SRCE-2013.12.31-10K
Table of Contents

 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
(Mark One)
 
x           ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2013
 
OR
 
o            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                                to                                
 
Commission file number 0-6233
 
1ST SOURCE CORPORATION
(Exact name of registrant as specified in its charter)
Indiana
 
35-1068133
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
100 North Michigan Street, South Bend, Indiana
 
46601
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: (574) 235-2000
 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock — without par value
 
The NASDAQ Stock Market LLC
 
Securities registered pursuant to section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,”  “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
 
Accelerated filer x
 
 
 
Non-accelerated filer o
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
 
The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 30, 2013 was $465,841,482
 
The number of shares outstanding of each of the registrant’s classes of stock as of February 14, 2014: Common Stock, without par value — 24,274,210 shares
 
DOCUMENTS INCORPORATED BY REFERENCE

Portions of the 2014 Proxy Statement for the 2014 annual meeting of shareholders to be held April 24, 2014, are incorporated by reference into Part III.
 
 
 
 
 



Table of Contents

TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certifications
 

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Part I
Item 1.  Business.
1st Source Corporation
1st Source Corporation, an Indiana corporation incorporated in 1971, is a bank holding company headquartered in South Bend, Indiana that provides, through its subsidiaries (collectively referred to as “1st Source”, “we”, and “our”), a broad array of financial products and services. 1st Source Bank (“Bank”), its banking subsidiary, offers commercial and consumer banking services, trust and investment management services, and insurance to individual and business clients through most of our 77 banking center locations in 17 counties in Indiana and Michigan. 1st Source Bank’s Specialty Finance Group, with 22 locations nationwide, offers specialized financing services for new and used private and cargo aircraft, automobiles and light trucks for leasing and rental agencies, medium and heavy duty trucks, construction and environmental equipment. While our lending portfolio is concentrated in certain equipment types, we serve a diverse client base. We are not dependent upon any single industry or client. At December 31, 2013, we had consolidated total assets of $4.72 billion, loans and leases of $3.55 billion, deposits of $3.65 billion, and total shareholders’ equity of $585.38 million.
Our principal executive office is located at 100 North Michigan Street, South Bend, Indiana 46601 and our telephone number is 574 235-2000. Access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports is available, free of charge, at www.1stsource.com soon after the material is electronically filed with the Securities and Exchange Commission (SEC).
1st Source Bank
1st Source Bank is a wholly owned subsidiary of 1st Source Corporation that offers a broad range of consumer and commercial banking services through its lending operations, retail branches, and fee based businesses.
Commercial, Agricultural, and Real Estate Loans — 1st Source Bank provides commercial, small business, agricultural, and real estate loans to primarily privately owned business clients mainly located within our regional market area. Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing. Other services include commercial leasing, cash management services and retirement planning services.
Consumer Services — 1st Source Bank provides a full range of consumer banking products and services through our banking centers and at 1stsource.com. In a number of our markets 1st Source also offers insurance products through 1st Source Insurance offices. The traditional banking services include checking and savings accounts, certificates of deposits and Individual Retirement Accounts. 1st Source offers a full line of on-line and mobile banking products which includes bill payment. As an added convenience, a strategically located Automated Teller Machine network serves our customers and supports the debit and credit card programs of the bank. Consumers also have the ability to obtain consumer loans, real estate loans and lines of credit in any of our banking centers or on-line. Finally, 1st Source offers a variety of financial planning, financial literacy and other consultative services to our customers.
Trust Services — 1st Source Bank provides a wide range of trust, investment, agency, and custodial services for individual, corporate, and not-for-profit clients. These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans, and charitable foundations.
Specialty Finance Group Services — 1st Source Bank, through its Specialty Finance Group, provides a broad range of comprehensive equipment loan and lease finance products addressing the financing needs of a broad array of companies. This group can be broken down into four areas: auto and light trucks; medium and heavy duty trucks; new and used aircraft; and construction and environmental equipment.
The auto and light truck division consists of financings to automobile rental and leasing companies, light truck rental and leasing companies, and special purpose vehicles. The auto and light truck finance receivables generally range from $100,000 to $20 million with fixed or variable interest rates and terms of one to five years.
The medium and heavy duty truck division provides financing for highway tractors and trailers and delivery trucks to the commercial trucking industry. Medium and heavy duty truck finance receivables generally range from $500,000 to $15 million with fixed or variable interest rates and terms of three to seven years.
Aircraft financing consists of financings for new and used general aviation aircraft (including helicopters) for private and corporate aircraft users, aircraft distributors and dealers, air charter operators, air cargo carriers, and other aircraft operators. We have for many years selectively entered the international aircraft markets, primarily Brazil and Mexico, on a limited basis where desirable aircraft financing opportunities exist for private and corporate aircraft users. Aircraft finance receivables generally range from $500,000 to $15 million with fixed or variable interest rates and terms of one to ten years.

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Construction and environmental equipment financing includes financing of equipment (i.e., asphalt and concrete plants, bulldozers, excavators, cranes, loaders, and trash and recycling equipment, etc.) to the construction industry. Construction and environmental equipment finance receivables generally range from $50,000 to $20 million with fixed or variable interest rates and terms of one to five years.
We also generate equipment rental income through the leasing of construction equipment, medium and heavy duty trucks, automobiles, and other equipment to clients through operating leases.
Specialty Finance Group Subsidiaries
The Specialty Finance Group also consists of separate wholly owned subsidiaries of 1st Source Bank which include: Michigan Transportation Finance Corporation, 1st Source Specialty Finance, Inc., SFG Aircraft, Inc., 1st Source Intermediate Holding, LLC, SFG Commercial Aircraft Leasing, Inc., and SFG Equipment Leasing Corporation I.
1st Source Insurance, Inc.
1st Source Insurance, Inc. is a wholly owned subsidiary of 1st Source Bank that provides insurance products and services to individuals and businesses covering corporate and personal property, casualty insurance, and individual and group health and life insurance. 1st Source Insurance, Inc. has eight offices.
1st Source Corporation Investment Advisors, Inc.
1st Source Corporation Investment Advisors, Inc. (Investment Advisors) is a wholly owned subsidiary of 1st Source Bank that provides investment advisory services to trust and investment clients of 1st Source Bank and to Wasatch Advisors, Inc., the investment advisor of the Wasatch Mutual Fund family. Investment Advisors is registered as an investment advisor with the Securities and Exchange Commission under the Investment Advisors Act of 1940. Investment Advisors serves strictly in an advisory capacity and, as such, does not hold any client securities.
Other Consolidated Subsidiaries
We have other subsidiaries that are not significant to the consolidated entity.
1st Source Master Trust
Our unconsolidated subsidiary includes 1st Source Master Trust. This subsidiary was created for the purpose of issuing $57.00 million of trust preferred securities and lending the proceeds to 1st Source. We guarantee, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities.
Competition
The activities in which we and the Bank engage in are highly competitive. Our businesses and the geographic markets we serve require us to compete with other banks, some of which are affiliated with large bank holding companies headquartered outside of our principal market. We generally compete on the basis of client service and responsiveness to client needs, available loan and deposit products, the rates of interest charged on loans and leases, the rates of interest paid for funds, other credit and service charges, the quality of services rendered, the convenience of banking facilities, and in the case of loans and leases to large commercial borrowers, relative lending limits.
In addition to competing with other banks within our primary service areas, the Bank also competes with other financial service companies, such as credit unions, industrial loan associations, securities firms, insurance companies, small loan companies, finance companies, mortgage companies, real estate investment trusts, certain governmental agencies, credit organizations, and other enterprises.
Additional competition for depositors’ funds comes from United States Government securities, private issuers of debt obligations, and suppliers of other investment alternatives for depositors. Many of our non-bank competitors are not subject to the same extensive Federal and State regulations that govern bank holding companies and banks. Such non-bank competitors may, as a result, have certain advantages over us in providing some services.
We compete against these financial institutions by being convenient to do business with, and by taking the time to listen and understand our clients’ needs. We deliver personalized, one-on-one banking through knowledgeable local members of the community always keeping the clients best interest in mind while offering a full array of products and highly personalized services. We rely on our history and our reputation in northern Indiana dating back to 1863.
Employees
At December 31, 2013, we had approximately 1,100 employees on a full-time equivalent basis. We provide a wide range of employee benefits and consider employee relations to be good.

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Regulation and Supervision
General — 1st Source and the Bank are extensively regulated under Federal and State law. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws or regulations may have a material effect on our business and our prospective business. Our operations may be affected by legislative changes and by the policies of various regulatory authorities. We are unable to predict the nature or the extent of the effects on our business and earnings that fiscal or monetary policies, economic controls, or new Federal or State legislation may have in the future.
We are a registered bank holding company under the Bank Holding Company Act of 1956 (BHCA) and, as such, we are subject to regulation, supervision, and examination by the Board of Governors of the Federal Reserve System (Federal Reserve). We are required to file annual reports with the Federal Reserve and to provide the Federal Reserve such additional information as it may require.
1st Source Bank, as an Indiana state bank and member of the Federal Reserve System, is supervised by the Indiana Department of Financial Institutions (DFI) and the Federal Reserve. As such, 1st Source Bank is regularly examined by and subject to regulations promulgated by the DFI and the Federal Reserve. Because the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance to 1st Source Bank, we are also subject to supervision and regulation by the FDIC (even though the FDIC is not our primary Federal regulator).
Bank Holding Company Act — Under the BHCA, as amended, our activities are limited to business so closely related to banking, managing, or controlling banks as to be a proper incident thereto. We are also subject to capital requirements applied on a consolidated basis in a form substantially similar to those required of the Bank. The BHCA also requires a bank holding company to obtain approval from the Federal Reserve before (i) acquiring, or holding more than 5% voting interest in any bank or bank holding company, (ii) acquiring all or substantially all of the assets of another bank or bank holding company, or (iii) merging or consolidating with another bank holding company.
The BHCA also restricts non-bank activities to those which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or of managing or controlling banks. As discussed below, the Gramm-Leach-Bliley Act (GLBA), which was enacted in 1999, established a new type of bank holding company known as a “financial holding company” that has powers that are not otherwise available to bank holding companies.
The Federal Deposit Insurance Corporation Improvement Act of 1991 — The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was adopted to supervise and regulate a wide variety of banking issues. In general, FDICIA provided for the recapitalization of the former Bank Insurance Fund, deposit insurance reform, including the implementation of risk-based deposit insurance premiums, the establishment of five capital levels for financial institutions (“well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”) that would impose more scrutiny and restrictions on less capitalized institutions, along with a number of other supervisory and regulatory issues. At December 31, 2013, the Bank was categorized as “well capitalized,” meaning that our total risk-based capital ratio exceeded 10.00%, our Tier 1 risk-based capital ratio exceeded 6.00%, our leverage ratio exceeded 5.00%, and we are not subject to a regulatory order, agreement, or directive to meet and maintain a specific capital level for any capital measure.
Federal Deposit Insurance Reform Act — On February 1, 2006, Congress approved the Federal Deposit Insurance Reform Act of 2005 (FDIRA). Among other things, the FDIRA provides for the merger of the Bank Insurance Fund with the Savings Association Insurance Fund and for an immediate increase in Federal deposit insurance for certain retirement accounts up to $250,000. The statute further provides for the indexing of the maximum deposit insurance coverage for all types of deposit accounts in the future to account for inflation. The FDIRA also requires the FDIC to provide certain banks and thrifts that were in existence prior to December 31, 1996 with one-time credits against future premiums based on the amount of their payments to the Bank Insurance Fund or Savings Association Insurance Fund prior to that date.
FDIC Deposit Insurance Assessments —The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was signed into law on July 21, 2010, changes how the FDIC will calculate future deposit insurance premiums payable by insured depository institutions. The Dodd-Frank Act directs the FDIC to amend its assessment regulations so that future assessments will generally be based upon a depository institution’s average total consolidated assets minus the average tangible equity of the insured depository institution during the assessment period, whereas assessments were previously based on the amount of an institution’s insured deposits. The minimum deposit insurance fund rate will increase from 1.15% to 1.35% by September 30, 2020, and the cost of the increase will be borne by depository institutions with assets of $10 billion or more.
The Dodd-Frank Act also provides the FDIC with discretion to determine whether to pay rebates to insured depository institutions when its deposit insurance reserves exceed certain thresholds. Previously, the FDIC was required to give rebates to depository institutions equal to the excess once the reserve ratio exceeded 1.50%, and was required to rebate 50% of the excess over 1.35% but not more than 1.5% of insured deposits. The FDIC adopted a final rule on February 7, 2011 that implements these provisions of the Dodd-Frank Act.

