form10k.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-K
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the fiscal year ended:   December 31, 2011
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:  001-33572
 
Bank of Marin Bancorp
(Exact name of Registrant as specified in its charter)
 
California   20-8859754
(State or other jurisdiction of incorporation)    (IRS Employer Identification No.)
     
504 Redwood Blvd., Suite 100, Novato, CA   94947
(Address of principal executive office)    (Zip Code)
                                                                                                                                                                                                            
(415) 763-4520
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12 (b) of the Act:

None

Securities registered pursuant to section 12(g) of the Act:
 
Common Stock, No Par Value,
and attached Share Purchase Rights
  NASDAQ Capital Market
(Title of each class)   Name of each exchange on which registered)
 
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
 
Note – checking the box above will not relieve any registrant required to file reports pursuant to section 13 or 15(d) of the Exchange Act from their obligations under these sections.
 
Indicate by check mark whether the registrant (1) has filed all reports 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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 is not contained herein, and will not be contained, to the best of the 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, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check One):
 
Large accelerated filer  o Accelerated filer  x
Non-accelerated filer  o Smaller reporting company o
 
Indicate by check mark if the registrant is a shell company, as defined in Rule 12b(2) of the Exchange Act.
Yes  o                      No  x
 
As of June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting and non-voting common equity held by non-affiliates, based upon the closing price per share of the registrant’s common stock as reported by the NASDAQ, was approximately $182 million.  For the purpose of this response, directors and officers of the Registrant are considered the affiliates at that date.

As of February 29, 2012 there were 5,345,732 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held on May 15, 2012 are incorporated by reference into Part III.
 


 
 

 

TABLE OF CONTENTS
 
PART I   1
     
Forward-Looking Statements 1
     
ITEM 1. BUSINESS 1
ITEM 1A. RISK FACTORS 9
ITEM 1B. UNRESOLVED STAFF COMMENTS 17
ITEM 2. PROPERTIES 17
ITEM 3. LEGAL PROCEEDINGS 17
ITEM 4. MINE SAFETY DISCLOSURES 17
     
PART II   18
     
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES 18
ITEM 6. SELECTED FINANCIAL DATA 20
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 20
  Forward-Looking Statements 20
  Executive Summary 20
  Critical Accounting Policies 22
     
  RESULTS OF OPERATIONS 25
  Net Interest Income 26
  Provision for Loan Losses 30
  Non-interest Income 30
  Non-interest Expense 31
  Provision for Income Taxes 33
     
  FINANCIAL CONDITION 34
  Investment Securities 34
  Loans 35
  Allowance for Loan Losses 38
  Other Assets 41
  Deposits 42
  Borrowings 43
  Deferred Compensation Obligations 43
  Off Balance Sheet Arrangements 43
  Commitments 43
  Capital Adequacy 44
  Liquidity 44
     
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 45
     
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 47
     
  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 53
  Note 1:  Summary of Significant Accounting Policies 53
  Note 2:  Acquisition 59
  Note 3:  Investment Securities 63
  Note 4:  Loans and Allowance for Loan Losses 65
  Note 5:  Bank Premises and Equipment 73
  Note 6:  Bank Owned Life Insurance 73
  Note 7:  Deposits 73
  Note 8:  Borrowings 74
 
 
  Note 9:  Stockholders' Equity and Stock Option Plans 75
  Note 10: Fair Value of Assets and Liabilities 79
  Note 11: Benefit Plans 82
  Note 12:  Income Taxes 83
  Note 13:  Commitments and Contingencies 85
  Note 14:  Concentrations of Credit Risk 86
  Note 15 : Derivative Financial Instruments and Hedging Activities 86
  Note 16:  Regulatory Matters 88
  Note 17:  Financial Instruments with Off-Balance Sheet Risk 89
  Note 18:  Condensed Bank of Marin Bancorp Parent Only Financial Statements 90
     
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 92
     
ITEM 9A. CONTROLS AND PROCEDURES 92
     
ITEM 9B. OTHER INFORMATION 93
     
PART III   94
     
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 94
     
ITEM 11. EXECUTIVE COMPENSATION 94
     
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS 94
     
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE 94
     
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 94
     
PART IV   95
     
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES 95
     
SIGNATURES 97
EXHIBIT INDEX 99
 
 
 


PART I
Forward-Looking Statements

This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act").  Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.

Our forward-looking statements may include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of our revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may."

Forward-looking statements are based on Management's current expectations regarding economic, legislative, and regulatory issues that may impact our earnings in future periods. A number of factors - many of which are beyond Management’s control - could cause future results to vary materially from current Management’s expectations. Such factors include, but are not limited to, estimated fair values related to the assets acquired and liabilities assumed of the former Charter Oak Bank; general economic conditions, the current financial uncertainty in the United States and abroad, changes in interest rates, deposit flows, real estate values and competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services. These and other important factors are detailed in Item 1A Risk Factors section of this report. Forward-looking statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.

ITEM 1.

Bank of Marin (the “Bank”) was incorporated in August 1989, received its charter from the California Superintendent of Banks (now the California Department of Financial Institutions or “DFI”) and commenced operations in January 1990. The Bank is an insured bank under the Federal Deposit Insurance Act (“FDIC”). On July 1, 2007 (the “Effective Date”), a bank holding company reorganization was completed whereby Bank of Marin Bancorp (“Bancorp”) became the parent holding company for the Bank, the sole and wholly-owned subsidiary of Bancorp. On the Effective Date, each outstanding share of Bank of Marin common stock was converted into one share of Bank of Marin Bancorp common stock. Bancorp is listed at NASDAQ and assumed the ticker symbol BMRC, which was formerly used by the Bank. Prior to the Effective Date, the Bank filed reports and proxy statements with the FDIC pursuant to Sections 12 of the Securities Exchange Act of 1934 (the “1934 Act”). Upon formation of the holding company, Bancorp became subject to regulation under the Bank Holding Company Act of 1956, as amended, which subjects Bancorp to Federal Reserve Board (“FRB”) reporting and examination requirements.

References in this report to “Bancorp” mean Bank of Marin Bancorp, parent holding company for the Bank. References to “we,” “our,” “us” mean the holding company and the Bank that are consolidated for financial reporting purposes.

Virtually all of our business is conducted through Bancorp’s sole subsidiary, the Bank, which is headquartered in Novato, California.  As of December 31, 2011, we operated through seventeen offices in San Francisco, Marin, Napa and Sonoma counties with a strong focus on supporting the local community. Our customer base is made up of business and personal banking relationships from the communities near the branch office locations.  Our business banking focus is on small to medium-sized businesses, professionals and not-for-profit organizations.
 
We offer a broad range of commercial and retail deposit and lending programs designed to meet the needs of our target markets.  Our loan products include commercial real estate loans, commercial and industrial loans and lines of credit, construction financing, consumer loans, and home equity lines of credit.  Merchant card services are available for our customers in retail businesses. Through a third party vendor, we offer a proprietary Visa® credit card product combined with a rewards program to our customers, as well as a Business Visa® program for business and professional customers. We also offer cash management sweep to business clients through a third party vendor.
 
 
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We offer a variety of personal and business checking and savings accounts, and a number of time deposit alternatives, including time certificates of deposit, Individual Retirement Accounts (“IRAs”), Health Savings Accounts, and Certificate of Deposit Account Registry Service (“CDARS®”). CDARS® is a network through which we offer full FDIC insurance coverage in excess of the regulatory maximum by placing deposits in multiple banks participating in the network.  We also offer remote deposit capture, Automated Clearing House services (“ACH”), social security and pension checks, fraud prevention services including identity theft insurance and image lockbox services.  A valet deposit pick-up service is available to our professional and business clients.  Automatic teller machines (“ATM's”) are available at each branch location.

Our ATM network is linked to the PLUS, CIRRUS and NYCE networks.  In January 2009, we began offering free access to a network of nation-wide surcharge-free ATM’s called MoneyPass.  We also offer our depositors 24-hour access to their accounts by telephone and through our internet banking products available to personal and business account holders.

We offer Wealth Management and Trust Services (“WMTS”) which include customized investment portfolio management, financial planning, trust administration, estate settlement and custody services, and advice of charitable giving.  We also offer 401(k) plan services to small and medium businesses through a third party vendor.

We offer branch-based Private Banking as a natural extension of our services. Our Private Banking includes deposit services and loans, as well as a full range of banking services.

We do not directly offer international banking services, but do make such services available to our customers through other financial institutions with whom we have correspondent banking relationships.

We hold no patents, licenses (other than licenses required by the appropriate banking regulatory agencies), franchises or concessions.  The Bank has registered the service marks "The Spirit of Marin", the words “Bank of Marin”, the Bank of Marin logo, and the Bank of Marin tagline “Committed to your business and our community” with the United States Patent & Trademark Office.  In addition, Bancorp has registered the service marks for the words “Bank of Marin Bancorp” and for the Bank of Marin Bancorp logo with the United States Patent & Trademark Office.

All service marks registered by Bancorp or the Bank are registered on the United States Patent & Trademark Office Principal Register, with the exception of the words "Bank of Marin Bancorp" which is registered on the United States Patent & Trademark Office Supplemental Register.

Acquisition

As discussed in Note 2 to the Consolidated Financial Statements in Item 8 of this report, in February 2011, we expanded our community banking footprint to Napa County through an FDIC-assisted acquisition of $107.8 million of assets and assumption of $107.7 million of liabilities of the former Charter Oak Bank (the “Acquisition”). No capital has been raised to complete this transaction, as Bancorp has grown capital through the retention of earnings in order to take advantage of such acquisition opportunities. The acquired operations of the former Charter Oak Bank contributed approximately $2.0 million to our results of operations for the period February 18 to December 31, 2011.

Market Area

Our primary market area consists of Marin, San Francisco, Napa and Sonoma Counties.  Our customer base is primarily made up of business and personal banking relationships within these market areas.

We attract deposit relationships from individuals, merchants, small to medium-sized businesses, not-for-profit organizations and professionals who live and/or work in the communities comprising our market areas.  As of December 31, 2011, approximately 74% of our deposits are in Marin and southern Sonoma counties, and approximately 60% of our deposits are from businesses and 40% are from individuals.
 
 
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Competition

The banking business in California generally, and in our market area specifically, is highly competitive with respect to attracting both loan and deposit relationships.  The increasingly competitive environment is impacted by changes in regulation, interest rate environment, technology and product delivery systems, and the consolidation among financial service providers. The banking industry is seeing extreme competition for quality loans.  Larger banks are seeking to expand lending to small businesses, which are traditionally community bank customers.  The Marin County market area is dominated by two major nation-wide banks, each of which has more branch offices than us in the defined service area.  Additionally, there are several thrifts, credit unions and other independent banks.

As of June 30, 2011, the latest data available shows 90 banking offices with $9.0 billion in total deposits served the Marin County market.  As of that same date, there were approximately 5 thrift offices in Marin with $0.7 billion in total deposits.  We have the largest business core deposit market share, representing 25.4% of business core deposits in Marin County1.  A significant driver of our franchise value is the growth and stability of our checking and savings deposits, which are a low cost funding source for our loan portfolio. We have also gained overall deposit market share in our primary market area in 20111. The four financial institutions with the greatest deposit market share in Marin County are Wells Fargo Bank, Bank of America, Bank of Marin, and Westamerica Bank with deposit market shares of 28.0% and 17.9%, 10.0%, and 8.3%, respectively1.

In the southern Sonoma County area of Petaluma, there are approximately 26 banking and thrift offices with $1.4 billion in total deposits as of June 30, 2011.  Compared with our share of 5.0%, the four banking institutions with the greatest overall market share, Wells Fargo Bank, Bank of America, Bank of the West, and Exchange Bank had deposit market shares in Petaluma of 28.3%, 15.6%, 10.0%, and 8.9%, respectively1.

We also compete for depositors' funds with money market mutual funds and with non-bank financial institutions such as brokerage firms and insurance companies.  Among the competitive advantages held by some of these non-bank financial institutions is their ability to finance extensive advertising campaigns and to allocate investment assets to regions of California or other states with areas of highest demand and, therefore, often higher yield.

Nation-wide banks have the competitive advantages of national advertising campaigns and technology infrastructure to achieve economies of scale.  Large commercial banks also have substantially greater lending limits and have the ability to offer certain services which are not offered directly by us.

In order to compete with the numerous, and often larger, financial institutions in our primary market area, we use, to the fullest extent possible, the flexibility and rapid response capabilities which are accorded by our independent status.  Our competitive advantages also include an emphasis on personalized services, community involvement, philanthropic giving, local promotional activities and personal contacts.  The commitment and dedication of our organizers, directors, officers and staff have also contributed greatly to our success in competing for business.

