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RCKB > SEC Filings for RCKB > Form 10-K on 14-Mar-2013All Recent SEC Filings

Show all filings for ROCKVILLE FINANCIAL, INC. /CT/ | Request a Trial to NEW EDGAR Online Pro



Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to help the reader understand Rockville Financial, Inc., our operations and our present business environment. We believe accuracy, transparency and clarity are the primary goals of successful financial reporting. We remain committed to transparency in our financial reporting, providing our stockholders with informative financial disclosures and presenting an accurate view of our financial disclosures, financial position and operating results.

MD&A is provided as a supplement to - and should be read in conjunction with - our Consolidated Financial Statements and the accompanying Notes thereto contained in Part II, Item 8, Financial Statements and Supplementary Data of this report. The following sections are included in MD&A:

Our Business - a general description of our business, our objectives and the challenges and risks of our business.

Critical Accounting Estimates - a discussion of accounting estimates that require critical judgments and estimates.

Operating Results - an analysis of our Company's consolidated results of operations for the periods presented in our Consolidated Financial Statements.

Financial Condition, Liquidity and Capital Resources - an overview of financial condition and market and interest rate risk

Our Business


By assets, Rockville Financial, Inc. is the third largest publically traded banking institution headquartered in Connecticut with consolidated assets of $2.00 billion and stockholders' equity of $320.6 million at December 31, 2012. Rockville's business philosophy is to operate as a community bank with local decision-making authority. The Company delivers financial services to individuals, families, businesses and municipalities throughout Connecticut and the region through its 21 banking offices, two loan production offices, 37 ATMs, telephone banking, mobile banking and internet website ( The Company's common stock is traded on the NASDAQ Global Select Stock Exchange under the symbol "RCKB."

The Company's results of operations depend primarily on net interest income, which is the difference between the income earned on its loan and securities portfolios and its cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by the Company's provision for loan losses, non-interest income and non-interest expense. Non-interest income primarily consists of fee income from depositors, mortgage servicing income and loan sale income and increases in cash surrender value of bank-owned life insurance ("BOLI"). Non-interest expense consist principally of salaries and employee benefits, occupancy, service bureau fees, marketing, professional fees, FDIC insurance assessments, other real estate owned and other operating expenses.

Results of operations are also significantly affected by general economic and competitive conditions and changes in interest rates as well as government policies and actions of regulatory authorities. Future changes in applicable laws, regulations or government policies may materially affect the Company. Uncertainty and challenges surrounding future economic growth, consumer confidence, credit availability, competition and corporate earnings remains. Management believes that overall credit quality continues to be somewhat affected by weaknesses in national and regional economic conditions, including high unemployment levels, particularly in Connecticut.

Our Objectives

The Company seeks to grow organically and continually deliver superior value to its customers, stockholders, employees and communities through achievement of its core operating objectives which are to:

Grow and retain primary households to increase core deposit relationships with a focus on checking, savings and money market accounts for personal, business and municipal depositors;

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Build high quality, profitable loan portfolios using primarily organic growth and also purchase strategies, while also continuing to build efficiencies in its robust secondary mortgage banking business;

Build and diversify revenue streams through development of banking-related fee income; in particular through the expansion of its financial advisory services;

Maintain expense discipline and improve operating efficiencies;

Invest in technology to enhance superior customer service and products; and

Maintain a rigorous risk identification and management process

Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on equity and assets, net interest margin, non-interest income, operating expenses related to total assets and efficiency ratio, asset quality, loan and deposit growth, capital management, liquidity and interest rate sensitivity levels, customer service standards, market share and peer comparisons.

Challenges and Risks

As we look forward, management has identified five key challenges and risks that are likely to present challenges for near term performance:

Interest Rate Risk. The growth of the net interest margin is vital to our continued success and enhanced profitability. For the year ended December 31, 2012 our tax-equivalent net interest margin increased 41 basis points to 3.81%, by (a) significantly reducing our deposit costs, particularly on higher cost time deposits, while growing core deposits; (b) reducing our wholesale funding costs and (c) growing and diversifying our investment portfolio to include tax-exempt municipal obligations. These positive factors more than offset decreases in the yield on loans. For the three months ended December 31, 2012, the tax-equivalent net interest margin decreased 6 basis points to 3.74% from the prior quarter. We expect there to be further compression in the margin as we move into 2013 reflecting continued pressure on earning asset yields and the reduced ability to decrease the cost of funding relative to 2012. Further, pricing remains competitive, securities continue to re-price lower, and funding costs are nearing their floor. In an effort to mitigate interest rate risk on the Company's balance sheet in 2013, management expects to incrementally decrease the duration of assets by adding variable rate loans and securities either that are adjustable in nature or are hedged at the loan level through the use of swap instruments. Concurrently, the Company will incrementally increase the duration of liabilities through the use of wholesale funding options and incentives to retail and commercial customers to take longer-term duration deposits. When combined, the net duration of the balance sheet should decline; better positioning the balance sheet for rising interest rates. If market rates remain low in 2013, the implementation of this strategy will have an adverse impact on earnings.