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Emergency Economic Stabilization Act of 2008 — On October 3, 2008, President George W. Bush signed the Emergency Economic Stabilization Act of 2008 (EESA). This Act temporarily increased the standard maximum deposit insurance amount from $100,000 to $250,000 effective immediately. This temporary increase in the scope of deposit insurance coverage was originally set to expire on December 31, 2013, but the Dodd-Frank Act made this temporary increase permanent. Under the Troubled Asset Relief Program established by EESA, the U.S. Treasury Department (Treasury) announced a Capital Purchase Program (CPP). CPP was designed to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and support the U.S. economy. Under the program, Treasury could purchase up to $250 billion of senior preferred shares on standardized terms as described in the program’s term sheet. The program was available to qualifying U.S. controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that submitted applications to Treasury by November 14, 2008. EESA provided for Treasury to determine an applicant’s eligibility to participate in the CPP after consulting with the appropriate federal banking agency.
1st Source submitted an application to participate in the CPP and obtained Treasury approval on December 11, 2008. On January 23, 2009, 1st Source issued preferred stock valued at $111.00 million and a warrant to acquire 837,947 shares of its common stock to Treasury pursuant to the CPP. The warrant was exercisable at any time during the ten-year period following issuance at an exercise price of $19.87 per share. On December 29, 2010, 1st Source redeemed all of the preferred stock issued to the Treasury under CPP for $111.68 million, which included accrued and unpaid dividends payable to Treasury on the preferred stock. On March 8, 2011, 1st Source repurchased the common stock warrant for $3.75 million.
Securities and Exchange Commission (SEC) and The Nasdaq Stock Market (Nasdaq) — We are under the jurisdiction of the SEC and certain state securities commissions for matters relating to the offering and sale of our securities and our investment advisory services. We are subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. We are listed on the Nasdaq Global Select Market under the trading symbol “SRCE,” and we are subject to the rules of Nasdaq for listed companies.
Interstate Branching — Congress enacted the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Interstate Act) to allow bank holding companies to expand, by acquiring existing banks, into all states, even those which had theretofore restricted entry. The legislation also authorized a bank to open de novo branches in other states, but only to the extent that the law of the bank’s home state, as well as the law of the state where the branch was to be located, permitted an out-of-state bank to open a de novo branch. The Interstate Act also authorized, subject to future action by individual states, a bank holding company to convert its subsidiary banks located in different states under a single charter.
The Dodd-Frank Act amended the Interstate Act by expanding the authority of a state or national bank to open offices in other states. A state or national bank may now open a de novo branch in another state if the law of the state where the branch is to be located would permit a state bank chartered by that state to open the branch. This amendment repealed the restriction under the Interstate Act that permitted an out-of-state bank to open a de novo branch in another state only if the bank’s home state and the state where the branch was to be located had each enacted reciprocal de novo interstate branching laws.
Gramm-Leach-Bliley Act of 1999 — The GLBA is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry, and other financial service providers. It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The GLBA establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are “financial in nature,” which include securities and insurance brokerage, securities underwriting, insurance underwriting, and merchant banking. The GLBA also sets forth a system of functional regulation that makes the Federal Reserve the “umbrella supervisor” for holding companies, while providing for the supervision of the holding company’s subsidiaries by other Federal and state agencies. A bank holding company may not become a financial holding company if any of its subsidiary financial institutions are not well-capitalized or well-managed. Further, each bank subsidiary of the holding company must have received at least a satisfactory Community Reinvestment Act (CRA) rating. The GLBA also expands the types of financial activities a national bank may conduct through a financial subsidiary, addresses state regulation of insurance, generally prohibits unitary thrift holding companies organized after May 4, 1999 from participating in new activities that are not financial in nature, provides privacy protection for nonpublic customer information of financial institutions, modernizes the Federal Home Loan Bank system, and makes miscellaneous regulatory improvements. The Federal Reserve and the Secretary of the Treasury must coordinate their supervision regarding approval of new financial activities to be conducted through a financial holding company or through a financial subsidiary of a bank. While the provisions of the GLBA regarding activities that may be conducted through a financial subsidiary directly apply only to national banks, those provisions indirectly apply to state-chartered banks. In addition, the Bank is subject to other provisions of the GLBA, including those relating to CRA and privacy, regardless of whether we elect to become a financial holding company or to conduct activities through a financial subsidiary. We do not currently intend to file notice with the Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary.

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Financial Privacy — In accordance with the GLBA, Federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about customers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLBA affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. We are also subject to various state laws that generally require us to notify any customer whose personal financial information may have been released to an unauthorized person as the result of a breach of our data security policies and procedures.
USA Patriot Act of 2001 — The USA Patriot Act of 2001 (USA Patriot Act) was signed into law following the terrorist attacks of September 11, 2001. The USA Patriot Act is comprehensive anti-terrorism legislation that, among other things, substantially broadened the scope of anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions.
The regulations adopted by the Treasury under the USA Patriot Act require financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering, and terrorist financing. Additionally, the regulations require that we, upon request from the appropriate Federal regulatory agency, provide records related to anti-money laundering, perform due diligence of private banking and correspondent accounts, establish standards for verifying customer identity, and perform other related duties.
Failure of a financial institution to comply with the USA Patriot Act’s requirements could have serious legal and reputational consequences for the institution.
Regulations Governing Capital Adequacy — The Federal bank regulatory agencies use capital adequacy guidelines in their examination and regulation of bank holding companies and banks. If capital falls below the minimum levels established by these guidelines, a bank holding company or bank will be required to submit an acceptable plan for achieving compliance with the capital guidelines and will be subject to denial of applications and appropriate supervisory enforcement actions. The various regulatory capital requirements that we are subject to are disclosed in Part II, Item 8, Financial Statements and Supplementary Data — Note 20 of the Notes to Consolidated Financial Statements.
Community Reinvestment Act — The Community Reinvestment Act of 1977 requires that, in connection with examinations of financial institutions within their jurisdiction, the Federal banking regulators must evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. Federal banking regulators are required to consider a financial institution’s performance in these areas as they review applications filed by the institution to engage in mergers or acquisitions or to open a branch or facility.
Regulations Governing Extensions of Credit — 1st Source Bank is subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to 1st Source or our subsidiaries, or investments in our securities and on the use of our securities as collateral for loans to any borrowers. These regulations and restrictions may limit our ability to obtain funds from the Bank for our cash needs, including funds for acquisitions and for payment of dividends, interest and operating expenses. Further, the BHCA, certain regulations of the Federal Reserve, state laws and many other Federal laws govern the extensions of credit and generally prohibit a bank from extending credit, engaging in a lease or sale of property, or furnishing services to a customer on the condition that the customer obtain additional services from the bank’s holding company or from one of its subsidiaries.
1st Source Bank is also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders, or any related interest of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and subject to credit underwriting procedures that are at least as stringent as those prevailing at the time for comparable transactions with non affiliates, and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. The Bank is also subject to certain lending limits and restrictions on overdrafts to such persons.
Reserve Requirements — The Federal Reserve requires all depository institutions to maintain reserves against their transaction account deposits. The Bank must maintain reserves of 3.00% against net transaction accounts greater than $13.30 million and up to $89.00 million (subject to adjustment by the Federal Reserve) and reserves of 10.00% must be maintained against that portion of net transaction accounts in excess of $89.00 million. These amounts are indexed to inflation and adjusted annually by the Federal Reserve.
Dividends — The ability of the Bank to pay dividends is limited by state and Federal laws and regulations that require 1st Source Bank to obtain the prior approval of the DFI and the Federal Reserve Bank of Chicago before paying a dividend that, together with other dividends it has paid during a calendar year, would exceed the sum of its net income for the year to date combined with its retained net income for the previous two years. The amount of dividends the Bank may pay may also be limited by certain covenant agreements and by the principles of prudent bank management. See Part II, Item 5, Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for further discussion of dividend limitations.

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Monetary Policy and Economic Control — The commercial banking business in which we engage is affected not only by general economic conditions, but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowing, availability of borrowing at the “discount window,” open market operations, the imposition of changes in reserve requirements against member banks’ deposits and assets of foreign branches, and the imposition of, and changes in, reserve requirements against certain borrowings by banks and their affiliates are some of the instruments of monetary policy available to the Federal Reserve. These monetary policies are used in varying combinations to influence overall growth and distributions of bank loans, investments, and deposits, and such use may affect interest rates charged on loans and leases or paid on deposits. The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks and are expected to do so in the future. The monetary policies of the Federal Reserve are influenced by various factors, including economic growth, inflation, unemployment, short-term and long-term changes in the international trade balance, and in the fiscal policies of the U.S. Government. Future monetary policies and the effect of such policies on our future business and earnings, and the effect on the future business and earnings of the Bank cannot be predicted.
Sarbanes-Oxley Act of 2002 — The Sarbanes-Oxley Act of 2002 (SOA) includes provisions intended to enhance corporate responsibility and protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws, and which increase penalties for accounting and auditing improprieties at public traded companies. The SOA generally applies to all companies that file or are required to file periodic reports with the SEC under the Exchange Act.
Among other things, the SOA creates the Public Company Accounting Oversight Board as an independent body subject to SEC supervision with responsibility for setting auditing, quality control, and ethical standards for auditors of public companies. The SOA also requires public companies to make faster and more-extensive financial disclosures, requires the chief executive officer and the chief financial officer of public companies to provide signed certifications as to the accuracy and completeness of financial information filed with the SEC, and provides enhanced criminal and civil penalties for violations of the Federal securities laws.
The SOA also addresses functions and responsibilities of audit committees of public companies. The statute, by mandating certain stock exchange listing rules, makes the audit committee directly responsible for the appointment, compensation, and oversight of the work of the company’s outside auditor, and requires the auditor to report directly to the audit committee. The SOA authorizes each audit committee to engage independent counsel and other advisors, and requires a public company to provide the appropriate funding, as determined by its audit committee, to pay the company’s auditors and any advisors that its audit committee retains. The SOA also requires public companies to prepare an internal control report and assessment by management, along with an attestation to this report prepared by the company’s independent registered public accounting firm, in their annual reports to stockholders.
Secure and Fair Enforcement for Mortgage Licensing Act — The Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (S.A.F.E. Act) establishes a nationwide licensing and registration system for mortgage loan originators. The S.A.F.E. Act requires an employee of a bank, savings association or credit union and certain of their subsidiaries that are regulated by a federal banking agency (agency-regulated institutions) who acts as a residential mortgage loan originator to register with the Nationwide Mortgage Licensing System and Registry (NMLS), obtain a unique identifier, and maintain this registration.
The federal banking agencies adopted a final rule that was published on August 23, 2010 to implement these provisions. The final rule requires, among other things, that a loan originator submit to the NMLS certain information concerning his or her personal history and experience, undergo an FBI criminal background check, and authorize the NMLS to obtain information related to any administrative, civil, or criminal findings by any governmental agency regarding the loan originator.
Dodd-Frank Wall Street Reform and Consumer Protection Act — On July 21, 2010, President Obama signed into law the Dodd-Frank Act, which significantly changes the regulation of financial institutions and the financial services industry. The Dodd-Frank Act includes provisions affecting large and small financial institutions alike, including several provisions that will profoundly affect how community banks, thrifts, and small bank and thrift holding companies will be regulated in the future. Among other things, these provisions abolish the Office of Thrift Supervision and transfer its functions to the other federal banking agencies, relax rules regarding interstate branching, allow financial institutions to pay interest on business checking accounts, and impose new capital requirements on bank and thrift holding companies. The Dodd-Frank Act also includes several corporate governance provisions that apply to all public companies, not just financial institutions. These include provisions mandating certain disclosures regarding executive compensation and provisions addressing proxy access by shareholders.
The Dodd-Frank Act also makes permanent the temporary increase in deposit insurance coverage from $100,000 to $250,000 that was included in the EESA, and extended until December 31, 2012 the period during which the FDIC provided unlimited deposit insurance for “noninterest-bearing transaction accounts.” After that date, deposit insurance coverage of non-interest bearing transaction accounts at an insured depository institution is subject to the same restrictions that apply to other deposit accounts at the institution.

