| RISK FACTORS In addition to the other information in this Annual Report on Form 10-K, shareholders or prospective investors should carefully consider the following risk factors: Our business is concentrated in and dependent upon the continued growth and welfare of our primary market areas |
| We operate primarily in four geographical markets, all of which are located in Northern Indiana and are further described in the “Business” section included under Item 1 of Part I of this Form 10-K We have developed a particularly strong presence in the South Region, which includes Kosciusko County and portions of contiguous counties, the North Region, which includes portions of Elkhart and St |
| Joseph County, and the Central Region, which includes portions of Elkhart County and contiguous counties |
| These regions represent the more mature markets |
| In addition, we have experienced rapid growth in the East Region, which includes Allen and DeKalb Counties |
| Our success depends upon the business activity, population, income levels, deposits and real estate activity in these markets |
| Although our customers’ business and financial interests may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce our growth rate, affect the ability of our customers to repay their loans to us and generally affect our financial condition and results of operations |
| Because of our geographic concentration, we are less able than other regional or national financial institutions to diversify our credit risks across multiple markets |
| We may experience difficulties in managing our growth and our growth strategy involves risks that may negatively impact our net income |
| As part of our general growth strategy, we may expand into additional communities or attempt to strengthen our position in our current markets by opening new branches and acquiring existing branches of other financial institutions |
| To the extent that we undertake additional branch openings and acquisitions, we are likely to continue to experience the effects of higher operating expenses relative to operating income from the new operations, which may have an adverse effect on our levels of reported net income, return on average equity and return on average assets |
| Other effects of engaging in such growth strategies may include potential diversion of our management’s time and attention and general disruption to our business |
| Although we do not have any current plans to do so, we may also acquire banks and related businesses that we believe provide a strategic fit with our business or engage in de novo bank formations |
| To the extent that we grow through acquisitions and de novo bank formations, we cannot assure you that we will be able to adequately and profitably manage this growth |
| Acquiring other banks and businesses will involve similar risks to those commonly associated with branching, but may also involve additional risks, including: • potential exposure to unknown or contingent liabilities of banks and businesses we acquire; • exposure to potential asset quality issues of the acquired bank or related business; • difficulty and expense of integrating the operations and personnel of banks and businesses we acquire; and • the possible loss of key employees and customers of the banks and businesses we acquire |
| We face intense competition in all phases of our business from other banks and financial institutions |
| The banking and financial services business in our market is highly competitive |
| Our competitors include large regional banks, local community banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market mutual funds, credit unions, farm credit services and other non-bank financial service providers |
| Many of these competitors are not subject to the same regulatory restrictions as we are and are able to provide customers with a feasible alternative to traditional banking services |
| 30 ______________________________________________________________________ [67]Table of Contents Increased competition in our market may also result in a decrease in the amounts of our loans and deposits, reduced spreads between loan rates and deposit rates or loan terms that are more favorable to the borrower |
| If increased competition causes us to significantly discount the interest rates we offer on loans or increase the amount we pay on deposits, our net interest income could be adversely impacted |
| If increased competition causes us to relax our underwriting standards, we could be exposed to higher losses from lending activities |
| Additionally, many of our competitors are much larger in total assets and capitalization, have greater access to capital markets and larger lending limits and offer a broader range of financial services than we can offer |
| Interest rates and other conditions impact our results of operations |
| Our profitability is in part a function of the spread between the interest rates earned on investments and loans and the interest rates paid on deposits and other interest-bearing liabilities |
| Like most banking institutions, our net interest spread and margin will be affected by general economic conditions and other factors, including fiscal and monetary policies of the federal government, that influence market interest rates and our ability to respond to changes in such rates |
| At any given time, our assets and liabilities will be such that they are affected differently by a given change in interest rates |
| As a result, an increase or decrease in rates, the length of loan terms or the mix of adjustable and fixed rate loans in our portfolio could have a positive or negative effect on our net income, capital and liquidity |
| We measure interest rate risk under various rate scenarios and using specific criteria and assumptions |
| A summary of this process, along with the results of our net interest income simulations is presented at “Quantitative and Qualitative Disclosures About Market Risk” included under Item 7a of Part II of this Form 10-K Although we believe our current level of interest rate sensitivity is reasonable and effectively managed, significant fluctuations in interest rates may have an adverse effect on our business, financial condition and results of operations |
| We must effectively manage our credit risk |
| There are risks inherent in making any loan, including risks inherent in dealing with individual borrowers, risks of nonpayment, risks resulting from uncertainties as to the future value of collateral and risks resulting from changes in economic and industry conditions |
| We attempt to minimize our credit risk through prudent loan application approval procedures, careful monitoring of the concentration of our loans within specific industries, a centralized credit administration department and periodic independent reviews of outstanding loans by our loan review department |
| However, we cannot assure you that such approval and monitoring procedures will reduce these credit risks |
| The majority of the bank’s loan portfolio is invested in commercial and commercial real estate loans |
| These loans represent higher dollar volumes to fewer customers |
| As a result, we may assume greater lending risks than other community banking-type financial institutions that have a lesser concentration of such loans and are more retail oriented |
| Our lending activity and the risks commonly associated with such lending are further described in the “Management’s Discussion and Analysis” section included under Item 7 of Part II of this Form 10-K Commercial and industrial and agri-business loans make up a significant portion of our loan portfolio |
| Commercial and industrial and agri-business loans were dlra964dtta6 million, or approximately 81prca of our total loan portfolio as of December 31, 2005 |
| Our commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower |
| Most often, this collateral is accounts receivable, inventory, machinery or real estate |
| Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists |
| Whenever possible, we require a personal guarantee on commercial loans |
| As a result, in the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers |
| The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business |
| 31 ______________________________________________________________________ [68]Table of Contents Our loan portfolio has a large concentration of commercial real estate loans, which involve risks specific to real estate value |
| Real estate lending (including commercial, construction, and, to a much lesser extent, residential) is a large portion of our loan portfolio |
| The market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located |
| Although a significant portion of such loans are secured by real estate as a secondary form of collateral, adverse developments affecting real estate values in one or more of our markets could increase the credit risk associated with our loan portfolio |
