Compliance Management; Andover Banking Group

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Last Updated: 08 May 2020

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Summary:

The issues strategies of compliance management in today’s complex public and private organizations have gained high importance. Here we analysis, the course will address both the theoretical and pragmatic aspects of managing compliance. Applying the experience of managing compliance in a global financial services organization, the course will include: the public policy and regulatory aspects of managing compliance, role of risk in compliance, administrating an effective and efficient compliance management program, the intertwining of ethics and compliance, managing compliance on a multi-jurisdictional basis, the role of policy development and management in administrating an effective compliance program, and creating an effective control environment for managing compliance.

OVERVIEW OF THE COMPLIANCE EXAMINATION

INTRODUCTION The new CEO of Andover promotes compliance with federal consumer protection laws; fair lending statutes and regulations, and the Community Reinvestment Act through supervisory and outreach programs. The new CEO of Andover conducts three types of supervisory activities to review an institution's compliance posture - compliance examinations, visitations, and investigations. Compliance examinations are the primary means the CEO uses to determine whether a financial institution is meeting its responsibility to comply with the requirements and proscriptions of federal consumer protection laws and regulations.

The CEO to review the compliance posture of newly chartered institutions coming under FDIC-supervision, or in the interval between compliance examinations to review an institution’s progress on corrective actions conducts visitations. Visitations are usually targeted events aimed at specific operational areas, or entire compliance management systems previously identified as significantly deficient.

Compliance examinations and visitations may also be considered during the review of an application submitted to the CEO. Finally, investigations are conducted primarily to follow up on particular consumer inquiries or complaints, including fair lending complaints. This chapter provides a general overview of the CEO compliance examination. The purposes of compliance examinations are to:· assess the quality of an CEO supervised institution's compliance management system for implementing federal consumer protection statutes and regulations; · review compliance with relevant laws and regulations; and initiate effective supervisory action when elements of an institution's compliance management system are deficient or when significant violations of law are found.

EXAMINATION APPROACH

The CEO compliance examinations follow a unique method that blends both risk-focused and process-oriented approaches. Risk focusing involves using information gathered about a financial institution to direct CEO examiner resources to those operational areas that present the greatest compliance risks. Concentrating on the institution's internal control infrastructure and methods, or the "process" used to ensure compliance with federal consumer protection laws and regulations, acknowledges that the ultimate responsibility for compliance rests with the institution and encourages examination efficiency.

Determining Risk Risk-focusing involves developing a compliance risk profile for an institution using various sources of information about its business lines, organizational structure, operations, and past supervisory performance; assessing the quality of an institution's compliance management system in light of the risks associated with the level and complexity of its business operations and product and service offerings; and testing selected transactions based on risk such as when an operational area is determined to be high risk and the institution's compliance management efforts appear weak.

The compliance examiner considers

- The knowledge level and attitude of management and personnel;

- Management’s responsiveness to emerging issues and past or self-identified compliance deficiencies; ·

- Compliance organizational structure, such as reporting relationships and recent experiences with staff turnover

- Management information systems;

- Policies and procedures

- Training;

- Monitoring and audit programs.

Based on the results of this review, the examiner may conclude that weaknesses in the institution's compliance management system may result in current or future non-compliance with federal consumer protection laws, regulations, or policy statements. The examiner must determine, based on this analysis, whether transaction testing is warranted to further study particular risk in an entire operational area or regulation, or only a limited aspect of an area or regulation. Generally, the more confidence an examiner has in an institution's compliance management system, the less transaction testing an examiner may do.

The examination approach appropriately recognizes that the board of directors and management of a financial institution are responsible for complying with all federal consumer protection laws and regulations. While the formality and complexity of compliance management systems will vary greatly among institutions, the he expects the board of directors and management of each institution to have a viable system in place to manage its compliance risk, consistent with its size and product mix. Managing the examination based on risk maximizes examiner efficiency and may reduce the on-site examination presence, while emphasizing areas requiring elevated supervisory attention. By focusing on compliance management systems, examiners will be able to identify the root causes of deficiencies and suggest appropriate corrective actions designed to address the problem.

