends upon Old National’s continued ability to compete successfully in Old National’s market area.

Our business could suffer if we fail to attract and retain skilled people.

Our success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities we engage in can be intense. We may not be able to hire the best people or to keep them. The loss of any of our key personnel or an inability to continue to attract, retain, and motivate key personnel could adversely affect our business.

We have risk related to legal proceedings.

We are involved in judicial, regulatory, and arbitration proceedings concerning matters arising from our business activities and fiduciary responsibilities. We establish reserves for legal claims when payments associated with the claims become probable and the costs can be reasonably estimated. We may still incur legal costs for a matter even if we have not established a reserve. In addition, the actual cost of resolving a legal claim may be substantially higher than any amounts reserved for that matter. The ultimate resolution of a pending or future legal proceeding, depending on the remedy sought and granted, could materially adversely affect our results of operations and financial condition.

Risks Related to Old National’s Stock

We may not be able to pay dividends in the future in accordance with past practice.

Old National has traditionally paid a quarterly 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 Old National’s earnings, capital requirements, financial condition, and other factors considered relevant by Old National’s Board of Directors.

Old National is an entity separate and distinct from Old National Bank. Old National Bank conducts most of our operations and Old National depends upon dividends from Old National Bank to service its debt and to pay dividends to Old National’s shareholders. The availability of dividends from Old National Bank is limited by various statutes and regulations. It is possible, depending upon the financial condition including liquidity and

 

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capital adequacy of Old National Bank and other factors, that the OCC could assert that the payment of dividends or other payments is an unsafe or unsound practice. In addition, the payment of dividends by our other subsidiaries is also subject to the laws of the subsidiary’s state of incorporation, and regulatory capital and liquidity requirements applicable to such subsidiaries. At December 31, 2017, Old National Bank could pay dividends of $47.1 million without prior regulatory approval. In the event that Old National Bank was unable to pay dividends to us, we in turn would likely have to reduce or stop paying dividends on our Common Stock. Our failure to pay dividends on our Common Stock could have a material adverse effect on the market price of our Common Stock. See “Business – Supervision and Regulation – Dividend Limitations” and Note 24 to the consolidated financial statements.

The price of Old National’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 Old National’s Common Stock. In addition, the following factors may cause the market price for shares of Old National’s Common Stock to fluctuate:

 

    announcements of developments related to Old National’s business;

 

    fluctuations in Old National’s results of operations;

 

    sales or purchases of substantial amounts of Old National’s securities in the marketplace;

 

    general conditions in Old National’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

 

    Old National’s announcement of new acquisitions or other projects.

As previously noted, the Dodd-Frank Act and its implementing regulations impose various additional requirements on bank holding companies with $10 billion or more in total assets, including compliance with portions of the Federal Reserve’s enhanced prudential oversight requirements and annual stress testing requirements. Compliance with the annual stress testing requirements, part of which must be publicly disclosed, may also be negatively interpreted by the market generally or our customers and, as a result, may adversely affect our stock price or our ability to retain our customers or effectively compete for new business opportunities.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

As of December 31, 2017, Old National and its affiliates operated a total of 191 banking centers, primarily in the states of Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. Of these facilities, 120 were owned. We lease 71 banking centers from unaffiliated third parties. The terms of these leases range from two years and six months to twenty-five years. See Note 7 to the consolidated financial statements.

Impacting the number of Old National’s banking centers in 2017 was the acquisition of Anchor (MN) (17 banking centers) and the consolidation of 29 banking centers throughout the franchise.

Old National also has several administrative offices located throughout its footprint, including the executive offices of Old National which are located at 1 Main Street, Evansville, Indiana. This building, which was previously leased, was purchased in 2016.

 

ITEM 3. LEGAL PROCEEDINGS

In the normal course of business, Old National and its subsidiaries have been named, from time to time, as defendants in various legal actions. Certain of the actual or threatened legal actions may include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages.

Old National contests liability and/or the amount of damages as appropriate in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Old National cannot predict with certainty the loss or range of loss, if any, related to such matters, how or if such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, or other relief, if any, might be.

 

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Subject to the foregoing, Old National believes, based on current knowledge and after consultation with counsel, that the outcome of such pending matters will not have a material adverse effect on the consolidated financial condition of Old National, although the outcome of such matters could be material to Old National’s operating results and cash flows for a particular future period, depending on, among other things, the level of Old National’s revenues or income for such period. Old National will accrue for a loss contingency if (1) it is probable that a future event will occur and confirm the loss and (2) the amount of the loss can be reasonably estimated.

Old National is not currently involved in any material litigation.

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Old National’s Common Stock is traded on the NASDAQ under the ticker symbol ONB. The following table lists the high and low closing sales prices as reported by the NASDAQ, share volume, and dividend data for 2017 and 2016:

 

     Price Per Share      Share
Volume
     Dividend
Declared
 
     High      Low        

2017

           

First Quarter

   $ 18.90      $ 16.60        44,867,619      $ 0.13  

Second Quarter

     17.60        15.80        59,583,275        0.13  

Third Quarter

     18.30        15.55        45,933,639        0.13  

Fourth Quarter

     18.75        16.90        48,719,404        0.13  

2016

           

First Quarter

   $ 13.18      $ 10.85        72,116,846      $ 0.13  

Second Quarter

     13.40        11.64        72,798,438        0.13  

Third Quarter

     14.16        12.08        48,908,322        0.13  

Fourth Quarter

     18.35        13.80        51,422,870        0.13  

There were 43,684 shareholders of record as of December 31, 2017. Old National declared cash dividends of $0.52 per share during the years ended December 31, 2017 and 2016. Old National’s ability to pay cash dividends depends primarily on cash dividends received from Old National Bank. Dividend payments from Old National Bank are subject to various regulatory restrictions. See Note 24 to the consolidated financial statements for additional information.

The following table summarizes the purchases of equity securities made by Old National during the fourth quarter of 2017:

 

Period

   Total
Number
of Shares
Purchased
     Average
Price
Paid
Per Share
     Total Number
of Shares
Purchased as
Part of Publicly
Announced Plans
or Programs
     Maximum Number of
Shares that May Yet
Be Purchased Under
the Plans or Programs
 

10/01/17 - 10/31/17

     2,095      $ 18.55        —          —    

11/01/17 - 11/30/17

     236        18.05        —          —    

12/01/17 - 12/31/17

     53        18.25        —          —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     2,384      $ 18.49        —          —    
  

 

 

    

 

 

    

 

 

    

 

 

 

The Board of Directors did not authorize a stock repurchase plan for 2017. During the twelve months ended December 31, 2017, Old National repurchased a limited number of shares associated with employee share-based incentive programs.

On January 25, 2018, the Board of Directors declared a quarterly cash dividend of $0.13 per common share. The Board of Directors did not authorize a stock repurchase plan for 2018.

 

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EQUITY COMPENSATION PLAN INFORMATION

The following table contains information concerning the 2008 Equity Incentive Plan approved by security holders, as of December 31, 2017.

 

     Number of securities to
be issued upon exercise
of outstanding options,
warrants, and rights
     Weighted-average
exercise price of
outstanding
options, warrants,
and rights
     Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a))
 

Plan Category

   (a)      (b)      (c)  

Equity compensation plans approved by security holders

     1,480,548      $ 13.67        4,766,750  

Equity compensation plans not approved by security holders

     —          —          —    
  

 

 

    

 

 

    

 

 

 

Total

     1,480,548      $ 13.67        4,766,750  
  

 

 

    

 

 

    

 

 

 

At December 31, 2017, 4.8 million shares remain available for issuance under the 2008 Equity Incentive Plan.

 

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The following table compares cumulative five-year total shareholder returns, assuming reinvestment of dividends, for our common stock to cumulative total returns of a broad-based equity market index and two published industry indices. The comparison of shareholder returns (change in December year end stock price plus reinvested dividends) for each of the periods assumes that $100 was invested on December 31, 2012, in common stock of each of the Company, the S&P Small Cap 600 Index, the NYSE Financial Index and the SNL Bank and Thrift Index with investment weighted on the basis of market capitalization.

 

LOGO

 

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ITEM 6. SELECTED FINANCIAL DATA

 

(dollars in thousands, except per share data)

  2017     2016     2015     2014     2013  

Operating Results

         

Net interest income

  $ 437,168     $ 402,703     $ 366,116     $ 366,370     $ 317,424  

Conversion to fully taxable equivalent (1)

    23,091       21,293       19,543       16,999       16,876  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income—tax equivalent basis

    460,259       423,996       385,659       383,369       334,300  

Provision for loan losses

    3,050       960       2,923       3,097       (2,319

Noninterest income

    183,382       252,830       230,632       165,129       184,758  

Noninterest expense

    448,836       454,147       430,932       386,438       361,984  

Net income

    95,725       134,264       116,716       103,667       100,920  

Common Share Data (2)

         

Weighted average diluted shares

    138,513       128,301       116,255       108,365       101,198  

Net income (diluted)

  $ 0.69     $ 1.05     $ 1.00     $ 0.95     $ 1.00  

Cash dividends

    0.52       0.52       0.48       0.44       0.40  

Common dividend payout ratio (3)

    75     50     48     46     40

Book value at year-end

    14.17     $ 13.42     $ 13.05     $ 12.54     $ 11.64  

Stock price at year-end

    17.45       18.15       13.56       14.88       15.37  

Balance Sheet Data (at December 31)

         

Loans (4)

  $ 11,136,051     $ 9,101,194     $ 6,962,215     $ 6,531,691     $ 5,090,669  

Total assets

    17,518,292       14,860,237       11,991,527       11,646,051       9,581,744  

Deposits

    12,605,764       10,743,253       8,400,860       8,490,664       7,210,903  

Borrowings

    2,578,204       2,152,086       1,920,246       1,469,911       1,018,720  

Shareholders’ equity

    2,154,397       1,814,417       1,491,170       1,465,764       1,162,640  

Performance Ratios

         

Return on average assets

    0.63     0.98     0.98     0.99     1.05

Return on average common shareholders’ equity

    4.98       7.84       7.88       7.91       8.54  

Net interest margin (5)

    3.48       3.58       3.72       4.22       4.02  

Efficiency ratio (5)

    68.87       65.82       68.65       70.03       68.61  

Asset Quality (6)

         

Net charge-offs (recoveries) to average loans

    0.03     0.04     (0.02 )%      0.04     0.10

Allowance for loan losses to ending loans

    0.45       0.55       0.75       0.76       0.93  

Allowance for loan losses

  $ 50,381     $ 49,808     $ 52,233     $ 47,849     $ 47,145  

Underperforming assets (7)

    154,220       164,657       160,072       170,535       165,656  

Allowance for loan losses to nonaccrual loans (8)

    40.33     37.90     39.46     33.97     36.71

Other Data

         

Full-time equivalent employees

    2,801       2,733       2,652       2,938       2,608  

Banking centers

    191       203       160       195       169  

 

(1) Calculated using the federal statutory tax rate in effect of 35% for all periods.
(2) Diluted data assumes the exercise of stock options and the vesting of restricted stock.
(3) Cash dividends per share divided by net income per share (basic).
(4) Includes loans held for sale.
(5) Represents a non-GAAP financial measure. Refer to the “Non-GAAP Financial Measures” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for reconciliations to GAAP financial measures.
(6) Excludes loans held for sale.
(7) Includes nonaccrual loans, renegotiated loans, loans 90 days past due still accruing and other real estate owned. Includes $12.4 million, $24.4 million, and $45.5 million of covered assets in 2015, 2014, and 2013, respectively, acquired in an FDIC assisted transaction, which were covered by loss sharing agreements with the FDIC providing for specified loss protection. On June 22, 2016, Old National entered into an early termination agreement with the FDIC that terminated all loss share agreements.
(8) Includes approximately $12.6 million, $16.7 million, $15.9 million, $41.2 million, and $38.3 million for 2017, 2016, 2015, 2014, and 2013, respectively, of purchased credit impaired loans that are categorized as nonaccrual because the collection of principal or interest is doubtful. These loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

     Page  

General Overview

     31  

Corporate Developments in Fiscal 2017

     31  

Business Outlook

     31  

Financial Highlights

     33  

Non-GAAP Financial Measures

     34  

Results of Operations

     35  

Financial Condition

     43  

Risk Management

     48  

Off-Balance Sheet Arrangements

     58  

Contractual Obligations, Commitments, and Contingent Liabilities

     59  

Critical Accounting Policies and Estimates

     60  

 

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The following discussion is an analysis of our results of operations for the fiscal years ended December 31, 2017, 2016, and 2015, and financial condition as of December 31, 2017 and 2016. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes. This discussion contains forward-looking statements concerning our business. Readers are cautioned that, by their nature, forward-looking statements are based on estimates and assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from our expectations that are expressed or implied by any forward-looking statement. The discussion in Item 1A, “Risk Factors,” lists some of the factors that could cause our actual results to vary materially from those expressed or implied by any forward-looking statements, and such discussion is incorporated into this discussion by reference.

GENERAL OVERVIEW

Old National is the largest financial holding company incorporated in the state of Indiana and maintains its principal executive offices in Evansville, Indiana. Old National, through Old National Bank, provides a wide range of services, including commercial and consumer loan and depository services, and other traditional banking services. Old National also provides services to supplement the traditional banking business including fiduciary and wealth management services, investment and brokerage services, investment consulting, and other financial services.

Our basic mission is to be THE community bank in the cities and towns we serve. We focus on establishing and maintaining long-term relationships with customers, and are committed to serving the financial needs of the communities in our market area. Old National provides financial services primarily in Indiana, Kentucky, Michigan, Wisconsin, and Minnesota.

CORPORATE DEVELOPMENTS IN FISCAL 2017

In 2017, we expanded our footprint into the state of Minnesota through our acquisition of Anchor (MN). In addition to our entry into this new market, management remained keenly focused on organic growth and efficiency efforts. This is evidenced by the following 2017 highlights:

 

    organic loan growth of almost 5% (including loans held for sale), organic commercial and commercial real estate loan growth of 10%;

 

    cost of total deposits increased just two basis points to 0.19%;

 

    credit quality metrics remain strong, with net charge-offs to average loans of 0.03%;

 

    noninterest expenses remained well controlled, decreasing to $448.8 million; and

 

    the on-going assessment of our service and delivery network, resulting in the consolidation of 29 banking centers in 2017.

