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FISI > SEC Filings for FISI > Form 10-K on 12-Mar-2014All Recent SEC Filings




Annual Report


The following is a discussion and analysis of our financial position and results of operations and should be read in conjunction with the information set forth under Part I, Item 1A, "Risks Factors", and our consolidated financial statements and notes thereto appearing under Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K.


Financial Institutions, Inc. is a financial holding company headquartered in New York State, providing banking and nonbanking financial services to individuals and businesses primarily in our Western and Central New York footprint. We have also expanded our indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. Through our wholly-owned banking subsidiary, Five Star Bank, we offer a wide range of services, including business and consumer loan and depository services, brokerage and investment advisory services, as well as other financial services and traditional banking services.

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.


Industry Overview

In December 2013, the Federal Open Market Committee of the Federal Reserve Board ("FOMC") kept the target range for federal funds rate at 0-25 basis points noting that a highly accommodative stance of monetary policy will remain appropriate after the economy strengthens to support maximum employment and price stability. The FOMC expects to maintain the target federal funds rate at 0-25 basis points for at least as long as the unemployment rate remains above 6.5%, inflation projections are no more than 0.5% above the FOMCs 2% long-run goal and longer-term inflation expectations continue to be well-anchored. The FOMC also announced that due to cumulative progress toward maximum employment and the improvement in the labor market outlook, it will reduce the purchase of agency mortgage-backed securities to $35 billion per month, down from the previous pace of $40 billion per month. The FOMC will also reduce the purchase of longer-term Treasury securities from its previous pace of $45 billion per month to $40 billion per month. These actions are intended to lower longer-term interest rates and support the mortgage and credit markets, among other things.

The actions by the FOMC have compressed net interest income and net interest margins for the banking industry by maintaining low rates on interest-earning assets. Throughout 2013, margins in the banking industry were pressured downward as higher-yielding legacy assets rolled off and were reinvested in the current low rate environment. Low interest rates, coupled with a competitive lending environment, have proven challenging for the profitability of the banking industry. It is expected that these challenges will continue until interest rates rise.

Although the expectation for capital spending increased during 2013, it is significantly lower than the pre-recession pace of 2006-2007. Reduced capital spending has resulted in record levels of deposits and tempered small businesses demand for loans. The high level of liquidity from the amount of deposits has exacerbated the pressure on net interest margins in the banking industry, as banks are challenged to deploy the excess liquidity at profitable spreads.

The banking industry continues to be impacted by new legislative and regulatory reform proposals. In July 2013, the Board of Governors of the Federal Reserve Bank, the FDIC, and the Office of the Comptroller of the Currency (OCC) approved the final U.S. version of the Basel III agreement. Basel III replaces the federal banking agencies' general risk-based capital rules, includes a narrower definition of capital and requires higher minimum capital levels. Basel III will be effective for us in 2015. In December 2013, the federal banking agencies also adopted final rules implementing a provision of the Dodd-Frank Act known as the Volcker Rule, a complex regulation that prohibits banks from engaging in proprietary trading and investments in certain asset classes. Upon initial issuance, a significant unintended consequence emerged, as banks faced impairments on certain investments that were no longer allowed to be held. While the federal banking agencies issued additional guidance in January 2014 allowing banks to retain certain investments that were originally prohibited by the Volcker Rule, it underscored the complexity of the Rule and the potential ramifications to the industry. A comprehensive discussion of legislative and regulatory matters affecting us can be found in the Supervision and Regulation section included in Part 1, Item 1, of this Annual Report on Form 10-K.

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2013 Financial Performance Review

During 2013 we continued to strengthen our balance sheet, as measured by ongoing deposit growth and quality loan growth in commercial and consumer indirect lending. Our deposit and lending growth is the result of our execution on key strategic initiatives over the last few years. We have done all of this while controlling expenses through disciplined expense management.

In 2013, we reported net income of $25.5 million compared to $23.4 million for 2012. This resulted in a 0.91% return on average assets and a 13.00% return on average tangible common equity. Net income available to common shareholders was $24.1 million or $1.75 per diluted share for 2013, compared to $22.0 million or $1.60 per diluted common share for 2012. We declared cash dividends of $0.74 during 2013, an increase of $0.17 per common share or 30% compared to the prior year. In addition, we grew our base of consumer and business customers while our efficiency ratio improved to 58.48% in 2013 from 62.87% in 2012.

Fully-taxable equivalent net interest income was $94.2 million in 2013, an increase of $3.4 million, or 4%, compared with 2012. This reflected the impact of 19% growth in average investment securities and 10% average loan growth, offset by a 31 basis point decline in the net interest margin to 3.64%. The loan growth reflected a 7% increase in average commercial loans, an 18% increase in average home equities and a 13% increase in average automobile loans.