Employees

At December 31, 2011, we employed 232 full-time equivalent (“FTE”) staff.  The actual number of employees, including part-time employees, at year-end 2011 included 4 executive officers, 88 other corporate officers and 155 staff. None of our employees are presently represented by a union or covered by a collective bargaining agreement.  We believe that our employee relations are good.  We have been recognized as one of the “Best Places to Work in the San Francisco Bay Area” by the San Francisco Business Times and the “Best Places to Work” by North Bay Business Journal.

SUPERVISION AND REGULATION

Bank holding companies and banks are extensively regulated under both federal and state law.  The following discussion summarizes certain significant laws, rules and regulations affecting Bancorp and the Bank.
 

1  Based on the latest available FDIC deposit market share data as of June 30, 2011.
 
 
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Bank Holding Company Regulation

Upon formation of the bank holding company on July 1, 2007, we became subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHCA”) which subjects Bancorp to FRB reporting and examination requirements.  Under the FRB’s regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks.

The BHCA regulates the activities of holding companies including acquisitions, mergers and consolidations and, together with the Gramm-Leach Bliley Act of 1999, the scope of allowable banking activities. Bancorp is also a bank holding company within the meaning of the California Financial Code. As such, Bancorp and its subsidiaries are subject to examination by, and may be required to file reports with, the DFI.

Bank Regulation

Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole.  These regulations affect our lending practices, consumer protections, capital structure, investment practices and dividend policy.

As a state chartered bank, we are subject to regulation and examination by the DFI.  We are also subject to regulation, supervision and periodic examination by the FDIC. If, as a result of an examination of the Bank, the FDIC or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of our operations are unsatisfactory, or that we have violated any law or regulation, various remedies are available to those regulators including issuing a “cease and desist” order, restricting our growth or removing officers and directors.

The following discussion summarizes certain significant laws, rules and regulations affecting both Bancorp and the Bank. The Bank addresses the many state and federal regulations it is subject to through a comprehensive compliance program that addresses the various risks associated with these issues.

Dividends

The payment of cash dividends by the Bank to Bancorp is subject to restrictions set forth in the California Financial Code (the “Code”).  Prior to any distribution from the Bank to Bancorp, a calculation is made to ensure compliance with the provisions of the Code and to ensure that the Bank remains within capital guidelines set forth by the DFI and the FDIC.  Management anticipates that there will be sufficient earnings at the Bank level to provide dividends to Bancorp to meet its funding requirements for 2012.  See also Note 9 to the Consolidated Financial Statements, under the heading “Dividends” in Item 8 of this report.

FDIC Insurance Assessments

Our deposits are insured by the FDIC to the maximum amount permitted by law, which is currently $250,000 per depositor. The 2010 enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) made the deposit insurance coverage permanent at the $250,000 level retroactive to January 1, 2008.
The Dodd-Frank act also provides depositors at all FDIC-insured institutions with unlimited deposit insurance coverage on traditional checking accounts that do not pay interest and Interest on Lawyers Trust Accounts beginning December 31, 2010 through the end of 2012.

During 2009 and 2010, we elected to participate in the Temporary Transaction Account Guarantee Program, which provided full deposit insurance coverage to non-interest bearing transaction accounts (including low-interest negotiable order of withdrawal accounts and interest on lawyer trust accounts), by paying a 10 basis point surcharge on the non-interest bearing transaction accounts over $250,000 through December 31, 2009, and a 15 basis point surcharge through December 31, 2010, when the program ended.

On November 12, 2009, the FDIC finalized a Deposit Insurance Fund restoration plan that required banks to prepay, on December 30, 2009, their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. Under the plan, banks were assessed through 2010 according to the risk-based premium schedule adopted in April 2009.
 
 
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On February 7, 2011, as required by the Dodd-Frank Act, the FDIC approved a rule that changes the FDIC insurance assessment base from adjusted domestic deposits to a bank’s average consolidated total assets minus average tangible equity, defined as Tier 1 capital.  Since the new base is larger than the current base, the new rule lowers assessment rates to between 2.5 and 9 basis points on the broader base for banks in the lowest risk category, and 30 to 45 basis points for banks in the highest risk category. The change was effective beginning with the second quarter of 2011. Since we have a solid core deposit base and do not rely heavily on borrowings and brokered deposits, the benefit of the lower assessment rate (which has dropped by approximately half for us) significantly outweighed the effect of a wider assessment base.

Community Reinvestment Act

We are subject to the provisions of the Community Reinvestment Act (“CRA”), under which all banks and thrifts have a continuing and affirmative obligation, consistent with safe and sound operations, to help meet the credit needs of their entire communities, including low and moderate income neighborhoods.  The act requires a depository institution’s primary federal regulator, in connection with its examination of the institution, to assess the institution’s record in meeting the requirements in CRA. The regulatory agency’s assessment of the institution’s record is made available to the public.  The record is taken into consideration when the institution establishes a new branch that accepts deposits, relocates an office, applies to merge or consolidate, or expands into other activities.  Our CRA performance is evaluated by the FDIC under the intermediate small bank requirements.  The FDIC’s last CRA performance examination was performed on us and completed on May 7, 2009 with a rating of “Satisfactory”.

Anti Money–Laundering Regulations

A series of banking laws and regulations beginning with the Bank Secrecy Act in 1970 require banks to prevent, detect, and report illicit or illegal financial activities to the federal government to prevent money laundering, international drug trafficking, and terrorism. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with high risk customers, foreign financial institutions, and foreign individuals and entities.  We have extensive controls in place to comply with these requirements.

Privacy and Data Security

The Gramm-Leach Bliley Act (“GLBA”) of 1999 imposes requirements on financial institutions with respect to consumer privacy.  The GLBA generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure.  Financial institutions are further required to disclose their privacy policies to consumers annually.  The GLBA also directs federal regulators, including the FDIC, to prescribe standards for the security of consumer information.  We are subject to such standards, as well as standards for notifying consumers in the event of a security breach.  We must disclose our privacy policy to consumers and permit consumers to “opt out” of having non-public customer information disclosed to third parties.  We are required to have an information security program to safeguard the confidentiality and security of customer information and to ensure proper disposal of information that is no longer needed.  Customers must be notified when unauthorized disclosure involves sensitive customer information that may be misused.

Consumer Protection Regulations

Our lending activities are subject to a variety of statutes and regulations designed to protect consumers, including the Fair Credit Reporting Act, Equal Credit Opportunity Act, the Fair Housing Act, and the Truth-in-Lending Act. Our deposit operations are also subject to laws and regulations that protect consumer rights including Funds Availability, Truth in Savings, and Electronic Funds Transfers. Additional rules govern check writing ability on certain interest earning accounts and prescribe procedures for complying with administrative subpoenas of financial records. Additionally, a provision of the Federal Reserve Regulation E has been changed effective July 1, 2010 that puts restrictions on institutions assessing overdraft fees on consumer’s accounts relating to debit card usage or other forms of electronic transfer.  As a result, our overdraft fee income has been negatively impacted.  See also analysis captioned “Non interest income” in Item 7 of this report.
 
 
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Restriction on Transactions between Member Banks and their Affiliates

Transactions between Bancorp and the Bank are quantitatively and qualitatively restricted under Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W. Section 23A places restrictions on the Bank’s “covered transactions” with Bancorp, including loans and other extensions of credit, investments in the securities of, and purchases of assets from Bancorp. Section 23B requires that certain transactions, including all covered transactions, be on market terms and conditions. Federal Reserve Regulation W combines statutory restrictions on transactions between the Bank and Bancorp with FRB interpretations in an effort to simplify compliance with Sections 23A and 23B.

Capital Requirements

The FRB and the FDIC have adopted risk-based capital guidelines for bank holding companies and banks. Bancorp’s ratios exceed the required minimum ratios for capital adequacy purposes and the Bank meets the definition for well capitalized.  Undercapitalized depository institutions may be subject to significant restrictions. Payment of interest and principal on subordinated debt of the Bank could be restricted or prohibited, with some exceptions, if the Bank were categorized as "critically undercapitalized" under applicable FDIC regulations. For further information on risk-based capital, see Note 16 to the Consolidated Financial Statements in Item 8 of this Form 10-K.

The current risk-based capital guidelines which apply to the Bank are based upon the 1988 capital accord of international Basel Committee referred to as “Basel I.” In January 2009, the Basel Committee proposed to reconsider regulatory-capital standards, supervisory and risk-management requirements and additional disclosures to further strengthen the Basel framework in response to recent worldwide economic developments. The proposed changes, otherwise known as the “Basel III” standards, if adopted, could lead to significantly higher capital requirements, higher capital charges and more restrictive leverage and liquidity ratios. Federal banking regulators have recently issued proposed rules relating to the Basel III requirements.  In the proposed rule it is anticipated that the Basel III requirements will be applicable to all U.S. bank holding companies with consolidated assets of $50 billion or more and any nonbank financial firms that may be designated as systemically important companies.  Bancorp is uncertain as to what eventual effect this will have on a companies such as us, with less than $50 billion in consolidated assets.  There is always the possibility that some of the Basel III requirements may be implemented by bank regulators for banks with less than $50 billion in consolidated assets as a “best practice.”

Sarbanes-Oxley Act of 2002

We are subject to the requirements of the Sarbanes-Oxley Act of 2002 which implemented legislative reforms intended to address corporate and accounting improprieties and among other things:
 
 
required executive certification of financial presentations;
 
increased requirements for board audit committees and their members;
 
enhanced disclosure of controls and procedures and internal control over financial reporting;
 
enhanced controls over, and reporting of, insider trading; and
 
increased penalties for financial crimes and forfeiture of executive bonuses in certain circumstances.

Emergency Economic Stabilization Act of 2009 (the “EESA”)

In response to the financial crisis affecting the banking system and financial markets and going concern threats of investment banks and other financial institutions, on October 3, 2008, the EESA was signed into law, which gave the U.S. Treasury the authority to, among other things, inject $700 billion capital into the market to stabilize the financial industry.  Pursuant to the EESA, the U.S. Treasury also purchased senior preferred shares from the largest nine financial institutions in the nation and the other financial institutions in a program known as the Treasury Capital Purchase Program (“TCPP”) that was carved out of the Troubled Asset Relief Program (“TARP”).  As a result of our participation in the TCPP, we were subject to restrictions on executive compensation and limitations on dividends and stock repurchases from December 5, 2008 to March 31, 2009, the period that the preferred stock issued to the U.S. Treasury was outstanding. We also issued a warrant to the U.S. Treasury as part of the TCPP to acquire 154,908 shares of our common stock (as adjusted to date).  The warrant was auctioned by the U.S. Treasury and purchased by two institutional investors during November 2011 and remains outstanding.  See Note 9 to the Consolidated Financial Statements in Item 8 of this report for discussion regarding the warrant.
 
 
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The American Recovery and Reinvestment Act of 2009 (the “Recovery Act”)
 
The Recovery Act was signed into law on February 17, 2009 in an effort, among other things, to jumpstart the U.S. economy, prevent job losses, expand educational opportunities, and provide affordable health care and tax relief.  Among the various measures in the Recovery Act, it imposes further restriction on executive compensation and corporate expenditure limits of recipients of the TCPP funds, while allowing them to repurchase the preferred stock at liquidation amount without regard to the original TCPP transaction terms. See Note 9 to the Consolidated Financial Statements in Item 8 of this report for discussion regarding our repurchase of preferred stock issued under the TCPP.

The Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, a landmark financial reform bill comprised of massive volume of new rules and restrictions that will impact banks going forward. It includes key provisions aimed at preventing a repeat of the 2008 financial crisis and a new process for winding down failing, systemically important institutions in a manner as close to a controlled bankruptcy as possible. The Act includes other key provisions as follows:
 
(1) The Act establishes a new Financial Stability Oversight Council to monitor systemic financial risks. The FRB is given extensive new authorities to impose strict controls on large bank holding companies with total consolidated assets equal to or in excess of $50 billion and systemically significant nonbank financial companies to limit the risk they might pose for the economy and to other large interconnected companies. The FRB can also take direct control of troubled financial companies that are considered systemically significant.
 
The Act restricts the amount of trust preferred securities (“TPS”) that may be considered as Tier 1 Capital. For bank holding companies below $15 billion in total assets, TPS issued before May 19, 2010 will be grandfathered, so their status as Tier 1 capital does not change. Beginning January 1, 2013, bank holding companies above $15 billion in assets will have a three-year phase-in period to fill the capital gap caused by the disallowance of the TPS issued before May 19, 2010.  However going forward, TPS will be disallowed as Tier 1 capital.

(2) The Act creates a new process to liquidate failed financial firms in an orderly manner, including giving the FDIC broader authority to operate or liquidate a failing financial company.

(3) The Act also establishes a new independent Federal regulatory body for consumer protection within the Federal Reserve System known as the Bureau of Consumer Financial Protection (the "Bureau"), which will assume responsibility for most consumer protection laws (except the Community Reinvestment Act). It will also be in charge of setting appropriate consumer banking fees and caps. The Office of Comptroller of the Currency will continue to have authority to preempt state banking and consumer protection laws if these laws "prevent or significantly" interfere with the business of banking.