Net interest income increased to $437.2 million, or 9%, from $402.7 million in 2016 and noninterest expenses remained well controlled, decreasing to $448.8 million from $454.1 million in 2016. Noninterest income decreased to $183.4 million in 2017 from $252.8 million in 2016 primarily due to a $41.9 million gain and lower insurance premiums and commissions in 2016 resulting from the sale of ONI in May 2016, partially offset by higher wealth management fees, investment product fees, and capital markets income in 2017. Net income for 2017 was $95.7 million, compared to 2016 net income of $134.3 million. Diluted earnings per share were $0.69 per share in 2017, compared to $1.05 per share in 2016. Net income in 2017 included $39.3 million of additional tax expense recorded in December 2017 to estimate the revaluation of Old National’s deferred tax assets due to the lowering of the federal corporate tax rate to 21%.

BUSINESS OUTLOOK

The U.S. economy experienced growth during 2017, with increasing exports, jobs, and manufacturing production. Real GDP has increased, and unemployment is in line with a full-employment economy. Short-term interest rates increased 75 basis points in 2017 as the Federal Reserve increased the discount rate 25 basis points at their March, June, and December meetings. The rate increases were driven by the Federal Reserve’s inflation and wage pressure expectations in conjunction with a moderately expanding economy. Additional rate increases in 2018 will benefit Old National as our assets tend to re-price faster and with more margin than our liabilities. In addition, Old National’s dominant market share in many of the communities in which we serve will become more valuable as deposits typically cost less than other types of funding. Of note, while many short-term rates (i.e., Federal Funds, LIBOR, and Prime) are now hovering near decade highs, while the yield curve itself remains stubbornly flat (e.g. key yield curve spreads are near decade lows) – a dichotomy that we continue to monitor for its implications to both the U.S. economy and our balance sheet positioning.

 

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In the regulatory environment, we note several key appointments were either confirmed or announced in 2017 and early 2018, including new heads of the Federal Reserve, OCC, FDIC, CFPB, and SEC. The impact of these changes is expected to have the most direct impact on our larger bank competitors. However, we believe there will be a shift in regulatory approach that is a compromise between a size-based and a principles-based approach.

Our focus for 2018 remains basic banking – loan growth, fee-based income, and expense management.

The impact of the tax reform bill will have a positive two-fold impact for Old National. First for our clients as an expected uptick in technology investments, inventory expansion, and other capital expenditures resulting in loan growth and second, for our shareholders, in the way of increased earnings as a result of reduced corporate taxes that management will evaluate using a longer time horizon. This anticipated loan growth will be supported by the strength of our low-cost core deposit franchise. While we do not see any major adverse cyclical shifts in our loan portfolios, we will remain diligent to our risk profile and underwriting standards.

Our fee-based business continues to take advantage of the rising market and strong sales production. We expect this trend to continue and further build out these fee-based product sets in our Minnesota market.    

We will continue to invest and focus on improving the client experience and reducing our operating cost at the same time by enhancing technology and processes. As we adapt to changing customer behaviors, we will continue to evaluate our franchise for additional consolidation opportunities in 2018.

Our appetite for future partnerships is such that we remain an active looker and a selective, disciplined buyer. We believe our ability to bring a larger balance sheet with better capital and an enhanced product set allows a potential new market partner to better serve their clients. However, given the quality Old National franchise that exists today, we do not feel compelled to enter into a partnership.

We remain optimistic as we look ahead to 2018 given the strength of our franchise and remain diligent on growing our pretax pre-provisioned income as well as continuing our expense discipline. We are reaffirming our commitment to driving and sustaining positive operating leverage.

 

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FINANCIAL HIGHLIGHTS

The following table sets forth certain financial highlights of Old National:

 

     Three Months Ended     Years Ended  

(dollars and shares in thousands,

except per share data)

   December 31,     September 30,     December 31,     December 31,  
   2017     2017     2016     2017     2016  

Income Statement:

          

Net interest income

   $ 118,556     $ 108,478     $ 109,917     $ 437,168     $ 402,703  

Taxable equivalent adjustment (1)

     6,139       5,621       5,506       23,091       21,293  

Provision for loan losses

     1,037       311       (1,756     3,050       960  

Noninterest income

     44,825       46,366       62,751       183,382       252,830  

Noninterest expense

     140,432       103,702       126,258       448,836       454,147  

Net income (loss)

     (18,493     39,372       33,456       95,725       134,264  

Common Share Data:

          

Weighted average diluted shares

     146,875       135,796       135,383       138,513       128,301  

Net income (loss) (diluted)

   $ (0.13   $ 0.29     $ 0.25     $ 0.69     $ 1.05  

Cash dividends

     0.13       0.13       0.13     $ 0.52     $ 0.52  

Common dividend payout ratio (2)

     N/M       43     52     75     50

Book value

   $ 14.17     $ 14.07     $ 13.42     $ 14.17     $ 13.42  

Stock price

     17.45       18.30       18.15       17.45       18.15  

Tangible common book value (3)

     8.37       9.02       8.30       8.37       8.30  

Performance Ratios:

          

Return on average assets

     (0.45 )%      1.05     0.91     0.63     0.98

Return on average common equity

     (3.51     8.31       7.33       4.98       7.84  

Return on tangible common equity (3)

     (5.12     13.44       12.68       8.12       12.69  

Return on average tangible common equity (3)

     (5.05     13.58       12.57       8.59       13.73  

Net interest margin (3)

     3.47       3.52       3.63       3.48       3.58  

Efficiency ratio (3)

     81.60       64.17       69.53       68.87       65.82  

Net charge-offs (recoveries) to average loans

     0.03       0.05       —         0.03       0.04  

Allowance for loan losses to ending loans

     0.45       0.53       0.55       0.45       0.55  

Non-performing loans to ending loans

     1.30       1.46       1.62       1.30       1.62  

Balance Sheet:

          

Total loans

   $ 11,118,121     $ 9,398,124     $ 9,010,512     $ 11,118,121     $ 9,010,512  

Total assets

     17,518,292       15,065,800     $ 14,860,237       17,518,292       14,860,237  

Total deposits

     12,605,764       10,606,784       10,743,253       12,605,764       10,743,253  

Total borrowed funds

     2,578,204       2,411,111       2,152,086       2,578,204       2,152,086  

Total shareholders’ equity

     2,154,397       1,906,823       1,814,417       2,154,397       1,814,417  

Nonfinancial Data:

          

Full-time equivalent employees

     2,801       2,592       2,733       2,801       2,733  

Banking centers

     191       188       203       191       203  

 

N/M = Not meaningful

 

(1) Calculated using the federal statutory tax rate in effect of 35% for all periods.
(2) Cash dividends per share divided by net income per share (basic).
(3) Represents a non-GAAP financial measure. Refer to the “Non-GAAP Financial Measures” section for reconciliations to GAAP financial measures.

 

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NON-GAAP FINANCIAL MEASURES

Non-GAAP financial measures exclude certain items that are included in the financial results presented in accordance with GAAP. Management believes these non-GAAP financial measures enhance an investor’s understanding of the financial results of Old National by providing a meaningful basis for period-to-period comparisons, assisting in operating results analysis, and predicting future performance.

The following table presents GAAP to non-GAAP reconciliations.

 

(dollars and shares in thousands,    Three Months Ended
December 31,
   

Years Ended

December 31,

 

except per share data)

   2017     2016     2017     2016  

Tangible common book value:

        

Shareholders’ equity (GAAP)

   $ 2,154,397     $ 1,814,417     $ 2,154,397     $ 1,814,417  

Deduct: Goodwill

     828,051       655,018       828,051       655,018  

Intangible assets

     53,096       37,677       53,096       37,677  
  

 

 

   

 

 

   

 

 

   

 

 

 

Tangible shareholders’ equity (non-GAAP)

   $ 1,273,250     $ 1,121,722     $ 1,273,250     $ 1,121,722  
  

 

 

   

 

 

   

 

 

   

 

 

 

Period end common shares

     152,040       135,159       152,040       135,159  

Tangible common book value

     8.37       8.30       8.37       8.30  

Return on tangible common equity:

        

Net income (GAAP)

   $ (18,493   $ 33,456     $ 95,725     $ 134,264  

Add: Intangible amortization (net of tax)

     2,210       2,107       7,697       8,116  
  

 

 

   

 

 

   

 

 

   

 

 

 

Tangible net income (non-GAAP)

   $ (16,283   $ 35,563     $ 103,422     $ 142,380  
  

 

 

   

 

 

   

 

 

   

 

 

 

Tangible shareholders’ equity (non-GAAP) (see above)

   $ 1,273,250     $ 1,121,722     $ 1,273,250     $ 1,121,722  

Return on tangible common equity

     (5.12 )%      12.68     8.12     12.69

Return on average tangible common equity:

        

Tangible net income (non-GAAP) (see above)

   $ (16,283   $ 35,563     $ 103,422     $ 142,380  

Average shareholders’ equity (GAAP)

   $ 2,104,646     $ 1,825,993     $ 1,923,645     $ 1,712,574  

Deduct: Average goodwill

     776,862       655,041       685,729       635,440  

Average intangible assets

     37,802       39,239       34,392       40,317  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average tangible shareholders’ equity (non-GAAP)

   $ 1,289,982     $ 1,131,713     $ 1,203,524     $ 1,036,817  
  

 

 

   

 

 

   

 

 

   

 

 

 

Return on average tangible common equity

     (5.05 )%      12.57     8.59     13.73

Net interest margin:

        

Net interest income (GAAP)

   $ 118,556     $ 109,917     $ 437,168     $ 402,703  

Taxable equivalent adjustment

     6,139       5,506       23,091       21,293  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis (non-GAAP)

   $ 124,695     $ 115,423     $ 460,259     $ 423,996  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average earning assets

   $ 14,389,502     $ 12,713,345     $ 13,237,906     $ 11,840,967  

Net interest margin

     3.47     3.63     3.48     3.58

Efficiency ratio:

        

Noninterest expense (GAAP)

   $ 140,432     $ 126,258     $ 448,836     $ 454,147  

Deduct: Intangible amortization expense

     3,399       3,241       11,841       12,486  
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted noninterest expense (non-GAAP)

   $ 137,033     $ 123,017     $ 436,995     $ 441,661  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis (non-GAAP) (see above)

   $ 124,695     $ 115,423     $ 460,259     $ 423,996  

Noninterest income

     44,825       62,751       183,382       252,830  

Deduct: Net securities gains (losses)

     1,588       1,239       9,135       5,848  
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted total revenue (non-GAAP)

   $ 167,932     $ 176,935     $ 634,506     $ 670,978  
  

 

 

   

 

 

   

 

 

   

 

 

 

Efficiency ratio

     81.60     69.53     68.87     65.82

 

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Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although these non-GAAP financial measures are frequently used by investors to evaluate a company, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP. These non-GAAP measures are not necessarily comparable to similar measures that may be represented by other companies.

RESULTS OF OPERATIONS

The following table sets forth certain income statement information of Old National for the years ended December 31, 2017, 2016, and 2015:

 

     Years Ended December 31,  

(dollars in thousands)

   2017     2016     2015  

Income Statement Summary:

      

Net interest income

   $ 437,168     $ 402,703     $ 366,116  

Provision for loan losses

     3,050       960       2,923  

Noninterest income

     183,382       252,830       230,632  

Noninterest expense

     448,836       454,147       430,932  

Other Data:

      

Return on average common equity

     4.98     7.84     7.88

Return on tangible common equity (1)

     8.12     12.69     14.27

Return on average tangible common equity (1)

     8.59     13.73     14.57

Efficiency ratio (1)

     68.87     65.82     68.65

Tier 1 leverage ratio

     8.27     8.43     8.54

Net charge-offs (recoveries) to average loans

     0.03     0.04     (0.02 )% 

 

(1) Represents a non-GAAP financial measure. Refer to “Non-GAAP Financial Measures” section for reconciliations to GAAP financial measures.

Comparison of Fiscal Years 2017 and 2016

Net Interest Income

Net interest income is the most significant component of our earnings, comprising 70% of 2017 revenues. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources, and interest rate fluctuations. Other factors include the level of accretion income on purchased loans, prepayment risk on mortgage and investment-related assets, and the composition and maturity of earning assets and interest-bearing liabilities.

Short-term interest rates increased 75 basis points in 2017 as the Federal Reserve increased the discount rate 25 basis points at their March, June, and December meetings. The rate increases were driven by the Federal Reserve’s inflation and wage pressure expectations in conjunction with a moderately expanding economy. The Treasury yield curve flattened as short-term rates rose while long-term interest rates remained flat. Collectively, these factors marginally improved the outlook for our net interest income and margin.

Loans typically generate more interest income than investment securities with similar maturities. Funding from client deposits generally costs less than wholesale funding sources. Factors such as general economic activity, Federal Reserve monetary policy, and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize the mix of assets and funding and the net interest income and margin.

Net interest income is the excess of interest received from earning assets over interest paid on interest-bearing liabilities. For analytical purposes, net interest income is also presented in the table that follows, adjusted to a taxable equivalent basis to reflect what our tax-exempt assets would need to yield in order to achieve the same after-tax yield as a taxable asset. We used the federal statutory tax rate in effect of 35% for all periods. This analysis portrays the income tax benefits associated in tax-exempt assets and helps to facilitate a comparison between taxable and tax-exempt assets. Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully taxable equivalent basis. Therefore, management believes these measures provide useful information for both management and investors by allowing them to make peer comparisons.

 

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Table of Contents
     Years Ended December 31,  

(dollars in thousands)

   2017     2016     2015  

Net interest income

   $ 437,168     $ 402,703     $ 366,116  

Conversion to fully taxable equivalent

     23,091       21,293       19,543  
  

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis

   $ 460,259     $ 423,996     $ 385,659  
  

 

 

   

 

 

   

 

 

 

Average earning assets

   $ 13,237,906     $ 11,840,967     $ 10,363,098  

Net interest margin

     3.30     3.40     3.53

Net interest margin - taxable equivalent basis

     3.48     3.58     3.72

Net interest income was $437.2 million in 2017, a $34.5 million increase from $402.7 million in 2016. Taxable equivalent net interest income was $460.3 million in 2017, a 9% increase from $424.0 million in 2016. The net interest margin on a fully taxable equivalent basis was 3.48% in 2017, a 10 basis point decrease compared to 3.58% in 2016. The increase in net interest income in 2017 when compared to 2016 was primarily due to higher average earning assets of $1.397 billion in 2017. Partially offsetting higher average earning assets were higher average interest bearing liabilities of $1.160 billion and a decrease in accretion income of $17.3 million. Net interest income in both 2017 and 2016 included accretion income (interest income in excess of contractual interest income) associated with acquired loans. Accretion income totaled $40.8 million in 2017, compared to $58.1 million in 2016. We expect accretion income on our PCI loans to decrease over time, but this may be offset by future acquisitions.