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The Dodd-Frank Act also establishes the Consumer Financial Protection Bureau (CFPB) as an independent entity within the Federal Reserve. Effective July 10, 2011, the CFPB assumed primary responsibility for administering substantially all of the consumer compliance regulations, including Regulation Z issued under the Truth in Lending Act and Regulation X issued under the Real Estate Settlement Procedures Act, formerly administered by other federal agencies. The CFPB also has the authority to promulgate consumer protection regulations that will apply to all entities, including banks, that offer consumer financial services or products. Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards affecting, among other things, originator compensation, minimum repayment standards, and pre-payment penalties. The Dodd-Frank Act contains numerous other provisions affecting financial institutions of all types, many of which may have an impact on our operating environment in substantial and unpredictable ways.
Because many of the regulations required to implement the Dodd-Frank Act have not yet been issued, the statute’s effect on the financial services industry in general, and on us in particular, is uncertain at this time. The Dodd-Frank Act is likely to affect our cost of doing business, however, and may limit or expand the scope of our permissible activities and affect the competitive balance within our industry and market areas. Our management continues to monitor the implementation of the Dodd-Frank Act and as new regulations are issued, will assess their effect on our business, financial condition, and results of operations.
Capital Standards — In July 2013, the Federal Reserve and other federal banking agencies approved final rules implementing the Basel Committee on Banking Supervision's capital guidelines for all U.S. banks and for bank holding companies with greater than $500 million in assets. Under these final rules, minimum requirements will increase for both the quantity and quality of capital held by 1st Source and the Bank. The rules include a new common equity Tier 1 capital ratio of 4.5%, a minimum Tier 1 capital ratio of 6.0%, a total capital ratio of 8.0%, and a minimum leverage ratio of 4.0%. The final rules also require a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement will be phased in over three years beginning in 2016. The capital buffer requirement effectively raises the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5%, and the total capital ratio to 10.5% on a fully phased-in basis.
The final rules also increase the required capital for certain categories of assets, including higher-risk construction real estate loans and certain exposures related to securitizations. The final rules do not, however, adopt the changes in the proposed rule to the risk weights assigned to certain mortgage loan assets. The final rules instead adopt the risk weights for residential mortgages under the existing general risk-based capital rules, which assign a risk weight of either 50% (for most first-lien exposures) or 100% for other residential mortgage exposures. Similarly, the final rules do not adopt the proposed rule's elimination of Tier 1 treatment of trust preferred securities for banking organizations with less than $15 billion in assets as of December 31, 2010. Instead, the final rules permit these banking organizations to retain non-qualifying Tier 1 capital trust preferred securities issued prior to May 19, 2010.
These new minimum capital ratios will become effective for us on January 1, 2015 and will be fully phased-in on January 1, 2019. Management believes that, as of December 31, 2013, 1st Source and 1st Source Bank would met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect.
Pending Legislation — Because of concerns relating to competitiveness and the safety and soundness of the banking industry, Congress often considers a number of wide-ranging proposals for altering the structure, regulation, and competitive relationships of the nation’s financial institutions. We cannot predict whether or in what form any proposals will be adopted or the extent to which our business may be affected.
Item 1A.  Risk Factors.
An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that we believe affect us are described below. See “Forward Looking Statements” under Item 7 of this report for a discussion of other important factors that can affect our business.
Credit Risks
We are subject to credit risks relating to our loan and lease portfolios — We have certain lending policies and procedures in place that are designed to optimize loan and lease income within an acceptable level of risk. Our management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing our management with frequent reports related to loan and lease production, loan quality, concentrations of credit, loan and lease delinquencies, and nonperforming and potential problem loans and leases. Diversification in the loan and lease portfolios is a means of managing risk associated with fluctuations and economic conditions.
We maintain an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to our management. The loan and lease review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as our policies and procedures.

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Commercial and commercial real estate loans generally involve higher credit risks than residential real estate and consumer loans. Because payments on loans secured by commercial real estate or equipment are often dependent upon the successful operation and management of the underlying assets, repayment of such loans may be influenced to a great extent by conditions in the market or the economy. We seek to minimize these risks through our underwriting standards. We obtain financial information and perform credit risk analysis on our customers. Credit criteria may include, but are not limited to, assessments of income, cash flows, collateral, and net worth; asset ownership; bank and trade credit references; credit bureau reports; and operational history.
Commercial real estate or equipment loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and generate positive cash flows. Our management examines current and projected cash flows of the borrower to determine the ability of the borrower to repay their obligations as agreed. Underwriting standards are designed to promote relationship banking rather than transactional banking. Most commercial and industrial loans are secured by the assets being financed or other business assets; however, some loans may be made on an unsecured basis. Our credit policy sets different maximum exposure limits both by business sector and our current and historical relationship and previous experience with each customer.
We offer both fixed-rate and adjustable-rate consumer mortgage loans secured by properties, substantially all of which are located in our primary market area. Adjustable-rate mortgage loans help reduce our exposure to changes in interest rates; however, during periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase as a result of repricing and the increased payments required from the borrower. Additionally, some residential mortgages are sold into the secondary market and serviced by our principal banking subsidiary, 1st Source Bank.
Consumer loans are primarily all other non-real estate loans to individuals in our regional market area. Consumer loans can entail risk, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets. In these cases, any repossessed collateral may not provide an adequate source of repayment of the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy.
The 1st Source Specialty Finance Group loan and lease portfolio consists of commercial loans and leases secured by construction and transportation equipment, including aircraft, autos, trucks, and vans. Finance receivables for this Group generally provide for monthly payments and may include prepayment penalty provisions.
Our construction and transportation related businesses could be adversely affected by slowdowns in the economy. Clients who rely on the use of assets financed through the Specialty Finance Group to produce income could be negatively affected, and we could experience substantial loan and lease losses. By the nature of the businesses these clients operate in, we could be adversely affected by rapid increases of fuel costs. Since some of the relationships in these industries are large, a slowdown could have a significant adverse impact on our performance.
Our construction and transportation related businesses could be adversely impacted by the negative effects caused by high fuel costs, terrorist and other potential attacks, and other destabilizing events. These factors could contribute to the deterioration of the quality of our loan and lease portfolio, as they could have a negative impact on the travel and transportation sensitive businesses for which our specialty finance businesses provide financing.
In addition, our leasing and equipment financing activity is subject to the risk of cyclical downturns, industry concentration and clumping, and other adverse economic developments affecting these industries and markets. This area of lending, with transportation in particular, is dependent upon general economic conditions and the strength of the travel, construction, and transportation industries.
Our reserve for loan and lease losses may prove to be insufficient to absorb probable losses in our loan and lease portfolio — In the financial services industry, there is always a risk that certain borrowers may not repay borrowings. The determination of the appropriate level of the reserve for loan and lease losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Our reserve for loan and lease losses may not be sufficient to cover the loan and lease losses that we may actually incur. If we experience defaults by borrowers in any of our businesses, our earnings could be negatively affected. Changes in local economic conditions could adversely affect credit quality, particularly in our local business loan and lease portfolio. Changes in national or international economic conditions could also adversely affect the quality of our loan and lease portfolio and negate, to some extent, the benefits of national or international diversification through our Specialty Finance Group’s portfolio. In addition, bank regulatory agencies periodically review our reserve for loan and lease losses and may require an increase in the provision for loan and lease losses or the recognition of further loan or lease charge-offs based upon their judgments, which may be different from ours.

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The soundness of other financial institutions could adversely affect us — Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due us. Any such losses could have a material adverse effect on our financial condition and results of operations.
Certain investments could have a negative impact — As a result of recent economic conditions, some municipalities are struggling to meet financial obligations. We have investment securities which are subject to credit risk if the issuers are unable to meet their obligations to us. Although we believe the issuers will be able to meet their obligations, there can be no certainty regarding future results. In addition, we face further credit analysis requirements as a result of the Dodd-Frank Act and rules promulgated by the Federal Reserve.
Our liability for residential mortgage loan repurchases could be insufficient — The agreements under which we sell residential mortgage loans in the secondary market contain various representations and warranties regarding the acceptability of loans for purchase. On occasion, we may be asked to indemnify the loan purchaser for credit losses on loans that were later deemed ineligible for purchase or we may be asked to repurchase the loan. We have established a mortgage loan repurchase liability which represents our best estimate of the losses we may incur. This estimate is based on specific loan repurchase requests and a historical loss ratio with respect to origination dollar volume. Because the level of mortgage loan repurchase losses are dependent on economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment. Within the industry, repurchase demands in recent years have increased and while we believe the loans we have underwritten and sold have met or exceeded applicable transaction parameters, we must acknowledge the current trend of mortgage insurance rescissions and speculative repurchase requests. If significant additions to our existing repurchase liability are required, it could have a material adverse impact on our financial condition and results of operations.
Market Risks
Fluctuations or continued stagnation in interest rates could reduce our profitability and affect the value of our assets — Like other financial institutions, we are subject to interest rate risk. Our primary source of income is net interest income, which is the difference between interest earned on loans and leases and investments, and interest paid on deposits and borrowings. We expect that we will periodically experience imbalances in the interest rate sensitivities of our assets and liabilities and the relationships of various interest rates to each other. Over any defined period of time, our interest-earning assets may be more sensitive to changes in market interest rates than our interest-bearing liabilities, or vice-versa. In addition, the individual market interest rates underlying our loan and lease and deposit products may not change to the same degree over a given time period. In any event, if market interest rates should move contrary to our position, earnings may be negatively affected. In addition, loan and lease volume and quality and deposit volume and mix can be affected by market interest rates as can the businesses of our clients. Changes in levels of market interest rates could have a material adverse effect on our net interest spread, asset quality, origination volume, and overall profitability.
Market interest rates are beyond our control, and they fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, may negatively affect our ability to originate loans and leases, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately could affect our earnings.
Adverse changes in economic conditions could impair our financial condition and results of operations — We are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, unemployment, and the strength of the U.S. economy and the local economies in which we operate, all of which are beyond our control. A deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for our products and services. Economic turmoil in the European Union represents significant risk to the global economy. Economic collapse of any EU member or similar severe crisis in Europe could adversely impact us and our clients.

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Liquidity Risks
We could experience an unexpected inability to obtain needed liquidity — Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits, and to take advantage of interest rate market opportunities and is essential to a financial institution’s business. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets, and its access to alternative sources of funds. We seek to ensure our funding needs are met by maintaining a level of liquidity through asset and liability management. If we become unable to obtain funds when needed, it could have a material adverse effect on our business, financial condition, and results of operations. Additionally, under Indiana law governing the collateralization of public fund deposits, the Indiana Board for Depositories determines which financial institutions are required to pledge collateral based on the strength of their financial ratings. We have been informed that no collateral is required for our public fund deposits. However, the Board of Depositories could alter this requirement in the future and adversely impact our liquidity.
We rely on dividends from our subsidiaries — Our parent company, 1st Source Corporation, receives substantially all of its revenue from dividends from our subsidiaries. These dividends are the principal source of funds to pay dividends on our common stock and interest and principal on our debt. Various federal and/or state laws and regulations limit the amount of dividends that our subsidiaries may pay to our parent company. In the event our subsidiaries are unable to pay dividends to our parent company, we may not be able to service debt, pay obligations or pay dividends on our common stock. The inability to receive dividends from our subsidiaries could have a material adverse effect on our business, financial condition and results of operations.
Operational Risks
We are dependent upon the services of our management team — Our future success and profitability is substantially dependent upon our management and the banking abilities of our senior executives. We believe that our future results will also depend in part upon our ability to attract and retain highly skilled and qualified management. We are especially dependent on a limited number of key management personnel, many of whom do not have employment agreements with us. The loss of the chief executive officer and other senior management and key personnel could have a material adverse impact on our operations because other officers may not have the experience and expertise to readily replace these individuals. Many of these senior officers have primary contact with our clients and are important in maintaining personalized relationships with our client base. The unexpected loss of services of one or more of these key employees could have a material adverse effect on our operations and possibly result in reduced revenues if we were unable to find suitable replacements promptly. Competition for senior personnel is intense, and we may not be successful in attracting and retaining such personnel. Changes in key personnel and their responsibilities may be disruptive to our businesses and could have a material adverse effect on our businesses, financial condition, and results of operations.
Technology security breaches and constant technological change — Information security risks have increased significantly due to the use of online, telephone, and mobile banking channels by clients and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties. Any compromise of our security could deter our clients from using our banking services. We depend on the services of a variety of third party vendors to meet data processing and communication needs. We rely on security systems to provide the security and authentication necessary to effect secure transmission of data against damage by theft, fire, power loss, telecommunications failure or similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms, and other disruptive problems caused by hackers. Computer break-ins, phishing and other disruptions of customer or vendor systems could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure. We also maintain a cyber insurance policy that is designed to cover loss resulting from cyber security breaches. These precautions may not protect our systems from compromises or breaches of our security measures that could result in damage to our reputation and business.
The financial services industry is constantly undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better service clients and reduce costs. Our future success depends, in part, upon our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands, as well as create additional efficiencies within our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services quickly or be successful in marketing these products and services to our clients. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