(4) The Act effects changes in the FDIC assessment as discussed in section “FDIC Insurance Assessmentsabove.

(5) The Act places certain limitations on investment and other activities by depository institutions, holding companies and their affiliates, including comprehensive regulation of all over-the-counter derivatives.

(6) The Act states that the FRB is authorized to regulate interchange fees on debit cards and certain general-use prepaid card transactions paid to issuing banks with assets in excess of $10 billion to ensure that they are “reasonable and proportional” to the cost of processing individual transactions, and to prohibit debit and general-use prepaid payment card networks and issuers from requiring transactions to be processed on a single payment network. The FRB issued its final rule on June 29, 2011.

The impact of the Act on our banking operations is still uncertain due to the massive volume of new rules still subject to adoption and interpretation.
 
 
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Available Information

On our internet web site, www.bankofmarin.com, we post the following filings as soon as reasonably practicable after they are filed with or furnished to the SEC: Annual Report on Form 10-K, Proxy Statement for the Annual Meeting of Shareholders, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934.  The text of the Code of Ethical Conduct for Bancorp and the Bank is also included on the website. All such filings on our website are available free of charge.  This website address is for information only and is not intended to be an active link, or to incorporate any website information into this document. In addition, copies of our filings are available by requesting them in writing or by phone from:

Corporate Secretary
Bank of Marin
504 Redwood Blvd., Suite 100
Novato, CA 94947
415-763-4523

 
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ITEM 1A. 
RISK FACTORS

An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that Management believes may affect our business are described below. Before making an investment decision, investors should carefully consider the risks and uncertainties described below, together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing our business. Additional risks and uncertainties that Management is not aware of or focused on or that Management currently deems immaterial may also impair business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected.

Our Earnings are Significantly Influenced by General Business and Economic Conditions

We are operating in an uncertain economic environment. While there are signs of economic conditions improving, the persistent high unemployment rate, weak business and consumer spending, the U.S. budget deficit and uncertainty in European economies underline that the economy remains very fragile. Economic recovery is expected to be slow and long.  The housing market is not expected to recover soon amid a bleak job market. Business activity across a wide range of industries and regions is greatly affected. Local and state governments are in difficulty due to the reduction in sales taxes resulting from the lack of consumer spending and property taxes resulting from declining property values.  Financial institutions continue to be affected by the contraction of the real estate market, elevated foreclosure rates, long-term high unemployment and underemployment rates and a stricter regulatory environment.  While our market areas have not experienced the same degree of challenge in unemployment as other areas2, the effects of these issues have trickled down to households and businesses in our markets.  There can be no assurance that the recent economic improvement is sustainable and credit worthiness of our borrowers will not deteriorate.
 
Continued declines in real estate values and home sale volumes, financial stress on borrowers, including job losses, and customers’ inability to pay debt could adversely affect our financial condition and results of operations in the following aspects:

 
Demand for our products and services may decline
 
Low cost or non-interest bearing deposits may decrease
 
Collateral for our loans, especially real estate, may decline further in value
 
Loan delinquencies, problem assets and foreclosures may increase.
 
Our deposit growth level has outpaced our loan growth recently, which leads to excess liquidity earning a less favorable yield. As the economy is still vulnerable, businesses are wary about capital expenditures or expansion of working capital and consumers are de-leveraging their debts.  Hence, we have noticed a low level of loan demand due to an unfavorable economic climate and intensified competition for creditworthy borrowers, all of which could impact our ability to generate profitable loans.

Nonperforming Assets Take Significant Time To Resolve And Adversely Affect Our Results Of Operations And Financial Condition.

Our nonperforming assets have been maintained at a manageable level historically.  As discussed in Note 2 to the Consolidated Financial Statements in Item 8 of this report, we acquired certain assets of the failed Charter Oak Bank on February 18, 2011.  The Acquisition may expose us to credit issues of acquired assets, which may become nonperforming in the future.
 

2  Based on the latest available labor market information from Employment Development Department.   Preliminary December 2011 results show that the unemployment rate in Marin County was the lowest in California at 6.5%.  The unemployment rates in Sonoma and Napa County are 8.9% and 9.0%, compared to the state of California at 10.9%.
 
 
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Nonperforming assets may adversely affect our net income in various ways. Until economic and market conditions improve, we expect to continue to incur elevated losses relating to nonperforming assets. We do not record interest income on non-accrual loans, thereby adversely affecting our income and increasing our loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related loan to the then fair value of the collateral, which may result in a loss. While we have tried to reduce our problem assets through workouts, restructurings and otherwise, decreases in the value of these assets, or the underlying collateral, or in these borrowers’ performance or financial conditions, whether or not due to economic and market conditions beyond our control, could adversely affect our business, results of operations and financial condition. In addition, the resolution of nonperforming assets requires significant commitments of time from management, which can be detrimental to the performance of other responsibilities. There can be no assurance that we will not experience further increases in nonperforming loans in the future.

Purchased Loans from the Acquisition May Lose Value if the Estimated Fair Value is Inaccurate

Our determination regarding the fair value of loans purchased in the Acquisition could be inaccurate, which could materially and adversely affect our business, financial condition, results of operations and future prospects. Management makes various assumptions and judgments about the collectability of the acquired loans, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of secured loans. The timing and amount of future expected cash flows is hence subject to a great degree of uncertainty. Increases in the amount of future losses in response to different economic conditions or adverse developments in the acquired loan portfolio may result in increased credit loss provisions and could have a negative impact on our operating results.

Recently Enacted Legislation and Other Measures Undertaken by the Government May not Help Stabilize the U.S. Financial System and The Impact of New Financial Reform Legislation is Yet to be Determined

As discussed in Item 1, Section captioned “Supervision and Regulation” above, in 2010, President Obama signed into law a landmark financial reform bill—the Dodd-Frank Act. The rules under the Dodd-Frank Act may change banking statutes and the operating environment of Bancorp and the Bank in substantial and unpredictable ways, and could increase the cost of doing business, decrease our revenues, limit or expand permissible activities or affect the competitive balance depending upon whether or how regulations are implemented. We may be forced to invest significant management attention and resources to make any necessary changes related to the Dodd-Frank Act and any regulations promulgated there under.  The ultimate effect of the changes would have on the financial condition or results of operations of Bancorp or the Bank is uncertain at this time.

The actual impact of the recently enacted legislation and such related measures undertaken to alleviate the aftermaths of the credit crisis is unknown. The capital and credit markets have experienced volatility and disruption at an unprecedented level in the past few years.  In some cases, the markets have produced downward pressure on credit availability for certain issuers without regard to those issuers’ underlying financial strength. If the recent years’ disruption and volatility return, there can be no assurance that we will not experience an adverse effect on our ability to access credit or capital.

In addition to changes resulting from the Dodd-Frank Act, recent rules published by the Basel Committee on Banking Supervision, could lead to significantly higher capital requirements, higher capital charges and more restrictive leverage and liquidity ratios. On September 28, 2011, the Basel Committee upheld its view to require an additional loss absorbency amount ranging from 1% to 2.5% on tier 1 capital for global systemically important banks (“G-SIBs”).  While we are not a G-SIB, general expectations of key stakeholders are that the Basel rules will trickle down and affect smaller banks like us, and therefore increase our capital requirements, particularly the tier one common equity ratio, in the future. As a result, it may affect the results of our financial condition or business’ prospects in the future.

The Recent Repeal of Federal Prohibitions on Payment of Interest on Demand Deposits Could Increase Our Interest Expense
 
On July 21, 2011, the Dodd-Frank Act lifted the prohibitions on payment of interest on demand deposits. Financial institutions can start paying interest on demand deposits in an effort to compete for deposits.  Although we do not currently pay interest on business demand deposits and the current low interest rate environment may delay any significant change in interest rates offered by our main competitors, we may experience increases to our interest expense and interest rate sensitivity and an overall decrease in the net interest margin if we are to offer interest on demand deposits to attract or retain customers in the future.   As a result, it may affect the results of our financial condition, or business’ prospects in the future, especially when interest rates begin to rise.
 
 
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We May Experience Unfavorable Outcomes with Growth
 
We seek to expand our franchise safely and consistently. A successful growth strategy requires us to manage multiple aspects of the business simultaneously, such as following adequate loan underwriting standards, balancing loan and deposit growth without increasing interest rate risk or compressing our net interest margin, maintaining sufficient capital, and recruiting, training and retaining qualified professionals.  We have recently expanded into the Napa and the greater Sonoma markets, which may have characteristics unfamiliar to us. We may also experience a lag in profitability associated with the new branch openings.
 
Our growth strategy also includes merger and acquisition opportunities that either enhance our market presence or have potential for improved profitability through financial management, economies of scale or expanded services. As discussed in Note 2 to the Consolidated Financial Statement in Item 8 of this report, we acquired certain assets and certain liabilities of Napa-based Charter Oak Bank on February 18, 2011 through an FDIC-assisted transaction. While FDIC-assisted acquisitions provide attractive opportunities in part due to loans purchased at significant discounts, acquiring other banks or branches involves risks such as exposure to potential asset quality issues of the target company, potential disruption to our normal business activities and diversion of Management’s time and attention due to integration and conversion efforts. If we pursue our growth strategy too aggressively and fail to execute integration properly, we may not be able to achieve expected synergies or other anticipated benefits.
 
Interchange Reimbursement Fees and Related Practices Have Been Receiving Significant Legal and Regulatory Scrutiny, and the Resulting Regulations Could Have a Significant Impact on Interchange Fees We Earn

The Dodd-Frank Act includes provisions that regulate the debit interchange rates and certain other network industry practices (the “Durbin Amendment”). In addition, the FRB now has the power to regulate network fees to the extent necessary to prevent evasion of the new rules on interchange rates. The FRB issued a rule to restrict interchange fees on debit cards to 21 cents per transaction and 5 basis points multiplied by the value of the transaction for institutions with $10 billion or more in assets.  Interchange represents a transfer of value between the financial institutions participating in payment networks such as Visa and NYCE, in which we participate. In connection with transactions initiated with cards in a payments system, interchange reimbursement fees are typically paid to issuers, the financial institutions such as us that issue debit cards to cardholders. They are typically paid by network owners, the financial institutions that offer network connectivity and payment acceptance services to merchants.

Despite the statutory attempt to separate out smaller banks from the price controls embodied in the Durbin amendment, the marketplace may drive business to the lowest cost option. Merchants may switch to lower-cost cards and accounts of larger institutions, applying downward pressure on the fees paid to small institutions to compete. In January 2010, Visa announced that it will implement a two-tiered pricing system for debit interchange – one for banks with more than $10 billion in assets, and one for all those under the $10 billion threshold. There is no obligation for networks, such as Visa, to maintain their multiple-tier pricing structure. Community banks such as us may ultimately be harmed as a result. We may be forced to charge lower fees to customers, affecting our profitability. Owners of networks in which we do not participate could elect to charge higher discount rates to merchants, leading merchants not to accept cards for payment, or to steer Visa cardholders to alternate payment systems, hence reducing our transaction volumes.
 
 
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Negative Conditions Affecting Real Estate May Harm Our Business

Concentration of our lending activities in the California real estate sector could negatively impact our results of operations if the adverse changes in the real estate market in our lending area intensify. Although we do not offer traditional first mortgages, nor have sub-prime or Alt-A residential loans or significant amount of securities backed by such loans in the portfolio, we are not immune from the effect of the set-back of the real estate market. Approximately 85% of our loans were secured by real estate at December 31, 2011, of which 61% were secured by commercial real estate and the remaining 24% by residential real estate. Real estate valuations are impacted by demand, and demand is driven by factors such as employment; when unemployment rises, demand drops. The unemployment rate has stayed at an elevated level since 2009. Most of the properties that secure our loans are located within Marin, San Francisco and Sonoma Counties. While we have seen improvement in real estate sales volume, the selling prices continue to be at a distressed level3.

Loans secured by commercial real estate include those secured by small office buildings, owner-user office/warehouses, mixed-use residential/commercial properties and retail properties. In 2011, office vacancy rates in Marin County have fallen from 25.7% to 23.3%, while industrial vacancy rates have risen from 5.9% to 7.8% and retail rates have fallen slightly from 5.5% to 5.1%4.  In Sonoma County, vacancy rates are generally higher than in Marin County: the rate of industrial, retail, and office vacancies changed from 13.9%, 8.5%, and 22.3% in 2010 to 13.7%, 6.6%, and 23.3% in 2011, respectively4. There can be no assurance that the companies or properties securing our loans will generate sufficient cash flows to allow the borrowers to make full and timely loan payments to us.