With the new 21% statutory federal tax rate, the conversion factor to a fully taxable equivalent basis will decrease in 2018. The decline will have no impact on net income, but will cause the net interest margin on a fully taxable equivalent basis to decrease approximately 9 basis points in 2018.

The following table presents a three-year average balance sheet and for each major asset and liability category, its related interest income and yield, or its expense and rate for the years ended December 31.

 

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     2017     2016     2015  

(tax equivalent basis,

dollars in thousands)

   Average
Balance
    Income/
Expense
     Yield/
Rate
    Average
Balance
    Income/
Expense
     Yield/
Rate
    Average
Balance
    Income/
Expense
     Yield/
Rate
 

Earning Assets

                     

Money market and other interest-earning investments (1)

   $ 35,584     $ 258        0.72   $ 32,697     $ 130        0.40   $ 43,383     $ 47        0.11

Investment securities: (2) U.S. Treasury & government- sponsored agencies (3)

     2,085,317       42,235        2.03       1,968,408       37,381        1.90       1,967,293       36,725        1.87  

States and political subdivisions (4)

     1,134,532       53,359        4.70       1,125,713       53,003        4.71       1,023,983       49,162        4.80  

Other securities

     450,127       11,863        2.64       438,832       10,391        2.37       444,520       10,903        2.45  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

     3,669,976       107,457        2.93       3,532,953       100,775        2.85       3,435,796       96,790        2.82  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Loans (including loans held for sale): (5)

 

                  

Commercial (4)

     2,083,779       85,747        4.11       1,835,317       70,591        3.85       1,754,141       75,900        4.33  

Commercial real estate

     3,426,757       171,483        5.00       2,648,911       150,592        5.69       1,862,055       118,237        6.35  

Residential real estate

     2,146,279       85,340        3.98       1,995,060       80,963        4.06       1,712,636       70,908        4.14  

Consumer

     1,875,531       68,142        3.63       1,796,029       65,376        3.64       1,555,087       56,850        3.66  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total loans

     9,532,346       410,712        4.31       8,275,317       367,522        4.44       6,883,919       321,895        4.68  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

     13,237,906     $ 518,427        3.92     11,840,967     $ 468,427        3.96     10,363,098     $ 418,732        4.04
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Less: Allowance for loan losses

     (50,845          (52,215          (50,538     

Non-Earning Assets

                     

Cash and due from banks

     207,677            192,401            163,275       

Other assets

     1,907,963            1,661,200            1,451,125       
  

 

 

        

 

 

        

 

 

      

Total assets

   $ 15,302,701          $ 13,642,353          $ 11,926,960       
  

 

 

        

 

 

        

 

 

      

Interest-Bearing Liabilities

                     

NOW deposits

     2,676,760     $ 2,224        0.08   $ 2,389,143     $ 1,529        0.06   $ 2,160,019     $ 758        0.04

Savings deposits

     2,964,875       4,980        0.17       2,595,622       3,723        0.14       2,299,357       3,199        0.14  

Money market deposits

     762,540       831        0.11       763,909       840        0.11       677,414       577        0.09  

Time deposits

     1,487,077       12,321        0.83       1,361,647       11,191        0.82       1,063,782       9,634        0.91  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

     7,891,252       20,356        0.26       7,110,321       17,283        0.24       6,200,572       14,168        0.23  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Federal funds purchased and interbank borrowings

     187,426       1,966        1.05       137,997       673        0.49       126,124       265        0.21  

Securities sold under agreements to repurchase

     336,539       1,270        0.38       368,757       1,509        0.41       406,117       1,488        0.37  

Federal Home Loan Bank advances

     1,481,314       24,818        1.68       1,121,413       15,547        1.39       793,703       8,122        1.02  

Other borrowings

     224,793       9,758        4.34       222,708       9,419        4.23       217,978       9,030        4.14  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

   $ 10,121,324     $ 58,168        0.57   $ 8,961,196     $ 44,431        0.50   $ 7,744,494     $ 33,073        0.43
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest-Bearing Liabilities

                     

Demand deposits

     3,111,672            2,776,140            2,500,571       

Other liabilities

     146,060            192,443            200,994       

Shareholders’ equity

     1,923,645            1,712,574            1,480,901       
  

 

 

        

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 15,302,701          $ 13,642,353          $ 11,926,960       
  

 

 

        

 

 

        

 

 

      

Interest Margin Recap

                     

Interest income/average earning assets

     $ 518,427        3.92     $ 468,427        3.96     $ 418,732        4.04

Interest expense/average earning assets

       58,168        0.44         44,431        0.38         33,073        0.32  
    

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

 

Net interest income and margin

     $ 460,259        3.48     $ 423,996        3.58     $ 385,659        3.72
    

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

 

 

(1) The 2017, 2016, and 2015 average balances include $21.2 million, $24.8 million, and $35.2 million, respectively, of required and excess balances held at the Federal Reserve.
(2) Changes in fair value are reflected in the average balance; however, yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.
(3) Includes U.S. government-sponsored entities and agency mortgage-backed securities at December 31, 2017.
(4) Interest on state and political subdivision investment securities and commercial loans includes the effect of taxable equivalent adjustments of $15.6 million and $7.5 million, respectively, in 2017; $15.2 million and $6.1 million, respectively, in 2016; and $13.7 million and $5.9 million, respectively, in 2015; using the federal statutory tax rate in effect of 35% for all periods.
(5) Includes principal balances of nonaccrual loans. Interest income relating to nonaccrual loans is included only if received.

 

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The yield on average earning assets decreased 4 basis points from 3.96% in 2016 to 3.92% in 2017 and the cost of interest-bearing liabilities increased 7 basis points from 0.50% in 2016 to 0.57% in 2017. Average earning assets increased by $1.397 billion, or 12%. The increase in average earning assets consisted of a $1.257 billion increase in loans, a $137.0 million increase in lower yielding investment securities, and a $2.9 million increase in money market and other interest-earning investments. Average interest-bearing liabilities increased $1.160 billion, or 13%. The increase in average interest-bearing liabilities consisted of a $780.9 million increase in interest-bearing deposits, a $49.4 million increase in federal funds purchased and interbank borrowings, a $359.9 million increase in FHLB advances, and a $2.1 million increase in other borrowings, partially offset by a $32.2 million decrease in securities sold under agreements to repurchase. Average noninterest-bearing deposits increased by $335.5 million.

The increase in average earning assets in 2017 compared to 2016 was primarily due to our acquisitions of Anchor (WI) in May 2016 and Anchor (MN) in November 2017. Including loans held for sale, the loan portfolio, which generally has an average yield higher than the investment portfolio, was approximately 72% of average interest earning assets in 2017 compared to 70% in 2016.

Average loans including loans held for sale increased $1.257 billion in 2017 compared to 2016 reflecting loans acquired from Anchor (WI) in May 2016 and Anchor (MN) in November 2017, along with $377.3 million of average organic loan growth. Loans including loans held for sale attributable to the Anchor (WI) acquisition totaled $1.647 billion as of the closing date of the acquisition, which was May 1, 2016. Loans including loans held for sale attributable to the Anchor (MN) acquisition totaled $1.595 billion as of the closing date of the acquisition, which was November 1, 2017.

The increases in average investments and average deposits also reflected the Anchor (WI) and Anchor (MN) acquisitions.

Average non-interest bearing deposits increased $335.5 million in 2017 compared to 2016 reflecting the Anchor (WI) and Anchor (MN) acquisitions. Average interest bearing deposits increased $780.9 million in 2017 compared to 2016 reflecting the Anchor (WI) and Anchor (MN) acquisitions.

Average borrowed funds increased $379.2 million in 2017 compared to 2016 primarily due to increased funding needed as a result of growth in our loan portfolio that outpaced deposit growth.

 

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The following table shows fluctuations in taxable equivalent net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the years ended December 31.

 

     From 2016 to 2017     From 2015 to 2016  
     Total     Attributed to     Total      Attributed to  

(dollars in thousands)

   Change     Volume     Rate     Change      Volume     Rate  

Interest Income

             

Money market and other interest-earning investments

   $ 128     $ 16     $ 112     $ 83      $ (27   $ 110  

Investment securities (1)

     6,682       3,960       2,722       3,985        2,754       1,231  

Loans (1)

     43,190       54,994       (11,804     45,627        63,428       (17,801
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total interest income

     50,000       58,970       (8,970     49,695        66,155       (16,460
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Interest Expense

             

NOW deposits

     695       212       483       771        114       657  

Savings deposits

     1,257       575       682       524        419       105  

Money market deposits

     (9     (1     (8     263        84       179  

Time deposits

     1,130       1,035       95       1,557        2,572       (1,015

Federal funds purchased and interbank borrowings

     1,293       380       913       408        41       367  

Securities sold under agreements to repurchase

     (239     (127     (112     21        (145     166  

Federal Home Loan Bank advances

     9,271       5,510       3,761       7,425        3,948       3,477  

Other borrowings

     339       89       250       389        198       191  
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total interest expense

     13,737       7,673       6,064       11,358        7,231       4,127  
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Net interest income

   $ 36,263     $ 51,297     $ (15,034   $ 38,337      $ 58,924     $ (20,587
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

 

The variance not solely due to rate or volume is allocated equally between the rate and volume variances.

 

(1) Interest on investment securities and loans includes the effect of taxable equivalent adjustments of $15.6 million and $7.5 million, respectively, in 2017; $15.2 million and $6.2 million, respectively, in 2016; and $13.7 million and $5.9 million, respectively, in 2015; using the federal statutory rate in effect of 35% for all periods.

Provision for Loan Losses

The provision for loan losses was an expense of $3.1 million in 2017, compared to an expense of $1.0 million in 2016. Net charge-offs totaled $2.5 million in 2017, compared to net charge-offs of $3.4 million in 2016. The higher provision for loan losses is the result of a change in specific allocations on impaired loans. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense. For additional information about non-performing loans, charge-offs, and additional items impacting the provision, refer to the “Risk Management – Credit Risk” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Noninterest Income

We generate revenues in the form of noninterest income through client fees, sales commissions, and other gains and losses from our core banking franchise and other related businesses, such as wealth management, investment consulting, and investment products. This source of revenue as a percentage of total revenue was 30% in 2017 compared to 39% in 2016.

 

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The following table details the components of noninterest income for the years ended December 31.

 

     Years Ended December 31,     % Change From
Prior Year
 

(dollars in thousands)

   2017     2016     2015     2017     2016  

Wealth management fees

   $ 37,316     $ 34,641     $ 34,395       7.7     0.7

Service charges on deposit accounts

     41,331       41,578       43,372       (0.6     (4.1

Debit card and ATM fees

     17,676       16,769       21,340       5.4       (21.4

Mortgage banking revenue

     18,449       20,240       12,540       (8.8     61.4  

Insurance premiums and commissions

     617       20,527       42,714       (97.0     (51.9

Investment product fees

     20,977       18,822       17,924       11.4       5.0  

Capital markets income

     6,544       3,227       1,082       102.8       198.2  

Company-owned life insurance

     8,654       8,479       8,604       2.1       (1.5

Net securities gains (losses)

     9,135       5,848       5,718       56.2       2.3  

Recognition of deferred gain on sale leaseback transactions

     2,080       16,057       16,444       (87.0     (2.4

Gain on sale of ONB Insurance Group, Inc.

     —         41,864       —         (100.0     N/M  

Net gain on branch divestitures

     —         —         15,627       N/M       (100.0

Change in FDIC indemnification asset

     —         233       (9,034     (100.0     (102.6

Other income

     20,603       24,545       19,906       (16.1     23.3  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 183,382     $ 252,830     $ 230,632       (27.5 )%      9.6
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Noninterest income to total revenue (1)

     28.5     37.4     37.4    

 

(1) Total revenue includes the effect of a taxable equivalent adjustment of $23.1 million in 2017, $21.3 million in 2016, and $19.5 million in 2015.

N/M = Not meaningful

The decrease in noninterest income in 2017 when compared to 2016 was primarily due to a pre-tax gain of $41.9 million resulting from the sale of ONI in May 2016, lower insurance premiums and commissions, and lower recognition of deferred gain on sale leaseback transactions.

Wealth management fees increased $2.7 million in 2017 compared to 2016 reflecting market appreciation and strong sales production.

Service charges and overdraft fees decreased $0.2 million in 2017 compared to 2016 primarily due to lower overdraft charges, partially offset by higher service charges and overdraft fees attributable to the Anchor (WI) and Anchor (MN) acquisitions.

Mortgage banking revenue decreased $1.8 million in 2017 compared to 2016 primarily due to the industry-wide reduction in refinance activity and higher interest rates in 2017.

Insurance premiums and commissions decreased $19.9 million in 2017 reflecting the sale of ONI in May 2016.

Investment product fees increased $2.2 million in 2017 compared to 2016 primarily due to higher investment product fees attributable to the Anchor (WI) and Anchor (MN) acquisitions.

Capital markets income is comprised of customer interest rate swap fees, foreign currency exchange fees, and net gains (losses) on foreign currency adjustments. Capital markets income increased $3.3 million in 2017 compared to 2016 primarily due to higher customer interest rate swap fees resulting from strong commercial loan production during 2017.

Net securities gains increased $3.3 million in 2017 compared to 2016 primarily due to higher realized gains on sales of available-for-sale securities in 2017.

Recognition of deferred gain on sale leaseback transactions decreased $14.0 million in 2017 compared to 2016. Old National purchased 23 properties during 2016 that it had previously leased, resulting in the recognition of approximately $12.0 million of pre-tax deferred gains.

 

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In 2016, we recorded a $41.9 million pre-tax gain resulting from the sale of ONI in May 2016. The after-tax gain related to the sale totaled $17.6 million.

Other income decreased $3.9 million in 2017 when compared to 2016 reflecting lower recoveries on loans originated by AnchorBank (WI) that had been fully charged off prior to the acquisition. Recoveries on loans originated by AnchorBank (WI) totaled $4.0 million in 2017, compared to $7.6 million in 2016.

Noninterest Expense

The following table details the components of noninterest expense for the years ended December 31.