ROLE OF THE COMPLIANCE EXAMINER

Compliance examiners play a crucial role in the supervisory process. The compliance examination, along with follow-up supervisory attention to an institution's compliance program deficiencies and violations, helps to ensure that consumers and businesses obtain the benefits and protections afforded them under federal law. To this end, an examiner's efforts should help the financial institution improve its compliance posture and prevent future violations. Primarily, examiners must-

- Establish an examination scope focused on assessed risk areas;

- Evaluate an institution's compliance management system;

- Conduct transaction testing where risks intersect with weaknesses

In the compliance management system or uncertainties about aspects of that system report findings to the board of directors and management of the institution. As part of the examination process, examiners are expected to take a reasoned, common sense approach to examining and use sound judgment when making decisions; maintain ongoing communication with financial institution management throughout an examination; · assist an institution to help itself improve performance by providing management with sound recommendations for enhancing its compliance management system share experiences and knowledge of successful compliance management systems; and provide guidance regarding the various consumer and fair lending laws and regulations.

EXAMINATION MANAGEMENT

Compliance examinations primarily involve four stages - pre-examination planning and analysis, on-site examination, reaching conclusions, and communicating findings to institution management via meetings and a report of examination Pre-examination Planning and Analysis Pre-examination planning involves gathering information available in CEO’s records and databases and delivering a letter to a financial institution requesting specific information and documents for detailed analysis by the examination team (see Chapter III.A). Proper examination preparation and planning maximizes an examination team's time and resources. The Examiner-in-Charge directs the analysis of the pre-examination information, and begins to develop the scope of the examination and plan for resource deployment to areas of highest risk. The scope of an examination will be preliminarily established prior to entering the financial institution, and should continue to be refined through the results of examiner discussion with senior management, the compliance officer (or staff assigned), and the internal auditor. While on site at an institution, an examiner may limit the scope of the compliance review based on reliable procedures and controls in place.

Similarly, the examiner may expand the review based on, for example, management's view about compliance, a lack of necessary procedures or controls, the presence of violations, or the presence of new or significantly amended regulations. On-site Examination During the on-site phase of an examination, an examiner thoroughly reviews an institution's compliance management system to assess its quality and viability, and documents system weaknesses and violations of federal consumer protection laws and regulations. The compliance review includes, among other things, an evaluation of the commitment of the board of directors, management, and staff to compliance; · qualifications of the compliance officer or designated staff.

An examiner must consider the size, level, and complexity of an institution's operations when evaluating the adequacy of an institution's compliance management system. The examination procedures enable an examiner to identify and quantify compliance risk; make an assessment of an institution's compliance infrastructure and methods for identifying, monitoring, and controlling compliance risk; and determine the transaction testing needed to assess the integrity of the compliance management system. The number of transactions selected and the type of sampling used should be relative to the perceived risk and the need to assess the level of compliance in an activity or function. Reaching Conclusions at the conclusion of the on-site examination,

Determining the cause(s) of a program deficiency or violation is critical to recommending solutions that will successfully address problem areas and strengthen an institution's compliance posture for the future Communicating Findings Examiners must discuss findings and recommendations with management and obtain a commitment for corrective action. These discussions will be held during the course of the examination and at an exit meeting with senior management and/or the board of directors. The results of the examination will also be communicated to the board of directors and management of the institution in a Report of Examination. The Report of Examination is a stand-alone document that details:

- Scope of the examination;

- Compliance rating; ·

- Examiner’s comments and conclusions on compliance management;

- Significant violations and other matters of supervisory concern; and

- Management’s response to findings.

- The Report of Examination provides an account of the strengths and weaknesses of a compliance management system. It is more than an exception-based document and should add value to the institution's compliance efforts.

Compliance management there is a common thread running through quality assurance, Privacy Act compliance, and company policy implementation. They all take their starting point as a document - internal or external - and use it to determine the actions of people within the organisation. All of these are forms of 'compliance management': ensuring that the actions of a set of people comply with a set of rules. There are two compliance management models that you can use to ensure this ten Commandments model: publish the set of rules, and punish people who transgress them. The quality management model: publish an intermediate set of policies and procedures which comply with the rules, and ensure that people follow the policies and procedures The 'ten commandments' model works well where there is a simple set of rules that everyone can understand. It breaks down completely where there is a complex set of rules (such as ISO 9001, or the Privacy Act) which need interpretation, or are just too large to memorise or access.