Maintaining credit quality and rigorous risk management. The national economy experienced improvement through 2012 but, high unemployment, delinquencies and foreclosures are still top concerns. During this turbulent time, Rockville continued to maintain its strong credit quality as delinquencies, non-performing loans and charge-offs all outperform the average of our peer group. Our ratios of non-performing loans to total loans was 1.00%, total delinquencies to total loans was 1.67% and our allowance for loan losses to total loans was 1.15% at December 31, 2012. Net loan charge-offs decreased to $1.1 million for the year ended December 31, 2012, a decrease from $1.3 million for the year ended December 31, 2011. We are not immune to the trends in loan delinquencies and provisions that permeate the industry, the effects of which will continue to be felt throughout 2013 as home sales are expected to remain somewhat sluggish and delinquencies and foreclosures remain high throughout the country. However, we expect to be able to continue to maintain strong asset quality relative to industry levels as we have not experienced the severity of problems associated with the housing crisis nationally. In continuing to exercise rigorous risk management and prudent credit practices, we will also further enhance credit processes.

Deploying capital. We ended 2012 with Tier 1 leverage capital at 16.51%, which is substantially above our peer group average, and has remained strong throughout the economic crisis. We continuously search for the best use for our capital to enhance shareholder value. Key tactics include organic growth of commercial loans; further developing our residential mortgage business; investment in new business lines, technology and process improvements; returning capital through paying dividends and repurchasing shares; branch acquisitions; de-novo branching; and whole bank acquisitions. Management analyzes all capital deployment opportunities using a comprehensive approach to understand earnings accretion, capital dilution, payback, internal rates of return and return on invested capital.

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Competition in the marketplace. Rockville faces competition within the financial services industry from some well-established national and local companies. We expect loan and deposit competition to remain vigorous. However, we are poised to take advantage of the continuing industry consolidation in our market and consumers' willingness to switch financial service providers because of their skepticism of "big banks." Therefore, we must continue to recruit and retain the best talent, expand our product offerings, improve operating efficiencies and develop and maintain our brand to increase market share to benefit from these opportunities.

New regulation. The banking industry continued to be impacted by regulatory changes during 2012. These regulatory changes were made to ensure long-term stability in the financial markets. The regulatory changes include, the passage of the Dodd-Frank Act in 2010 and proposed capital regulations announced in June 2012 to implement Basel III capital standards. Dodd-Frank will significantly change the current bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the rules and regulations, and consequently, many of the details and much of the impacts of the Dodd-Frank Act may not be known for many months or years, including any regulations promulgated by the Consumer Financial Protection Bureau. Basel III would increase the minimum levels of required capital, narrow the definition of capital, and place greater emphasis on common equity. The Basel III standardized proposal would also modify the risk weights for various asset classes. The Company is still in the process of assessing the impacts of these complex proposals; however, we believe we will continue to exceed all estimated well-capitalized regulatory requirements over the course of the proposed phase-in period, and on a fully phased-in basis. While the implementation of Basel III was recently delayed, its eventual enactment will represent a leap in complexity and compliance costs for the Company. In complying with new regulations, there can be no assurance that Rockville will not be impacted in a way we cannot currently predict or mitigate, but we will continue to attempt to navigate this landscape for the long-term benefit of our shareholders.

All five of these challenges and risks - net interest margin, maintaining credit quality and rigorous risk management, deploying capital, competition in the marketplace and new regulation - have the potential to have a material adverse effect on Rockville; however, we believe Rockville is well positioned to appropriately address these challenges and risks.

See also Item 1A, Risk Factors in Part I of this report for additional information about risks and uncertainties facing Rockville.

Critical Accounting Estimates

Our Consolidated Financial Statements are prepared in accordance with generally accepted accounting principles. Our significant accounting policies are discussed in Note 1, of the Notes to Consolidated Financial Statements, and included in Item 8, Financial Statements and Supplementary Data, of this report. Management believes that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, and they require management's most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board.