In late 2006, Federal banking regulators issued final guidance regarding commercial real estate lending to address a concern that rising commercial real estate lending concentrations may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the investor commercial real estate market. This guidance suggests that institutions that are potentially exposed to significant commercial real estate concentration risk will be subject to increased regulatory scrutiny.  Institutions that have experienced rapid growth in commercial real estate lending, have notable exposure to a specific type of commercial real estate lending, or are approaching or exceed certain supervisory criteria that measure an institution’s commercial real estate portfolio against its capital levels, may be subject to such increased regulatory scrutiny.  Although regulators have not notified us of any concern, there is no assurance that we will not be subject to additional scrutiny in the future.

We are Subject to Interest Rate Risk

Our earnings and cash flows are largely dependent upon our net interest income.  Net interest income is the difference between interest income earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds. Interest rates are sensitive to many factors outside our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the FRB, which regulates the supply of money and credit in the United States. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and interest we pay on deposits and borrowings, but could also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the average duration of our mortgage-backed securities portfolio. Our portfolio of securities is subject to interest rate risk and will generally decline in value if market interest rates increase, and generally increase in value if market interest rates decline. Our mortgage-backed security portfolio is also subject to prepayment risk in a low interest rate environment.

In response to the recessionary state of the national economy, the gloomy housing market and the volatility of financial markets, the Federal Open Market Committee of the FRB (“FOMC”) started a series of decreases in Federal funds target rate with seven decreases in 2008, bringing the target rate to a historically low range of 0% to 0.25% through December 2011. In their statement after the first FOMC meeting in 2012, they expect the exceptionally low interest rates to continue through 2014.

Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on the net interest margin. Although we believe we have implemented effective asset and liability management strategies, any substantial, prolonged low interest rate environment could have an adverse effect on our financial condition and results of operations. See the sections captioned “Net Interest Income” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Quantitative and Qualitative Disclosures about Market Risk in Item 7A of this report for further discussion related to management of interest rate risk.


3  Home sales were up 5.3% in Marin County and 9.6% in Sonoma County in 2011.
 
4  Based on the latest available real estate information from Keegan & Coppin Company, Inc.
 
 
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In the current environment of historically low interest rates, it is important for us to mitigate exposure to future increases in interest rates. If interest rates rise by more than 100 basis points, we anticipate that net interest income will rise assuming no additional deposit rate sensitivity. However, it may still take several upward market rate movements for variable rate loans at floors to move above their floor rates. Further, a rise in index rates leads to lower debt service coverage of variable rate loans if the borrower’s operating cash flow doesn’t also rise. This creates a leveraged paradox of an improving economy (leading to higher interest rates), but lower credit quality as short-term rates move up faster than the cash flow or income of the borrowers. Higher interest rates may also depress loan demand, making it more difficult for us to grow loans.

We are Subject to Significant Credit Risk and Loan Losses May Exceed Our Allowance for Loan Losses in the Future

We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents Management’s best estimate of probable losses that may be incurred within the existing portfolio of loans. The level of the allowance reflects Management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality and present economic, political and regulatory conditions. The determination of the appropriate level of the allowance for loan 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. Further, we generally rely on appraisals of the collateral or comparable sales data to determine the level of specific reserve and/or the charge-off amount on certain collateral dependent loans. Inaccurate assumptions in the appraisals or an inappropriate choice of the valuation techniques may lead to an inadequate level of specific reserve or charge-offs.

Changes in economic conditions affecting borrowers, new information regarding existing loans and their collateral, identification of additional problem loans and other factors, may require an increase in our allowance for loan losses.  In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs.  In addition, if charge-offs in future periods exceed the allowance for loan losses or the cashflows from the acquired loans do not perform as expected, we will need to record additional provision for loan losses.  Any increases in the allowance for loan losses will result in an adverse impact on net income and capital.

We Face Intense Competition with Other Financial Institutions to Attract and Retain Banking Customers

We are facing significant competition for customers from other banks and financial institutions located in the markets we serve.  We compete with commercial banks, saving banks, credit unions, non-bank financial services companies and other financial institutions operating within or near our serving areas.  Many of our non-bank competitors are not subject to the same extensive regulations as we are, thus, they are able to offer greater flexibility in competing for business.  We anticipate intense competition will be continued for the coming year due to the recent consolidation of many financial institutions and more changes in legislature, regulation and technology. Further, we expect loan demand to continue to be challenging due to the uncertain economic climate and the intensifying competition for creditworthy borrowers, both of which could lead to loan rate concession pressure and could impact our ability to generate profitable loans.

Going forward, we may see tighter competition in the industry as banks seek to take market share in the most profitable customer segments, particularly the small business segment and the mass-affluent segment, which offers a rich source of deposits as well as more profitable and less risky customer relationships.  Further, with the rebound of the equity markets, our deposit customers may perceive alternative investment opportunities as providing superior expected returns. Technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments or other deposit accounts such as online virtual banks and non-bank service providers. The current low interest rate environment could increase such transfers of deposits to higher yielding deposits or other investments. Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs. When our customers move money into higher yielding deposits or in favor of alternative investments, we can lose a relatively inexpensive source of funds, thus increasing our funding costs.
 
 
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We also compete with nation-wide and regional banks much larger than our size, which may be able to benefit from economies of scale through their wider branch network, national advertising campaigns and sophisticated technology infrastructure.
 
We intend to seek additional deposits by continuing to establish and strengthen our personal relationships with our existing customers and by offering deposit products that are competitive with those offered by other financial institutions in our markets. If these efforts are unsuccessful, we may need to fund our asset growth through borrowings, other non-core funding or public offerings of our common stock which could be leveraged.  Increased debt would further increase our leverage, reduce our borrowing capacity and increase our reliance on non-core funds and counterparties’ credit availability.  A public offering may have a dilutive effect on earnings per share and share ownership.

Our Ability to Access Markets for Funding and Acquire and Retain Customers Could be Adversely Affected by the Deterioration of Other Financial Institutions or the Financial Service Industry’s Reputation

Reputation risk is the risk to liquidity, earnings and capital arising from negative publicity regarding the financial services industry.  The financial services industry continues to be featured in negative headlines about their roles in the past global and national credit crisis and the resulting stabilization legislation enacted by the U.S. federal government.  These reports can be damaging to the industry’s image and potentially erode consumer confidence in insured financial institutions.  Bank failures in California, including in our own markets, have had a negative impact and additional failures are expected.  In addition, our ability to engage in routine funding and other transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems, losses of depositor, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions. We could experience increases in deposits and assets as a direct or indirect result of other banks’ difficulties or failure, which would increase the capital we need to support such growth or we could experience severe and unexpected decreases in deposits which could adversely impact our liquidity and heighten regulatory concern.

Bancorp and the Bank are Subject to Extensive Government Regulation and Supervision

Bancorp and the Bank are subject to extensive federal and state governmental supervision, regulation and control. Holding company regulations affect the range of activities in which Bancorp is engaged. Banking regulations affect the Bank’s lending practices, capital structure, investment practices and dividend policy among other controls. Future legislative changes or interpretations may also alter the structure and competitive relationship among financial institutions. Legislation is regularly introduced in the U.S Congress and the California Legislature which would impact our operating environment in perhaps substantial and unpredictable ways.  The nature and extent of future legislative and regulatory changes affecting us is unpredictable at this time.

The historic disruptions in the financial marketplace over the past few years have prompted the Obama administration to reform the financial market regulation. This reform includes additional regulations over consumer financial products, bond rating agencies and the creation of a regime for regulating systemic risk across all types of financial service firms. In light of recent economic conditions as well as regulatory and congressional criticism, further restrictions on financial service companies may adversely impact our results of operations and financial condition, as well as increase our compliance risk.

Compliance risk is the current and prospective risk to earnings or capital arising from violations of, or nonconformance with, laws, rules, regulations, prescribed practices, internal policies, and procedures, or ethical standards set forth by regulators.  Compliance risk also arises in situations where the laws or rules governing certain bank products or activities of our clients may be ambiguous or untested.  This risk exposes Bancorp and the Bank to potential fines, civil money penalties, payment of damages and the voiding of contracts.  Compliance risk can lead to diminished reputation, reduced franchise value, limited business opportunities, reduced expansion potential and an inability to enforce contracts.

For further information on supervision and regulation, see the section captioned “Supervision and Regulation” in Item 1 above.
 
 
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Bancorp Relies on Dividends from the Bank to Pay Cash Dividends to Shareholders

Bancorp is a separate legal entity from its subsidiary, the Bank.  Bancorp receives substantially all of its revenue from the Bank in the form of dividends, which is Bancorp’s principal source of funds to pay cash dividends to Bancorp’s common shareholders. Various federal and state laws and regulations limit the amount of dividends that the Bank may pay to Bancorp. In the event that the Bank is unable to pay dividends to Bancorp, Bancorp may not be able to pay dividends to its shareholders. As a result, it could have an adverse effect on Bancorp’s stock price and investment value.

Under federal law, capital distributions from the Bank would become prohibited, with limited exceptions, if the Bank were categorized as "undercapitalized" under applicable FRB or FDIC regulations.  In addition, as a California bank, the Bank is subject to state law restrictions on the payment of dividends. For further information on the distribution limit from the Bank to Bancorp, see the section captioned “Bank Regulation” in Item 1 above and “Dividends” in Note 9 to the Consolidated Financial Statements in Item 8 below.

The Trading Volume of Bancorp’s Common Stock is Less than That of Other Larger Financial Services Companies

Our common stock is listed on the NASDAQ’s Capital Market.  Our trading volume is less than that of nationwide or regional financial institutions.  A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence of willing buyers and sellers of common stock 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.  Given the lower trading volume of our common stock, significant trades of our stock in a given time, or the expectations of these trades, could cause the stock price to be more volatile.

Failure of Correspondent Banks and Counterparties May Affect our Liquidity

In the past few years, the financial services industry in general was materially and adversely affected by the credit crises.  We have witnessed failure of banks in the industry in recent years and the trend is expected to continue. We rely on our correspondent banks for lines of credit.  We also have two correspondent banks as counterparties in our derivative transactions (see Note 15 to the Consolidated Financial Statements).  While we continually monitor the financial health of our correspondent banks and we have diverse sources of liquidity, should any one of our correspondent banks become financially impaired, our available credit may decline and/or they may be unable to honor their commitments.

Unexpected Early Termination of Our Interest Rate Swap Agreements May Impact Our Earnings

We have entered into interest-rate swap agreements, primarily as an asset/liability management strategy, in order to mitigate the changes in the fair value of specified long-term fixed-rate loans and firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates.  These hedges allow us to offer long-term fixed rate loans to customers without assuming the interest rate risk of a long-term asset by swapping our fixed-rate interest stream for a floating-rate interest stream. In the event of default by the borrowers on our hedged loans, we may have to terminate these designated interest-rate swap agreements early, resulting in severe prepayment penalties charged by our counterparties.  On the other hand, when these interest-rate swap agreements are in an asset position, we are subject to the credit risk of our counterparties, who may default on the interest-rate swap agreements, leaving us vulnerable to interest rate movements.

Securities May Lose Value due to Credit Quality of the Issuers

We hold securities issued and/or guaranteed by Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”).  In 2008, the U.S. Government placed both FNMA and FHLMC under conservatorship. Starting in December 2008, the U.S. Government also began purchasing mortgage-backed securities (“MBS”) issued by FNMA.  Further, in December 2009, the U.S. Treasury also announced unlimited capital support for FNMA and FHLMC for the next three years.  As a result, the MBS issued by FNMA and FHLMC has experienced an increase in fair value and our available-for-sale security portfolio has benefitted from this government support.  However, the Obama administration released its report to Congress on reforming the housing-finance market on February 11, 2011. The proposal would wind down FNMA and FHLMC and incrementally shrink the government’s housing-finance footprint by, among other things, gradually increasing the firms’ guarantee pricing, reducing their conforming loan limits, and phasing in a 10-percent down-payment requirement. When the U.S. Government starts selling the MBS securities issued by FNMA and FHLMC, when the government support is phased-out or completely withdrawn, or if either the FNMA or FHLMC comes under further financial stress or deteriorates in their credit worthiness, the fair value of our securities issued or guaranteed by these entities could be negatively affected.
 
 
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We also invest in obligations of state and political subdivisions, some of which are experiencing financial difficulties in part due to loss of property tax from falling home values and declines in sales tax revenues from a reduction in retail activities. The 2009 federal stimulus plan funds flowing out to state governments across the country are running down and are expected to continue to decline and be fully utilized by 2013. State and political subdivisions are expected to undergo further financial stress due to the reduced federal funding. While we seek to minimize our exposure by diversifying geographic location of our portfolio and investing in investment grade securities, there is no guarantee that the issuers will remain financially sound to be current with their payments on these debentures.