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Our accounting estimates and risk management processes rely on analytical and forecasting models — The processes we use to estimate our probable loan losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on our financial condition and results of operations, depends upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are adequate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation. If the models we use for interest rate risk and asset-liability management are inadequate, we may incur increased or unexpected losses upon changes in market interest rates or other market measures. If the models we use for determining our probable loan losses are inadequate, the reserve for loan and lease losses may not be sufficient to support future charge-offs. If the models we use to measure the fair value of financial instruments is inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what we could realize upon sale or settlement of such financial instruments. Any such failure in our analytical or forecasting models could have a material adverse effect on our business, financial condition and results of operations.
Legal/Compliance Risks
We are subject to extensive government regulation and supervision — Our operations are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not security holders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible change. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulation or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs and limit the types of financial services and products we may offer. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
Changes in accounting standards could impact reported earnings — Current accounting and tax rules, standards, policies and interpretations influence the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies and interpretations are constantly evolving and may change significantly over time. Events that may not have a direct impact on us, such as bankruptcy of major U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the Securities and Exchange Commission, the Public Company Accounting Oversight Board and various taxing authorities, responding by adopting and/or proposing substantive revision to laws, regulations, rules, standards, policies and interpretations. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. A change in accounting standards may adversely affect our reported financial condition and results of operations.
Substantial ownership concentration — Our directors, executive officers and 1st Source Bank, as trustee, collectively hold a significant ownership concentration of our common shares. Due to this significant level of ownership among our affiliates, our directors, executive officers, and 1st Source Bank, as trustee, may be able to influence the outcome of director elections or impact significant transactions, such as mergers or acquisitions, or any other matter that might otherwise be favored by other stockholders.
Reputational Risks
Competition from other financial services providers could adversely impact our results of operations — The banking and financial services business is highly competitive. We face competition in making loans and leases, attracting deposits and providing insurance, investment, trust, and other financial services. Increased competition in the banking and financial services businesses may reduce our market share, impair our growth or cause the prices we charge for our services to decline. Our results of operations may be adversely impacted in future periods depending upon the level and nature of competition we encounter in our various market areas.
Managing reputational risk is important to attracting and maintaining customers, investors, and employees — Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies, and questionable or fraudulent activities of our customers. We have policies and procedures in place that seek to protect our reputation and promote ethical conduct. Nonetheless, negative publicity may arise regarding our business, employees, or customers, with or without merit, and could result in the loss of customers, investors, and employees; costly litigation; a decline in revenues; and increased government regulation.
 Item 1B.  Unresolved Staff Comments.
None

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Item 2.  Properties.
Our headquarters building is located in downtown South Bend, Indiana. The building is part of a larger complex, including a 300-room hotel and a 500-car parking garage. In December 2010, we entered into a new 10.5 year lease on our headquarters building which became effective January 1, 2011. As of December 31, 2013, 1st Source leases approximately 69% of the office space in this complex.
At December 31, 2013, we also owned property and/or buildings on which 56 of 1st Source Bank’s 77 banking centers were located, including the facilities in Allen, Elkhart, Fulton, Huntington, Kosciusko, LaPorte, Marshall, Porter, St. Joseph, Starke, Tippecanoe, Wells, and Whitley Counties in the State of Indiana and Berrien and Cass Counties in the State of Michigan, as well as an operations center, warehouse, and our former headquarters building, which is utilized for additional business operations. The Bank leases additional property and/or buildings to and from third parties under lease agreements negotiated at arms-length.
Item 3.  Legal Proceedings.
As previously reported, 1st Source Bank, as the trustee (the “Trustee”) of the Morris Family Trusts for Ernestine M. Raclin, Chairman Emeritus of the Company, and other beneficiaries, requested approval of the Probate Court of St. Joseph County Indiana to divide the Morris Family Trusts into four separate family trust lines. The Trustee also sought other relief regarding the trusts including approving its accounts. The action was taken in light of possible changes in tax laws and for financial and estate planning purposes, including the possible divesture of some 1st Source Corporation common stock owned by the Trusts. Shares at issue in the probate action held by the Morris Family Trusts represent approximately 21% of the outstanding common stock of the Company. 1st Source Bank has served as Trustee continuously since 1985.
The four family trust lines correspond to the four children of Mrs. Raclin. (Mrs. Raclin's daughter, Carmen is the wife of Christopher J. Murphy III, the Chairman of the Board and Chief Executive Officer of the Company.) In a response filed on September 28, 2012, two of the siblings and their respective children filed a joint answer to the Trustee’s petition and a counter-petition setting forth their objection to the Trustee’s proposed division of the Morris Family Trusts into four family trust lines. They also sought affirmative relief, alleging that the Trustee has breached its duties by, among other things, acquiring an inappropriate and unreasonably high concentration in common stock of the Company in 1971 and, for decades thereafter, failing to prudently, impartially and timely diversify the assets of the Morris Family Trusts uninfluenced by the impact on the Company or its executives.
The relief sought includes removal of the Trustee, unspecified damages and payment by 1st Source Bank of all fees, costs and expenses incurred by the Trustee for, among other things, all matters related to the preparation and prosecution of the probate action. Mrs. Raclin, the two remaining siblings and their children, respectively, filed their joint answer to the petition indicating their previous and ongoing support for the Trustee’s acquisition of and continuing investment in the common stock of the Company. The Company believes there is no basis for the relief requested in the objection and counter-petition. The Trustee is defending the matter vigorously. The Board of Directors of the Company has formed a special committee of independent directors that actively monitors the progress of the matter.
1st Source and our subsidiaries are involved in various other legal proceedings incidental to the conduct of our businesses. Our management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
Item 4.  Mine Safety Disclosures.
None
Part II
Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock is traded on the NASDAQ Global Select Market under the symbol “SRCE.” The following table sets forth for each quarter the high and low sales prices for our common stock, as reported by NASDAQ, and the cash dividends paid per share for each quarter.
 
 
2013 Sales Price
 
Cash Dividends
 
2012 Sales Price
 
Cash Dividends
Common Stock Prices (quarter ended) 
 
High
 
Low
 
Paid
 
High
 
Low
 
Paid
March 31
 
$
24.79

 
$
21.88

 
$
0.17

 
$
26.79

 
$
23.54

 
$
0.16

June 30
 
25.25

 
22.65

 
0.17

 
24.86

 
20.51

 
0.16

September 30
 
28.82

 
23.87

 
0.17

 
23.97

 
21.40

 
0.17

December 31
 
32.92

 
25.64

 
0.17

 
23.15

 
19.70

 
0.17

As of February 14, 2014, there were 908 holders of record of 1st Source common stock.

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Comparison of Five Year Cumulative Total Return*
Among 1st Source, Morningstar Market Weighted NASDAQ Index** and Peer Group Index***
 
* Assumes $100 invested on December 31, 2008, in 1st Source Corporation common stock, NASDAQ market index, and peer group index.
** The Morningstar Weighted NASDAQ Index Return is calculated using all companies which trade as NASD Capital Markets, NASD Global Markets or NASD Global Select. It includes both domestic and foreign companies. The index is weighted by the then current shares outstanding and assumes dividends reinvested. The return is calculated on a monthly basis.
*** The peer group is a market-capitalization-weighted stock index of 151 banking companies in Illinois, Indiana, Michigan, Ohio, and Wisconsin.
NOTE: Total return assumes reinvestment of dividends.
The following table shows our share repurchase activity during the three months ended December 31, 2013.
Period
 
Total Number of
Shares Purchased
 
Average Price
Paid Per Share
 
Total Number of
Shares Purchased as
Part of Publicly Announced
Plans or Programs*
 
Maximum Number (or Approximate
Dollar Value) of Shares that
may yet be Purchased Under
the Plans or Programs
October 01 - 31, 2013
 
24

 
$
26.54

 
24

 
880,135

November 01 - 30, 2013
 

 

 

 
880,135

December 01 - 31, 2013
 
167

 
31.85

 
167

 
879,968

 
*1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on April 26, 2007. Under the terms of the plan, 1st Source may repurchase up to 2,000,000 shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception of the plan, 1st Source has repurchased a total of 1,120,032 shares.
Federal laws and regulations contain restrictions on the ability of 1st Source and the Bank to pay dividends. For information regarding restrictions on dividends, see Part I, Item 1, Business - Regulation and Supervision - Dividends and Part II, Item 8, Financial Statements and Supplementary Data - Note 20 of the Notes to Consolidated Financial Statements.

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Item 6.  Selected Financial Data.
The following table shows selected financial data and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes presented elsewhere herein.
(Dollars in thousands, except per share amounts)
 
2013
 
2012
 
2011
 
2010
 
2009
Interest income
 
$
179,585

 
$
182,085

 
$
187,523

 
$
200,626

 
$
200,412

Interest expense
 
22,768

 
30,309

 
39,123

 
53,129

 
72,200

Net interest income
 
156,817

 
151,776

 
148,400

 
147,497

 
128,212

Provision for loan and lease losses
 
772

 
5,752

 
3,129

 
19,207

 
31,101

Net interest income after provision for loan and lease losses
 
156,045

 
146,024

 
145,271

 
128,290

 
97,111

Noninterest income
 
77,212

 
81,192

 
80,872

 
86,691

 
85,530

Noninterest expense
 
149,314

 
151,536

 
152,354

 
154,505

 
151,123

Income before income taxes
 
83,943

 
75,680

 
73,789

 
60,476

 
31,518

Income taxes
 
28,985

 
26,047

 
25,594

 
19,232

 
6,028

Net income
 
54,958

 
49,633

 
48,195

 
41,244

 
25,490

Net income available to common shareholders
 
$
54,958

 
$
49,633

 
$
48,195

 
$
29,655

 
$
19,074

 
 
 
 
 
 
 
 
 
 
 
Assets at year-end
 
$
4,722,826

 
$
4,550,693

 
$
4,374,071

 
$
4,445,281

 
$
4,542,100

Long-term debt and mandatorily redeemable securities at year-end
 
58,335

 
71,021

 
37,156

 
24,816

 
19,761

Shareholders’ equity at year-end (1)
 
585,378

 
558,655

 
523,918

 
486,383

 
570,320

Basic net income per common share
 
2.23

 
2.02

 
1.96

 
1.21

 
0.79

Diluted net income per common share
 
2.23

 
2.02

 
1.96

 
1.21

 
0.79

Cash dividends per common share
 
0.68

 
0.66

 
0.64

 
0.61

 
0.59

Dividend payout ratio
 
30.49
%
 
32.67
%
 
32.65
%
 
50.41
%
 
74.68
%
Return on average assets
 
1.19
%
 
1.11
%
 
1.09
%
 
0.91
%
 
0.57
%
Return on average common equity
 
9.55
%
 
9.10
%
 
9.51
%
 
6.10
%
 
4.07
%
Average common equity to average assets
 
12.49
%
 
12.20
%
 
11.51
%
 
10.69
%
 
10.40
%
 
(1) Results for 2009 include the issuance of Preferred Stock under TARP which was redeemed in the fourth quarter of 2010.
Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The purpose of this analysis is to provide the reader with information relevant to understanding and assessing our results of operations for each of the past three years and financial condition for each of the past two years. In order to fully appreciate this analysis the reader is encouraged to review the consolidated financial statements and statistical data presented in this document.
Forward-Looking Statements
This report, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements. Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.
All statements other than statements of historical fact are statements that could be forward-looking statements. Words such as “believe,” “contemplate,” “seek,” “estimate,” “plan,” “project,” “anticipate,” “possible,” “assume,” “expect,” “intend,” “targeted,” “continue,” “remain,” “will,” “should,” “indicate,” “would,” “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date.