| Additionally, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service |
| Economic events or governmental regulations outside of the control of the borrower or lender could negatively impact the future cash flow and market values of the affected properties |
| If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition |
| Our consumer loans generally have a higher degree of risk of default than our other loans |
| At December 31, 2005, consumer loans totaled dlra159dtta4 million, or 13prca, of our total loan and lease portfolio |
| Consumer loans typically have shorter terms and lower balances with higher yields as compared to one-to four-family residential loans, but generally carry higher risks of default |
| Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances |
| Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on these loans |
| Our allowance for loan losses may prove to be insufficient to absorb potential losses in our loan portfolio |
| We established our allowance for loan losses in consultation with management and regulatory authorities and maintain it at a level considered adequate by management to absorb loan losses that are inherent in the portfolio |
| The amount of future loan losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control, and such losses may exceed current estimates |
| At December 31, 2005, our allowance for loan losses as a percentage of total loans was 1dtta07prca and as a percentage of total non-performing loans was approximately 170prca |
| Although management believes that the allowance for loan losses is adequate to absorb losses on any existing loans that may become uncollectible, we cannot predict loan losses with certainty, and we cannot assure you that our allowance for loan losses will prove sufficient to cover actual loan losses in the future |
| Loan losses in excess of our reserves may adversely affect our business, financial condition and results of operations |
| Additional information regarding our allowance for loan losses and the methodology we use to determine an appropriate level of reserves is located in the “Management’s Discussion and Analysis” section included under Item 7 of Part II of this Form 10-K Our continued pace of growth may require us to raise additional capital in the future, but that capital may not be available when it is needed |
| We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations |
| We anticipate that our existing capital resources will satisfy our capital requirements for the foreseeable future |
| However, we may at some point need to raise additional capital to support our continued growth |
| Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance |
| Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us |
| If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth, branching, de novo bank formations and/or acquisitions could be materially impaired |
| 32 ______________________________________________________________________ [69]Table of Contents Our community banking strategy relies heavily on our management team, and the unexpected loss of key managers may adversely affect our operations |
| Much of our success to date has been influenced strongly by our ability to attract and to retain senior management experienced in banking and financial services and familiar with the communities in our market areas |
| Our ability to retain executive officers, the current management teams, branch managers and loan officers of our bank subsidiary will continue to be important to the successful implementation of our strategy |
| It is also critical, as we grow, to be able to attract and retain qualified additional management and loan officers with the appropriate level of experience and knowledge about our market areas to implement our community-based operating strategy |
| The unexpected loss of services of any key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our business, financial condition and results of operations |
| Government regulation can result in limitations on our operations |
| We operate in a highly regulated environment and are subject to supervision and regulation by a number of governmental regulatory agencies, including the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Indiana Department of Financial Institutions |
| Regulations adopted by these agencies, which are generally intended to provide protection for depositors and customers rather than for the benefit of shareholders, govern a comprehensive range of matters relating to ownership and control of our shares, our acquisition of other companies and businesses, permissible activities for us to engage in, maintenance of adequate capital levels and other aspects of our operations |
| These bank regulators possess broad authority to prevent or remedy unsafe or unsound practices or violations of law |
| The laws and regulations applicable to the banking industry could change at any time and we cannot predict the effects of these changes on our business and profitability |
| Increased regulation could increase our cost of compliance and adversely affect profitability |
| For example, new legislation or regulation may limit the manner in which we may conduct our business, including our ability to offer new products, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads |
| We have a continuing need for technological change and we may not have the resources to effectively implement new technology |
| The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services |
| In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs |
| Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our market areas |
| Many of our larger competitors have substantially greater resources to invest in technological improvements |
| As a result, they may be able to offer additional or superior products to those that we will be able to offer, which would put us at a competitive disadvantage |
| Accordingly, we cannot provide you with assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers |
| There is a limited trading market for our common shares, and you may not be able to resell your shares at or above the price shareholders paid for them |
| Although our common shares are listed for trading on the National Market of the NASDAQ Stock Market, the trading in our common shares has less liquidity than many other companies quoted on the NASDAQ National Market |
| A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the market of willing buyers and sellers of our common shares at any given time |
| This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control |
| We cannot assure you that volume of trading in our common shares will increase in the future |
| 33 ______________________________________________________________________ [70]Table of Contents System failure or breaches of our network security could subject us to increased operating costs as well as litigation and other liabilities |
| The computer systems and network infrastructure we use could be vulnerable to unforeseen problems |
| Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers |
| Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations |
| Computer break-ins, phishing and other disruptions could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and may cause existing and potential customers to refrain from doing business with us |
| Although we, with the help of third-party service providers, intend to continue to implement security technology and establish operational procedures to prevent such damage, there can be no assurance that these security measures will be successful |
| In addition, advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms we and our third-party service providers use to encrypt and protect customer transaction data |
| A failure of such security measures could have a material adverse effect on our financial condition and results of operations |
| We are subject to certain operational risks, including, but not limited to, customer or employee fraud and data processing system failures and errors |
| Employee errors and misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation |
| Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information |
| It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases |
| Employee errors could also subject us to financial claims for negligence |
| We maintain a system of internal controls and insurance coverage to mitigate operational risks, including data processing system failures and errors and customer or employee fraud |
| Should our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could have a material adverse effect on our business, financial condition and results of operations |