Noninterest income was $24.8 million in 2013, relatively unchanged from the prior year. Service charges on deposits increased $1.3 million and ATM and debit card income increased $382 thousand in 2013, reflecting volume growth resulting from the 2012 branch acquisitions and changes we made in the second quarter of 2013 to our fee waiver process. An increase in sales volume primarily contributed to a $241 thousand increase in investment advisory income in 2013. Mortgage banking income was down $1.4 million due to a reduction in volume, lower gains on sale, and a higher percentage of originations retained on our balance sheet.

Noninterest expense was $69.4 million in 2013, a 3% decrease compared with 2012. Noninterest expense for 2012 included expenses totaling $3.0 million related to the 2012 branch acquisitions and $2.6 million related to the retirement of our former CEO. These expenses were included in salaries and employee benefits ($2.9 million), occupancy and equipment ($56 thousand), professional services ($1.1 million), computer and data processing ($480 thousand), supplies and postage ($395 thousand), advertising and promotions ($56 thousand) and other expense ($591 thousand) for 2012. Excluding these expenses, which we consider to be non-recurring in nature, noninterest expense increased $3.6 million or 5% when comparing 2013 to 2012.

Asset quality related metrics remain strong despite the increase in nonaccrual and non-performing assets in 2013. Nonaccrual loans increased $7.5 million compared to a year ago to $16.6 million. Non-performing assets increased $7.0 million compared to a year ago to $17.1 million, or 0.58% of total assets. The increases primarily reflect the addition of one commercial mortgage loan with a principal balance of $6.9 million at December 31, 2013. The provision for loan losses increased $2.0 million, or 27%, from 2012 as we continue to maintain the allowance for loan losses consistent with the growth in our loan portfolio and trends in asset quality. Net charge-offs increased $1.4 million, or 24%, from the prior year to $7.1 million. Net charge-offs were an annualized 0.40% of average loans in the current year compared to 0.36% in 2012.

The tangible common equity to tangible assets ratio at December 31, 2013, was 6.51%, down 35 basis points from a year ago. Our leverage ratio at year end was 7.63%, down from 7.71% at the end of 2012. The decrease in the tangible common equity to tangible assets and leverage ratios reflect our asset growth outpacing the increase in retained earnings. Our tier 1 and total risk-based capital ratios were 10.82% and 12.08%, respectively, at December 31, 2013, up from 10.73% and 11.98%, respectively, at December 31, 2012.

Branch Consolidations

In October 2013, we closed our Pavilion and North Java branches and transferred customer accounts and employees into nearby branches. These branch consolidations are one component of our long term strategic plan, which provides for the optimal combination of branches and online/mobile banking technologies, supported by highly experienced bankers, to offer customers convenience and high service levels while maintaining an efficient, competitive cost structure. Expenses related to the consolidation of these two branches were not material. In January 2014, we consolidated one of our supermarket branches into a nearby location in Batavia.

Dissolution of Broker-Dealer

During late 2013, our subsidiary, Five Star Investment Services, Inc. ("FSIS") ceased operations as an active broker-dealer and the securities licenses of advisors associated with FSIS who elected to transfer, as well as their respective client accounts which had previously cleared through a third-party platform, were transferred to the LPL Financial ("LPL") clearing platform. Following the completion of these transfer activities, FSB began offering investment and securities-related services, including brokerage and investment advice through a strategic partnership with LPL. FSB has employees who are LPL registered representatives, located throughout its branch network, offering customers insurance and investment products including stocks, bonds, mutual funds, annuities, and managed accounts through a program called Five Star Investment Services. FSIS withdrew its registration with the Financial Industry Regulatory Authority ("FINRA") effective December 31, 2013, and is expected to be dissolved in 2014.

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2012 Branch Acquisitions

During 2012, we successfully completed the acquisition of eight retail bank branch locations in Upstate New York. Former HSBC Bank USA, N.A. branches located in Albion, Elmira, Elmira Heights, and Horseheads were acquired in August, complementing the former First Niagara Bank, N.A. locations in Batavia, Brockport, Medina, and Seneca Falls acquired in June. Through the acquisition we assumed deposits of $286.8 million and acquired in-market performing loans of $75.6 million. The acquisition of these branch offices was a marked success. We were able to integrate the offices and customer accounts seamlessly. Through detailed planning, we ensured that our sales and support staff members were ready to assist customers with any questions or issues. The feedback we received from our customers was positive and executing on our detailed planning process ultimately resulted in deposit retention rates that were better than expected. We incurred approximately $3.0 million in pre-tax expense during 2012 related to the branch acquisitions.