The quality management model is widely used, and is actually specified by regimes such as ISO 9001, and the Financial Services Reform Act. However, each of these regimes looks at the model in the context of the implementation of a single set of rules (AQTF, ISO 9001, etc). The problem facing most organisations now is that they have to cope with more than one set of rules. Many organisations have ISO 9001 certification, and in fact we'll assume for the rest of this article that the organisations we're dealing with either have ISO 9001 certification, or intend to get it, or have something equivalent. On top of that, all organisations have to comply with the law.

Andover Banking Group

Andover Group is an independent Australian based private investment banking business engaged in the provision of corporate advisory and investment management services. For over twenty years, the principals of Andover have been providing innovative investment banking services to public and private client companies across a broad range of industries. With offices in Sydney and the Washington D.C. region, Andover assists clients interested in executing on transactions in Australia and New Zealand, cross-border transactions with North America and capitalizing on investment opportunities in those regions.

Andover Capital Partners

Andover Capital Partners is an investment firm committed to generating substantial capital growth for our investors. We have strong interest in private equity investment opportunities across a range of industries where management teams are committed to growing the businesses they operate. Areas of focus include early stage venture, middle stage expansion and later stage LBOs, MBOs and MBIs. Andover Capital Partners is a Corporate Member of the Australian Private Equity ; Venture Capital Association.

Andover Australia America Venture Fund No. 1

The Fund has a strong preference for investing in businesses that fulfil the following criteria:

· Quality businesses at an early to middle life cycle stage (excluding seed stage start-ups)

· Generate or have the potential to generate high free cash flow

· Proven entrepreneurial management team committed to growing the business

· Proprietary technology product or service with international application

· Clear ownership of intellectual property

· Significant prospects for rapid and high growth in shareholder value over two to four years

· Attractive valuation, investment and governance terms on entry

· Excellent exit prospects via an IPO or trade sale

Company Description:

Andover Bancorp Incorporated. The principal activity of the Group is attracting deposits from the general public and investing in residential, commercial real estate, construction, consumer, commercial loans and lease financing and in various securities. Retail activities, an important source of franchise value to the banks, consist of branch operations, home mortgage and consumer lending, and mortgage banking. The bank offer a variety of retail products through branch offices, automated teller machines, the telephone call centre, online banking capabilities and product specialists. Other non-banking services include an insurance program and investment services provided by third parties. During the year 2000, the company acquired GBT Bancorp and its wholly owned subsidiary, Gloucester Bank ; Trust Company. Interest and fees on loans accounted for 78% of 2000 revenues; other interest income, 19% and non-interest income, 3%.

Quarterly Report

Management's Discussion and Analysis of Financial Condition and Results of Operations

Management's discussion and analysis should be read in conjunction with the company's consolidated financial statements and notes thereto contained in this report and the company's 2004 Annual Report on Form 10-K.

Special Note Regarding Forward-Looking Statements

This report contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact. Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as "anticipates", "believes", "expects", "intends", "may", "plans", "pursue", "views" and similar terms or expressions. Various statements contained in Item 2 - "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 3 - "Quantitative and Qualitative Disclosures About Market Risk," including, but not limited to, statements related to management's views on the banking environment and the economy, market expansion and opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements. The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the company's future results. The following important factors, among others, could cause the company's results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein:

(i) Changes in interest rates could negatively impact net interest income;

(ii) Changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the company's reserve for loan losses;

(iii) Changes in consumer spending could negatively impact the company's credit quality and financial results;

(iv) Increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the company's competitive position within its market area and reduce demand for the company's products and services;

(v) Deterioration of securities markets could adversely affect the value or credit quality of the company's assets and the availability of funding sources necessary to meet the company's liquidity needs;

(vi) Changes in technology could adversely impact the company's operations and increase technology-related expenditures;

(vii) Increases in employee compensation and benefit expenses could adversely affect the company's financial results;

(viii) Changes in laws and regulations that apply to the company's business and operations could increase the company's regulatory compliance costs and adversely affect the company's business environment, operations and financial results

(ix) Changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board could negatively impact the company's financial results. Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.