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All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise, or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made. We have expressed our expectations, beliefs, and projections in good faith and we believe they have a reasonable basis. However, we make no assurances that our expectations, beliefs, or projections will be achieved or accomplished. The results or outcomes indicated by our forward-looking statements may not be realized due to a variety of factors, including, without limitation, the following:
Local, regional, national, and international economic conditions and the impact they may have on us and our clients and our assessment of that impact.
Changes in the level of nonperforming assets and charge-offs.
Changes in estimates of future cash reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.
The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.
Inflation, interest rate, securities market, and monetary fluctuations.
Political instability.
Acts of war or terrorism.
Substantial increases in the cost of fuel.
The timely development and acceptance of new products and services and perceived overall value of these products and services by others.
Changes in consumer spending, borrowings, and savings habits.
Changes in the financial performance and/or condition of our borrowers.
Technological changes.
Acquisitions and integration of acquired businesses.
The ability to increase market share and control expenses.
Changes in the competitive environment among bank holding companies.
The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, and insurance) with which we and our subsidiaries must comply.
The effect of changes in accounting policies and practices and auditing requirements, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standard setters.
Changes in our organization, compensation, and benefit plans.
The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquires and the results of regulatory examinations or reviews.
Greater than expected costs or difficulties related to the integration of new products and lines of business.
Our success at managing the risks described in Item 1A. Risk Factors.
Application of Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP) and follow general practices within the industries in which we operate. Application of these principles requires management to make estimates or judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates or judgments reflect management’s view of the most appropriate manner in which to record and report our overall financial performance. Because these estimates or judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. As such, changes in these estimates, judgments, and/or assumptions may have a significant impact on our financial statements. All accounting policies are important, and all policies described in Part II, Item 8, Financial Statements and Supplementary Data, Note 1 (Note 1), should be reviewed for a greater understanding of how our financial performance is recorded and reported.

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We have identified the following three policies as being critical because they require management to make particularly difficult, subjective, and/or complex estimates or judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the determination of the reserve for loan and lease losses, fair value measurements, and the valuation of mortgage servicing rights. Management believes it has used the best information available to make the estimations or judgments necessary to value the related assets and liabilities. Actual performance that differs from estimates or judgments and future changes in the key variables could change future valuations and impact net income. Management has reviewed the application of these policies with the Audit Committee of the Board of Directors. Following is a discussion of the areas we view as our most critical accounting policies.
Reserve for Loan and Lease Losses — The reserve for loan and lease losses represents management’s estimate of probable losses inherent in the loan and lease portfolio and the establishment of a reserve that is sufficient to absorb those losses. In determining an appropriate reserve, management makes numerous judgments, assumptions, and estimates based on continuous review of the loan and lease portfolio, estimates of client performance, collateral values, and disposition, as well as historical loss rates and expected cash flows. In assessing these factors, management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. Nonetheless, if management’s underlying assumptions prove to be inaccurate, the reserve for loan and lease losses would have to be adjusted. Our accounting policy related to the reserve is disclosed in Note 1 under the heading “Reserve for Loan and Lease Losses.”
Fair Value Measurements — We use fair value measurements to record certain financial instruments and to determine fair value disclosures. Available-for-sale securities, trading account securities, mortgage loans held for sale, and interest rate swap agreements are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial assets on a nonrecurring basis. These nonrecurring fair value adjustments typically involve write-downs of, or specific reserves against, individual assets. GAAP establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used in the measurement are observable or unobservable. Observable inputs reflect market-driven or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data.
The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market data. For financial instruments that trade actively and have quoted market prices or observable market data, there is minimal subjectivity involved in measuring fair value. When observable market prices and data are not fully available, management judgment is necessary to estimate fair value. In addition, changes in the market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. Therefore, when market data is not available, we use valuation techniques that require more management judgment to estimate the appropriate fair value measurement. Fair value is discussed further in Note 1 under the heading “Fair Value Measurements” and in Note 21, “Fair Value Measurements.”
Mortgage Servicing Rights Valuation — We recognize as assets the rights to service mortgage loans for others, known as mortgage servicing rights, whether the servicing rights are acquired through purchases or through originated loans. Mortgage servicing rights do not trade in an active open market with readily observable market prices. Although sales of mortgage servicing rights do occur, the precise terms and conditions may not be readily available. As such, the value of mortgage servicing assets is established and valued using discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. The estimated rates of mortgage loan prepayments are the most significant factors driving the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced. In determining the fair value of the mortgage servicing assets, mortgage interest rates (which are used to determine prepayment rates), and discount rates are held constant over the estimated life of the portfolio. Estimated mortgage loan prepayment rates are derived from a third-party model and adjusted to reflect our actual prepayment experience. Mortgage servicing assets are carried at the lower of amortized cost or fair value. The values of these assets are sensitive to changes in the assumptions used and readily available market pricing does not exist. The valuation of mortgage servicing assets is discussed further in Note 21, “Fair Value Measurements.”
Earnings Summary
Net income in 2013 was $54.96 million, up from $49.63 million in 2012 and up from $48.20 million in 2011. Diluted net income per common share was $2.23 in 2013, $2.02 in 2012, and $1.96 in 2011. Return on average total assets was 1.19% in 2013 compared to 1.11% in 2012, and 1.09% in 2011. Return on average common shareholders’ equity was 9.55% in 2013 versus 9.10% in 2012, and 9.51% in 2011.

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Net income in 2013, as compared to 2012, was positively impacted by a $5.04 million or 3.32% increase in net interest income and $4.98 million or 86.58% decrease in provision for loan and lease losses over 2012, which was offset by a $3.98 million or 4.90% decrease in noninterest income and a $2.94 million or 11.28% increase in income tax expense. Net income in 2012 was positively impacted by a $3.38 million or 2.27% increase in net interest income from 2011, which was offset by an increase of $2.62 million or 83.83% in provision for loan and lease losses.
Dividends paid on common stock in 2013 amounted to $0.68 per share, compared to $0.66 per share in 2012, and $0.64 per share in 2011. The level of earnings reinvested and dividend payouts are determined by the Board of Directors based on management’s assessment of future growth opportunities and the level of capital necessary to support them.
Net Interest Income — Our primary source of earnings is net interest income, the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities while deposits and borrowings represent the major portion of interest-bearing liabilities. For purposes of the following discussion, comparison of net interest income is done on a tax equivalent basis, which provides a common basis for comparing yields on earning assets exempt from federal income taxes to those which are fully taxable.
Net interest margin (the ratio of net interest income to average earning assets) is significantly affected by movements in interest rates and changes in the mix of earning assets and the liabilities that fund those assets. Net interest margin on a fully taxable equivalent basis was 3.67% in 2013, compared to 3.69% in 2012 and 2011. The stable margins in 2013 and 2012 reflect the decline in funding costs offset by lower yields on earnings assets. Net interest income was $156.82 million for 2013, compared to $151.78 million for 2012 and $148.40 million for 2011. Tax-equivalent net interest income totaled $158.64 million for 2013, up $4.80 million from the $153.84 million reported in 2012. Tax-equivalent net interest income for 2012 was up $2.93 million from the $150.91 million reported for 2011.
During 2013, average earning assets increased $151.46 million while average interest-bearing liabilities increased $47.03 million over the comparable period in 2012. The yield on average earning assets decreased 22 basis points to 4.19% for 2013 from 4.41% for 2012 due to reduced market interest rates. Total cost of average interest-bearing liabilities decreased 25 basis points to 0.69% during 2013 from 0.94% in 2012 as liabilities were impacted by decreases in market rates and rate re-pricing on maturing certificates of deposit. The result was a decrease of 2 basis points to net interest spread, or the difference between interest income on earning assets and expense on interest-bearing liabilities.
The largest contributor to the decrease in the yield on average earning assets in 2013 was the 33 basis point decrease in the loan and lease portfolio yield. Average net loans and leases increased $224.45 million or 6.99% in 2013 from 2012 while the yield decreased to 4.69%.
During 2013, the tax-equivalent yield on securities available for sale decreased 16 basis points to 2.26% while the average balance decreased $41.59 million. Average mortgages held for sale decreased $9.13 million during 2013 and the yield increased 42 basis points. Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve Bank excess balances, Federal Reserve Bank and Federal Home Loan Bank stock and commercial paper decreased $22.26 million during 2013 while the yield increased 73 basis points. The increase in yield was primarily a result of lower outstanding balances at higher rates.
Average interest-bearing deposits increased $52.40 million during 2013 while the effective rate paid on those deposits decreased 19 basis points. Average noninterest-bearing demand deposits increased $73.90 million during 2013.
Average short-term borrowings increased $16.87 million during 2013 while the effective rate paid increased 2 basis points. Average long-term debt increased $7.42 million during 2013 as the effective rate decreased 45 basis points.
Average subordinated notes decreased $29.66 million during 2013 while the effective rate paid decreased by 15 basis points. The decrease in yield and average balance during 2013 was due to the redemption of trust preferred securities in December 2012.

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The following table provides an analysis of net interest income and illustrates interest income earned and interest expense charged for each major component of interest earning assets and the interest bearing liabilities. Yields/rates are computed on a tax-equivalent basis, using a 35% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding.
 
 
2013
 
2012
 
2011
(Dollars in thousands)
 
Average Balance
 
Interest Income/Expense
 
Yield/Rate
 
Average Balance
 
Interest Income/Expense
 
Yield/Rate
 
Average Balance
 
Interest Income/Expense
 
Yield/Rate
ASSETS
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Investment securities:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Taxable
 
$
731,371

 
$
14,414

 
1.97
%
 
$
775,103

 
$
16,426

 
2.12
%
 
$
780,215

 
$
18,533

 
2.38
%
Tax-exempt
 
109,427

 
4,565

 
4.17

 
107,289

 
4,939

 
4.60

 
119,680

 
5,921

 
4.95

Mortgages held for sale
 
7,571

 
300

 
3.96

 
16,700

 
592

 
3.54

 
10,959

 
468

 
4.27

Net loans and leases
 
3,433,938

 
161,192

 
4.69

 
3,209,490

 
161,253

 
5.02

 
3,078,581

 
164,117

 
5.33

Other investments
 
43,600

 
940

 
2.16

 
65,861

 
943

 
1.43

 
100,862

 
991

 
0.98

Total earning assets
 
4,325,907

 
181,411

 
4.19

 
4,174,443

 
184,153

 
4.41

 
4,090,297

 
190,030

 
4.65

Cash and due from banks
 
58,762

 
 

 
 

 
60,099

 
 

 
 

 
59,698

 
 

 
 

Reserve for loan and lease losses
 
(85,203
)
 
 

 
 

 
(83,430
)
 
 

 
 

 
(86,617
)
 
 

 
 

Other assets
 
308,483

 
 

 
 

 
321,767

 
 

 
 

 
339,176

 
 

 
 

Total assets
 
$
4,607,949

 
 

 
 

 
$
4,472,879

 
 

 
 

 
$
4,402,554

 
 

 
 

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest bearing deposits
 
$
3,010,183

 
$
16,604

 
0.55
%
 
$
2,957,785

 
$
21,877

 
0.74
%
 
$
3,014,033

 
$
30,762

 
1.02
%
Short-term borrowings
 
154,804

 
211

 
0.14

 
137,937

 
169

 
0.12

 
149,428

 
300

 
0.20

Subordinated notes
 
58,764

 
4,220

 
7.18

 
88,425

 
6,484

 
7.33

 
89,692

 
6,589

 
7.35

Long-term debt and mandatorily redeemable securities
 
62,807

 
1,733

 
2.76

 
55,383

 
1,779

 
3.21

 
33,093

 
1,472

 
4.45

Total interest bearing liabilities
 
3,286,558

 
22,768

 
0.69

 
3,239,530

 
30,309

 
0.94

 
3,286,246

 
39,123

 
1.19

Noninterest bearing deposits
 
690,326

 
 