Deterioration of Credit Quality or Insolvency of Insurance Companies May Impede our Ability to Recover Losses

The recent financial crisis has led certain major insurance companies to the verge of bankruptcy. We have property, casualty and financial institution risk coverage underwritten by several insurance companies, who may not avoid the insolvency risk permeating the insurance industry. In addition, some of our investment in obligations of state and political subdivisions is insured by several insurance companies.  While we closely monitor credit ratings of our insurers and insurers of our municipality securities, and we are poised to make quick changes if needed, we cannot predict an unexpected inability to honor commitments.  We also invest in bank-owned life insurance policies on certain members of senior management, which may lose value in the event of the carriers’ insolvency.  In the event that our bank-owned life insurance policy carriers’ credit ratings fall below investment grade, we may exchange policies underwritten by them to another carrier at a cost charged by the original carrier, or we may terminate the policies which may result in adverse tax consequences.
 
Our loan portfolio is also primarily secured by properties located in earthquake or fire-prone zones.  In the event of a disaster that causes pervasive damage to the region in which we operate, not only the Bank, but also the loan collateral may suffer losses not recovered by insurance.

We Rely on Technology and Continually Encounter Technological Change

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology will enable efficiency and meeting customer’s changing needs. Our future success depends, 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, as well as to create additional efficiencies in 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 or be successful in marketing these products and services to retain and compete for customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact of the long-term aspect our business and, in turn, our financial condition and results of operations.

We May Experience a Breach in Cyber-security

Our business requires the secure handling of sensitive client information. We also rely heavily on communications and information systems to conduct our business.  Cyber incidents include intentional attacks or unintentional events that can include gaining unauthorized access to digital systems to disrupt operations, corrupting data, stealing sensitive information or causing denial-of-service on our Web sites.  We store, process and transmit account information in connection with lending and deposit relationships, including funds transfer and online banking.  A breach of cyber-security systems of the Bank, our vendors or customers, or widely publicized breaches of other financial institutions could significantly harm our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability.  While we have systems and procedures designed to prevent security breaches, we cannot be certain that advances in criminal capabilities, physical system or network break-ins or inappropriate access will not compromise or breach the technology protecting our networks or proprietary client information.

 
Page - 16

 
We Rely on Third-Party Vendors for Important Aspects of Our Operation

We depend on the accuracy and completeness of information provided by certain key vendors, including but not limited to data processing, payroll processing, technology support, investment security safekeeping and accounting.  Our ability to operate, as well as our financial condition and results of operations, could be negatively affected in the event of an interruption of an information system, an undetected error, or in the event of a natural disaster whereby certain vendors are unable to maintain business continuity.

We May Not Be Able To Attract and Retain Key Employees

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most activities engaged by us can be intense and we may not be able to hire skilled people or retain them. We do not currently have non-competitive agreements with any of our senior officers. The unexpected loss of services of key personnel could have a material adverse impact on our business because of the skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

Severe Weather, Natural Disasters or Other Climate Change Related Matters Could Significantly Impact Our Business

Our primary market is located in an earthquake-prone zone in northern California. Other severe weather or disasters, such as severe rainstorms, wildfire or flood, could interrupt our business operations unexpectedly. Climate-related physical changes and hazards could also pose credit risks for us.  For example, our borrowers may have collateral properties located in coastal areas at risk to rise in sea level. The properties pledged as collateral on our loan portfolio could also be damaged by tsunamis, floods, earthquake or wildfires and thereby the recoverability of our loan could be impaired.  A number of factors affect our credit losses, including the extent of damage to the collateral, the extent of damage not covered by insurance, the extent to which unemployment and other economic conditions caused by the natural disaster adversely affect the ability of borrowers to repay their loans, and the cost of collection and foreclosure to us.  Lastly, there could be increased insurance premiums and deductibles, or a decrease in the availability of coverage, due to severe weather-related losses. The ultimate impact on our business of a natural disaster, whether or not caused by climate change, is difficult to predict.

ITEM 1B. 
UNRESOLVED STAFF COMMENTS

None
 
ITEM 2. 
 
We lease our corporate headquarters building, which houses our primary loan production, operations, and administrative offices, in Novato, California.  We also lease other branch or office facilities within our primary market areas in the cities of Corte Madera, San Rafael, Novato, Sausalito, Mill Valley, Greenbrae, Petaluma, Santa Rosa, Sonoma, Napa and San Francisco, California.  We consider our properties to be suitable and adequate for our needs. For additional information on properties, see Notes 5 and 13 to the Consolidated Financial Statements included in Item 8 of this Form 10-K.
 
ITEM 3.
 
There are no pending, or to Management's knowledge any threatened, material legal proceedings to which we are a party, or to which any of our properties are subject.  There are no material legal proceedings to which any director, any nominee for election as a director, any executive officer, or any associate of any such director, nominee or officer is a party adverse to us.

We are responsible for our proportionate share of certain litigation indemnifications provided to Visa U.S.A. by its member banks in connection with lawsuits related to anti-trust charges and interchange fees. For further details, see Note 13 to the Consolidated Financial Statements in Item 8 of this Form 10-K.
 
ITEM 4.
MINE SAFETY DISCLOSURES
 
Not applicable
 
 
Page - 17

 
PART II

ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Bancorp common stock trades on the NASDAQ Capital Market under the symbol BMRC.  At February 29, 2012, 5,345,732 shares of Bancorp’s common stock, no par value, were outstanding and held by approximately 1,900 holders of record.  The following table sets forth, for the periods indicated, the range of high and low intraday sales prices of Bancorp’s common stock.

Calendar
   
2011
   
2010
 
 Quarter
   
High
   
Low
   
High
   
Low
 
1st Quarter
    $ 37.72     $ 31.80     $ 33.60     $ 29.19  
2nd Quarter
    $ 39.39     $ 34.04     $ 36.14     $ 30.80  
3rd Quarter
    $ 39.85     $ 32.34     $ 35.50     $ 30.08  
4th Quarter
    $ 38.63     $ 32.10     $ 36.00     $ 31.69  

The table below shows cash dividends paid to common shareholders on a quarterly basis in the last two fiscal years.
 
Calendar
   
2011
   
2010
 
 Quarter
   
Per Share
   
Dollars
   
Per Share
   
Dollars
 
1st Quarter
    $ 0.16     $ 848,000     $ 0.15     $ 785,000  
2nd Quarter
    $ 0.16     $ 851,000     $ 0.15     $ 787,000  
3rd Quarter
    $ 0.16     $ 852,000     $ 0.15     $ 789,000  
4th Quarter
    $ 0.17     $ 906,000     $ 0.16     $ 844,000  

For additional information regarding our ability to pay dividends, see discussion in Note 9 to the Consolidated Financial Statement, under the heading “Dividends,” in Item 8 of this report.

There were no purchases made by or on behalf of Bancorp or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Bancorp’s common stock during the fourth quarter of 2011.

On July 2, 2007, Bancorp executed a shareholder rights agreement (“Rights Agreement”) designed to discourage takeovers that involve abusive tactics or do not provide fair value to shareholders. Refer to Exhibit 4.1 to Registration Statement on Form 8-A12B filed with the Securities and Exchange Commission on July 2, 2007.

Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes information as of December 31, 2011, with respect to equity compensation plans.  All plans have been approved by the shareholders.
 
   
(A)
Shares to be issued
upon exercise of
outstanding options
   
(B)
Weighted average
exercise price of
outstanding options
   
(C)
Shares available for future
issuance (Excluding shares
in column A)
 
Equity compensation plans approved by shareholders
    299,806 1   $  30.71       471,519 2

1 Represents shares of common stock issuable upon exercise of outstanding options under the Bank of Marin 1990 Stock Option Plan, the Bank of Marin 1999 Stock Option Plan and the Bank of Marin Bancorp 2007 Equity Plan.

2 Represents shares of common stock available for future grants under the 2007 Equity Plan and the 2010 Director Stock Plan.
 
 
Page - 18


Stock Price Performance Graph

The following graph, provided by Keefe, Bruyette, & Woods, Inc., shows a comparison of cumulative total shareholder return on our common stock during the five fiscal years ended December 31, 2011 compared to Russell 2000 Stock index and peer group index of other financial institutions. We have been part of the Russell 2000 index since July 2009. The comparison assumes $100 was invested on December 31, 2006 in our common stock and all of the dividends were reinvested. The performance graph represents past performance and should not be considered to be an indication of future performance. Ticker symbol BMRC represents the common stock of Bank of Marin Bancorp subsequent to its formation July 1, 2007 and represents the common stock of Bank of Marin for periods prior to the formation of the bank holding company.
   
2006
   
2007
   
2008
   
2009
   
2010
   
2011
 
BMRC
    100       81       67       90       97       104  
Peer Group1
    100       66       31       18       20       19  
Russell 2000
    100       98       65       83       105       101  
 
1BMRC Peer Group represents public California banks with assets between $500 million to $2 billion as of December 31, 2011: FMCB, FCAL, EXSR, BSRR, PFBC, HTBK, AMBZ, BBNK, RCBC, PMBC, HEOP, PPBI, BOCH, NOVB, CVCY, CUNB, FNRN, FNBG, UBFO, CWBC, SWBCD, OVLY, AMRB, PBCA, SAEB, FENB, PFCF, PVLY. The peer group composite index is weighted  by market capitalization and reinvests dividends on the ex-date and adjusts for stock splits, if applicable.
 
Source: Company Reports, FactSet, and SNL
 
 
Page - 19


ITEM 6.
SELECTED FINANCIAL DATA

As of For the Year Ended December 31,
 
2011
   
2010
   
2009
   
2008
   
2007
      2010/2011  
(dollars in thousands, except per share data)
                                 
% change
 
                                       
At December 31
                                     
Total assets
  $ 1,393,263     $ 1,208,150     $ 1,121,672     $ 1,049,557     $ 933,901       15.3 %
Total loans
    1,031,154       941,400       917,748       890,544       724,878       9.5 %
Total deposits
    1,202,972       1,015,739       944,061       852,290       834,642       18.4 %
Total stockholders' equity
    135,551       121,920       109,051       125,546       87,774       11.2 %
Equity-to-asset ratio
    9.7 %     10.1 %     9.7 %     12.0 %     9.4 %     -3.6 %
                                                 
For year ended December 31
                                               
Net interest income
  $ 63,819     $ 54,909     $ 52,567     $ 48,359     $ 42,742       16.2 %
Provision for loan losses
    7,050       5,350       5,510       5,010       685       31.8 %
Non-interest income
    6,269       5,521       5,182       5,356       5,718       13.5 %
Non-interest expense
    38,283       33,357       31,696       28,677       27,673       14.8 %
Net income
    15,564       13,552       12,765       12,150       12,324       14.8 %
Net income per share (diluted)
    2.89       2.55       2.19       2.31       2.31       13.3 %
Tax-equivalent net interest margin
    5.13 %     4.95 %     5.17 %     5.41 %     5.07 %     3.6 %
Cash dividend payout ratio on common stock 1
    22.1 %     23.6 %     25.8 %     23.9 %     21.4 %     -6.3 %

1
Calculated as dividends on common share divided by basic net income per common share.

ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of  financial condition as of December 31, 2011 and 2010 and results of operations for each of the years in the three-year period ended December 31, 2011 should be read in conjunction with our consolidated financial statements and related notes thereto, included in Part II Item 8 of this report.  Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.

Forward-Looking Statements

The disclosures set forth in this item are qualified by important factors detailed in Part I captioned Forward-Looking Statements and Item 1A captioned Risk Factors of this report and other cautionary statements set forth elsewhere in the report.

Executive Summary

We reported record annual earnings of $15.6 million in 2011, an increase of $2.0 million, or 14.8% from $13.6 million a year ago.  2011 earnings include the impact of the FDIC assisted acquisition of certain assets and the assumption of certain liabilities of the former Charter Oak Bank on February 18, 2011 partially offset by the $924 thousand pre-payment penalty on the early pay-off of a $20 million fixed-rate FHLB advance.  Diluted earnings per share for the year ended December 31, 2011 totaled $2.89, up $0.34 from $2.55 in the prior year.

The acquired operations of the former Charter Oak Bank contributed approximately $3.2 million to Bancorp’s pre-tax 2011 income, including, among other things, $2.9 million of accretion on purchased non-credit impaired loans, $2.3 million in loan loss provision, $1.9 million of gains recognized in interest income on pay-offs of purchased credit-impaired loans (“PCI”) loans, $1.0 million in Acquisition related third party costs, $683 thousand impairment write-off of the core deposit intangible asset and $146 thousand in pre-tax bargain purchase gain.  The income amounts discussed above exclude allocated overhead and allocated cost of funds.  The accretion on purchased non-credit impaired loans is expected to decline significantly over the next year.

In addition to our entry into the Napa market through the Acquisition, in 2011 we have expanded our community banking footprint in Sonoma County.  In October 2011, the Bank opened a branch in downtown Sonoma and expanded our Santa Rosa loan production office into a full service branch. We have experienced an increase in non-interest expenses and may experience a short-term lag in profitability associated with the new branch openings. We expect that these strategic initiatives will contribute to our profitability in the long term.
 