The combined assets acquired and deposits assumed in the two transactions were recorded at their estimated fair values as follows:

                    Cash                            $ 195,778
                    Loans                              75,635
                    Bank premises and equipment         1,938
                    Goodwill                           11,167
                    Core deposit intangible asset       2,042
                    Other assets                          601

                    Total assets acquired           $ 287,161

                    Deposits assumed                $ 286,819
                    Other liabilities                     342

                    Total liabilities assumed       $ 287,161

For detailed information on the accounting for the branch acquisitions, see Note 2, Branch Acquisitions, of the notes to consolidated financial statements.

2014 Expectations

Net interest income is expected to increase moderately in 2014. We anticipate an increase in earning assets as we remained focused on loan growth, which will be partly funded with expected paydowns and liquidity from our securities portfolio. However, those benefits to net interest income are expected to be partially offset by continued downward pressure on net interest margin. We plan to maintain a disciplined approach to loan pricing, but asset yields remain under pressure due to the low interest rate environment, while the opportunity for deposit repricing is limited.

The commercial loan portfolio is expected to grow consistent with our strategic initiatives and continued support of middle market lending. Automobile loan originations remain strong, reflecting the positive impact from our investment in automotive dealer relationships. The home equity portfolio is expected to increase as the lower origination cost to customers and the convenient application process has made these products an increasingly attractive alternative to conventional residential mortgage loans, accordingly we expect run-off to outpace new originations in the residential mortgage portfolio.

We anticipate the increase in total loans will modestly outpace growth in total deposits. This reflects our continued focus on the overall cost of funds, through the use of short-term borrowings as well as the continued shift towards low- and no-cost demand deposits and money market deposit accounts.

Noninterest income is expected to be slightly higher than recent levels, reflecting our continued efforts to increase both account and transaction-based fee income. Management will continue to explore opportunities to increase noninterest income from non-deposit related sources.

Noninterest expense is expected to remain around current levels as we remain committed to diligent expense control during 2014.

We do not expect significant changes in overall asset quality and allowance measurements.

The effective tax rate for 2014 is expected to be lower, primarily reflecting the impacts of tax-exempt income, tax advantaged investments, and the formation of our real estate investment trust in early 2014.

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DECEMBER 31, 2013 AND DECEMBER 31, 2012

Significant Items Influencing Financial Performance Comparisons

Earnings comparisons among the years ended December 31, 2013 and 2012 were impacted by the significant items summarized below.

Retirement of Former CEO. In August 2012, Peter G. Humphrey our former President and Chief Executive Officer retired. We incurred approximately $2.6 million in pre-tax expense during 2012 related to the retirement of Mr. Humphrey.

2012 Branch Acquisitions. During 2012, we completed the acquisition of eight retail bank branch locations in Upstate New York. We incurred approximately $3.0 million in pre-tax expense during 2012 related to the branch acquisitions.

Net Interest Income and Net Interest Margin

Net interest income is the primary source of our revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds ("net free funds"), principally noninterest-bearing demand deposits and shareholders' equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis for the years ended December 31 (in thousands):

                                                       2013            2012           2011
Interest income per consolidated statements of
income                                               $  98,931       $ 97,567       $ 95,118
Adjustment to fully taxable equivalent basis             2,650          2,284          2,062

Interest income adjusted to a fully taxable
equivalent basis                                       101,581         99,851         97,180
Interest expense per consolidated statement of
income                                                   7,337          9,051         13,255

Net interest income on a taxable equivalent
basis                                                $  94,244       $ 90,800       $ 83,925

2013 Leverage Strategy

During the first quarter of 2013, we utilized the proceeds of short-term FHLB advances to purchase high-quality investment securities as part of a leverage strategy of approximately $100 million. Our purchase of investment securities was comprised of mortgage-backed securities, U.S. Government agencies and sponsored enterprise bonds and tax-exempt municipal bonds. All of the securities purchased were of high credit quality with a low to moderate duration. This strategy allowed us to increase net interest income by taking advantage of the positive interest rate spread between the FHLB advances and the newly acquired investment securities. While the underlying leverage strategy contributed to a lower net interest margin, it successfully increased net interest income by approximately $1.1 million for the year ended December 31, 2013.

Taxable equivalent net interest income of $94.2 million for 2013 was $3.4 million or 4% higher than 2012. The impact of a decline in average yields on our assets was diminished by a $288.7 million or 13% increase in interest-earning assets. The average balance of loans rose $158.1 million or 10% to $1.75 billion, reflecting growth in most loan categories. Consistent with our strategic plan, we continue to pursue loan development efforts in the commercial and consumer indirect lending portfolios in accordance with prudent underwriting standards.