 
 

 
616,426

 
 

 
 

 
541,421

 
 

 
 

Other liabilities
 
55,403

 
 

 
 

 
71,292

 
 

 
 

 
67,948

 
 

 
 

Shareholders’ equity
 
575,662

 
 

 
 

 
545,631

 
 

 
 

 
506,939

 
 

 
 

Total liabilities and shareholders’ equity
 
$
4,607,949

 
 

 
 

 
$
4,472,879

 
 

 
 

 
$
4,402,554

 
 

 
 

Net interest income
 
 

 
$
158,643

 
 

 
 

 
$
153,844

 
 

 
 

 
$
150,907

 
 

Net interest margin on a tax equivalent basis
 
 

 
 

 
3.67
%
 
 

 
 

 
3.69
%
 
 

 
 

 
3.69
%

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Table of Contents

The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. The following table shows changes in tax equivalent interest earned and interest paid, resulting from changes in volume and changes in rates:
 
 
Increase (Decrease) due to
 
 
(Dollars in thousands)
 
Volume
 
Rate
 
Net
2013 compared to 2012
 
 

 
 

 
 

Interest earned on:
 
 

 
 

 
 

Investment securities:
 
 

 
 

 
 

Taxable
 
$
(886
)
 
$
(1,126
)
 
$
(2,012
)
Tax-exempt
 
98

 
(472
)
 
(374
)
Mortgages held for sale
 
(372
)
 
80

 
(292
)
Net loans and leases
 
10,900

 
(10,961
)
 
(61
)
Other investments
 
(403
)
 
400

 
(3
)
Total earning assets
 
$
9,337

 
$
(12,079
)
 
$
(2,742
)
Interest paid on:
 
 

 
 

 
 

Interest bearing deposits
 
$
456

 
$
(5,729
)
 
$
(5,273
)
Short-term borrowings
 
12

 
30

 
42

Subordinated notes
 
(2,134
)
 
(130
)
 
(2,264
)
Long-term debt and mandatorily redeemable securities
 
835

 
(881
)
 
(46
)
Total interest bearing liabilities
 
$
(831
)
 
$
(6,710
)
 
$
(7,541
)
Net interest income
 
$
10,168

 
$
(5,369
)
 
$
4,799

 
 
 
 
 
 
 
2012 compared to 2011
 
 

 
 

 
 

Interest earned on:
 
 

 
 

 
 

Investment securities:
 
 

 
 

 
 

Taxable
 
$
(90
)
 
$
(2,017
)
 
$
(2,107
)
Tax-exempt
 
(581
)
 
(401
)
 
(982
)
Mortgages held for sale
 
184

 
(60
)
 
124

Net loans and leases
 
8,256

 
(11,120
)
 
(2,864
)
Other investments
 
150

 
(198
)
 
(48
)
Total interest earning assets
 
$
7,919

 
$
(13,796
)
 
$
(5,877
)
Interest paid on:
 
 

 
 

 
 

Interest bearing deposits
 
$
(593
)
 
$
(8,292
)
 
$
(8,885
)
Short-term borrowings
 
(19
)
 
(112
)
 
(131
)
Subordinated notes
 
(87
)
 
(18
)
 
(105
)
Long-term debt and mandatorily redeemable securities
 
523

 
(216
)
 
307

Total interest bearing liabilities
 
$
(176
)
 
$
(8,638
)
 
$
(8,814
)
Net interest income
 
$
8,095

 
$
(5,158
)
 
$
2,937

Noninterest Income — Noninterest income decreased $3.98 million or 4.90% in 2013 from 2012 following a $0.32 million or 0.40% increase in 2012 over 2011. The following table shows noninterest income for the most recent three years ended December 31:
(Dollars in thousands)
 
2013
 
2012
 
2011
Noninterest income:
 
 

 
 

 
 

Trust fees
 
$
17,383

 
$
16,498

 
$
16,327

Service charges on deposit accounts
 
9,177

 
10,418

 
10,993

Debit card income
 
8,882

 
8,389

 
7,495

Mortgage banking income
 
5,944

 
8,357

 
3,839

Insurance commissions
 
5,492

 
5,494

 
4,793

Equipment rental income
 
16,229

 
18,796

 
23,361

Investment securities and other investment gains
 
454

 
580

 
1,399

Other income
 
13,651

 
12,660

 
12,665

Total noninterest income
 
$
77,212

 
$
81,192

 
$
80,872


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Trust fees (which include investment management fees, estate administration fees, mutual fund fees, annuity fees, and fiduciary fees) increased by $0.89 million or 5.36% in 2013 from 2012 compared to an increase of $0.17 million or 1.05% in 2012 over 2011. Trust fees are largely based on the size of client relationships and the market value of assets under management. The market value of trust assets under management at December 31, 2013 and 2012 was $3.80 billion and $3.40 billion, respectively. At December 31, 2013, these trust assets were comprised of $2.32 billion of personal and agency trusts and estate administration assets, $1.04 billion of employee benefit plan assets, $340.49 million of individual retirement accounts, and $105.95 million of custody assets. The increase in trust fees in 2013 and 2012 was primarily a result of an increase in the market values of investments held in the trust accounts of clients.
Service charges on deposit accounts decreased $1.24 million or 11.91% in 2013 from 2012 compared to a decrease of $0.58 million or 5.23% in 2012 from 2011. The decline in service charges on deposit accounts in 2013 and 2012 was primarily due to lower volumes of nonsufficient fund transactions.
Debit card income increased $0.49 million or 5.88% in 2013 from 2012 compared to an increase of $0.89 million or 11.93% in 2012 from 2011. The increase in 2013 was the result of increased transaction fees coupled with an increase in the amount of debit card transactions. The increase in 2012 was the result of an increase in the amount of debit card transactions.
Mortgage banking income decreased $2.41 million or 28.87% in 2013 over 2012, compared to an increase of $4.52 million or 117.69% in 2012 over 2011. We had no mortgage servicing rights impairment in 2013 compared to $0.24 million in valuation recovery adjustments in 2012 and $0.24 million of impairment in 2011. During 2013, 2012 and 2011, we determined that no permanent write-down was necessary for previously recorded impairment on mortgage servicing assets. During 2013, mortgage banking income was negatively impacted by lower loan production volumes as compared to 2012. Mortgage banking income was positively impacted by higher loan production volumes and higher margins on loan sales in 2012 as compared to 2011.
Insurance commissions were flat in 2013 from 2012 compared to an increase of $0.70 million or 14.63% in 2012 from 2011. The increase in 2012 was due to the acquisition of a benefits agency’s book of business in January 2012.
Equipment rental income generated from operating leases declined by $2.57 million or 13.66% during 2013 from 2012 compared to a decrease of $4.57 million or 19.54% during 2012 from 2011. The average equipment rental portfolio decreased 15.31% in 2013 over 2012 and 19.10% in 2012 over 2011 due to decreased demand, resulting in lower rental income. In addition, new leases are at lower rates due to current market conditions including lower rates and increased competition.
Investment securities and other investment gains totaled $0.45 million for the year ended 2013 compared to gains of $0.58 million for the year ended 2012 and gains of $1.40 million for the year ended 2011. During 2013, we recognized partnership valuation net gains, offset by an investment portfolio loss on an adjustable rate security. In 2012, we recorded investment portfolio gains on the sale of corporate equity and agency securities and recognized partnership valuation net gains.
Other income increased $0.99 million or 7.83% in 2013 from 2012 and was flat in 2012 from 2011. The increase in 2013 was mainly due to the collection of fees on previously charged off loans in a addition to higher mutual fund income and dividend income.
Noninterest Expense — Noninterest expense decreased $2.22 million or 1.47% in 2013 over 2012 following a $0.82 million or 0.54% decrease in 2012 from 2011. The following table shows Noninterest expense for the recent three years ended December 31:
(Dollars in thousands) 
 
2013
 
2012
 
2011
Noninterest expense:
 
 

 
 

 
 

Salaries and employee benefits
 
$
79,783

 
$
82,599

 
$
77,261

Net occupancy expense
 
8,700

 
7,819

 
8,714

Furniture and equipment expense
 
16,895

 
15,406

 
14,130

Depreciation — leased equipment
 
13,055

 
15,202

 
18,650

Professional fees
 
5,321

 
6,083

 
5,508

Supplies and communications
 
5,690

 
5,701

 
5,453

FDIC and other insurance
 
3,462

 
3,602

 
4,421

Business development and marketing expense
 
4,938

 
4,232

 
4,032

Loan and lease collection and repossession expense
 
4,030

 
5,772

 
6,724

Other expense
 
7,440

 
5,120

 
7,461

Total noninterest expense
 
$
149,314

 
$
151,536

 
$
152,354

Total salaries and employee benefits decreased $2.82 million or 3.41% in 2013 from 2012, following a $5.34 million or 6.91% increase in 2012 from 2011.

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Table of Contents

Employee salaries declined $2.36 million or 3.56% in 2013 from 2012 compared to an increase of $3.72 million of 5.94% in 2012 from 2011. The decrease in 2013 was a result of lower base salaries and producer commissions. Lower base salary expense was primarily due to fewer full time equivalent employees offset by increases from the annual performance raises. Loan producer commissions were lower due to decreased residential mortgage loan production volumes. The increase in 2012 was primarily due to higher base salaries, executive incentive expense and loan producer commissions. Higher base salary expense was primarily due to more full time equivalent employees and annual performance raises. Loan producer commissions were higher due to increased residential mortgage loan production volumes.
Employee benefits decreased by $0.46 million or 2.80% in 2013 from 2012, compared to an increase of $1.62 million or 11.04% in 2012 from 2011. The decrease in 2013 was primarily due to fewer full time equivalent employees, offset by higher group insurance costs. The increase in 2012 was primarily due to higher group insurance costs.
Occupancy expense increased $0.88 million or 11.27% in 2013 from 2012, compared to a decrease of $0.90 million or 10.27% in 2012 from 2011. The higher expense in 2013 was mainly due to the receipt of real estate tax refunds in 2012, higher depreciation on buildings as a result of branch remodeling in 2013, and new branches opened during 2013. The lower expense in 2012 was mainly due to reduced real estate taxes as a result of the successful appeals of assessed values.
Furniture and equipment expense, including depreciation, grew by $1.49 million or 9.67% in 2013 from 2012 compared to an increase of $1.28 million or 9.03% in 2012 from 2011. The higher expense during 2013 and 2012 was in the areas of equipment depreciation, computer processing charges and software maintenance.
Depreciation on equipment owned under operating leases decreased $2.15 million or 14.12% in 2013 from 2012, following a $3.45 million or 18.49% decrease in 2012 from 2011. In 2013 and 2012, depreciation on equipment owned under operating leases decreased in conjunction with the decrease in equipment rental income.
Professional fees declined by $0.76 million or 12.53% in 2013 from 2012, compared to a $0.58 million or 10.44% increase in 2012 from 2011. The decrease in 2013 was the result of reduced utilization of consulting services. The increase in 2012 was primarily due to higher consulting fees offset by lower legal fees.
Supplies and communications expense was flat in 2013 from 2012, compared to a $0.25 million or 4.55% increase in 2012 from 2011. During 2012, data communication costs were higher than prior year.
FDIC and other insurance expense was flat in 2013 from 2012 versus a $0.82 million or 18.53% decrease in 2012 over 2011. The decrease in 2012 was due to lower FDIC premiums based on average total consolidated assets minus the average tangible equity of the insured depository institution during the assessment period, whereas assessments were previously based on the amount of an institution's insured deposits.
Business development and marketing expense increased $0.71 million or 16.68% in 2013 from 2012 compared to a $0.20 million or 4.96% increase in 2012 from 2011. The higher expense in 2013 was the result of increased charitable contributions. Increased promotions and marketing activity resulted in higher costs in 2012.
Loan and lease collection and repossession expenses decreased $1.74 million or 30.18% in 2013 from 2012 compared to a decrease of $0.95 million or 14.16% in 2012 from 2011. Loan and lease collection and repossession expense was lower in 2013 mainly due to a reduction in the average repossessions outstanding and reduced valuation adjustments as credit quality slowly improves. The decrease in 2012 was mainly due to reduced ORE operating costs, collection and repossession expense, and valuation adjustments as compared to 2011. These reductions were offset by higher mortgage loan repurchase losses.
Other expenses increased $2.32 million or 45.31% in 2013 as compared to 2012 and decreased $2.34 million or 31.38% in 2012 from 2011. The increase in 2013 was mainly due to the gain on the sale of the corporate headquarters' parking garage that occurred in 2012, a previously reported trustee matter, and a higher provision on unfunded loan commitments. The decline in 2012 was mainly due to a lower provision on unfunded loan commitments and the gain on sale of the corporate headquarters’ parking garage.
Income Taxes — 1st Source recognized income tax expense in 2013 of $28.99 million, compared to $26.05 million in 2012, and $25.59 million in 2011. The effective tax rate in 2013 was 34.53% compared to 34.42% in 2012, and 34.69% in 2011.
Effective January 1, 2014, the Indiana Financial Institutions tax rate decreases from 8.5% to 8.0% and will continue to decrease by 0.5% each of the next three years. As a result of the change, we decreased the carrying value of certain state deferred tax assets. The impact of the change was not material and was recorded in the financial statements during the second quarter of 2013. For a detailed analysis of 1st Source’s income taxes see Part II, Item 8, Financial Statements and Supplementary Data — Note 17 of the Notes to Consolidated Financial Statements.