 
Page - 20


We are committed to building strong lending relationships in new and core markets. Total loans reached $1.0 billion at December 31, 2011, representing an increase of $89.8 million, or 9.5%.  The increase reflects the loans in the Napa market totaling $56.3 million at December 31, 2011, primarily the remaining loans purchased in the Acquisition as well as growth in the Bank’s commercial real estate, commercial and industrial and home equity portfolios, partially offset by a decreased emphasis on certain product lines, including construction and other residential lending.

Non-accrual loans totaled $12.0 million, or 1.16% of Bancorp’s loan portfolio at December 31, 2011, compared to $12.9 million or 1.37% a year ago.

The provision for loan losses totaled $7.1 million and $5.4 million in 2011 and 2010, respectively. The increase in the provision for loan losses is primarily driven by $2.3 million of loan loss provision related to the acquired loans, where credit quality has deteriorated since the Acquisition.  The allowance for loan losses of $14.6 million totaled 1.42% of loans at December 31, 2011 compared to $12.4 million or 1.32% at December 31, 2010. The increase in the allowance for loan losses as a percentage of loans reflects a higher level of impaired loans and the related specific reserves. Net charge-offs in 2011 totaled $4.8 million compared to $3.6 million in the prior year.  The increase in net loan charge-offs primarily relates to $1.5 million of charge-offs related to the acquired loans.

Our continued focus on responsible community banking fundamentals and our strong customer relationships has led to higher deposits, a core funding source for our loan portfolio. Total deposits grew $187.2 million, or 18.4%, from a year ago to $1.2 billion at December 31, 2011.  The higher level of deposits reflects growth in most categories, except CDARS® time deposits, which decreased $20.6 million.  Non-interest bearing deposits grew $77.4 million or 27.4% to $359.6 million and comprised 29.9% of total deposits at December 31, 2011, compared to 27.8% a year ago.  The increase in total deposits includes deposits in the Napa market, primarily assumed in the Acquisition, totaling $57.9 million at December 31, 2011.

The tax-equivalent net interest margin was 5.13% in 2011 compared to 4.95% in 2010.  Tax-equivalent net interest income for 2011 totaled $64.9 million, representing an increase of $9.1 million, or 16.3% compared to 2010.  The increase primarily reflects the acquisition of loans from the former Charter Oak Bank and a reduction in the cost of deposits, partially offset by the $924 thousand pre-payment penalty on the Federal Home Loan Bank of San Francisco (“FHLB”) advance in the third quarter of 2011.

In the current environment of historically low interest rates, the largest factors likely to affect our net interest margin in 2012 will be our ability to reduce low-yielding excess liquidity by generating profitable loans to creditworthy borrowers, as well as our responsiveness to competitive pricing on loans and deposits in our market. The Acquisition, especially the accretion on acquired non-PCI loans (expected to decline significantly over the next year) and gains on payoffs of PCI loans, favorably impacted our 2011 net interest margin.  We will need to grow loans significantly to maintain the elevated level of net interest margin.   Further, as fixed rate loans mature, we expect loan production to continue to be challenging due to the uncertain economic climate and the intensifying competition for creditworthy borrowers, both of which could lead to loan rate concession pressure and could impact our ability to generate profitable loans. Lastly, approximately 13% of our loans are variable rate loans, whose repricing intervals lag between one to five years after their applicable rate indices change. The downward repricing on these variable loans will put pressure on our net interest margin.  Refer to Table 10, Loan Portfolio Maturity Distribution and Interest Rate Sensitivity for further information.  It is imperative for us to manage customer and product profitability, especially when the interest rate environment remains stable.

If interest rates increase, we anticipate that net interest income will rise.  The increase in interest income from asset repricing may be partially offset by deposit rate sensitivity. Additionally, it may take several upward market rate movements for variable rate loans at floors to move above the floor rates.
 
 
Page - 21

 
Critical Accounting Policies

Critical accounting policies are those that are both most important to the portrayal of our financial condition and results of operations and require Management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
 
Management has determined the following five accounting policies to be critical: Allowance for Loan Losses, Acquired Loans, Other-than-temporary Impairment of Investment Securities, Accounting for Income Taxes and Fair Value Measurements.

Allowance for Loan Losses

Allowance for loan losses is based upon estimates of loan losses and is maintained at a level considered adequate to provide for probable losses inherent in the outstanding loan portfolio. The allowance is increased by provisions charged to expense and reduced by charge-offs, net of recoveries. In periodic evaluations of the adequacy of the allowance balance, Management considers our past loan loss experience by type of credit, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, current economic conditions and other factors. We formally assess the adequacy of the allowance for loan losses on a quarterly basis. These assessments include the periodic re-grading of loans based on changes in their individual credit characteristics including delinquency, seasoning, recent financial performance of the borrower, economic factors, changes in the interest rate environment, and other factors as warranted. Loans are initially graded when originated. They are reviewed as they are renewed, when there is a new loan to the same borrower and/or when identified facts demonstrate heightened risk of default. Confirmation of the quality of our grading process is obtained by independent reviews conducted by outside consultants specifically hired for this purpose and by periodic examination by various bank regulatory agencies. Management monitors delinquent loans continuously and identifies problem loans to be evaluated individually for impairment testing. For loans that are determined impaired, formal impairment measurement is performed at least quarterly on a loan-by-loan basis.

Our method for assessing the appropriateness of the allowance includes specific allowances for identified problem loans, an allowance factor for categories of credits, and allowances for changing environmental factors (e.g., portfolio trends, concentration of credit, growth, economic factors). Allowances for identified problem loans are based on specific analysis of individual credits. Loss estimation factors for loan categories are based on analysis of local economic factors applicable to each loan category, including consideration of our historical charge-off history. Allowances for changing environmental factors are Management's best estimate of the probable impact these changes have had on the loan portfolio as a whole.

For our methodology on estimating the allowance for loan losses on acquired loans, refer to the section Acquired Loans below.
 
Acquired Loans
 
Acquired loans are recorded at their estimated fair values at acquisition date in accordance with ASC 805 Business Combinations, factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded for acquired loans as of the acquisition date.
 
The process of estimating fair values of the acquired loans, including the estimate of losses that are expected to be incurred over the estimated remaining lives of the loans at acquisition date and the ongoing updates to Management's expectation of future cash flows, requires significant subjective judgments and assumptions, particularly considering the current economic environment. The economic environment and the lack of market liquidity and transparency are factors that have influenced, and may continue to affect, these assumptions and estimates.
 
We estimated the fair value of acquired loans at the acquisition date based on a discounted cash flow methodology that considered factors including the type of loan and related collateral, risk classification, fixed or variable interest rate, term of loan and whether or not the loan was amortizing, and current discount rates. Loans were grouped together according to similar characteristics and were treated in the aggregate when applying various valuation techniques. The estimate of expected cash flows incorporates our best estimate of current key assumptions, such as property values, default rates, loss severity and prepayment speeds. The discount rates used for loans were based on current market rates for new originations of comparable loans, where available, and include adjustments for liquidity concerns. To the extent comparable market rates are not readily available, a discount rate was derived based on the assumptions of market participants' cost of funds, servicing costs and return requirements for comparable risk assets.  In either case, the discount rate does not include a factor for credit losses, as that has been considered in estimating the cash flows. The initial estimate of cash flows to be collected was derived from assumptions such as default rates, loss severities and prepayment speeds.
 
 
Page - 22

 
In conjunction with the Acquisition, we purchased certain loans with evidence of credit quality deterioration subsequent to their origination and for which it was probable, at acquisition, that we would be unable to collect all contractually required payments. Management has applied significant subjective judgment in determining which loans are PCI loans. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status, risk grades and recent loan-to-value percentages. Revolving credit agreements (e.g. home equity lines of credit and revolving commercial loans), where the borrower had revolving privileges at acquisition date, are not considered PCI loans because the timing and amount of cash flows cannot be reasonably estimated.
 
The accounting guidance for PCI loans provides that the excess of the cash flows initially expected to be collected over the fair value of the loans at the acquisition date (i.e., the accretable yield) should be accreted into interest income at a level rate of return over the remaining term of the loan, provided that the timing and amount of future cash flows is reasonably estimable. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference and is not recorded.
 
The initial estimate of cash flows expected to be collected is updated each quarter and requires the continued usage of key assumptions and estimates similar to the initial estimate of fair value. Given the current economic environment, we must apply judgment to develop our estimate of cash flows for PCI loans given the impact of real estate value changes, changing loss severities and prepayment speeds.
 
For purposes of accounting for the PCI loans purchased in the Acquisition, we elected not to apply the pooling method but to account for these loans individually. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full by the borrower, foreclosure of the collateral or troubled debt restructurings, result in removal of the loan from the PCI loan portfolio at its carrying amount.
 
If we have probable and significant increases in cash flows expected to be collected on PCI loans, we first reverse any previously established allowance for loan loss and then increase interest income as a prospective yield adjustment over the remaining life of the loans. The impact of changes in variable interest rates is recognized prospectively as adjustments to interest income. All PCI loans that were classified as nonperforming loans prior to Acquisition were no longer classified as nonperforming because, at Acquisition, we believed that we would fully collect the new carrying value of these loans. Subsequent to Acquisition, specific allowances are allocated to PCI loans that have experienced credit deterioration through an increase to the allowance for loan losses. The amount of cash flows expected to be collected and, accordingly, the adequacy of the allowance for loan losses are particularly sensitive to changes in loan credit quality. When there is doubt as to the timing and amount of future cash flows to be collected, PCI are classified as non-accrual loans. It is important to note that judgment is required to classify PCI loans as performing or non-accrual, and is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected.
 
For acquired loans not considered PCI loans, we elect to recognize the entire fair value discount accretion based on the acquired loan’s contractual cash flows using an effective interest rate method for term loans, and on a straight line basis to interest income for revolving lines, as the timing and amount of cash flows under revolving lines are not predictable. Subsequent to Acquisition, if the probable and estimable losses for non-PCI loans exceed the amount of the remaining unaccreted discount, the excess is established as an allowance for loan losses.
 
For further information regarding our acquired loans, see Note 2 and Note 4 to our Consolidated Financial Statements in this Form 10-K.
 
 
Page - 23

 
Other-than-temporary Impairment of Investment Securities 

At each financial statement date, we assess whether declines in the fair value of held-to-maturity and available-for-sale securities below their costs are deemed to be other than temporary.  We consider, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. Evidence evaluated includes, but is not limited to, the remaining payment terms of the instrument and economic factors that are relevant to the collectability of the instrument, such as: current prepayment speeds, the current financial condition of the issuer(s), industry analyst reports, credit ratings, credit default rates, interest rate trends and the value of any underlying collateral. Credit-related other-than-temporary impairment results in a charge to earnings and the corresponding establishment of a new cost basis for the security. Non-credit-related other-than-temporary impairment results in a charge to other comprehensive income, net of applicable taxes, and the corresponding establishment of a new cost basis for the security. The other-than-temporary impairment recognized in other comprehensive income for debt securities classified as held-to-maturity is accreted from other comprehensive income to the amortized cost of the debt security over the remaining life of the debt security in a prospective manner on the basis of the amount and timing of future estimated cash flows.

Accounting for Income Taxes

Income taxes reported in the financial statements are computed based on an asset and liability approach. We recognize the amount of taxes payable or refundable for the current year, and deferred tax assets and liabilities for the expected future tax consequences that have been recognized in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We record net deferred tax assets to the extent it is more likely than not that they will be realized. In evaluating our ability to recover the deferred tax assets, Management considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations. In projecting future taxable income, Management develops assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates being used to manage the underlying business. Bancorp files consolidated federal and combined state income tax returns.

We recognize the financial statement effect of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. For tax positions that meet the more-likely-than-not threshold, we may recognize only the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority. Management believes that all of our tax positions taken meet the more-likely-than-not recognition threshold.  To the extent tax authorities disagree with these tax positions, our effective tax rates could be materially affected in the period of settlement with the taxing authorities.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities available for sale, derivatives, and loans held for sale, if any, are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record certain assets at fair value on a non-recurring basis, such as purchased loans recorded at acquisition date, certain impaired loans held for investment and securities held to maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.

We have established and documented a process for determining fair value. We maximize the use of observable inputs when developing fair value measurements. Whenever there is no readily available market data, Management uses its best estimate and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of Management’s judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial statements. For detailed information on our use of fair value measurements and our related valuation methodologies, see Note 10 to the Consolidated Financial Statements in Item 8 of this Form 10-K.
 