 

     Years Ended December 31,      % Change From
Prior Year
 

(dollars in thousands)

   2017      2016      2015      2017     2016  

Salaries and employee benefits

   $ 246,738      $ 252,892      $ 243,875        (2.4 )%      3.7

Occupancy

     46,511        50,947        53,239        (8.7     (4.3

Equipment

     13,560        13,448        13,183        0.8       2.0  

Marketing

     13,172        14,620        10,410        (9.9     40.4  

Data processing

     32,306        32,002        27,309        0.9       17.2  

Communication

     9,284        9,959        9,586        (6.8     3.9  

Professional fees

     16,840        15,705        11,756        7.2       33.6  

Loan expense

     6,596        7,632        6,373        (13.6     19.8  

Supplies

     2,406        2,865        2,275        (16.0     25.9  

FDIC assessment

     9,480        8,681        7,503        9.2       15.7  

Other real estate owned expense

     3,376        4,195        2,703        (19.5     55.2  

Amortization of intangibles

     11,841        12,486        11,746        (5.2     6.3  

Amortization of tax credit investments

     11,733        —          —          N/M       N/M  

Other expense

     24,993        28,715        30,974        (13.0     (7.3
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expense

   $ 448,836      $ 454,147      $ 430,932        (1.2 )%      5.4
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

N/M = Not meaningful

Noninterest expense decreased $5.3 million in 2017 when compared to 2016 primarily due to the reduction of costs associated with the divestiture of ONI in May 2016. Offsetting these decreases was $11.7 million of amortization of tax credit investments in 2017. In addition, noninterest expense in 2017 included $12.3 million of acquisition and integration costs associated with Anchor (MN), compared to $15.9 million in 2016 of acquisition and integration costs associated with Anchor (WI).

Salaries and benefits is the largest component of noninterest expense. Salaries and benefits decreased $6.2 million in 2017 compared to 2016. Impacting salaries and benefits expense were the acquisitions of Anchor (WI) and Anchor (MN), and the divestiture of ONI described above. Also contributing to the decrease in salaries and benefits were lower pension expenses of $11.9 million in 2017 reflecting the termination of Old National’s Retirement Plan effective May 15, 2016. The decreases were partially offset by higher incentive compensation in 2017.

Occupancy expenses decreased $4.4 million in 2017 compared to 2016 primarily due to 29 banking center consolidations in 2017. The decrease was partially offset by higher occupancy expenses attributable to the Anchor (WI) and Anchor (MN) acquisitions.

Marketing expense decreased $1.4 million in 2017 compared to 2016 primarily due to lower public relations expense.

Professional fees increased $1.1 million in 2017 compared to 2016 primarily due to $3.5 million in pre-tax expenses recorded in 2017 related to a client-experience improvement initiative currently in process at Old National. Upon completion of this initiative, Old National expects the costs incurred to considerably improve how we serve our clients and increase efficiency in 2018. The increase was partially offset by lower professional fees related to acquisition and integration costs associated with Anchor (WI).

Amortization of tax credit investments was $11.7 million in 2017 reflecting the completion of several investment tax credit projects during the fourth quarter of 2017. There was no amortization related to tax credit investments recorded in noninterest expense in 2016. See Note 16 to the consolidated financial statements for additional information on our tax credit investments.

 

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Other expense decreased $3.7 million in 2017 compared to 2016 primarily due to lower charitable contributions of $2.7 million and lower impairments of long-lived assets of $1.6 million.

Provision for Income Taxes

We record a provision for income taxes currently payable and for income taxes payable or benefits to be received in the future, which arise due to timing differences in the recognition of certain items for financial statement and income tax purposes. The major difference between the effective tax rate applied to our financial statement income and the federal statutory tax rate is caused by interest on tax-exempt securities and loans. The effective tax rate was 43.3% in 2017 compared to 33.0% in 2016. The higher effective tax rate in 2017 when compared to 2016 is the result of $39.3 million of additional tax expense to estimate the revaluation of deferred tax assets due to the lowering of the federal corporate tax rate to 21%, partially offset by an increase in federal tax credits available. See Note 16 to the consolidated financial statements for additional details on Old National’s income tax provision.

Comparison of Fiscal Years 2016 and 2015

In 2016, we generated net income of $134.3 million and diluted net income per share of $1.05 compared to $116.7 million and diluted net income per share of $1.00, respectively, in 2015. The 2016 earnings included a $36.6 million increase in net interest income, a $1.9 million decrease in provision for loan losses, and a $22.2 million increase in noninterest income. These increases to net income were partially offset by a $23.2 million increase in noninterest expense and a $20.0 million increase in income tax expense. The successful conversion and integration of our acquisition of Anchor (WI) in 2016, strong loan growth, and consistently low credit metrics all contributed to positive 2016 performance when compared to 2015.

Net interest income was $402.7 million in 2016, a $36.6 million increase from $366.1 million in 2015. Taxable equivalent net interest income was $424.0 million in 2016, a 10% increase from $385.7 million in 2015. The net interest margin on a fully taxable equivalent basis was 3.58% in 2016, a 14 basis point decrease compared to 3.72% in 2015. Average earning assets increased by $1.478 billion during 2016 and the yield on average earning assets decreased 8 basis points from 4.04% in 2015 to 3.96% in 2016. Average interest-bearing liabilities increased $1.217 billion and the cost of interest-bearing liabilities increased from 0.43% in 2015 to 0.50% in 2016.

The provision for loan losses was an expense of $1.0 million in 2016, compared to an expense of $2.9 million in 2015. Charge-offs remained low during 2016 and we continued to see positive trends in credit quality.

Noninterest income was $252.8 million in 2016, an increase of $22.2 million, or 10%, compared to $230.6 million in 2015. The increase in noninterest income in 2016 was primarily due to a pre-tax gain of $41.9 million resulting from the sale of ONI in May 2016 and noninterest income attributable to the Anchor (WI) acquisition. The increase in noninterest income was partially offset by a $15.6 million gain on branch divestitures in the third quarter of 2015 and lower insurance premiums and commissions resulting from the sale on ONI.

Noninterest expense totaled $454.1 million in 2016, an increase of $23.2 million, or 5%, from $430.9 million in 2015. Noninterest expense during 2016 was impacted by our transition into the higher growth markets in Wisconsin, the divestitures of our Illinois franchise and our insurance business, and other branch restructuring during 2015. Also contributing to the increase in noninterest expense was a pension plan settlement loss of $9.8 million resulting from the termination of the Employee Retirement Plan in 2016.

The provision for income taxes was $66.2 million in 2016 compared to $46.2 million in 2015. Old National’s effective tax rate was 33.0% in 2016 compared to 28.3% in 2015. The higher effective tax rate in 2016 when compared to 2015 was primarily the result of the sale of ONI in May 2016 and the associated tax expense of $8.3 million to record a deferred tax liability relating to ONI’s nondeductible goodwill.

 

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FINANCIAL CONDITION

Overview

At December 31, 2017, our assets were $17.518 billion, an 18% increase compared to $14.860 billion at December 31, 2016. The increase was primarily due to the acquisition of Anchor (MN) in November 2017, which had $2.222 billion in assets as of the closing date of the acquisition.

Earning Assets

Our earning assets are comprised of investment securities, portfolio loans, loans held for sale, money market investments, interest earning accounts with the Federal Reserve, and trading securities. Earning assets were $15.209 billion at December 31, 2017, an increase of 19% compared to $12.796 billion at December 31, 2016.

Investment Securities

We classify the majority of our investment securities as available-for-sale to give management the flexibility to sell the securities prior to maturity if needed, based on fluctuating interest rates or changes in our funding requirements. However, we also have $6.9 million of fixed-rate mortgage-backed securities and $677.2 million of state and political subdivision securities in our held-to-maturity investment portfolio at December 31, 2017.

Trading securities, which consist of mutual funds held in trusts associated with deferred compensation plans for former directors and executives, are recorded at fair value and totaled $5.6 million at December 31, 2017, compared to $5.0 million at December 31, 2016.

At December 31, 2017, the investment securities portfolio, including trading securities, was $4.006 billion compared to $3.649 billion at December 31, 2016, an increase of $356.6 million, or 10%. Investment securities attributable to the Anchor (MN) acquisition totaled $308.8 million as of the closing date of the acquisition. Investment securities represented 26% of earning assets at December 31, 2017, compared to 29% at December 31, 2016. Investment securities decreased as a percentage of total earning assets due to a proportionately larger increase in loan balances. Stronger commercial loan demand in the future and management’s decision to deleverage the balance sheet could result in a reduction in the securities portfolio. As of December 31, 2017, management does not intend to sell any securities in an unrealized loss position and does not believe we will be required to sell such securities.

The investment securities available-for-sale portfolio had net unrealized losses of $56.4 million at December 31, 2017, compared to net unrealized losses of $61.5 million at December 31, 2016. Net unrealized losses decreased from December 31, 2016 to December 31, 2017 primarily due to the effect of a decrease in long-term interest rates on municipal bonds.

The investment portfolio had an effective duration of 4.15 at December 31, 2017, compared 4.61 at December 31, 2016. Effective duration measures the percentage change in value of the portfolio in response to a change in interest rates. Generally, there is more uncertainty in interest rates over a longer average maturity, resulting in a higher duration percentage. The weighted average yields on available-for-sale investment securities were 2.43% in 2017 and 2.44% in 2016. The average yields on the held-to-maturity portfolio were 5.44% in 2017 and 5.35% in 2016.

At December 31, 2017, Old National had a concentration of investment securities issued by certain states and their political subdivisions with the following aggregate market values: $375.1 million by Indiana, which represented 17.4% of shareholders’ equity, and $182.7 million by Texas, which represented 8.5% of shareholders’ equity. Of the Indiana municipal bonds, 98% are rated “A” or better, and the remaining 2% generally represent non-rated local interest bonds where Old National has a market presence. All of the Texas municipal bonds are rated “AA” or better, and the majority of issues are backed by the “AAA” rated State of Texas Permanent School Fund Guarantee Program.

Loan Portfolio

We lend primarily to consumers and small to medium-sized commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling, and retailing. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Kentucky, Michigan, Wisconsin, and Minnesota.

 

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The following table presents the composition of the loan portfolio at December 31.

 

(dollars in thousands)

   2017      2016      2015      2014      2013      Four-Year
Growth Rate
 

Commercial

   $ 2,717,269      $ 1,917,099      $ 1,814,940      $ 1,646,767      $ 1,402,750        18.0

Commercial real estate

     4,354,552        3,130,853        1,868,972        1,751,907        1,242,818        36.8  

Consumer

     1,879,247        1,875,030        1,603,158        1,379,117        1,049,974        15.7  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans excluding residential real estate

     8,951,068        6,922,982        5,287,070        4,777,791        3,695,542        24.8  

Residential real estate

     2,167,053        2,087,530        1,661,335        1,540,410        1,387,422        11.8  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

     11,118,121        9,010,512        6,948,405        6,318,201        5,082,964        21.6
                 

 

 

 

Less: Allowance for loan losses

     50,381        49,808        52,233        47,849        47,145     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

Net loans

   $ 11,067,740      $ 8,960,704      $ 6,896,172      $ 6,270,352      $ 5,035,819     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

Commercial and Commercial Real Estate Loans

At December 31, 2017, commercial and commercial real estate loans were $7.072 billion, an increase of $2.024 billion, or 40%, compared to December 31, 2016. Commercial and commercial real estate loans attributable to the Anchor (MN) acquisition totaled $1.516 billion as of the closing date of the acquisition. Excluding these acquired loans, commercial and commercial real estate loans grew 10% in 2017.

The following table presents the maturity distribution and rate sensitivity of commercial loans at December 31, 2017 and an analysis of these loans that have predetermined and floating interest rates.

 

(dollars in thousands)    Within
1 Year
     1 - 5 Years      Beyond
5 Years
     Total      % of
Total
 

Interest rates:

              

Predetermined

   $ 154,147      $ 649,772      $ 606,103      $ 1,410,022        52

Floating

     688,557        408,632        210,058        1,307,247        48  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 842,704      $ 1,058,404      $ 816,161      $ 2,717,269        100
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Residential Real Estate Loans

Residential real estate loans, primarily 1-4 family properties, increased $79.5 million, or 4%, at December 31, 2017 compared to December 31, 2016. Residential real estate loans attributable to the Anchor (MN) acquisition totaled $34.0 million as of the closing date of the acquisition. Future increases in interest rates could result in a decline in the level of refinancings and new originations of residential real estate loans.

Consumer Loans

Consumer loans, including automobile loans, personal and home equity loans and lines of credit, and student loans, increased $4.2 million at December 31, 2017 compared to December 31, 2016. Consumer loans attributable to the Anchor (MN) acquisition totaled $43.9 million as of the closing date of the acquisition. We continue to see runoff in our less profitable indirect consumer loan portfolio.

Allowance for Loan Losses

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses incurred in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. Additional information about our Allowance for Loan Losses is included in the “Risk Management – Credit Risk” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Notes 1 and 5 to the consolidated financial statements.

 

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At December 31, 2017, the allowance for loan losses was $50.4 million, an increase of $0.6 million compared to $49.8 million at December 31, 2016. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense. As a percentage of total loans excluding loans held for sale, the allowance was 0.45% at December 31, 2017, compared to 0.55% at December 31, 2016. The decrease in the percentage from December 31, 2016 is primarily a result of the addition of the Anchor (MN) $1.594 billion loan portfolio. In accordance with ASC 805, no allowance for loan losses is recorded at the date of acquisition and a reserve is only established to absorb any subsequent credit deterioration or adverse changes in expected cash flows. The provision for loan losses was an expense of $3.1 million in 2017 compared to an expense of $1.0 million in 2016.

For commercial loans, the allowance for loan losses decreased by $2.2 million at December 31, 2017 compared to December 31, 2016. The allowance for loan losses as a percentage of the commercial loan portfolio decreased to 0.71% at December 31, 2017, from 1.12% at December 31, 2016. The lower allowance for loan losses as a percentage of the commercial loan portfolio is primarily the result of a change in the mix between acquired and originated loans and lower loss ratios.