Accounting Policies/Critical Accounting Estimates:

The company has not changed its significant accounting and reporting policies from those disclosed in its 2004 Annual Report on Form 10-K. In applying these accounting policies, management is required to exercise judgement in determining many of the methodologies, assumptions and estimates to be utilized. As discussed in the company's 2004 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill.

Management's estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ from those estimates.

Composition of Earnings:

The company had net income of $6.085 million for the nine months ended September 30, 2005 compared to $5.503 million for the same period in 2004, an increase of 11%. The company's earnings are largely dependent on its net interest margin or spread, which is the difference between the yield on interest earning assets (loans, investment securities and short-term investments) and the cost of funding those assets (total deposits and borrowings). The company's earnings are, therefore, subject to the risks associated with changes in the interest rate environment. In addition, other components effecting net income include the level of the provision for loan losses, non-interest income, non-interest expenses and income taxes.

The company's tax equivalent net interest margin increased by 32 basis points to 4.79% for the current nine-month period, compared to 4.47% for the same period in 2004. The increase in margin through September 30, 2005 resulted primarily from a 44 basis point increase in the yield on interest earning assets, partially offset by a 13 basis point increase in the cost of funds (i.e.: total deposits and borrowings). The increase in asset yields was driven primarily by higher market rates, especially variable rate loans tied to the Prime Lending Rate, which has increased 275 basis points since June 2004. Conversely, market rates on deposit products, especially non-certificate products, have advanced at a slower pace over the period. In addition, the company's average non-interest bearing deposits, a key component in maintaining a low overall cost of funds, increased $21.4 million, or 15%, over the comparable nine month period in the prior year.

Net interest income, which is the margin or spread in dollar terms amounted to $27.8 million for the nine months, ended September 30, 2005. The increase in net interest income was $4.4 million, or 19%, compared to the same period in 2004, and was attributed primarily to an $88.5 million, or 17%, increase in average loan balances.

The provision for loan losses charged to operations reflects management's assessment of the adequacy of the allowance for loan losses to support the estimated credit risk inherent in the loan portfolio, including the level of charge-offs during the period. The provision for loan losses was $835 thousand for the nine months ended September 30, 2005 and $1.350 million for the same period in 2004. Net recoveries for the first nine months of 2005 were $1 thousand as compared to net charge-offs of $592 thousand in the first nine months of 2004.

Management further discusses the provision for loan losses and its assessment of the allowance at September 30, 2005 under the heading "Asset Quality and the Allowance for Loan Losses" in the "Financial Condition" section of this Item 2 below.

The company's earnings are also directly impacted by non-interest income, consisting of traditional banking fee income such as deposit and loan fees, net gains/losses on the sales of investment securities and loans, and non-deposit revenue streams such as investment management, trust and insurance services. Non-interest income was $4.8 million and $5.3 million for the nine months ended September 30, 2005 and 2004, respectively. The decrease in 2005 was primarily due to reductions in net gains on sales of investment securities and loans and decreases in deposit service fees due to the higher earnings credit rates applied to business checking accounts in the current period, partially offset by an increase in the "other" income category. The "other" income category includes merchant credit card deposit fees and electronic banking fees, commercial letter of credit fees, check printing fees, and income related to bank-owned life insurance.

The increase was due primarily to the increases in merchant and electronic banking fee income, partially due to the sale of a merchant credit card services portfolio, income related to bank-owned life insurance, and an increase in fee income due to the company's growth and increase in transaction volume.

Operating expenses are also a key component of the company's financial results. Non-interest expense amounted to $22.3 million and $18.7 million for the nine months ended September 30, 2005 and 2004, respectively. The 19% increase primarily reflects increases in compensation costs and the infrastructure necessary to support the company's ongoing growth and strategic initiatives, 2004 branch expansion into the new markets of Andover, MA and Salem, NH, the opening of our second Tewksbury, MA branch in July 2005, as well as increases in professional costs associated with the financial reporting requirements of the Sarbanes-Oxley Act.