 
Page - 24


RESULTS OF OPERATIONS

Overview

Highlights of the financial results are presented in the following table:

   
As of and for the years ended December 31,
 
(dollars in thousands, except per share data)
 
2011
   
2010
   
2009
 
For the period:
                 
Net income
  $ 15,564     $ 13,552     $ 12,765  
Net income per share
                       
Basic
  $ 2.94     $ 2.59     $ 2.21  
Diluted
  $ 2.89     $ 2.55     $ 2.19  
Return on average equity
    12.01 %     11.67 %     11.46 %
Return on average assets
    1.16 %     1.14 %     1.16 %
Common stock dividend payout ratio
    22.11 %     23.55 %     25.79 %
Efficiency ratio
    54.62 %     55.20 %     54.89 %
At period end:
                       
Book value per common share
  $ 25.40     $ 23.05     $ 20.85  
Total assets
  $ 1,393,263     $ 1,208,150     $ 1,121,672  
Total loans
  $ 1,031,154     $ 941,400     $ 917,748  
Total deposits
  $ 1,202,972     $ 1,015,739     $ 944,061  
Loan-to-deposit ratio
    85.72 %     92.68 %     97.21 %
 
Summary of Quarterly Results of Operations

Table 1 sets forth the quarterly results of operations for 2011 and 2010:

Table 1
Summarized Statement of Income

   
2011 Quarters Ended
   
2010 Quarters Ended
 
(dollars in thousands, unaudited)
 
Dec. 31
   
Sept. 30
   
Jun. 30
   
Mar. 31
   
Dec. 31
   
Sept. 30
   
Jun. 30
   
Mar. 31
 
Interest income
  $ 16,666     $ 17,225     $ 18,137     $ 17,086     $ 15,364     $ 15,601     $ 15,505     $ 14,887  
Interest expense
    948       2,005       1,134       1,208       1,305       1,636       1,748       1,759  
Net interest income
    15,718       15,220       17,003       15,878       14,059       13,965       13,757       13,128  
Provision for loan losses
    2,500       500       3,000       1,050       1,050       1,400       1,350       1,550  
Net interest income after provision for loan losses
    13,218       14,720       14,003       14,828       13,009       12,565       12,407       11,578  
Non-interest income
    1,524       1,565       1,581       1,599       1,360       1,307       1,505       1,349  
Non-interest expense
    9,734       9,421       9,998       9,130       8,037       8,507       8,591       8,222  
Income before provision for income taxes
    5,008       6,864       5,586       7,297       6,332       5,365       5,321       4,705  
Provision for income taxes
    1,625       2,631       2,147       2,788       2,424       2,006       1,983       1,758  
Net income
  $ 3,383     $ 4,233     $ 3,439     $ 4,509     $ 3,908     $ 3,359     $ 3,338     $ 2,947  
Net income available to common stockholders
  $ 3,383     $ 4,233     $ 3,439     $ 4,509     $ 3,908     $ 3,359     $ 3,338     $ 2,947  
                                                                 
Net income per common share
                                                               
Basic
  $ 0.64     $ 0.80     $ 0.65     $ 0.85     $ 0.74     $ 0.64     $ 0.64     $ 0.56  
Diluted
  $ 0.63     $ 0.79     $ 0.64     $ 0.84     $ 0.73     $ 0.63     $ 0.63     $ 0.56  
 
 
Page - 25

 
Net Interest Income

Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is impacted by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on net interest margin.

Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis.  Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity.

Table 2, Distribution of Average Statements of Condition and Analysis of Net Interest Income, compares interest income and average interest-earning assets with interest expense and average interest-bearing liabilities for the three years ended December 31, 2011, 2010 and 2009. The table also indicates net interest income, net interest margin and net interest rate spread for each period presented.

Table 2
Distribution of Average Statements of Condition and Analysis of Net Interest Income
 
   
2011
   
2010
   
2009
 
         
Interest
               
Interest
               
Interest
       
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
(dollars in thousands)
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Assets
                                                     
Interest-bearing due from banks (1)
  $ 87,365     $ 222       0.25 %   $ 43,028     $ 143       0.33 %   $ 164     $ 1       0.60 %
Federal funds sold
    ---       ---       ---       3,049       2       0.07       1,752       4       0.23  
Investment securities
                                                                       
U.S. Government agencies (2)
    120,118       3,478       2.90       91,869       3,234       3.52       70,268       3,304       4.70  
Corporate CMOs and other (2)
    17,249       636       3.69       13,675       593       4.34       7,397       506       6.84  
Obligations of state and political subdivisions (3)
    38,204       1,935       5.06       30,893       1,741       5.64       29,221       1,677       5.74  
Loans and banker's acceptances (1) (3) (4)
    984,211       63,914       6.40       929,755       56,542       6.00       910,456       55,071       5.97  
Total interest-earning assets (1)
    1,247,147       70,185       5.55       1,112,269       62,255       5.52       1,019,258       60,563       5.86  
Cash and non-interest-bearing due from banks
    46,673                       34,383                       46,954                  
Bank premises and equipment, net
    9,136                       8,259                       8,140                  
Interest receivable and other assets, net
    34,183                       31,262                       26,041                  
Total assets
  $ 1,337,139                     $ 1,186,173                     $ 1,100,393                  
Liabilities and Stockholders' Equity
                                                                       
Interest-bearing transaction accounts
  $ 125,316     $ 151       0.12 %   $ 98,168     $ 110       0.11 %   $ 90,159     $ 115       0.13 %
Savings accounts
    69,792       98       0.14       51,738       104       0.20       45,944       94       0.20  
Money market accounts
    405,726       1,286       0.32       390,575       2,467       0.63       391,571       3,235       0.83  
CDARS® time accounts
    39,514       237       0.60       71,432       842       1.18       51,248       721       1.41  
Other time accounts
    151,866       1,314       0.87       124,631       1,495       1.20       97,924       1,541       1.57  
Overnight borrowings (1)
    ---       ---       ---       2       ---       0.29       10,659       28       0.26  
FHLB fixed-rate borrowings
    49,722       2,062       4.15       55,000       1,281       2.33       53,794       1,253       2.33  
Subordinated debenture (1)
    5,000       147       2.90       5,000       149       2.94       5,000       180       3.55  
Total interest-bearing liabilities
    846,936       5,295       0.63       796,546       6,448       0.81       746,299       7,167       0.96  
Demand accounts
    347,682                       263,742                       232,502                  
Interest payable and other liabilities
    12,983                       9,791                       9,873                  
Stockholders' equity
    129,538                       116,094                       111,359                  
Total liabilities & stockholders' equity
  $ 1,337,139                     $ 1,186,173                     $ 1,100,033                  
Tax-equivalent net interest income/margin (1)
          $ 64,890       5.13 %           $ 55,807       4.95 %           $ 53,396       5.17 %
Reported net interest income/margin
          $ 63,819       5.05 %           $ 54,909       4.87 %           $ 52,567       5.09 %
Tax-equivalent net interest rate spread
                    4.92 %                     4.71 %                     4.90 %

(1) Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable.
(2) Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity.  Investment security interest is earned on 30/360 day basis monthly.
(3) Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 35 percent.
(4) Average balances on loans outstanding include non-performing loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield.
 
 
Page - 26

 
2011 Compared with 2010:

Tax equivalent net interest income totaled $64.9 million and $55.8 million for the years ended December 31, 2011 and 2010, respectively. The $9.1 million or 16.3% increase was due to an increase in volume of interest-earning assets and the increase in loan yield, offset by the effect of lower yields on investment securities.

The tax-equivalent net interest margin increased to 5.13% in 2011, up eighteen basis points from 2010. The increase in the tax-equivalent net interest margin primarily reflects the acquisition of loans from the former Charter Oak Bank and a reduction in the cost of deposits, partially offset by the $924 thousand pre-payment penalty on the FHLB advance in the third quarter of 2011, as well as lower yields on investment securities and originated loans and a higher concentration of low yielding due from banks.  In 2011, PCI loans paid off early where the payoff amounts exceeded the recorded investment by $1.9 million which favorably impacted our net interest margin by fifteen basis points.  Accretion on the acquired non-PCI loans of $2.9 million contributed twenty-three basis points to the net interest margin.  The net interest spread increased twenty-one basis points from the same period last year for the same reasons.

Average interest-earning assets increased $134.9 million, or 12.1%, in 2011 compared to 2010.  This included increases in average interest-earning due from banks of $44.3 million, average investment securities of $39.1 million and average loan growth of $54.5 million (mainly due to the Acquisition on February 18, 2011).

Market interest rates are in part based on the target Federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the FOMC. In December of 2008, the target interest rate was brought to a historic low with a range of 0% to 0.25% where it remains as of December 31, 2011.

The yield on interest-earning assets increased three basis points in 2011 compared to 2010.  The yield on the loan portfolio, which comprised 78.9% and 83.6% of average earning assets in 2011 and 2010, respectively, increased forty basis points. The accretion on the acquired non-PCI loans of $2.9 million represents twenty-nine basis points of the increase and the early payoff on PCI loans where the payoff amounts exceeded the recorded investment by $1.9 million represents nineteen basis points of the increase. This increase is partially offset by the decrease in yields on investment securities due to lower yields on recently purchased securities in this low interest rate environment and a higher concentration of low yielding due from banks.  In addition, we have experienced downward repricing and rate concessions on the loan portfolio as well as the addition of new loans at lower current market rates.  The current level of accretion on non-PCI loans is expected to continue to decline.

The average balance of interest-bearing liabilities increased $50.4 million, or 6.3%, in 2011 compared to 2010.  Average deposits grew in most categories, except for CDARS® time deposits, which decreased $31.9 million.  The increase in average deposits was offset by a decrease in average FHLB borrowings of $5.3 million due to the early pay-off of a $20 million FHLB fixed-rate advance at 2.54% on September 19, 2011.

The rate on interest-bearing liabilities decreased eighteen basis points in 2011 compared to 2010, primarily reflecting lower offering rates on money market accounts, as well as the downward re-pricing of time deposits as they mature.  In 2011, the rate on other time deposits, CDARS®, and money market accounts decreased thirty-three basis points, fifty-eight basis points, and thirty-one basis points, respectively. The increase of 1.82% in the rate on FHLB borrowings is due to the $924 thousand pre-payment penalty on the early pay-off of the $20 million fixed-rate advance.

2010 Compared with 2009:

Tax equivalent net interest income totaled $55.8 million and $53.4 million for the years ended December 31, 2010 and 2009, respectively. The $2.4 million or 4.5% increase was due to an increase in volume of interest-earning assets, offset by the effect of lower yields on investment securities.

Average interest-earning assets increased $93.0 million, or 9.1%, in 2010 compared to 2009.  This included increases in average interest-bearing due from banks of $42.9 million, average investment securities of $29.6 million and average loan growth of $19.3 million. In October 2010, we opened our Santa Rosa loan production office, to position the Bank for additional loan growth, particularly in commercial and industrial loans.

The tax-equivalent net interest margin decreased to 4.95% in 2010, down twenty-two basis points from 2009. The decrease in the tax-equivalent net interest margin was primarily due to lower yields on investment securities (as a result of increased prepayments and lower yields on recent additions) and a shift in the relative composition of interest-earning assets from higher-yielding loans to lower-yielding interest-bearing due from banks. The excess liquidity from deposit inflows has not yet been deployed into funding new loans, as the banking industry as a whole has been experiencing challenges with loan demand and the competition for qualified borrowers intensified. The net interest spread decreased nineteen basis points from 2009 for the same reasons.
 
 
Page - 27


The yield on the loan portfolio, which comprised 83.6% and 89.3% of average earning assets in 2010 and 2009, respectively, increased three basis points in 2010 compared to 2009. This is mainly due to the shift in the mix of loans from construction and commercial loans to higher-yielding commercial real estate loans.  Interest foregone on non-accrual loans represented a seven-basis point reduction to the net interest margin in both 2010 and 2009.

The lower yields on investment securities are a result of increased prepayments resulting in accelerated amortization of premiums, and lower yields on recently purchased securities. The yield on private-label CMOs, agency securities and municipal bonds decreased 250 basis points, 118 basis points and ten basis points, respectively, in 2010.

The average balance of interest-bearing liabilities increased $50.2 million, or 6.7%, in 2010 compared to 2009.  The increases are pervasive in all categories of deposit accounts except money market accounts, with the most significant increase in time deposits (including CDARS®), which increased $46.9 million. These increases were partially offset by a decrease in overnight borrowings of $10.7 million. We have experienced a shift in the relative composition of interest-bearing deposits in 2010 compared to 2009 as the proportion of higher-costing time accounts has increased, while the proportion of money market deposit accounts has decreased.

The rate on interest-bearing liabilities decreased fifteen basis points in 2010 compared to 2009, primarily reflecting lower offering rates on money market accounts, as well as the downward re-pricing of time deposits as they mature.  In 2010, the rate on other time deposits, CDARS®, and money market accounts decreased thirty-seven basis points, twenty-three basis points, and twenty basis points, respectively. The rate on the subordinated debenture dropped sixty-one basis points due to a decline in the three-month LIBOR rate, to which the debenture rate is indexed.
 