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Financial Condition
Loan and Lease Portfolio — The following table shows 1st Source’s loan and lease distribution at the end of each of the last five years as of December 31:
(Dollars in thousands) 
 
2013
 
2012
 
2011
 
2010
 
2009
Commercial and agricultural loans
 
$
679,492

 
$
639,069

 
$
545,570

 
$
530,228

 
$
546,222

Auto, light truck and environmental equipment
 
424,500

 
438,147

 
435,965

 
396,500

 
349,741

Medium and heavy duty truck
 
205,003

 
172,002

 
159,796

 
162,824

 
204,545

Aircraft financing
 
738,133

 
696,479

 
620,782

 
614,357

 
617,384

Construction equipment financing
 
333,088

 
278,974

 
261,204

 
285,634

 
313,300

Commercial real estate
 
583,997

 
554,968

 
545,457

 
594,729

 
580,709

Residential real estate
 
460,981

 
438,641

 
423,606

 
390,951

 
371,514

Consumer loans
 
124,130

 
109,273

 
98,163

 
95,400

 
109,735

Total loans and leases
 
$
3,549,324

 
$
3,327,553

 
$
3,090,543

 
$
3,070,623

 
$
3,093,150

At December 31, 2013, 10.3% of total loans and leases were concentrated with auto rental and leasing.
Loans and leases, net of unearned discount, at December 31, 2013, were $3.55 billion and were 75.15% of total assets, compared to $3.33 billion and 73.12% of total assets at December 31, 2012. Average loans and leases, net of unearned discount, increased $224.45 million or 6.99% and increased $130.91 million or 4.25% in 2013 and 2012, respectively.
Commercial and agricultural lending, excluding those loans secured by real estate, increased $40.42 million or 6.33% in 2013 over 2012. Commercial and agricultural lending outstandings were $679.49 million and $639.07 million at December 31, 2013 and December 31, 2012, respectively. This increase was mainly attributed to an improved economy in our target markets, resulting in greater line of credit usage and the financing of increased capital expenditures by our clients. In 2013, we also grew our business client base.
Auto, light truck, and environmental equipment financing decreased $13.65 million or 3.11% in 2013 over 2012. At December 31, 2013, auto, light truck, and environmental equipment financing had outstandings of $424.50 million and $438.15 million at December 31, 2012. This decrease was primarily attributable to a decrease in environmental equipment financing as a result of decreased focus on originations of this product line.
Medium and heavy duty truck loans and leases grew by $33.00 million or 19.19% in 2013. Medium and heavy duty truck financing at December 31, 2013 and 2012 had outstandings of $205.00 million and $172.00 million, respectively. Most of the increase at December 31, 2013 from December 31, 2012 can be attributed to clients reacting to their aging equipment by normalizing their replacement policies. Consequently, demand has increased as the trucking industry acquired new equipment.
Aircraft financing at year-end 2013 increased $41.65 million or 5.98% from year-end 2012. Aircraft financing at December 31, 2013 and 2012 had outstandings of $738.13 million and $696.48 million, respectively. The increase was mainly due to a recovering business climate, and a perception in the markets that business aircraft values had bottomed.
Construction equipment financing increased $54.11 million or 19.40% in 2013 compared to 2012. Construction equipment financing at December 31, 2013 had outstandings of $333.09 million, compared to outstandings of $278.97 million at December 31, 2012. The increase in this category was primarily due to a gradual improvement in the construction industry and the need to replace older equipment in addition to increases in equipment rental.
Commercial loans secured by real estate, the majority of which is owner occupied, increased $29.03 million or 5.23% in 2013 over 2012. Commercial loans secured by real estate outstanding at December 31, 2013 were $584.00 million and $554.97 million at December 31, 2012. The increase was mainly due to general improvements in the business economy within our markets.
Residential real estate loans were $460.98 million at December 31, 2013 and $438.64 million at December 31, 2012. Residential real estate loans increased $22.34 million or 5.09% in 2013 from 2012. The increase in residential real estate loans was primarily due to our decision to retain more loans in our portfolio.
Consumer loans increased $14.86 million or 13.60% in 2013 over 2012. Consumer loans outstanding at December 31, 2013, were $124.13 million and $109.27 million at December 31, 2012. The increase during 2013 was due to higher demand in auto and personal line of credit loans as a result of lower interest rates.

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The following table shows the maturities of loans and leases in the categories of commercial and agriculture, auto, light truck and environmental equipment, medium and heavy duty truck, aircraft and construction equipment outstanding as of December 31, 2013.
(Dollars in thousands)
 
0-1 Year
 
1-5 Years
 
Over 5 Years
 
Total
Commercial and agricultural loans
 
$
370,254

 
$
259,700

 
$
49,538

 
$
679,492

Auto, light truck and environmental equipment
 
187,089

 
232,482

 
4,929

 
424,500

Medium and heavy duty truck
 
60,652

 
140,576

 
3,775

 
205,003

Aircraft financing
 
156,459

 
489,178

 
92,496

 
738,133

Construction equipment financing
 
89,303

 
228,124

 
15,661

 
333,088

Total
 
$
863,757

 
$
1,350,060

 
$
166,399

 
$
2,380,216

The following table shows amounts due after one year are also classified according to the sensitivity to changes in interest rates.
Rate Sensitivity (Dollars in thousands)
 
Fixed Rate
 
Variable Rate
 
Total
1 – 5 Years
 
$
828,446

 
$
521,614

 
$
1,350,060

Over 5 Years
 
38,995

 
127,404

 
166,399

Total
 
$
867,441

 
$
649,018

 
$
1,516,459

During 2013, approximately 58% of the Bank’s residential mortgage originations were sold into the secondary market. Mortgage loans held for sale were $6.08 million at December 31, 2013 and were $10.88 million at December 31, 2012. Although 1st Source Bank is participating in the U.S. Treasury Making Home Affordable programs, we do not feel it has a material effect on our financial condition or results of operations.
1st Source Bank sells residential mortgage loans to Fannie Mae and Freddie Mac, as well as FHA-insured and VA-guaranteed loans in Ginnie Mae mortgage-backed securities. Additionally, we have sold loans on a service released basis to various other financial institutions in recent years. The agreements under which we sell these mortgage loans contain various representations and warranties regarding the acceptability of loans for purchase. On occasion, we may be asked to indemnify the loan purchaser for credit losses on loans that were later deemed ineligible for purchase or we may be asked to repurchase a loan. Both circumstances are collectively referred to as “repurchases.” Within the industry, repurchase demands have increased during recent years. While we believe the loans we have underwritten and sold to these entities have met or exceeded applicable transaction parameters, we must acknowledge the trend of mortgage insurance rescissions and speculative repurchase requests.
Our liability for repurchases, included in accrued expenses and other liabilities on the Statements of Financial Condition, was $2.46 million and $1.59 million as of December 31, 2013 and 2012, respectively. Our expense for repurchase losses, included in loan and lease collection and repossession expense on the Statements of Income, was $1.99 million in 2013 compared to $2.05 million in 2012 and $1.47 million in 2011. The mortgage repurchase liability represents our best estimate of the loss that we may incur. The estimate is based on specific loan repurchase requests and a historical loss ratio with respect to origination dollar volume. Because the level of mortgage loan repurchase losses are dependent on economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment.
Credit Experience
Reserve for Loan and Lease Losses — Our reserve for loan and lease losses is provided for by direct charges to operations. Losses on loans and leases are charged against the reserve and likewise, recoveries during the period for prior losses are credited to the reserve. Our management evaluates the reserve quarterly, reviewing all loans and leases over a fixed-dollar amount ($100,000) where the internal credit quality grade is at or below a predetermined classification, actual and anticipated loss experience, current economic events in specific industries, and other pertinent factors including general economic conditions. Determination of the reserve is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows or fair value of collateral on collateral-dependent impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience, and consideration of environmental factors, principally economic risk and concentration risk, all of which may be susceptible to significant and unforeseen changes. We review the status of the loan and lease portfolio to identify borrowers that might develop financial problems in order to aid borrowers in the handling of their accounts and to mitigate losses. See Part II, Item 8, Financial Statements and Supplementary Data — Note 1 of the Notes to Consolidated Financial Statements for additional information on management’s evaluation of the reserve for loan and lease losses.
The reserve for loan and lease loss methodology has been consistently applied for several years, with enhancements instituted periodically. Reserve ratios are reviewed quarterly and revised periodically to reflect recent loss history and to incorporate current risks and trends which may not be recognized in historical data. As we update our historical charge-off analysis, we review the look-back periods for each business loan portfolio.

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Table of Contents

During 2013, the medium-term portion of the look-back period was five years given that 2009 through 2013 losses were considerably impacted by the severe recession. Although the recession began in December 2007, its financial consequences were not recognized in the loan portfolios until 2009. We gave the greatest weight to this recent five year period in our calculation, as we feel it is most consistent with our current expectations for 2014. Furthermore, we perform a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency in order to review portfolio trends and other factors, including specific industry risks and economic conditions, which may have an impact on the reserves and reserve ratios applied to various portfolios. We adjust the calculated historical based ratio as a result of our analysis of environmental factors, principally economic risk and concentration risk. Key economic factors affecting our portfolios are growth in gross domestic product, unemployment rates, housing market trends, commodity prices, inflation and global economic and political issues. Concentration risk is impacted primarily by geographic concentration in Northern Indiana and Southwestern Lower Michigan in our business banking and commercial real estate portfolios and by collateral concentration in our specialty finance portfolios.
The past three years we included a factor in our loss ratios for global risk, previously principally the European debt crisis. While we are less concerned about the implosion of Europe, we are increasingly aware of the risk that global issues may affect our customers. While we are unable to determine with any precision the impact of global economic and political issues on 1st Source Bank’s loan portfolios, we feel the risks are real and significant. We believe there is a risk of negative consequences for our borrowers that would affect their ability to repay their financial obligations. Therefore, we increased our loss ratios across all portfolios as of year-end 2011 and continued to include a factor for global risk in our analysis for 2013.
Another area of concern continues to be our aircraft portfolio where we have significant collateral concentration and a sizable foreign exposure. The aircraft industry was among the sectors affected most by the sluggish economy. Recently, we have seen some evidence that depressed private jet markets are improving. Nevertheless, we remain concerned about the prolonged low prices for several models and the negative effect the severe recession and the protracted recovery have had on our borrowers. We continue to experience higher default rates in this portfolio than in our other lending segments. We reassessed our ratios and made some upward adjustments based on our knowledge that many factors can effect this portfolio negatively.
We experienced ongoing improvement in the medium and heavy duty truck portfolio. We recognized sizable losses during 2009 and the first half of 2010; however, since then we have had no charge-offs. Current industry concerns are focused on a new highway finance law, revised greenhouse gas emissions standards, anticipated mandate for electronic logs to record driver hours of service and new regulations aimed at improving driver health and highway safety. Nevertheless, the underlying industry fundamentals are expected to remain relatively stable. As a result, we maintained our risk factors at levels consistent with last year.
Our construction equipment portfolio is characterized by increasing outstanding loan balances and improved credit quality in 2013. The construction industry, which was hard hit during the recession, is positioned to benefit from an improved housing market and increased demand in the energy sector. Historically, 1st Source has experienced less volatility in this portfolio than the industry as losses have been mitigated by appropriate underwriting and the advantage of strong collateral values due to the global market for used construction equipment. The underlying risk has not changed significantly for this portfolio; our reserve factors are similar to last year.
The auto, light truck and environmental equipment portfolio outstanding loan balances were relatively stable year-over-year, following three years of substantial growth. We are concerned about the softening of used car values, driven in large part by the increased production by manufacturers, as we move into 2014. As a result, we made an upward adjustment in the reserve ratio for the auto portfolio. We are not aggressively pursuing new business in our environmental equipment portfolio. Credit quality indicators are stable to improving with lower delinquency and Special Attention accounts. Our reserve ratio for the environmental equipment portfolio remains unchanged.
There are several industries represented in the commercial and agricultural portfolio. The outlook for the business banking portfolio is guardedly optimistic. While recent economic news indicates improvement, there are significant economic uncertainties and small business owners remain concerned. With the struggling job creation market, unemployment remains high albeit improving, which is a continued concern for our consumer portfolios. The outlook for the agriculture portfolio is good, with moderating crop prices and consistently strong land values. We have fewer accounts in Special Attention than we did at this time last year. We have reviewed the calculated loss ratios and the environmental factors and concentration issues affecting these portfolios and incorporated minor adjustments to the reserve ratios as deemed appropriate.
Similar to the commercial portfolio, our commercial real estate loans are concentrated in our local market with local customers, with over fifty percent of the Bank's exposure being owner occupied facilities where we are the primary relationship bank for our customers. Nevertheless, we are not immune to the dramatic declines in real estate values following the great recession, similar to other U.S. markets and we experienced losses from 2009 through 2011. We reduced our reserve ratios somewhat last year in response to improving market conditions, as evidenced by lower Special Attention accounts. That trend continued throughout 2013. However, as a result of our recent growth in the more risky non-owner occupied sector, we are maintaining the reserve ratios established last year.