For commercial real estate loans, the allowance for loan losses increased by $3.3 million at December 31, 2017 compared to December 31, 2016. The allowance for loan losses as a percentage of the commercial real estate loan portfolio decreased to 0.49% at December 31, 2017, from 0.58% at December 31, 2016. The lower allowance for loan losses as a percentage of the commercial real estate loan portfolio is the result of the increase in purchased loans that were recorded at fair value and improved asset quality. The fair value adjustment considers credit impairment resulting in no need for an allowance for loan losses at the date of acquisition. An allowance may be recorded in future periods if the loan experiences subsequent deterioration. See the discussion in the section “Asset Quality” for additional details.

The allowance for loan losses for residential real estate loans as a percentage of that portfolio was 0.08% at December 31, 2017 and 2016. The allowance for loan losses for consumer loans as a percentage of that portfolio decreased to 0.42% at December 31, 2017, from 0.45% at December 31, 2016.

Allowance for Losses on Unfunded Commitments

We maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. This allowance is classified as a liability on the balance sheet within accrued expenses and other liabilities, while the corresponding provision for these loan losses is recorded as a component of other expense. The allowance for losses on unfunded commitments was $3.1 million at December 31, 2017, compared to $3.2 million at December 31, 2016.

Loans Held for Sale

Mortgage loans held for immediate sale in the secondary market were $17.9 million at December 31, 2017, compared to $90.7 million at December 31, 2016. The decrease is primarily due to a decline in mortgage production resulting from higher rates and the timing of sales. Certain mortgage loans are committed for sale at or prior to origination at a contracted price to an outside investor. Other mortgage loans held for immediate sale are hedged with TBA forward agreements and committed for sale when they are ready for delivery and remain on the Company’s balance sheet for a short period of time (typically 30 to 60 days). These loans are sold without recourse, beyond customary representations and warranties, and Old National has not experienced material losses arising from these sales. Mortgage originations are subject to volatility due to interest rates and home sales, among other factors.

We have elected the fair value option under FASB ASC 825-10 prospectively for residential loans held for sale. The aggregate fair value exceeded the unpaid principal balance by $0.5 million as of December 31, 2017, compared to $0.1 million as of December 31, 2016.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets at December 31, 2017 totaled $881.1 million, an increase of $188.4 million compared to $692.7 million at December 31, 2016. During 2017, we recorded $200.3 million of goodwill and other intangible assets associated with the acquisition of Anchor (MN).

 

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Net Deferred Tax Assets

Net deferred tax assets decreased $71.0 million since December 31, 2016 primarily due to an estimated revaluation of our deferred tax assets due to the enactment of the Tax Cuts and Jobs Act (“H.R. 1”), which lowered the federal corporate tax rate to 21%. Under ASC 740, the effects of changes in tax rates and laws are recognized in the period in which the new legislation is enacted. Accordingly, Old National has recorded an estimated $39.3 million for the revaluation of Old National’s deferred tax assets. Shortly after the enactment date, the SEC issued Staff Accounting Bulletin (“SAB”) 118, which addresses the situations where the accounting for changes in tax laws is complete, incomplete but can be reasonably estimated, and incomplete and cannot be reasonably estimated. SAB 118 also permits a measurement period of up to one year from the date of enactment to refine the provisional accounting. Old National continues to analyze H.R. 1, including the impact on alternative minimum tax credits, as well as the acquisition accounting of Anchor (MN), and expects any refinements to the provisional accounting to be complete in 2018. Future decreases in the corporate tax rate could result in a loss in value of Old National’s deferred tax assets, but would reduce future income tax expense. See Note 16 to the consolidated financial statements for additional information.

Other Assets

Other assets increased $39.3 million, or 34%, since December 31, 2016 primarily due to an increase in various tax credit investments and higher accrued income taxes.

Funding

Total funding, comprised of deposits and wholesale borrowings, was $15.184 billion at December 31, 2017, an increase of $2.289 billion from $12.895 billion at December 31, 2016. Total deposits were $12.606 billion, including $10.971 billion in transaction accounts and $1.634 billion in time deposits at December 31, 2017. Total deposits increased $1.863 billion, or 17%, compared to December 31, 2016. Deposits attributable to the Anchor (MN) acquisition totaled $1.777 billion as of the closing date of the acquisition. Noninterest-bearing demand deposits increased $664.7 million from December 31, 2016 to December 31, 2017. NOW deposits increased $519.2 million from December 31, 2016 to December 31, 2017, while savings deposits increased $80.9 million. Money market deposits increased $431.3 million from December 31, 2016 to December 31, 2017, while time deposits increased $166.3 million.

We use wholesale funding to augment deposit funding and to help maintain our desired interest rate risk position. At December 31, 2017, wholesale borrowings, including federal funds purchased and interbank borrowings, securities sold under agreements to repurchase, FHLB advances, and other borrowings, totaled $2.578 billion, an increase of $426.1 million, or 20%, from December 31, 2016. The increase in wholesale funding from December 31, 2016 to December 31, 2017 was primarily due to an increase in FHLB advances and federal funds purchased and interbank borrowings. Wholesale funding as a percentage of total funding was 17% at December 31, 2017 and 2016. See Notes 12, 13, and 14 to the consolidated financial statements for additional details on our financing activities.

 

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The following table details the average balances of all funding sources for the years ended December 31.

 

                          % Change From
Prior Year
 

(dollars in thousands)

   2017      2016      2015      2017     2016  

Demand deposits

   $ 3,111,672      $ 2,776,140      $ 2,500,571        12.1     11.0

NOW deposits

     2,676,760        2,389,143        2,160,019        12.0       10.6  

Savings deposits

     2,964,875        2,595,622        2,299,357        14.2       12.9  

Money market deposits

     762,540        763,909        677,414        (0.2     12.8  

Time deposits

     1,487,077        1,361,647        1,063,782        9.2       28.0  
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total deposits

     11,002,924        9,886,461        8,701,143        11.3       13.6  

Federal funds purchased and interbank borrowings

     187,426        137,997        126,124        35.8       9.4  

Securities sold under agreements to repurchase

     336,539        368,757        406,117        (8.7     (9.2

Federal Home Loan Bank advances

     1,481,314        1,121,413        793,703        32.1       41.3  

Other borrowings

     224,793        222,708        217,978        0.9       2.2  
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total funding sources

   $ 13,232,996      $ 11,737,336      $ 10,245,065        12.7     14.6
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

The following table presents a maturity distribution for certificates of deposit with denominations of $100,000 or more at December 31.

 

            Maturity Distribution  
     Year-End      1-90      91-180      181-365      Beyond  

(dollars in thousands)

   Balance      Days      Days      Days      1 Year  

2017

   $ 727,496      $ 265,872      $ 109,584      $ 171,877      $ 180,163  

2016

     544,803        142,806        91,704        115,151        195,142  

2015

     303,759        56,273        28,657        86,625        132,204  

Accrued Expenses and Other Liabilities

Accrued expenses and other liabilities increased $29.4 million, or 20%, from December 31, 2016 primarily due an increase in unfunded commitments on various tax credit investments.

Capital

Shareholders’ equity totaled $2.154 billion, or 12% of total assets, at December 31, 2017 and $1.814 billion, or 12% of total assets, at December 31, 2016. Shareholders’ equity at December 31, 2017 included $300.8 million from the 16.5 million shares of Common Stock that were issued in conjunction with the acquisition of Anchor (MN). We paid cash dividends of $0.52 per share in 2017, which reduced equity by $72.6 million. Shares issued for reinvested dividends, stock options, restricted stock, and stock compensation plans increased shareholders’ equity by $6.9 million in 2017. Old National’s Common Stock is traded on the NASDAQ under the symbol “ONB” with 43,684 shareholders of record at December 31, 2017.

Capital Adequacy

Old National and the banking industry are subject to various regulatory capital requirements administered by the federal banking agencies. Management routinely analyzes Old National’s capital to ensure an optimized capital structure. Accordingly, such evaluations may result in Old National taking a capital action. For additional information on capital adequacy see Note 24 to the consolidated financial statements.

The Dodd-Frank Act requires bank holding companies and any subsidiary banks with consolidated assets of more than $10 billion and less than $50 billion, including Old National, to complete and publicly disclose annual stress tests. The objective of the stress test is to ensure that the financial institution has capital planning processes that account for its unique risks, and to help ensure that the institution has sufficient capital to continue operations throughout times of economic and financial stress. The stress tests are conducted with baseline, adverse, and severely adverse economic scenarios. Old National completed its annual stress test that covered a nine-quarter

 

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planning horizon beginning January 1, 2017 and ending on March 31, 2019 and publicly disclosed a summary of the stress test results on October 24, 2017. The stress test showed that Old National would maintain capital levels well above the regulatory guideline minimum levels for all periods and under all stress test scenarios.

RISK MANAGEMENT

Overview

Old National has adopted a Risk Appetite Statement to enable the Board of Directors, Executive Leadership Group, and Senior Management to better assess, understand, and mitigate the risks of Old National. The Risk Appetite Statement addresses the following major risks: strategic, market, liquidity, credit, operational/technology, regulatory/compliance/legal, reputational, and human resources. Our Chief Risk Officer is independent of management and reports directly to the Chair of the Board’s Enterprise Risk Management Committee. The following discussion addresses three of these major risks: credit, market, and liquidity.

Credit Risk

Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. Our primary credit risks result from our investment and lending activities.

Investment Activities

We carry a higher exposure to loss in our pooled trust preferred securities, which are collateralized debt obligations, due to illiquidity in that market and the performance of the underlying collateral. At December 31, 2017, we had pooled trust preferred securities with a fair value of $8.4 million, or less than 1% of the available-for-sale securities portfolio. These securities remained classified as available-for-sale and at December 31, 2017, the unrealized loss on our pooled trust preferred securities was approximately $8.2 million. The fair value of these securities should improve as we get closer to maturity. There was no OTTI recorded in 2017 or 2016.

All of our mortgage-backed securities are backed by U.S. government-sponsored or federal agencies. Municipal bonds, corporate bonds, and other debt securities are evaluated by reviewing the credit-worthiness of the issuer and general market conditions. See Note 3 to the consolidated financial statements for additional details about our investment security portfolio.

Counterparty Exposure

Counterparty exposure is the risk that the other party in a financial transaction will not fulfill its obligation. We define counterparty exposure as nonperformance risk in transactions involving federal funds sold and purchased, repurchase agreements, correspondent bank relationships, and derivative contracts with companies in the financial services industry. Old National manages exposure to counterparty risk in connection with its derivatives transactions by generally engaging in transactions with counterparties having ratings of at least A by Standard & Poor’s Rating Service or A2 by Moody’s Investors Service. Total credit exposure is monitored by counterparty, and managed within limits that management believes to be prudent. Old National’s net counterparty exposure was an asset of $182.3 million at December 31, 2017.

Lending Activities

Commercial

Commercial and industrial loans are made primarily for the purpose of financing equipment acquisition, expansion, working capital, and other general business purposes. Lease financing consists of direct financing leases and are used by commercial customers to finance capital purchases ranging from computer equipment to transportation equipment. The credit decisions for these transactions are based upon an assessment of the overall financial capacity of the applicant. A determination is made as to the applicant’s ability to repay in accordance with the proposed terms as well as an overall assessment of the risks involved. In addition to an evaluation of the applicant’s financial condition, a determination is made of the probable adequacy of the primary and secondary sources of repayment, such as additional collateral or personal guarantees, to be relied upon in the transaction. Credit agency reports of the applicant’s credit history supplement the analysis of the applicant’s creditworthiness.

 

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Commercial mortgages and construction loans are offered to real estate investors, developers, and builders primarily domiciled in the geographic market areas we serve: Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. These loans are secured by first mortgages on real estate at LTV margins deemed appropriate for the property type, quality, location, and sponsorship. Generally, these LTV ratios do not exceed 80%. The commercial properties are predominantly non-residential properties such as retail centers, apartments, industrial properties and, to a lesser extent, more specialized properties. Substantially all of our commercial real estate loans are secured by properties located in our primary market area.

In the underwriting of our commercial real estate loans, we obtain appraisals for the underlying properties. Decisions to lend are based on the economic viability of the property and the creditworthiness of the borrower. In evaluating a proposed commercial real estate loan, we primarily emphasize the ratio of the property’s projected net cash flows to the loan’s debt service requirement. The debt service coverage ratio normally is not less than 120% and it is computed after deduction for a vacancy factor and property expenses as appropriate. In addition, a personal guarantee of the loan or a portion thereof is often required from the principal(s) of the borrower. In most cases, we require title insurance insuring the priority of our lien, fire, and extended coverage casualty insurance, and flood insurance, if appropriate, in order to protect our security interest in the underlying property. In addition, business interruption insurance or other insurance may be required.

Construction loans are underwritten against projected cash flows derived from rental income, business income from an owner-occupant, or the sale of the property to an end-user. We may mitigate the risks associated with these types of loans by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements.

Consumer

We offer a variety of first mortgage and junior lien loans to consumers within our markets, with residential home mortgages comprising our largest consumer loan category. These loans are secured by a primary residence and are underwritten using traditional underwriting systems to assess the credit risks of the consumer. Decisions are primarily based on LTV ratios, DTI ratios, liquidity, and credit scores. A maximum LTV ratio of 80% is generally required, although higher levels are permitted with mortgage insurance or other mitigating factors. We offer fixed rate mortgages and variable rate mortgages with interest rates that are subject to change every year after the first, third, fifth, or seventh year, depending on the product and are based on fully-indexed rates such as LIBOR. We do not offer payment-option facilities, sub-prime loans, or any product with negative amortization.

Home equity loans are secured primarily by second mortgages on residential property of the borrower. The underwriting terms for the home equity product generally permits borrowing availability, in the aggregate, up to 90% of the appraised value of the collateral property at the time of origination. We offer fixed and variable rate home equity loans, with variable rate loans underwritten at fully-indexed rates. Decisions are primarily based on LTV ratios, DTI ratios, and credit scores. We do not offer home equity loan products with reduced documentation.

Automobile loans include loans and leases secured by new or used automobiles. We originate automobile loans and leases primarily on an indirect basis through selected dealerships. We require borrowers to maintain collision insurance on automobiles securing consumer loans, with us listed as loss payee. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity, including credit history and the ability to meet existing obligations and payments on the proposed loan. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount.

We assumed student loans in the acquisition of Anchor (WI) in May 2016. Student loans are guaranteed by the government from 97% to 100% and totaled $68.2 million at December 31, 2017, compared to $77.1 million at December 31, 2016.