Financial Position:

The company's primary sources of funds are deposits, borrowings from the Federal Home Loan Bank of Boston ("FHLB"), securities sold under agreements to repurchase, earnings and proceeds from the sales, maturities and paydowns on loans and investment securities. The company uses these funds to originate loans, purchase investment securities, conduct operations, expand the company's branch network, and pay dividends to shareholders.

Total assets increased $64.6 million, or 8%, since December 31, 2004, and amounted to $912.8 million at September 30, 2005. The December 31, 2004 balance was impacted by the inflow of $32 million to a demand deposit account in late December, which was withdrawn in early January 2005.

Total loans increased by $95.1 million, or 17%, over December 31, 2004. The growth was primarily in the commercial real estate portfolio and reflects the company's expansion into new markets, continued growth in mature markets and the company's continued commitment to developing strong commercial lending relationships with growing businesses, corporations, non-profit organizations, professionals and individuals.

Investments, consisting of investment securities and total short-term investments, decreased by $44.2 million, or 19%, since December 31, 2004 as proceeds from principal paydowns, calls and maturities were used primarily to fund loan growth.

Deposits increased by $43.0 million, or 6%, since December 31, 2004. The increase was concentrated primarily in the lower cost checking and non-interest bearing deposit balances. The December 31, 2004 balance reflects a $32 million demand deposit inflow that was withdrawn in early January 2005.

Borrowed funds increased $13.0 million since December 31, 2004. The increase was due primarily to loan growth exceeding deposit growth during the period.

Opportunities and Risks
Management views the current banking landscape as an opportunistic period and believes that the company has established a market presence in the Merrimack Valley and North Central regions of Massachusetts and in southern New Hampshire. Management also believes the company's business model, strong service culture, skilled management team and brand name create opportunities for the company to be the leading provider of banking and investment management services in its growing market area. Management continually strives to differentiate the company from competitors by providing innovative commercial and consumer banking, investment, and insurance products delivered through prompt and personal service based on management's familiarity and understanding of the banking needs of its customers, which include businesses, professionals, and consumers.

Management recognizes that substantial competition exists in the marketplace and views this as a key business risk. This market competition includes the expanded lending capabilities of credit unions, the shift to commercial lending by traditional savings banks, the presence of large regional and national commercial banks, as well as non-bank financial service competitors.

In this competitive marketplace, the company has continued to maintain very strong commercial loan growth through ongoing business development efforts and continued market expansion within existing and into new markets. The company expanded its market presence with two new branches that opened in Andover, MA and Salem, NH in 2004 and a second Tewksbury, MA office in July 2005, bringing the company's total branch network to fourteen. In addition, the company continues to look for market and branch opportunities that will increase franchise value and shareholder returns. Such expansion typically increases the company's operating expenses, primarily in salary and benefits, marketing, and occupancy, before the growth benefits are fully realized in those markets. In addition to growth and competition, the company's significant challenges continue to be the effective management of interest rate, credit and operational risk.

The company's interest rate risk management process involves evaluating various interest rate scenarios, competitive dynamics and market opportunities. At current interest rate levels, management considers the company's primary interest rate risk exposure to be margin or spread compression that may result from an interest yield curve that decreases, flattens or inverts.

Generally, under a decreasing interest rate scenario, both asset and liability yields re-price lower, but eventually interest rates reach a level that make further liability reductions minimal. Such a scenario occurred in the banking industry from 2000 to 2004. Significant margin contraction occurred as average interest rates approached historic lows, earning assets continued to re-price downward and interest-bearing liabilities eventually had little room to move significantly lower. In addition, as market rates declined prepayments on loans and mortgage backed investment securities accelerated, forcing companies to reinvest the proceeds at lower market rates. In 2004, the downward trend in interest rates stabilized and short-term market rates began to move upward.