Allowance For Loan Losses

Critical Estimates

The allowance for loan losses is maintained at a level estimated by management to provide for potential losses inherent within the loan portfolio. Potential losses are estimated based upon a quarterly review of the loan portfolio, which includes historic default and loss experience, specific problem loans, risk rating profile, economic conditions and other pertinent factors which, in management's judgment, warrant current recognition in the loss estimation process. Rockville's Chief Risk Officer reviews and concludes on the adequacy of the allowance and recommends any required changes to the reserve adequacy to Executive Management and the Board.

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Judgment and Uncertainties

We determine the adequacy of the allowance for loan losses by analyzing and estimating losses inherent in the portfolio. The allowance for loan losses contains uncertainties because the calculation requires management to use historical information as well as current economic data to make judgments on the adequacy of the allowance. As the allowance is affected by changing economic conditions and various external factors, it may impact the portfolio in a way currently unforeseen.

Effect if Actual Results Differ from Assumptions

Adverse changes in management's assessment of the factors used to determine the allowance for loan losses could lead to additional provisions. Actual loan losses could differ materially from management's estimates if actual losses and conditions differ significantly from the assumptions utilized. These factors and conditions include general economic conditions within Rockville's market, industry trends and concentrations, real estate and other collateral values, interest rates and the financial condition of the individual borrower. While management believes that it has established adequate specific and general allowances for probable losses on loans, actual results may prove different and the differences could be significant.

Other-Than-Temporary Impairment of Investments

Critical Estimates

The Company maintains a securities portfolio that is classified into two major categories: available for sale and held to maturity. Securities available for sale are recorded at estimated fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Held to maturity securities are recorded at amortized cost. Management determines the classifications of a security at the time of its purchase.

Quarterly, securities with unrealized losses are reviewed as deemed appropriate to assess whether the decline in fair value is temporary or other-than-temporary. The assessment is to determine whether the decline in value is from company-specific events, industry developments, general economic conditions, credit losses on debt or other reasons. Declines in the fair value of available for sale securities below their cost or amortized cost that are deemed to be other-than-temporary are reflected in earnings for equity securities and for debt securities that have an identified credit loss. Unrealized losses on debt securities with no identified credit loss component are reflected in other comprehensive income.

Judgments and Uncertainties

Significant judgment is involved in determining when a decline in fair value is other-than-temporary. The factors considered by management include, but are not limited to:

Percentage and length of time by which an issue is below book value;

Financial condition and near-term prospects of the issuer including their ability to meet contractual obligations in a timely manner;

Ratings of the security;

Whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions;

Whether the decline is due to interest rates and spreads or credit risk;

The value of underlying collateral; and

Our intent and ability to retain the investment for a period of time sufficient to allow for the anticipated recovery in the market value, or more likely than not, will be required to sell a debt security before its anticipated recovery which may not be until maturity.

Effect if Actual Results Differ from Assumptions

Adverse changes in management's assessment of the factors used to determine that a security was not other-than-temporarily impaired could lead to additional impairment charges. Conditions affecting a security that we determined to be temporary could become other-than-temporary and warrant an impairment charge. Additionally, a security that had no apparent risk could be affected by a sudden or acute market condition and necessitate an impairment charge.

The Company has one security that is currently valued at 42.5% of below book value that is not considered other-than-temporarily impaired. At December 31, 2012, this security had a fair value of $1.2 million compared to a book value of $2.8 million. Management is confident that the analysis used to decide that the security is not other-than-temporarily impaired is comprehensive and appropriate.

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Income Taxes

Critical Estimates

Significant management judgment is required in determining income tax expense and deferred tax assets and liabilities. The Company uses the asset and liability method of accounting for income taxes in which deferred tax assets and liabilities are established for the temporary differences between the financial reporting basis and the tax basis of the Company's asset and liabilities. The realization of the net deferred tax asset generally depends upon future levels of taxable income and the existence of prior years' taxable income, to which "carry back" refund claims could be made. A valuation allowance is maintained for deferred tax assets that management estimates are more likely than not to be unrealizable based on available evidence at the time the estimate is made.

Judgment and Uncertainties

Significant management judgment is required in determining income tax expense and deferred tax assets and liabilities. Some judgments are subjective and involve estimates and assumptions about matters that are inherently uncertain. In determining the valuation allowance, we use historical and forecasted future operating results, based upon approved business plans, including a review of the eligible carryforward periods, tax planning opportunities and other relevant considerations. Management believes that the accounting estimate related to the valuation allowance is a critical accounting estimate because the underlying assumptions can change from period to period. For example, variances in future projected operating performance could result in a change in the valuation allowance.