Asset Quality

Community-based lending personnel, along with region-based independent underwriting and analytic support staff, extend credit under guidelines established and administered by our Enterprise Risk Committee. This committee, which meets quarterly, is made up of outside directors. The committee monitors credit quality through its review of information such as delinquencies, credit exposures, peer comparisons, problem loans, and charge-offs. In addition, the committee reviews and approves recommended loan policy changes to assure it remains appropriate for the current lending environment.

 

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We lend primarily to small- and medium-sized commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling, and retailing. Old National manages concentrations of credit exposure by industry, product, geography, customer relationship, and loan size, with no concentration of loans exceeding 10% of its portfolio. At December 31, 2017, we had minimal exposure to foreign borrowers and no sovereign debt. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. We are experiencing a slow and gradual improvement in the economy of our principal markets. Management expects that trends in under-performing, criticized, and classified loans will be influenced by the degree to which the economy strengthens or weakens.

On November 1, 2017, Old National closed on its acquisition of Anchor (MN). As of the closing date of the acquisition, loans totaled $1.594 billion and other real estate owned totaled $1.1 million. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition date. Old National reviewed the acquired loans and determined that as of December 31, 2017, $47.0 million met the definition of criticized and $26.3 million were considered classified (of which $15.4 million are reported with nonaccrual loans). Our current preference would be to work these loans and avoid foreclosure actions unless additional credit deterioration becomes apparent. These acquired impaired loans, along with $1.1 million of other real estate owned, are included in our summary of under-performing, criticized, and classified assets found below.

 

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Summary of under-performing, criticized, and classified assets at December 31:

 

(dollars in thousands)

   2017     2016     2015     2014     2013  

Nonaccrual loans:

          

Commercial

   $ 27,202     $ 56,585     $ 57,536     $ 38,460     $ 28,635  

Commercial real estate

     62,425       44,026       47,350       67,402       52,363  

Residential real estate

     22,171       17,674       14,953       13,968       10,333  

Consumer

     13,129       13,122       5,198       5,903       5,318  

Covered loans (1)

     —         —         7,336       15,124       31,793  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonaccrual loans (2)

     124,927       131,407       132,373       140,857       128,442  

Renegotiated loans not on nonaccrual:

          

Noncovered loans

     19,589       14,376       14,147       12,710       15,596  

Covered loans (1)

     —         —         138       148       148  

Past due loans (90 days or more and still accruing):

          

Commercial

     144       23       565       33       —    

Commercial real estate

     —         —         —         138       —    

Residential real estate

     —         2       114       1       35  

Consumer

     750       303       227       286       189  

Covered loans (1)

     —         —         10       —         14  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total past due loans

     894       328       916       458       238  

Other real estate owned

     8,810       18,546       7,594       7,241       7,562  

Other real estate owned, covered (1)

     —         —         4,904       9,121       13,670  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total under-performing assets

   $ 154,220     $ 164,657     $ 160,072     $ 170,535     $ 165,656  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Classified loans (includes nonaccrual, renegotiated, past due 90 days, and other problem loans)

   $ 226,583     $ 220,429     $ 204,710     $ 233,486     $ 159,783  

Classified loans, covered (1)

     —         —         8,584       17,413       35,500  

Other classified assets (3)

     4,556       7,063       6,857       14,752       32,650  

Criticized loans

     188,085       95,462       132,898       194,809       135,401  

Criticized loans, covered (1)

     —         —         1,449       4,525       8,421  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total criticized and classified assets

   $ 419,224     $ 322,954     $ 354,498     $ 464,985     $ 371,755  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Asset Quality Ratios including covered assets:

          

Non-performing loans/total loans (4) (5)

     1.30     1.62     2.11     2.43     2.84

Under-performing assets/total loans and other real estate owned (4)

     1.39       1.82       2.30       2.69       3.25  

Under-performing assets/total assets

     0.88       1.11       1.33       1.46       1.73  

Allowance for loan losses/ under-performing assets (6)

     32.67       30.25       32.63       28.06       28.46  

Allowance for loan losses/nonaccrual loans (2)

     40.33       37.90       39.46       33.97       36.71  

 

(1) Old National entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans, and other real estate owned. On June 22, 2016, Old National entered into an early termination agreement with the FDIC that terminated all loss share agreements. Old National reclassified all covered assets to noncovered assets effective June 22, 2016.
(2) Includes approximately $12.6 million, $16.7 million, $15.9 million, $41.2 million, and $38.3 million for 2017, 2016, 2015, 2014, and 2013, respectively, of purchased credit impaired loans that are categorized as nonaccrual because the collection of principal or interest is doubtful. These loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.
(3) Includes 2 pooled trust preferred securities, 1 municipal security, and 1 insurance policy at December 31, 2017.
(4) Loans exclude loans held for sale.
(5) Non-performing loans include nonaccrual and renegotiated loans.
(6) Because the acquired loans were recorded at fair value in accordance with ASC 805 at the date of acquisition, the credit risk is incorporated in the fair value recorded. No allowance for loan losses is recorded on the acquisition date.

Under-performing assets totaled $154.2 million at December 31, 2017, compared to $164.7 million at December 31, 2016. Under-performing assets as a percentage of total loans and other real estate owned at December 31, 2017 were 1.39%, a 43 basis point improvement from 1.82% at December 31, 2016.

Nonaccrual loans decreased $6.5 million from December 31, 2016 to December 31, 2017 primarily due to a decrease in nonaccrual commercial loans. Substantially offsetting this decrease were increases in nonaccrual commercial real estate and residential real estate loans. Nonaccrual loans at December 31, 2017 include $15.4 million of loans related to the Anchor (MN) acquisition. As a percentage of nonaccrual loans, the allowance for

 

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loan losses was 40.33% at December 31, 2017, compared to 37.90% at December 31, 2016. PCI loans that were included in the nonaccrual category because the collection of principal or interest is doubtful totaled $12.6 million at December 31, 2017, compared to $16.7 million at December 31, 2016. However, they are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.

Interest income of approximately $6.7 million and $6.4 million would have been recorded on nonaccrual and renegotiated loans outstanding at December 31, 2017 and 2016, respectively, if such loans had been accruing interest throughout the year in accordance with their original terms. Excluding PCI loans accounted for under ASC 310-30, the amount of interest income actually recorded on nonaccrual and renegotiated loans was $1.6 million in 2017 and $1.4 million in 2016. We had $34.0 million of renegotiated loans which are included in nonaccrual loans at December 31, 2017, compared to $26.3 million at December 31, 2016.

Total criticized and classified assets were $419.2 million at December 31, 2017, an increase of $96.3 million from December 31, 2016. Other classified assets include investment securities that fell below investment grade rating totaling $4.6 million at December 31, 2017, compared to $7.1 million at December 31, 2016.

Old National may choose to restructure the contractual terms of certain loans. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit Old National by increasing the ultimate probability of collection.

Any loans that are modified are reviewed by Old National to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, Old National Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status. The modification of the terms of such loans include one or a combination of the following: a reduction of the stated interest rate of the loan, an extension of the maturity date at a stated rate of interest lower than the current market rate of new debt with similar risk, or a permanent reduction of the recorded investment of the loan.

Loans modified in a TDR are typically placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms for six months.

If we are unable to resolve a nonperforming loan issue, the credit will be charged off when it is apparent there will be a loss. For large commercial type loans, each relationship is individually analyzed for evidence of apparent loss based on quantitative benchmarks or subjectively based upon certain events or particular circumstances. Generally, Old National charges off small commercial loans scored through our small business credit center with contractual balances under $250,000 that are 90 days or more delinquent and do not have adequate collateral support. For residential and consumer loans, a charge off is recorded at the time foreclosure is initiated or when the loan becomes 120 to 180 days past due, whichever is earlier.

For commercial TDRs, an allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its computed value. To determine the value of the loan, one of the following methods is selected: (1) the present value of expected cash flows discounted at the loan’s original effective interest rate, (2) the loan’s observable market price, or (3) the fair value of the collateral value, if the loan is collateral dependent. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value. If there are significant changes in the amount or timing of the loan’s expected future cash flows, impairment is recalculated and the valuation allowance is adjusted accordingly.

When a residential or consumer loan is identified as a TDR, the loan is typically written down to its collateral value less selling costs.

At December 31, 2017, our TDRs consisted of $12.1 million of commercial loans, $34.7 million of commercial real estate loans, $3.3 million of residential loans, and $3.9 million of consumer loans totaling $54.0 million. Approximately $34.0 million of the TDRs at December 31, 2017 were included with nonaccrual loans. At December 31, 2016, our TDRs consisted of $16.8 million of commercial loans, $18.3 million of commercial real estate loans, $3.0 million of residential loans, and $2.6 million of consumer loans totaling $40.7 million. Approximately $26.3 million of the TDRs at December 31, 2016 were included with nonaccrual loans.

 

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Old National has allocated specific reserves to customers whose loan terms have been modified in TDRs totaling $5.7 million at December 31, 2017 and $4.0 million at December 31, 2016. As of December 31, 2017, Old National had committed to lend an additional $4.1 million to customers with outstanding loans that are classified as TDRs.

The terms of certain other loans were modified during 2017 that did not meet the definition of a TDR. It is our process to review all classified and criticized loans that, during the period, have been renewed, have entered into a forbearance agreement, have gone from principal and interest to interest only, or have extended the maturity date. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on its debt in the foreseeable future without the modification. The evaluation is performed under our internal underwriting policy. We also evaluate whether a concession has been granted or if we were adequately compensated through a market interest rate, additional collateral, or a bona fide guarantee. We also consider whether the modification was insignificant relative to the other terms of the agreement or the delay in a payment.

PCI loans are not considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. If a PCI loan is subsequently modified, and meets the definition of a TDR, it will be removed from PCI accounting and accounted for as a TDR only if the PCI loan was being accounted for individually. If the PCI loan is being accounted for as part of a pool, it will not be removed from the pool. At December 31, 2017, it has not been necessary to remove any loans from PCI accounting.

In general, once a modified loan is considered a TDR, the loan will always be considered a TDR, and therefore impaired, until it is paid in full, otherwise settled, sold, or charged off. However, guidance also permits for loans to be removed from TDR status when subsequently restructured under these circumstances: (1) at the time of the subsequent restructuring, the borrower is not experiencing financial difficulties, and this is documented by a current credit evaluation at the time of the restructuring, (2) under the terms of the subsequent restructuring agreement, the institution has granted no concession to the borrower; and (3) the subsequent restructuring agreement includes market terms that are no less favorable than those that would be offered for a comparable new loan. For loans subsequently restructured that have cumulative principal forgiveness, the loan should continue to be measured in accordance with ASC 310-10, Receivables – Overall. However, consistent with ASC 310-40-50-2, Troubled Debt Restructurings by Creditors, Creditor Disclosure of Troubled Debt Restructurings, the loan would not be required to be reported in the years following the restructuring if the subsequent restructuring meets both of these criteria: (1) has an interest rate at the time of the subsequent restructuring that is not less than a market interest rate; and (2) is performing in compliance with its modified terms after the subsequent restructuring.

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses incurred in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience.

 

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The activity in our allowance for loan losses was as follows:

 

(dollars in thousands)

   2017     2016     2015     2014     2013  

Balance at beginning of period

   $ 49,808     $ 52,233     $ 47,849     $ 47,145     $ 54,763  

Loans charged-off:

          

Commercial

     1,108       5,047       3,513       3,535       4,435  

Commercial real estate

     3,700       2,632       1,921       3,647       9,302  

Residential real estate

     985       800       1,039       793       1,487  

Consumer credit

     6,924       6,131       6,404       4,675       6,279  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

     12,717       14,610       12,877       12,650       21,503  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries on charged-off loans:

          

Commercial

     2,281       3,102       5,218       3,125       4,723  

Commercial real estate

     3,777       4,763       4,685       3,871       6,838  

Residential real estate

     255       174       354       205       310  

Consumer credit

     3,927       3,186       4,081       3,056       4,333  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     10,240       11,225       14,338       10,257       16,204  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs (recoveries)

     2,477       3,385       (1,461     2,393       5,299  

Provision for loan losses

     3,050       960       2,923       3,097       (2,319
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 50,381     $ 49,808     $ 52,233     $ 47,849     $ 47,145  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average loans for the year (1)

   $ 9,525,888     $ 8,265,169     $ 6,756,135     $ 5,703,294     $ 5,135,139  

Asset Quality Ratios:

          

Allowance/year-end loans (1)

     0.45     0.55     0.75     0.76     0.93

Allowance/average loans (1)

     0.53       0.60       0.77       0.84       0.92  

Net charge-offs (recoveries)/average loans (2)

     0.03       0.04       (0.02     0.04       0.10  

 

(1) Loans exclude loans held for sale.
(2) Net charge-offs include write-downs on loans transferred to held for sale.

The allowance for loan losses increased $0.6 million, or 1%, from December 31, 2016 to December 31, 2017. Net charge-offs totaled $2.5 million in 2017 compared to net charge-offs of $3.4 million in 2016. There were no industry segments representing a significant share of total net charge-offs. Net charge-offs (recoveries) to average loans was 0.03% in 2017 compared to 0.04% in 2016. Over the last twelve months, net charge-offs have remained low. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense.

As a percentage of total loans, the allowance ranged from 0.45% to 0.93% for the last five years, and was 0.45% at December 31, 2017. Our ratio of allowance for loan losses to total loans declined as of December 31, 2017 with the addition of Anchor (MN)’s $1.594 billion loan portfolio. In accordance with ASC 805, no allowance for loan losses is recorded at the date of acquisition and a reserve is only established to absorb any subsequent credit deterioration or adverse changes in expected cash flows.

 

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The following table provides additional details of the components of the allowance for loan losses, including ASC 450, Contingencies, for loans collectively evaluated for impairment, ASC 310-10, Receivables, for loans individually evaluated for impairment, and ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for loans acquired with deteriorated credit quality:

 

(dollars in thousands)

   Collectively
Evaluated for
Impairment
     Individually
Evaluated for
Impairment
     Acquired with
Deteriorated
Credit Quality
     Total  

Loan balance

   $ 11,087,585      $ 96,264      $ 70,810      $ 11,254,659  

Remaining purchase discount

     (105,321      (3,933      (27,284      (136,538
  

 

 

    

 

 

    

 

 

    

 

 

 

Loans, net of discount

   $ 10,982,264      $ 92,331      $ 43,526      $ 11,118,121  
  

 

 

    

 

 

    

 

 

    

 

 

 

Allowance, January 1, 2017

   $ 41,532      $ 7,998      $ 278      $ 49,808  

Charge-offs

     (7,862      (4,490      (365      (12,717

Recoveries

     3,951        5,423        866        10,240  

Provision expense

     2,516        1,147        (613      3,050  
  

 

 

    

 

 

    

 

 

    

 

 

 

Allowance, December 31, 2017

   $ 40,137      $ 10,078      $ 166      $ 50,381  
  

 

 

    

 

 

    

 

 

    

 

 

 

We maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. The reserve for unfunded loan commitments is classified as a liability account on the balance sheet and totaled $3.1 million at December 31, 2017, compared to $3.2 million at December 31, 2016.