Under the flat yield curve scenario, margin compression would eventually occur as short and long-term rates move toward similar levels. At current interest rate levels, this scenario would most likely occur with shorter-term liability costs increasing from market movements and competitive pressures, while longer term asset yields remain relatively stable or decrease. Over the last twelve months the yield curve has slowly moved in this direction as evidenced by the spread between the three month U.S. Treasury rate and the ten year U.S. Treasury rate contracting by 164 basis points.

The financial magnitude of this recent yield curve flattening has been somewhat mitigated by the company's product mix. Approximately 33% of loans reprice within thirty days of a change in the Prime Lending Rate, a short-term rate; approximately 45% of the company's deposits consist of lower cost checking accounts, which are considered unlikely to incur significant interest rate increases; other deposit products such as savings, money markets and certificates of deposit, have increased in rate, but at a slower pace than wholesale market rates. Over a longer period, the company expects that increases in deposit rates which could exceed increases in asset yields under a flattening yield curve scenario may eventually lead to margin compression.

An inverted yield curve would result in longer-term rates being less than shorter-term rates. As previously discussed, the company's primary revenue driver is net interest income, which is the difference between asset and liability returns. Under an inverted yield curve certain market liability yields would exceed certain asset returns. Again, the company's product mix would lessen the potential negative financial impact but to a lesser extent than under the flat curve scenario.

The management of interest rate risk is a significant component of the company's risk management process and is discussed in more detail in Item 3, "Quantitative and Qualitative Disclosures About Market Risk."

The credit risk of the portfolio depends on a wide variety of factors, including, among others, current and expected economic conditions, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or circumstances affecting their business, the continuity of borrowers' management teams and the credit management process. Management regularly monitors these factors, among others, through ongoing credit reviews by the credit department, an external loan review service, members of senior management and the loan and executive committees of the board of directors. The credit risk inherent in the loan portfolio is quantified through the allowance for loan losses, which is primarily increased through the provision for loan losses, as a direct charge to earnings. Management determined that the allowance for loan losses of $11.8 million, or 1.77% of total loans at September 30, 2005, was adequate to absorb reasonably anticipated losses due to the credit risk associated with the loan portfolio at that date. Management further discusses its assessment of the allowance at September 30, 2005 under the heading "Asset Quality and the Allowance for Loan Losses" in the "Financial Condition" section of this Item 2 below.

Management also recognizes, as a key component of the risk management process, the importance of effectively mitigating operational risk, particularly as it relates to technology administration, information security, and business continuity.

Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to continually monitor and safeguard information on its operating systems and that of third party service providers. The company contracts with outside parties to perform a broad scope of both internal and external security assessments on a regular basis. These third parties test the company's security controls and network configuration, and assess internal practices and other key items. The company also utilizes firewall technology to protect against unauthorized access and commercial software that continuously scans for computer viruses on the company's information systems. The company maintains an Information Security and Technology Practices policy applicable to all employees. The policy outlines the employee's responsibilities and key components of the company's Information Security and Technology Practices Program, which include the following: identification and assessment of risk; institution of policies and procedures to manage and control the risk; risk assessment of outsourced service providers; development of strategic security contingency plans; training of all officers and employees; and reporting to the board of directors. Significant technology issues, related changes in risk and results of third party security assessments are reported to the Board's Banking Technology and Audit Committees. The Board, through these committees, reviews the status of the Information Security and Technology Practices Program and makes adjustments to the policy as deemed necessary.

The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence that would disable the company for an extended period. The plan establishes responsibility for assessing a disruption of business, contains alternative strategies for the continuance of critical business functions, assigns responsibility for restoring services, and sets priorities by which impacted services will be restored.

Financial Condition

Short-term investments
Short-term investments classified as cash equivalents consist of overnight and term federal funds sold, money market mutual funds and discount U.S. agency notes maturing in less than ninety days. The remaining balance carried as "other short-term investments" consists of auction rate preferred securities with redemption options (auction dates) every 49 days, but which may not readily be converted to cash at par value until the next successful auction. Together, total short-term investments amounted to $12.5 million, or 1% of total assets, as of September 30, 2005 compared to $40.3 million, or 5% of total assets, at December 31, 2004. The reduction at September 30, 2005 was due to the redemption of $8.2 million of auction rate preferred securities and a decrease in overnight investments to assist in funding loan growth during the period.