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Table of Contents

The reserve for loan and lease losses at December 31, 2013, totaled $83.51 million and was 2.35% of loans and leases, compared to $83.31 million or 2.50% of loans and leases at December 31, 2012 and $81.64 million or 2.64% of loans and leases at December 31, 2011. It is our opinion that the reserve for loan and lease losses was appropriate to absorb losses inherent in the loan and lease portfolio as of December 31, 2013.
Charge-offs for loan and lease losses were $3.83 million for 2013, compared to $7.64 million for 2012 and $12.59 million for 2011. Charge-offs decreased in 2013 and 2012 due to a decrease in average nonperforming loans and leases reflecting a slowly improving economy. In 2012, a large auto rental loss accounted for almost fifty percent of gross losses and in excess of ninety percent of net charge-offs. The provision for loan and lease losses was $0.77 million for 2013, compared to the provision for loan and lease losses of $5.75 million for 2012 and the provision for loan and lease losses of $3.13 million for 2011.
The following table summarizes our loan and lease loss experience for each of the last five years ended December 31:
(Dollars in thousands)
 
2013
 
2012
 
2011
 
2010
 
2009
Amounts of loans and leases outstanding at end of period
 
$
3,549,324

 
$
3,327,553

 
$
3,090,543

 
$
3,070,623

 
$
3,093,150

Average amount of net loans and leases outstanding during period
 
$
3,433,938

 
$
3,209,490

 
$
3,078,581

 
$
3,109,508

 
$
3,154,820

Balance of reserve for loan and lease losses at beginning of period
 
$
83,311

 
$
81,644

 
$
86,874

 
$
88,236

 
$
79,776

Charge-offs:
 
 

 
 

 
 

 
 

 
 

Commercial and agricultural loans
 
538

 
524

 
1,667

 
4,000

 
8,809

Auto, light truck and environmental equipment
 
283

 
3,795

 
346

 
1,014

 
2,750

Medium and heavy duty truck
 

 

 

 
1,879

 
2,071

Aircraft financing
 
1,308

 
600

 
4,681

 
6,507

 
7,812

Construction equipment financing
 
88

 
120

 
853

 
2,372

 
1,476

Commercial real estate
 
170

 
471

 
3,120

 
6,219

 
2,654

Residential real estate
 
316

 
594

 
282

 
486

 
99

Consumer loans
 
1,125

 
1,532

 
1,640

 
1,629

 
2,544

Total charge-offs
 
3,828

 
7,636

 
12,589

 
24,106

 
28,215

Recoveries:
 
 

 
 

 
 

 
 

 
 

Commercial and agricultural loans
 
468

 
484

 
1,923

 
1,612

 
3,193

Auto, light truck and environmental equipment
 
253

 
1,223

 
175

 
80

 
310

Medium and heavy duty truck
 
348

 
192

 
2

 
50

 
5

Aircraft financing
 
884

 
711

 
964

 
636

 
983

Construction equipment financing
 
323

 
268

 
308

 
345

 
444

Commercial real estate
 
627

 
223

 
346

 
105

 
28

Residential real estate
 
14

 
43

 
56

 
47

 
8

Consumer loans
 
333

 
407

 
456

 
662

 
603

Total recoveries
 
3,250

 
3,551

 
4,230

 
3,537

 
5,574

Net charge-offs
 
578

 
4,085

 
8,359

 
20,569

 
22,641

Provision for loan and lease losses
 
772

 
5,752

 
3,129

 
19,207

 
31,101

Balance at end of period
 
$
83,505

 
$
83,311

 
$
81,644

 
$
86,874

 
$
88,236

Ratio of net charge-offs to average net loans and leases outstanding
 
0.02
%
 
0.13
%
 
0.27
%
 
0.66
%
 
0.72
%
Ratio of reserve for loan and lease losses to net loans and leases outstanding end of period
 
2.35
%
 
2.50
%
 
2.64
%
 
2.83
%
 
2.85
%
Coverage ratio of reserve for loan and lease losses to nonperforming loans and leases
 
225.73
%
 
226.03
%
 
143.49
%
 
115.50
%
 
104.84
%

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Table of Contents

The following table shows net charge-offs (recoveries) as a percentage of average loans and leases by portfolio type:
 
 
2013
 
2012
 
2011
 
2010
 
2009
Commercial and agricultural loans
 
0.01
 %
 
0.01
 %
 
(0.05
)%
 
0.44
%
 
0.95
%
Auto, light truck and environmental equipment
 
0.01

 
0.56

 
0.04

 
0.24

 
0.73

Medium and heavy duty truck
 
(0.19
)
 
(0.11
)
 

 
0.99

 
0.93

Aircraft financing
 
0.06

 
(0.02
)
 
0.61

 
0.96

 
1.09

Construction equipment financing
 
(0.08
)
 
(0.05
)
 
0.20

 
0.67

 
0.30

Commercial real estate
 
(0.08
)
 
0.05

 
0.49

 
1.05

 
0.45

Residential real estate
 
0.07

 
0.13

 
0.06

 
0.11

 
0.03

Consumer loans
 
0.67

 
1.08

 
1.24

 
0.95

 
1.63

Total net charge-offs to average portfolio loans and leases
 
0.02
 %
 
0.13
 %
 
0.27
 %
 
0.66
%
 
0.72
%
The reserve for loan and lease losses has been allocated according to the amount deemed necessary to provide for the estimated probable losses that have been incurred within the categories of loans and leases set forth in the table below. The following table shows the amount of such components of the reserve at December 31 and the ratio of such loan and lease categories to total outstanding loan and lease balances:
 
 
2013
 
2012
 
2011
 
2010
 
2009
(Dollars in thousands)
 
Reserve Amount
 
Percentage of Loans and Leases in Each Category to Total Loans and Leases
 
Reserve Amount
 
Percentage of Loans and Leases in Each Category to Total Loans and Leases
 
Reserve Amount
 
Percentage of Loans and Leases in Each Category to Total Loans and Leases
 
Reserve Amount
 
Percentage of Loans and Leases in Each Category to Total Loans and Leases
 
Reserve Amount
 
Percentage of Loans and Leases in Each Category to Total Loans and Leases
Commercial and agricultural loans
 
$
11,515

 
19.14
%
 
$
12,326

 
19.21
%
 
$
13,091

 
17.65
%
 
$
20,544

 
17.27
%
 
$
24,017

 
17.66
%
Auto, light truck, and environmental equipment
 
10,264

 
11.96

 
9,584

 
13.17

 
8,469

 
14.11

 
7,542

 
12.91

 
9,630

 
11.31

Medium and heavy duty truck
 
3,605

 
5.78

 
3,001

 
5.17

 
3,742

 
5.17

 
5,768

 
5.30

 
6,186

 
6.61

Aircraft financing
 
34,037

 
20.80

 
34,205

 
20.93

 
28,626

 
20.09

 
29,811

 
20.01

 
24,807

 
19.96

Construction equipment financing
 
5,972

 
9.38

 
5,390

 
8.38

 
6,295

 
8.45

 
8,439

 
9.30

 
8,875

 
10.13

Commercial real estate
 
12,406

 
16.45

 
13,778

 
16.68

 
16,772

 
17.65

 
11,177

 
19.37

 
10,453

 
18.76

Residential real estate
 
4,093

 
12.99

 
3,652

 
13.18

 
3,362

 
13.70

 
2,518

 
12.73

 
880

 
12.02

Consumer loans
 
1,613

 
3.50

 
1,375

 
3.28

 
1,287

 
3.18

 
1,075

 
3.11

 
3,388

 
3.55

Total
 
$
83,505

 
100.00
%
 
$
83,311

 
100.00
%
 
$
81,644

 
100.00
%
 
$
86,874

 
100.00
%
 
$
88,236

 
100.00
%
Nonperforming Assets — Nonperforming assets include loans past due over 90 days, nonaccrual loans, other real estate, former bank premises held for sale, repossessions and other nonperforming assets we own. Our policy is to discontinue the accrual of interest on loans and leases where principal or interest is past due and remains unpaid for 90 days or more, or when an individual analysis of a borrower’s credit worthiness indicates a credit should be placed on nonperforming status, except for residential mortgage loans, which are placed on nonaccrual at the time the loan is placed in foreclosure and consumer loans that are both well secured and in the process of collection.
Nonperforming assets amounted to $46.75 million at December 31, 2013, compared to $42.27 million at December 31, 2012, and $72.48 million at December 31, 2011. During 2013, interest income on nonaccrual loans and leases would have increased by approximately $2.93 million compared to $3.58 million in 2012 if these loans and leases had earned interest at their full contractual rate.
Nonperforming assets at December 31, 2013 increased from December 31, 2012, mainly due to increases in repossessed aircraft. The increase in nonaccrual loans and leases was spread among the various loan portfolios except for decreases in commercial real estate and construction equipment financing. The largest dollar increases during the most recent year occurred in the aircraft, auto, light truck and environmental equipment and commercial portfolios.

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Table of Contents

Nonperforming assets at December 31 (Dollars in thousands)
 
2013
 
2012
 
2011
 
2010
 
2009
Loans past due over 90 days
 
$
287

 
$
442

 
$
460

 
$
361

 
$
628

Nonaccrual loans and leases:
 
 

 
 

 
 

 
 

 
 
Commercial and agricultural loans
 
11,765

 
9,179

 
10,966

 
8,083

 
9,507

Auto, light truck and environmental equipment
 
3,699

 
858

 
2,002

 
3,330

 
9,200

Medium and heavy duty truck
 

 
52

 
1,599

 
5,068

 
11,624

Aircraft financing
 
10,365

 
5,292

 
12,526

 
17,897

 
6,024

Construction equipment financing
 
1,032

 
5,285

 
4,137

 
8,568

 
7,218

Commercial real estate
 
7,064

 
13,055

 
20,569

 
26,621

 
32,395

Residential real estate
 
2,399

 
2,323

 
4,380

 
4,958

 
6,605

Consumer loans
 
383

 
373

 
261

 
328

 
964

Total nonaccrual loans and leases
 
36,707

 
36,417

 
56,440

 
74,853

 
83,537

Total nonperforming loans and leases
 
36,994

 
36,859

 
56,900

 
75,214

 
84,165

Other real estate
 
4,539

 
4,311

 
7,621

 
6,392

 
4,039