The following table details the allowance for loan losses by loan category and the percent of loans in each category compared to total loans at December 31.

 

     2017     2016     2015     2014     2013  
            % of            % of            % of            % of            % of  
            Loans            Loans            Loans            Loans            Loans  
     Allowance      to Total     Allowance     

to Total

    Allowance     

to Total

    Allowance      to Total     Allowance      to Total  

(dollars in thousands)

   Amount      Loans     Amount      Loans     Amount      Loans     Amount      Loans     Amount      Loans  

Commercial

   $ 19,246        24.4   $ 21,481        21.3   $ 25,568        26.0   $ 17,401        25.8   $ 15,013        27.0

Commercial real estate

     21,436        39.2       18,173        34.7       15,993        26.6       17,348        27.1       19,031        22.8  

Residential real estate

     1,763        19.5       1,643        23.2       2,051        23.7       2,962        24.1       3,123        26.8  

Consumer credit

     7,936        16.9       8,511        20.8       7,684        22.2       6,586        20.7       4,574        19.1  

Covered loans

     —          —         —          —         937        1.5       3,552        2.3       5,404        4.3  
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 50,381        100.0   $ 49,808        100.0   $ 52,233        100.0   $ 47,849        100.0   $ 47,145        100.0
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Market Risk

Market risk is the risk that the estimated fair value of our assets, liabilities, and derivative financial instruments will decline as a result of changes in interest rates or financial market volatility, or that our net income will be significantly reduced by interest rate changes.

The objective of our interest rate management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.

Potential cash flows, sales, or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from our normal business activities of gathering deposits and extending loans. Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships, and re-pricing characteristics of financial instruments. Our earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve.

 

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In managing interest rate risk, we, through the Funds Management Committee, a committee of the Board of Directors, establish guidelines, for asset and liability management, including measurement of short and long-term sensitivities to changes in interest rates. Based on the results of our analysis, we may use different techniques to manage changing trends in interest rates including:

 

    adjusting balance sheet mix or altering interest rate characteristics of assets and liabilities;

 

    changing product pricing strategies;

 

    modifying characteristics of the investment securities portfolio; or

 

    using derivative financial instruments, to a limited degree.

A key element in our ongoing process is to measure and monitor interest rate risk using a model to quantify the impact of changing interest rates on Old National. The model quantifies the effects of various possible interest rate scenarios on projected net interest income. The model measures the impact on net interest income relative to a base case scenario. The base case scenario assumes that the balance sheet and interest rates are held at current levels. The model shows our projected net interest income sensitivity based on interest rate changes only and does not consider other forecast assumptions.

The following table illustrates our projected net interest income sensitivity over a two year cumulative horizon based on the asset/liability model as of December 31, 2017 and 2016:

 

     Immediate
Rate Decrease
-50
Basis Points
           Immediate Rate Increase  
              +100     +200     +300  

(dollars in thousands)

     Base      Basis Points     Basis Points     Basis Points  

December 31, 2017

           

Projected interest income:

           

Money market, other interest earning investments, and investment securities

   $ 225,619     $ 234,618      $ 247,478     $ 259,531     $ 272,707  

Loans

     856,693       914,205        1,026,924       1,138,107       1,248,623  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest income

     1,082,312       1,148,823        1,274,402       1,397,638       1,521,330  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Projected interest expense:

           

Deposits

     33,625       60,527        135,504       210,475       285,441  

Borrowings

     84,359       101,521        135,861       170,210       204,542  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest expense

     117,984       162,048        271,365       380,685       489,983  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest income

   $ 964,328     $ 986,775      $ 1,003,037     $ 1,016,953     $ 1,031,347  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Change from base

   $ (22,447      $ 16,262     $ 30,178     $ 44,572  

% change from base

     -2.27        1.65     3.06     4.52

December 31, 2016

           

Projected interest income:

           

Money market, other interest earning investments, and investment securities

   $ 226,586     $ 234,297      $ 246,329     $ 255,974     $ 265,942  

Loans

     628,100       672,942        762,859       852,007       940,961  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest income

     854,686       907,239        1,009,188       1,107,981       1,206,903  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Projected interest expense:

           

Deposits

     21,039       40,795        103,290       165,778       228,259  

Borrowings

     48,624       61,043        89,063       117,004       144,902  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest expense

     69,663       101,838        192,353       282,782       373,161  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest income

   $ 785,023     $ 805,401      $ 816,835     $ 825,199     $ 833,742  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Change from base

   $ (20,378      $ 11,434     $ 19,798     $ 28,341  

% change from base

     -2.53        1.42     2.46     3.52

Our asset sensitivity decreased slightly year over year primarily due to changes in our balance sheet mix, investment duration, and prepayment speed behavior.

 

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A key element in the measurement and modeling of interest rate risk is the re-pricing assumptions of our transaction deposit accounts, which have no contractual maturity dates. We assume this deposit base is comprised of both core and more volatile balances and consists of both non-interest bearing and interest bearing accounts. Core deposit balances are assumed to be less interest rate sensitive and provide longer term funding. Volatile balances are assumed to be more interest rate sensitive and shorter in term. As part of our semi-static balance sheet modeling, we assume interest rates paid on the volatile deposits move in conjunction with changes in interest rates, in order to retain these deposits. This may include current non-interest bearing accounts.

Because the models are driven by expected behavior in various interest rate scenarios and many factors besides market interest rates affect our net interest income, we recognize that model outputs are not guarantees of actual results. For this reason, we model many different combinations of interest rates and balance sheet assumptions to understand our overall sensitivity to market interest rate changes, including shocks, yield curve flattening, yield curve steepening, as well as forecasts of likely interest rate scenarios. At December 31, 2017, our projected net interest income sensitivity based on the asset/liability models we utilize was within the limits of our interest rate risk policy for the scenarios tested.

We use derivative instruments, primarily interest rate swaps, to mitigate interest rate risk, including certain cash flow hedges on variable-rate debt with a notional amount of $675 million at December 31, 2017. Our derivatives had an estimated fair value loss of $2.2 million at December 31, 2017, compared to an estimated fair value loss of $5.9 million at December 31, 2016. See Note 21 to the consolidated financial statements for further discussion of derivative financial instruments.

Liquidity Risk

Liquidity risk arises from the possibility that we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The Funds Management Committee of the Board of Directors establishes liquidity risk guidelines and, along with the Balance Sheet Management Committee, monitors liquidity risk. The objective of liquidity management is to ensure we have the ability to fund balance sheet growth and meet deposit and debt obligations in a timely and cost-effective manner. Management monitors liquidity through a regular review of asset and liability maturities, funding sources, and loan and deposit forecasts. We maintain strategic and contingency liquidity plans to ensure sufficient available funding to satisfy requirements for balance sheet growth, properly manage capital markets’ funding sources and to address unexpected liquidity requirements.

Loan repayments and maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of investment securities and prepayments of loans and mortgage-related securities are strongly influenced by interest rates, the housing market, general and local economic conditions, and competition in the marketplace. We continually monitor marketplace trends to identify patterns that might improve the predictability of the timing of deposit flows or asset prepayments.

A time deposit maturity schedule for Old National Bank is shown in the following table at December 31, 2017.

 

(dollars in thousands)              

Maturity Bucket

   Amount      Rate  

2018

   $ 1,111,266        0.30

2019

     229,944        0.97  

2020

     139,689        1.44  

2021

     62,777        1.40  

2022

     45,802        1.42  

2023 and beyond

     44,958        1.78  
  

 

 

    

 

 

 

Total

   $ 1,634,436        1.02
  

 

 

    

 

 

 

 

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Our ability to acquire funding at competitive prices is influenced by rating agencies’ views of our credit quality, liquidity, capital, and earnings. Moody’s Investor Service places us in an investment grade that indicates a low risk of default. For both Old National and Old National Bank:

 

    Moody’s Investor Service affirmed the Long-Term Rating of A3 of Old National’s senior unsecured/issuer rating on August 9, 2017.

 

    Moody’s Investor Service affirmed Old National Bank’s long-term deposit rating of Aa3 on August 9, 2017. The bank’s short-term deposit rating was affirmed at P-1 and the bank’s issuer rating was affirmed at A3.

The rating outlook from Moody’s Investor Service is negative. Moody’s Investor Service concluded a rating review of Old National Bank on August 9, 2017.

The credit ratings of Old National and Old National Bank at December 31, 2017 are shown in the following table.

 

     Moody’s Investor Service
     Long-term    Short-term

Old National

   A3    N/A

Old National Bank

   Aa3    P-1

N/A = not applicable

Old National Bank maintains relationships in capital markets with brokers and dealers to issue certificates of deposit and short-term and medium-term bank notes as well. At December 31, 2017, Old National and its subsidiaries had the following availability of liquid funds and borrowings:

 

(dollars in thousands)

   Parent
Company
     Subsidiaries  

Available liquid funds:

     

Cash and due from banks

   $ 46,886      $ 243,546  

Unencumbered government-issued debt securities

     —          1,252,299  

Unencumbered investment grade municipal securities

     —          664,494  

Unencumbered corporate securities

     —          142,413  

Availability of borrowings:

     

Amount available from Federal Reserve discount window*

     —          470,828  

Amount available from Federal Home Loan Bank Indianapolis*

     —          471,207  
  

 

 

    

 

 

 

Total available funds

   $ 46,886      $ 3,244,787  
  

 

 

    

 

 

 

 

* Based on collateral pledged

The Parent Company (Old National Bancorp) has routine funding requirements consisting primarily of operating expenses, dividends to shareholders, debt service, net derivative cash flows, and funds used for acquisitions. The Parent Company can obtain funding to meet its obligations from dividends and management fees collected from its subsidiaries, operating line of credit, and through the issuance of debt securities. Additionally, the Parent Company has a shelf registration in place with the SEC permitting ready access to the public debt and equity markets. At December 31, 2017, the Parent Company’s other borrowings outstanding were $230.7 million.

Federal banking laws regulate the amount of dividends that may be paid by banking subsidiaries without prior approval. Prior regulatory approval is required if dividends to be declared in any year would exceed net earnings of the current year plus retained net profits for the preceding two years. Prior regulatory approval to pay dividends was not required in 2016 or 2017 and is not currently required.

OFF-BALANCE SHEET ARRANGEMENTS

Off-balance sheet arrangements include commitments to extend credit and financial guarantees. Commitments to extend credit and financial guarantees are used to meet the financial needs of our customers. Our banking affiliates have entered into various agreements to extend credit, including loan commitments of $3.144 billion and standby letters of credit of $68.7 million at December 31, 2017. At December 31, 2017, approximately $2.896 billion of the

 

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loan commitments had fixed rates and $248.1 million had floating rates, with the floating interest rates ranging from 0% to 18%. At December 31, 2016, loan commitments were $2.354 billion and standby letters of credit were $51.7 million. The term of these off-balance sheet arrangements is typically one year or less.

Old National is a party in three separate risk participation transactions of interest rate swaps, which had total notional amount of $18.0 million at December 31, 2017.

CONTRACTUAL OBLIGATIONS, COMMITMENTS, AND CONTINGENT LIABILITIES

The following table presents our significant fixed and determinable contractual obligations and significant commitments at December 31, 2017. Further discussion of each obligation or commitment is included in the referenced note to the consolidated financial statements.

 

            Payments Due In         

(dollars in thousands)

   Note
Reference
     One Year
or Less
     One to
Three Years
     Three to
Five Years
     Over
Five Years
     Total  

Deposits without stated maturity

      $ 10,971,328      $ —        $ —        $ —        $ 10,971,328  

IRAs, consumer, and brokered certificates of deposit

     11        1,111,266        369,633        108,579        44,958        1,634,436  

Federal funds purchased and interbank borrowings

        335,033        —          —          —          335,033  

Securities sold under agreements to repurchase

     12        384,810        —          —          —          384,810  

Federal Home Loan Bank advances

     13        999,896        251,962        58,500        299,221        1,609,579  

Other borrowings

     14        127        284        332        248,039        248,782  

Fixed interest payments (1)

        22,835        36,245        33,736        54,962        147,778  

Operating leases

     7        18,919        34,328        29,719        63,828        146,794  

Other long-term liabilities (2)

        46,033        2,737        33        63        48,866  

 

(1) Our senior notes, subordinated notes, certain trust preferred securities, and certain FHLB advances have fixed rates ranging from 1.01% to 6.08%. All of our other long-term debt is at LIBOR based variable rates at December 31, 2017. The projected variable interest assumes no increase in LIBOR rates from December 31, 2017.
(2) Includes unfunded commitments on qualified affordable housing projects and other tax credit investments.

We rent certain premises and equipment under operating leases. See Note 7 to the consolidated financial statements for additional information on long-term lease arrangements.

We are party to various derivative contracts as a means to manage the balance sheet and our related exposure to changes in interest rates, to manage our residential real estate loan origination and sale activity, and to provide derivative contracts to our clients. Since the derivative liabilities recorded on the balance sheet change frequently and do not represent the amounts that may ultimately be paid under these contracts, these liabilities are not included in the table of contractual obligations presented above. Further discussion of derivative instruments is included in Note 21 to the consolidated financial statements.

In the normal course of business, various legal actions and proceedings are pending against us and our affiliates which are incidental to the business in which they are engaged. Further discussion of contingent liabilities is included in Note 22 to the consolidated financial statements.

In addition, liabilities recorded under FASB ASC 740-10 (FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109) are not included in the table because the amount and timing of any cash payments cannot be reasonably estimated. Further discussion of income taxes and liabilities recorded under FASB ASC 740-10 is included in Note 16 to the consolidated financial statements.

 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our accounting policies are described in Note 1 to the consolidated financial statements. Certain accounting policies require management to use significant judgment and estimates, which can have a material impact on the carrying value of certain assets and liabilities. We consider these policies to be critical accounting policies. The judgment and assumptions made are based upon historical experience or other factors that management believes to be reasonable under the circumstances. Because of the nature of the judgment and assumptions, actual results could differ from estimates, which could have a material effect on our financial condition and results of operations.