At September 30, 2005, all of the company's investment securities were classified as available-for-sale and carried at fair value. The investment portfolio's fair market value at September 30, 2005 was $171.2 million, representing 19% of total assets, and consisted of $166.8 million in fixed income securities and $4.4 million in professionally managed equity securities.

During the nine months ended September 30, 2005 the company purchased $12.2 million and sold $1.4 million of securities, recognizing $227 thousand in net gains. Principal pay downs, calls and maturities totalled $25.0 million during the period, and were primarily comprised of principal payments in the mortgage backed securities portfolio.

The company's primary lending focus is on the development of high quality commercial real estate, construction and commercial & industrial lending relationships with businesses, corporations, partnerships, non-profit organizations, professionals and individuals.

Commercial real estate loans were $310.8 million at September 30, 2005, compared to $257.7 million at December 31, 2004, an increase of $53.1 million, or 21%. Commercial real estate loans are typically secured by apartment buildings, office facilities, shopping malls, or other commercial property.

Commercial & industrial loans totalled $163.3 million at September 30, 2005, compared to $142.9 million at December 31, 2004, an increase of $20.4 million, or 14%. Commercial & industrial loans include working capital loans, equipment financing (including equipment leases), term loans, and revolving lines of credit. Also included in commercial loans are loans under various U.S. Small Business Administration programs amounting to $8.2 million at September 30, 2005 and $10.0 million at December 31, 2004.

Commercial construction loans amounted to $93.6 million at September 30, 2005, compared to $80.6 million at December 31, 2004, an increase of $13.0 million, or 16%. Construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property and loans for the purchase and improvement of raw land. Over the past twelve months commercial construction loans grew by $20.9 million, or 29%. The company attributes this growth to an experienced team of lenders focused on this market segment, the economic expansion of this sector and the company's expansion into new geographic market areas.

At September 30, 2005, the company had commercial loan balances participated out to various banks amounting to $16.0 million compared to $20.0 million at December 31, 2004. These portions participated out to other institutions are not carried as assets on the company's financial statements. Commercial loans originated by other banks in which the company is the participating institution are carried on the balance sheet and amounted to $14.9 million at September 30, 2005, compared to $19.1 million at December 31, 2004. The company's participation in these loans may range from 5% to 100% of the total loan commitment, with no single participation exceeding $5.0 million. The company performs an independent credit analysis of each commitment prior to participation in the loan.

Final Recommendations:

Examination Approach

The CEO uses two approaches in conducting consumer examinations, performance- and process-oriented procedures. For small community banks, the CEO defines a minimum core set of procedures. These procedures are. Overview 2 Comptroller's Handbook transaction-based and focuses on the results of operations rather than the methods used to achieve them. Examiners reach conclusions about the quality of risk management based on the results of transaction testing. For large banks, the CEO focuses on the bank’s method for identifying, measuring, controlling, and monitoring consumer compliance risks. Examiners evaluate the bank’s risk management system and perform limited transaction testing to confirm its reliability.

The minimum core set of procedures for small community banks are the “Community Bank Consumer Compliance” examination procedures and, typically, the “Community Reinvestment Act Examination Procedures.

Risk Assessment and Interagency Ratings:

Throughout the supervisory process, the CEO assesses and re-evaluates each institution’s risk profile. From a supervisory perspective, risk is the potential that events, expected or unexpected, may have an adverse impact on the bank’s capital or earnings. The CEO has defined nine categories of risk for bank supervision purposes in the Bank Supervision Process booklet. These risks are: credit, interest rate, liquidity, price, foreign exchange, transaction, compliance, strategic, and reputation. These categories are not mutually exclusive, any product or service may expose the bank to multiple risks. For analysis and discussion purposes, however, the CEO identifies and assesses the risks separately. The applicable risks associated with consumer protection laws are compliance, transaction, and reputation risk, as described below.