Effect if Actual Results Differ from Assumptions

Should actual factors and conditions differ materially from those considered by management, the actual realization of the net deferred tax asset could differ materially from the amounts recorded in the financial statements. If the Company is not able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset valuation allowance would be charged to income tax expense in the period such determination was made.

Pension and Other Post-Retirement Benefits

Critical Estimates

Pension costs and liabilities are dependent on assumptions used in calculating such amounts. Management uses key assumptions that include discount rates, expected return on plan assets, benefits earned, interest costs, mortality rates, increases in compensation, and other factors. The two most critical assumptions, estimated return on plan assets and the discount rate, are important elements of plan expense and asset/liability measurements. These critical assumptions are evaluated at least annually on a plan basis. Other assumptions are evaluated periodically and are updated to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors, and in accordance with U.S. GAAP the impact of these differences is accumulated and amortized over future periods.

The discount rate assumptions used to measure the post-retirement benefit obligations is set by reference to published high-quality bond indices, as well as certain yield curves. The Company used the Citigroup Pension Liability Index as a benchmark. A higher discount rate decreases the present value of benefit obligations and decreases pension expense.

The expected rate of return on plan assets is based on current and expected asset allocations, as well as the long-term historical risks and returns with each asset class within the plan portfolio. A lower expected rate of return on plan assets increases pension costs.

Judgment and Uncertainties

To reflect market interest rate conditions in calculating the projected benefit obligation, the pension discount rate was decreased from 4.35% at December 31, 2011 to 3.90% at December 31, 2012, and the post-retirement discount rate decreased from 4.10% to 3.65% at each of these periods. The discount rate for the supplemental executive retirement plans decreased from 4.25% at December 31, 2011 to 3.80% at December 31, 2012.

An expected rate of return on plan assets of 8.00% was utilized at December 31, 2012 and 2011.

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Effect if Actual Results Differ from Assumptions

While management believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect future pension or other post-retirement obligations and expense. Continued volatility in pension expense is expected as assumed investment returns vary from actual.

A 25 basis point decrease in the discount rate would have increased annual pension expense by $165,000, while a 25 basis point increase in the discount rate would have decreased annual pension expense by $156,000.

A 25 basis point decrease or increase in the expected return on assets would have increased or decreased annual pension expense by $53,000.

Share-Based Compensation

Critical Estimates

The Company accounts for stock options and restricted stock based on the grant date fair value of the award. These costs are recognized over the period during which an employee is required to provide services in exchange for the award, the requisite service period (usually the vesting period.) The Company expenses the grant date fair value of the Company's stock options and restricted stock with a corresponding increase in equity or a liability, depending on whether the instruments granted satisfy the equity or liability classification criteria. The Company uses the Black-Scholes option valuation model to value stock options.

Judgment and Uncertainties

Determining the appropriate fair-value model and calculating the estimated fair value of share-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life, expected dividend rate, risk-free interest rate and expected forfeiture rate. The Company develops estimates based on historical data and market information which can change significantly over time.

Effect if Actual Results Differ from Assumptions

Actual results that differ significantly from the Black-Scholes option valuation model, if realized, can present material differences to option expense.

Derivative Instruments and Hedging Activities

Critical Estimates

Currently, the Company uses interest rate swaps to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. The fair values of interest rate swaps are determined using the standard methodology of netting the discounted future fixed cash receipts (or payment) and the expected variable cash payments (or receipts.) The variable cash payment (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rates curves.

Judgment and Uncertainties

Determining the fair value of interest rate derivatives requires the use of the standard market methodology of discounting the future expected cash receipts that would occur if variable interest rates rise based upon the forward swap curve assumption and netting the cash receipt against the contractual cash payment observed at the instrument's effective date. The Company's estimates of variable interest rates used in the calculation of projected receipts are based on an expectation of future interest rates derived from observable market interest rate curves and volatilities. The Company further incorporates credit valuation adjustments to appropriately reflect both its own non-performance risk and the respective counterparty's non-performance risk in the fair value measurements and requirements for collateral transfer to secure the market value of the derivative instrument(s).

Effect if Actual Results Differ from Assumptions

Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with the

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derivatives utilize Level 3 inputs, such as estimates of the current credit spreads to evaluate the likelihood of default by itself and its counterparties. In adjusting the fair value of its derivative contracts for the effect of non-performance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees. Incorrect assumptions could result in an overstatement or understatement of the value of the derivative contract.

Operating Results

Income Statement Summary

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