The following accounting policies materially affect our reported earnings and financial condition and require significant judgments and estimates. Management has reviewed these critical accounting estimates and related disclosures with our Audit Committee.

Goodwill and Intangibles

 

    Description. For acquisitions, we are required to record the assets acquired, including identified intangible assets, and the liabilities assumed at their fair value. These often involve estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques that may include estimates of attrition, inflation, asset growth rates, or other relevant factors. In addition, the determination of the useful lives over which an intangible asset will be amortized is subjective. Under FASB ASC 350, Intangibles – Goodwill and Other, goodwill and indefinite-lived assets recorded must be reviewed for impairment on an annual basis, as well as on an interim basis if events or changes indicate that the asset might be impaired. An impairment loss must be recognized for any excess of carrying value over fair value of the goodwill or the indefinite-lived intangible asset.

 

    Judgments and Uncertainties. The determination of fair values is based on valuations using management’s assumptions of future growth rates, future attrition, discount rates, multiples of earnings or other relevant factors.

 

    Effect if Actual Results Differ From Assumptions. Changes in these factors, as well as downturns in economic or business conditions, could have a significant adverse impact on the carrying values of goodwill or intangible assets and could result in impairment losses affecting our financials as a whole and our banking subsidiary in which the goodwill or intangibles resides.

Acquired Impaired Loans

 

    Description. Loans acquired with evidence of credit deterioration since inception and for which it is probable that all contractual payments will not be received are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). These loans are recorded at fair value at the time of acquisition, with no carryover of the related allowance for loan losses. Fair value of acquired loans is determined using a discounted cash flow methodology based on assumptions about the amount and timing of principal and interest payments, principal prepayments and principal defaults and losses, and current market rates. In recording the acquisition date fair values of acquired impaired loans, management calculates a non-accretable difference (the credit component of the purchased loans) and an accretable difference (the yield component of the purchased loans).

Over the life of the acquired loans, we continue to estimate cash flows expected to be collected on pools of loans sharing common risk characteristics, which are treated in the aggregate when applying various valuation techniques. We evaluate at each balance sheet date whether the present value of our pools of loans determined using the effective interest rates has decreased significantly and if so, recognize a provision for loan loss in our consolidated statement of income. For any significant increases in cash flows expected to be collected, we adjust the amount of accretable yield recognized on a prospective basis over the pool’s remaining life.

 

    Judgments and Uncertainties. These cash flow evaluations are inherently subjective as they require management to make estimates about expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change.

 

    Effect if Actual Results Differ From Assumptions. Changes in these factors, as well as changing economic conditions will likely impact the carrying value of these acquired loans.

 

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Allowance for Loan Losses

 

    Description. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. The allowance represents management’s best estimate, but significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results of operations.

The allowance is increased through a provision charged to operating expense. Uncollectible loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. A loan is generally placed on nonaccrual status when principal or interest becomes 90 days past due unless it is well secured and in the process of collection, or earlier when concern exists as to the ultimate collectibility of principal or interest. We monitor the quality of our loan portfolio on an on-going basis and use a combination of detailed credit assessments by relationship managers and credit officers, historic loss trends, and economic and business environment factors in determining the allowance for loan losses. We record provisions for loan losses based on current loans outstanding, grade changes, mix of loans, and expected losses. A detailed loan loss evaluation on an individual loan basis for our highest risk loans is performed quarterly. Management follows the progress of the economy and how it might affect our borrowers in both the near and the intermediate term. We have a formalized and disciplined independent loan review program to evaluate loan administration, credit quality, and compliance with corporate loan standards. This program includes periodic, regular reviews of problem loan reports, delinquencies and charge-offs.

 

    Judgments and Uncertainties. We utilize a PD/LGD model as a tool to determine the adequacy of the allowance for loan losses for performing commercial and commercial real estate loans. The PD is forecast using a transition matrix to determine the likelihood of a customer’s AQR migrating from its current AQR to any other status within the time horizon. Transition rates are measured using Old National’s own historical experience. The model assumes that recent historical transition rates will continue into the future. The LGD is defined as credit loss incurred when an obligor of the bank defaults. The sum of all net charge-offs for a particular portfolio segment are divided by all loans that have defaulted over a given period of time. The expected loss derived from the model considers the PD, LGD, and exposure at default. Additionally, qualitative factors, such as changes in lending policies or procedures, and economic business conditions are also considered.

We use historic loss ratios adjusted for economic conditions to determine the appropriate level of allowance for residential real estate and consumer loans.

 

    Effect if Actual Results Differ From Assumptions. The allowance represents management’s best estimate, but significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results of operations.

Management’s analysis of probable losses in the portfolio at December 31, 2017 resulted in a range for allowance for loan losses of $15.2 million. The range pertains to general (FASB ASC 450, Contingencies) reserves for both retail and performing commercial loans. Specific (FASB ASC 310, Receivables) reserves do not have a range of probable loss. Due to the risks and uncertainty associated with the economy and our projection of loss rates inherent in the portfolio, we establish a range of probable outcomes (a high-end estimate and a low-end estimate) and evaluate our position within this range. The potential effect to net income based on our position in the range relative to the high and low endpoints is a decrease of $1.4 million and an increase of $8.4 million, respectively, after taking into account the tax effects. These sensitivities are hypothetical and may not represent actual results.

 

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Derivative Financial Instruments

 

    Description. As part of our overall interest rate risk management, we use derivative instruments to reduce exposure to changes in interest rates and market prices for financial instruments. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of derivative financial instruments and hedged items. To the extent hedging relationships are found to be effective, as determined by FASB ASC 815, Derivatives and Hedging (“ASC Topic 815”), changes in fair value of the derivatives are offset by changes in the fair value of the related hedged item or recorded to other comprehensive income. Management believes hedge effectiveness is evaluated properly in preparation of the financial statements. All of the derivative financial instruments we use have an active market and indications of fair value can be readily obtained. We are not using the “short-cut” method of accounting for any fair value derivatives.

 

    Judgments and Uncertainties. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of derivative financial instruments and hedged items.

 

    Effect if Actual Results Differ From Assumptions. To the extent hedging relationships are found to be effective, as determined by ASC Topic 815, changes in fair value of the derivatives are offset by changes in the fair value of the related hedged item or recorded to other comprehensive income. However, if in the future the derivative financial instruments used by us no longer qualify for hedge accounting treatment, all changes in fair value of the derivative would flow through the consolidated statements of income in other noninterest income, resulting in greater volatility in our earnings.

Income Taxes

 

    Description. We are subject to the income tax laws of the U.S., its states, and the municipalities in which we operate. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. We review income tax expense and the carrying value of deferred tax assets quarterly; and as new information becomes available, the balances are adjusted as appropriate. FASB ASC 740-10 (FIN 48) prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements. See Note 16 to the consolidated financial statements for a further description of our provision and related income tax assets and liabilities.

 

    Judgments and Uncertainties. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of these inherently complex tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be subject to review/adjudication by the court systems of the various tax jurisdictions or may be settled with the taxing authority upon examination or audit.

 

    Effect if Actual Results Differ From Assumptions. Although management believes that the judgments and estimates used are reasonable, actual results could differ and we may be exposed to losses or gains that could be material. To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement would result in a reduction in our effective income tax rate in the period of resolution.

Management has discussed the development and selection of these critical accounting estimates with the Audit Committee and the Audit Committee has reviewed our disclosure relating to it in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information contained under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk” of this Form 10-K is incorporated herein by reference in response to this item.

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

     Page  

Report of Management

     64  

Report of Independent Registered Public Accounting Firm

     65  

Consolidated Balance Sheets

     67  

Consolidated Statements of Income

     68  

Consolidated Statements of Comprehensive Income

     69  

Consolidated Statements of Changes in Shareholders’ Equity

     70  

Consolidated Statements of Cash Flows

     71  

Notes to Consolidated Financial Statements

     72  

Note 1. Basis of Presentation and Significant Accounting Policies

     72  

Note 2. Acquisition and Divestiture Activity

     84  

Note 3. Investment Securities

     87  

Note 4. Loans Held for Sale

     92  

Note 5. Loans and Allowance for Loan Losses

     92  

Note 6. Other Real Estate Owned

     104  

Note 7. Premises and Equipment

     105  

Note 8. Goodwill and Other Intangible Assets

     106  

Note 9. Loan Servicing Rights

     107  

Note 10. Qualified Affordable Housing Projects and Other Tax Credit Investments

     107  

Note 11. Deposits

     109  

Note 12. Securities Sold Under Agreements to Repurchase

     109  

Note 13. Federal Home Loan Bank Advances

     110  

Note 14. Other Borrowings

     110  

Note 15. Accumulated Other Comprehensive Income (Loss)

     113  

Note 16. Income Taxes

     114  

Note 17. Employee Benefit Plans

     117  

Note 18. Stock-Based Compensation

     118  

Note 19. Shareholders’ Equity

     120  

Note 20. Fair Value

     120  

Note 21. Derivative Financial Instruments

     129  

Note 22. Commitments and Contingencies

     131  

Note 23. Financial Guarantees

     132  

Note 24. Regulatory Restrictions

     132  

Note 25. Parent Company Financial Statements

     135  

Note 26. Segment Information

     136  

Note 27. Interim Financial Data (Unaudited)

     137  

 

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REPORT OF MANAGEMENT

MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING

Management is responsible for the preparation of the financial statements and related financial information appearing in this annual report on Form 10-K. The financial statements and notes have been prepared in conformity with accounting principles generally accepted in the United States and include some amounts which are estimates based upon currently available information and management’s judgment of current conditions and circumstances. Financial information throughout this annual report on Form 10-K is consistent with that in the financial statements.

Management maintains a system of internal accounting controls which is believed to provide, in all material respects, reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, transactions are properly authorized and recorded, and the financial records are reliable for preparing financial statements and maintaining accountability for assets. In addition, Old National has a Code of Business Conduct and Ethics, a Senior Financial and Executive Officer Code of Ethics and Corporate Governance Guidelines that outline high levels of ethical business standards. Old National has also appointed a Chief Ethics Officer and had a third party perform an independent validation of our ethics program. All systems of internal accounting controls are based on management’s judgment that the cost of controls should not exceed the benefits to be achieved and that no system can provide absolute assurance that control objectives are achieved. Management believes Old National’s system provides the appropriate balance between cost of controls and the related benefits.

In order to monitor compliance with this system of controls, Old National maintains an extensive internal audit program. Internal audit reports are issued to appropriate officers and significant audit exceptions, if any, are reviewed with management and the Audit Committee.

The Board of Directors, through an Audit Committee comprised solely of independent outside directors, oversees management’s discharge of its financial reporting responsibilities. The Audit Committee meets regularly with Old National’s independent registered public accounting firm, Crowe Horwath LLP, and the managers of financial reporting, internal audit, and risk. During these meetings, the committee meets privately with the independent registered public accounting firm as well as with financial reporting and internal audit personnel to review accounting, auditing, and financial reporting matters. The appointment of the independent registered public accounting firm is made by the Audit Committee.

The consolidated financial statements in this annual report on Form 10-K have been audited by Crowe Horwath LLP, for the purpose of determining that the consolidated financial statements are presented fairly, in all material respects in conformity with accounting principles generally accepted in the United States. Crowe Horwath LLP’s report on the financial statements follows.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Old National is responsible for establishing and maintaining adequate internal control over financial reporting. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Old National’s management assessed the effectiveness of Old National’s internal control over financial reporting as of December 31, 2017. In making this assessment, management used the criteria established in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control - Integrated Framework. As permitted, Old National has excluded the operations of Anchor Bancorp, Inc. acquired November 1, 2017, which is described in Note 2 to the consolidated financial statements. The assets acquired in this acquisition and excluded from management’s assessment on internal control over financial reporting comprised approximately 9.8% of total consolidated assets at December 31, 2017. Based on that assessment Old National has concluded that, as of December 31, 2017, Old National’s internal control over financial reporting is effective. Old National’s independent registered public accounting firm has audited the effectiveness of Old National’s internal control over financial reporting as of December 31, 2017 as stated in their report which follows.

 

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LOGO    Crowe Horwath LLP
   Independent Member Crowe Horwath International

Report of Independent Registered Public Accounting Firm

Shareholders and Board of Directors of Old National Bancorp

Evansville, Indiana

Opinions on the Financial Statements and Internal Control over Financial Reporting

We have audited the accompanying consolidated balance sheets of Old National Bancorp (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes (collectively referred to as the “financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2017 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.

Basis for Opinions

The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

 

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Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. As permitted, the Company has excluded the operations of Anchor Bancorp, Inc. acquired during 2017, which is described in Note 2 of the consolidated financial statements, from the scope of management’s report on internal control over financial reporting. As such, it has also been excluded from the scope of our audit of internal control over financial reporting. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

Definition and Limitations of Internal Control Over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

LOGO

Crowe Horwath LLP

We have served as the Company’s auditor since 2005, which is the year the engagement letter was signed for the audit of the 2006 financial statements.

Indianapolis, Indiana

February 15, 2018

 

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Table of Contents

OLD NATIONAL BANCORP

CONSOLIDATED BALANCE SHEETS

 

     December 31,  

(dollars and shares in thousands, except per share data)

   2017     2016  

Assets

    

Cash and due from banks

   $ 222,753     $ 209,381  

Money market and other interest-earning investments

     67,679       46,138  
  

 

 

   

 

 

 

Total cash and cash equivalents

     290,432       255,519  

Trading securities, at fair value

     5,584       4,982  

Investment securities - available-for-sale, at fair value

     3,196,207       2,797,174  

Investment securities - held-to-maturity, at amortized cost (fair value $727,703 and $784,172, respectively)

     684,063       745,090  

Federal Home Loan Bank/Federal Reserve Bank stock, at cost

     119,686       101,716  

Loans held for sale, at fair value

     17,930       90,682  

Loans, net of unearned income

     11,118,121       9,010,512  

Allowance for loan losses

     (50,381     (49,808
  

 

 

   

 

 

 

Net loans

     11,067,740       8,960,704  
  

 

 

   

 

 

 

Premises and equipment, net

     458,074       429,622  

Accrued interest receivable

     87,102       81,381  

Goodwill

     828,051       655,018  

Other intangible assets

     53,096       37,677  

Company-owned life insurance

     403,753       352,956