Compliance Risk:

Compliance risk is the risk to earnings or capital arising from violations or nonconformance with laws, rules, regulations, prescribed practices, or ethical. Overview 4 Comptroller's Handbook standards. The risk also arises in situations where the laws or rules governing certain bank products or activities of the bank’s clients may be ambiguous or untested. Compliance risk can expose the bank to potential fines, civil money penalties, payment of damages, and the voiding of contracts. Compliance risk can lead to a diminished reputation, reduced franchise value, limited business opportunities, lessened expansion potential, and lack of contract enforceability.

Compliance risk is the predominant risk facing banks with respect to consumer protection laws. This is particularly evident in the area of the Bank Secrecy Act and fair lending laws, where noncompliance can lead to significant fines and/or civil money penalties. Also, noncompliance with the Truth in Lending Act can cause the bank to reimburse customers due to understated annual percentage rates. The failure to properly implement rate changes on variable rate contracts can also lead to the payment of adjustments to customers. Noncompliance with any of the consumer protection laws can also lead to the imposition of a civil money penalty against the bank and/or its employees. All of the above can have an adverse impact on earnings and capital.

Transaction Risk
Transaction risk is the risk to earnings or capital arising from problems with service or product delivery. This risk is a function of internal controls, information systems, employee integrity, and operating processes.

Transaction risk exists in all products and services. Transaction risk is present in every transaction covered by a consumer protection law. Even the slightest error in processing that transaction can have serious repercussions on the institution.

To illustrate, transaction risk can be seen through incorrect adjustments being made to a consumer’s variable-rate contract with the bank when interest rates change. If the adjustments are inconsistent with the contract and adversely affect the consumer, the OCC may direct the bank to correct past entries. This may include payment or adjustment to the customer’s account to reflect the proper charges. Past occurrences have shown this can be a significant charge to earnings. Likewise, calculation of understated annual percentage rates has resulted in substantial charges to earnings..Comptroller's Handbook 5 Overview

Reputation Risk
Reputation risk is the risk to earnings or capital arising from negative public opinion. This affects the bank’s ability to establish new relationships or services, or continue servicing existing relationships. This risk can expose the bank to litigation, financial loss, or damage to its reputation. Reputation risk exposure is present throughout the organization and includes the responsibility to exercise an abundance of caution in dealing with its customers and community. This risk is present in such activities as asset management and agency transactions.

Risk Assessment
With respect to the supervision of large bank consumer compliance activities, examiners must evaluate the quantity of compliance and transaction risks, the quality of the management of those risks, the aggregate level of supervisory concern for compliance, transaction and reputation risks, and the direction of compliance, transaction, and reputation risk over the next 12 months. For community banks (those with assets less than $1 billion), examiners must consider the aggregate level of risk and the direction of risk for the three applicable areas (compliance, transaction, and reputation). Guidance is provided in the “Large Bank Supervision” and the “Community Bank Risk Assessment System” booklets on how to measure these risks.

Interagency Ratings
Examiners will continue to assign a composite rating for the institution’s consumer and CRA performance using interagency rating definitions as detailed in the appendix of this booklet, the CRA section of An Examiner’s Guide to Consumer Compliance, and The Comptroller’s Handbook booklet, “Community Reinvestment Act Examination Procedures.”. Overview 6 Comptroller's Handbook.

Examination Frequency

Such in a large bank, consumer compliance examinations are conducted on a two-year cycle. Community bank consumer compliance examinations were historically performed based on a random sample of banks each year. Between 1994 and year-end 1996, all community banks will have received a consumer compliance examination. Beginning in January 1997, consumer compliance examinations will occur every 24 or 36 months, based on the safety and soundness examination cycle. Community banks on a 12-month examination cycle will receive a compliance examination at least every 24 months. Community banks on an 18-month examination cycle will receive a compliance examination at least every 36 months. During the safety and soundness examination that occurs in the interval, examiners must at least follow-up on concerns noted at the prior compliance examination. More frequent examinations of CRA may be required if the CRA rating is more than 24 months old and a formal protest from the public is received regarding a corporate application.

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