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The increase in taxable equivalent net interest income was a function of a favorable volume variance as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $10.8 million, partially offset by an unfavorable rate variance that decreased taxable equivalent net interest income by $7.4 million. The change in mix and volume of earning assets increased taxable equivalent interest income by $10.8 million, while the change in volume and composition of interest-bearing liabilities decreased interest expense by $70 thousand, for a net favorable volume impact of $10.8 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $9.0 million, while changes in rates on interest-bearing liabilities lowered interest expense by $1.6 million, for a net unfavorable rate impact of $7.4 million.

The net interest margin for 2013 was 3.64% compared to 3.95% in 2012. As discussed in the industry overview above, the actions by the FOMC have compressed net interest income and net interest margins for the banking industry by maintaining low rates on interest-earning assets. Throughout 2013, margins in the banking industry were pressured downward as higher-yielding legacy assets rolled off and were reinvested in the current low rate environment. Low interest rates, coupled with a competitive lending environment, have proven challenging for the profitability of the banking industry. It is expected that these challenges will continue until interest rates rise.

The decrease in net interest margin was attributable to a 3 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The interest rate spread decreased by 28 basis points to 3.57% for the year ended December 31, 2013, as a 42 basis point decrease in the yield on earning assets more than offset the 14 basis point decrease in the cost of interest-bearing liabilities.

For 2013, the yield on average earning assets of 3.93% was 42 basis points lower than 2012. Loan yields decreased 44 basis points to 4.65%. Commercial mortgage and consumer indirect loans in particular, down 45 and 66 basis points, respectively, continued to experience lower yields given the competitive pricing pressures and re-pricing of loans in a low interest rate environment. The yield on investment securities dropped 25 basis points to 2.41%, also impacted by the low interest rate environment, prepayments of mortgage-related investment securities and the previously mentioned 2013 leverage strategy. Overall, earning asset rate changes reduced interest income by $9.0 million.

The average cost of interest-bearing deposits was 0.36% in 2013, 14 basis points lower than 2012, reflecting the low interest rate environment, mitigated by a focus on product pricing to retain balances. The cost of borrowings decreased 9 basis points to 0.39% for 2013. The interest-bearing liability rate changes reduced interest expense by $1.6 million during 2013.

Average interest-earning assets of $2.59 billion in 2013 were $288.7 million or 13% higher than 2012. Average investment securities increased $130.6 million while average loans increased $158.1 million or 10%. The growth in average loans was comprised of increases in most loan categories, with consumer and commercial loans up $116.9 million and $45.2 million, respectively, partially offset by a $4.1 million decrease in residential mortgage loans.

Average interest-bearing liabilities of $2.03 billion in 2013 were up $203.0 million or 11% versus 2012. On average, interest-bearing deposits grew $134.5 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $79.1 million. The increase in average deposits reflects the full-year impact of the deposits acquired in the 2012 branch acquisitions. Average borrowings increased $68.6 million, largely due to the incremental borrowings associated with the previously mentioned 2013 leverage strategy.

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The following tables present, for the periods indicated, information regarding:
(i) the average balance sheet; (ii) the amount of interest income from interest-earning assets and the resulting annualized yields (tax-exempt yields have been adjusted to a tax-equivalent basis using the applicable Federal tax rate in each year); (iii) the amount of interest expense on interest-bearing liabilities and the resulting annualized rates; (iv) net interest income;
(v) net interest rate spread; (vi) net interest income as a percentage of average interest-earning assets ("net interest margin"); and (vii) the ratio of average interest-earning assets to average interest-bearing liabilities. Investment securities are at amortized cost for both held to maturity and available for sale securities. Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Dollar amounts are shown in thousands.

                                                                                              Years ended December 31,
                                                        2013                                            2012                                            2011
                                        Average                        Average          Average                        Average          Average                        Average
                                        Balance         Interest         Rate           Balance         Interest         Rate           Balance         Interest         Rate
Interest-earning assets:
Federal funds sold and other
interest-earning deposits             $       191       $      -           0.19 %     $       113       $      -           0.29 %     $       140       $      -           0.20 %
Investment securities:
Taxable                                   601,146          12,541          2.09           525,912          12,202          2.32           545,112          14,185          2.60
Tax-exempt                                233,067           7,572          3.25           177,731           6,526          3.67           140,657           5,890          4.19

Total investment securities               834,213          20,113          2.41           703,643          18,728          2.66           685,769          20,075          2.93
. . .
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