 
Page - 28

 
Table 3, Analysis of Changes in Net Interest Income, separates the change in net interest income into two components: 1 Volume – change caused by increases or decreases in the average asset and liability balances outstanding, and 2 Yield/Rate – changes in average yields on earning assets and average rates for interest-bearing liabilities.

Table 3
Analysis of Changes in Net Interest Income

The table indicates that in 2011 and 2010, our net interest income was favorably affected by an increase in the volume of interest-earning assets and increase in loan yields (primarily due to accretion on acquired non-PCI loans and the impact of gains on early payoffs of loans acquired at a discount), partially offset by declines in yields on investment securities and market pricing pressures on loan yields. Further, net interest income in both 2011 and 2010 benefitted from lower rates on deposits, especially money market and time accounts.

   
2011 compared to 2010
   
2010 compared to 2009
 
         
Yield/
               
Yield/
       
(in thousands)
 
Volume
   
Rate1
   
Total
   
Volume
   
Rate1
   
Total
 
Assets
                                   
Interest-bearing due from banks
  $ 113     $ (34 )   $ 79     $ 142     $ -     $ 142  
Federal funds sold
    (2 )     -       (2 )     1       (3 )     (2 )
Investment securities
                                               
U. S. Government agencies
    818       (574 )     244       760       (830 )     (70 )
Obligations of state and political
                                               
Municipal bonds2
    370       (176 )     194       272       (185 )     87  
Corporate CMO
    132       (89 )     43       94       (30 )     64  
Loans and bankers’ acceptances2
    3,536       3,836       7,372       1,174       297       1,471  
Total interest-earning assets
    4,967       2,963       7,930       2,443       (751 )     1,692  
Liabilities
                                               
Interest-bearing transaction accounts
    33       8       41       9       (14 )     (5 )
Savings accounts
    25       (31 )     (6 )     12       (2 )     10  
Money market accounts
    48       (1,229 )     (1,181 )     (6 )     (762 )     (768 )
CDARS® time deposits
    (191 )     (414 )     (605 )     238       (117 )     121  
Other time accounts
    236       (417 )     (181 )     320       (366 )     (46 )
Overnight borrowings
    -       -       -       (31 )     3       (28 )
FHLB fixed-rate borrowings
    (220 )     1,001       781  3     28       -       28  
Subordinated debenture
    -       (2 )     (2 )     -       (31 )     (31 )
Total interest-bearing liabilities
    (69 )     (1,084 )     (1,153 )     570       (1,289 )     (719 )
Tax-equivalent net interest income
  $ 5,036     $ 4,047     $ 9,083     $ 1,873     $ 538     $ 2,411  

1 The changes for each category of interest income and expense are divided between the portion of change attributable to the variance in volume and the portion of change attributable to the variance in rate for that category. The unallocated change in rate or volume variance has been allocated between the rate and volume variances on a pro rata basis.
2 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 35 percent.
3 Amounts includes a $924 thousand prepayment penalty in 2011 discussed in Note 8 of the consolidated financial statements.
 
 
Page - 29

 
Provision for Loan Losses

Management assesses the adequacy of the allowance for loan losses on a quarterly basis based on several factors including growth of the loan portfolio, analysis of probable losses in the portfolio, recent loss experience and the current economic climate.  Actual losses on loans are charged against the allowance, and the allowance is increased through the provision for loan losses charged to expense.  For further discussion, see the section captioned “Critical Accounting Policies.”

Our provision for loan losses totaled $7.1 million in 2011 compared to $5.4 million in 2010. The increase in the provision for loan losses is primarily driven by $2.3 million of loan loss provision related to the acquired loans in the later half of 2011, where credit quality has deteriorated since the Acquisition.  The allowance for loan losses of $14.6 million totaled 1.42% of loans at December 31, 2011, compared to 1.32% at December 31, 2010, respectively.  Net charge-offs in 2011 totaled $4.8 million compared to $3.6 million in the prior year.  The increase in net charge-offs primarily relates to $1.5 million of charge-offs related to the acquired loans. See the section captioned “Allowance for Loan Losses” below for further analysis of the provision for loan losses.

Non-interest Income

The table below details the components of non-interest income.

Table 4
Significant Components of Non-interest Income

                     
2011 compared to 2010
   
2010 compared to 2009
 
   
Years Ended
   
Amount
   
Percent
   
Amount
   
Percent
 
   
December 31,
   
Increase
   
Increase
   
Increase
   
Increase
 
(in thousands)
 
2011
   
2010
   
2009
   
(Decrease)
   
(Decrease)
   
(Decrease)
   
(Decrease)
 
Service charges on deposit accounts
  $ 1,836     $ 1,797     $ 1,782     $ 39       2.2 %   $ 15       0.8 %
Wealth Management and Trust Services
    1,834       1,521       1,383       313       20.6       138       10.0  
Other non-interest income
                                                       
Earnings on Bank-owned life insurance
    752       690       696       62       9.0       (6 )     (0.8 )
Customer banking fees and other charges
    108       120       98       (12 )     (10.0 )     22       22.4  
Debit card interchange fees
    845       486       368       359       73.9       118       32.1  
Pre-tax bargain purchase gain
    147       ---       ---       147    
NM
      ---       ---  
Other income
    747       907       855       (160 )     (17.6 )     52       6.1  
Total other non-interest income
    2,599       2,203       2,017       396       18.0       186       9.2  
Total non-interest income
  $ 6,269     $ 5,521     $ 5,182     $ 748       13.5 %   $ 339       6.5 %
                                                         
NM - Not Meaningful
                                                       
 
2011 Compared with 2010:

When comparing 2011 to 2010, service charge income on deposit accounts increased due to a higher number of deposit accounts (mainly from the Acquisition), partially offset by a decrease in overdraft and non-sufficient funds fee income, primarily due to the new regulatory restriction on overdraft fee assessments (Federal Reserve Regulation E), which was effective July 1, 2010.

The increase in Wealth Management and Trust Services (“WMTS”) income is due to higher estate settlement fees and higher rates charged on corporate trust-related services in 2011, as well as an increase in the number of accounts and customer relationships. This is partially offset by volatility in the equity and bond markets which impacts the market value of trust assets and the related investment fees. As of December 31, 2011 and 2010, assets under management totaled approximately $251.4 million and $254.0 million, respectively.

The increase in Bank-owned life insurance (“BOLI”) income in 2011 compared to 2010 is primarily due to additional income earned on $2.5 million in new policies purchased in late March 2011.

The decrease in customer banking fees and other charges is due to less ATM surcharge and higher remote capture fee income waived, partially offset by higher credit card referral fees and check order income, relating to an increase in the number of customer accounts.
 
The increase in debit card interchange fees is primarily attributable to a steady increase in volume of debit card usage, as well as new accounts from the Acquisition. In June 2011, the FRB finalized a new regulation to restrict interchange fees charged for debit card transactions by banks with more than $10 billion in assets. Although we are exempt under the new rule, market pricing of the interchange fees may drive these revenues down. The effect on market pricing, if any, may take time to realize. Therefore, we cannot quantify the ultimate impact of this rule on such interchange fees.
 
 
Page - 30


2011 reflects the pre-tax bargain purchase gain of $147 thousand from the Acquisition.

Other income decreased due to lower merchant interchange income, partially offset by increases on the gain on disposal of repossessed assets, safe deposit box rental income and wire fee income.

2010 Compared with 2009:

When comparing 2010 to 2009, service charge income on deposit accounts remained relatively unchanged.

The increase in WMTS income was due to higher estate settlement and trust-services fees received in 2010, as well as the increase in assets under management. As of December 31, 2010 and 2009, assets under management totaled approximately $254.0 million and $252.5 million, respectively.

BOLI income remained relatively unchanged in 2010 compared to 2009.

The increase in customer banking fees and other charges was due to higher credit card referral fees, miscellaneous card fees, ATM surcharges and check order income, relating to an increase in the number of customer accounts, partially offset by higher remote capture fee income waived.

The increase in debit card interchange fees was primarily due to higher Visa® debit card fees, attributable to a higher volume of Visa® debit card usage, as well as a Bank-wide Visa® debit card promotion program.

The increase in other non-interest income was mainly due to an increase in merchant interchange due to a higher transaction volume from our merchant customers as well as one-time billing adjustments and an increase in the dividend received on FHLB stock, partially offset by a decrease in miscellaneous income.

Non-interest Expense

Table 5, Significant Components of Non-interest Expense, summarizes the amounts and changes in dollars and percentages. Our efficiency ratio (the ratio of non-interest expense divided by the sum of non-interest income and net interest income) totaled 54.62%, 55.20% and 54.89% in 2011, 2010 and 2009, respectively.

Table 5
Significant Components of Non-interest Expense

                     
2011 compared to 2010
   
2010 compared to 2009
 
   
Years Ended
   
Amount
   
Percent
   
Amount
   
Percent
 
   
December 31,
   
Increase
   
Increase
   
Increase
   
Increase
 
(dollars in thousands)
 
2011
   
2010
   
2009
   
(Decrease)
   
(Decrease)
   
(Decrease)
   
(Decrease)
 
Salaries and related benefits
  $ 20,211     $ 18,240     $ 17,001     $ 1,971       10.8 %   $ 1,239       7.3 %
Occupancy and equipment
    4,002       3,576       3,516       426       11.9 %     60       1.7 %
Depreciation and amortization
    1,293       1,344       1,370       (51 )     (3.8 %)     (26 )     (1.9 %)
FDIC Insurance
    1,000       1,506       1,800       (506 )     (33.6 %)     (294 )     (16.3 %)
Data processing costs
    2,690       1,916       1,650       774       40.4 %     266       16.1 %
Professional services
    2,499       1,917       1,727       582       30.4 %     190       11.0 %
Other non-interest expense
                                                       
Advertising
    589       459       528       130       28.3 %     (69 )     (13.1 )%
Director expense
    493       475       420       18       3.8 %     55       13.1 %
Impairment and amortization of core deposit intangible
    725       ---       ---       725    
NM
      ---       ---  
Other expense
    4,781       3,924       3,684       857       21.8 %     240       6.5 %
Total other non-interest expense
    6,588       4,858       4,632       1,730       35.6 %     226       4.9 %
Total non-interest expense
  $ 38,283     $ 33,357     $ 31,696     $ 4,926       14.8 %   $ 1,661       5.2 %

 
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2011 Compared with 2010:

The increase in salaries and benefits is primarily due to higher personnel-related costs associated with branch expansion, as well as annual merit increases. The number of average FTE totaled 226 and 201 in 2011 and 2010, respectively.

The increases in occupancy and equipment expense are mainly due to an increase in expenses related to branch expansion, including Napa, Sonoma and a full year of rent for our Santa Rosa branch, partially offset by a full year of cost savings from the relocation of our Corte Madera branch and leases re-negotiated at lower rates.

Depreciation and amortization expense decreased as 2010 reflected the accelerated amortization of leasehold improvements of our old Corte Madera branch when it relocated in July 2010.

The decrease in 2011 FDIC insurance expenses compared to 2010 reflects the revision to the FDIC insurance assessment base. As discussed in the section captioned “FDIC Insurance Assessments” in Item 1 Business above, in February 2011, as required by the Dodd-Frank Act, the FDIC approved a rule that changes the FDIC insurance assessment base from adjusted domestic deposits to a bank’s average consolidated total assets minus average tangible equity, defined as Tier 1 capital. While the new rule expanded the assessment base, it lowered assessment rate to between 2.5 and 9 basis points on the broader base for banks in the lowest risk category. The change was effective for the second quarter of 2011. Since we have a solid core deposit base and do not rely heavily on borrowings and brokered deposits, the benefits of the lower assessment rate significantly outweighed the effect of a wider assessment base. The decrease in FDIC insurance also reflects the expiration of the FDIC Transaction Account Guarantee Program (“TAGP”) on December 31, 2010, which provided unlimited insurance coverage on non-interest-bearing transaction accounts. We paid a 15 basis point surcharge per $100 covered balances in excess of $250 thousand from January to December 2010.

The increase in data processing expense is due to $455 thousand acquisition-related expenses, an annual contractual rate increase, as well as additional ongoing fees relating to a higher number of accounts.

The increase in professional service expenses in 2011 when compared to 2010 primarily reflects expenses incurred related to the Acquisition, including investment banking consultants, legal, accounting and valuation services. Additionally, we incurred more legal fees related to loan workouts in 2011 than in 2010.

Advertising expenses increased, primarily due to the additional expenses related to franchise expansion.

Director fees increased slightly due to the director compensation rate increase.

We recorded a core deposit intangible asset of $725 thousand at Acquisition, of which $683 thousand was written-off in the fourth quarter of 2011 and $42 thousand was amortized during the year. The write-off was primarily due to higher than anticipated runoff of the acquired deposits and a significant decline in alternative funding costs since the Acquisition.

The increase in other non-interest expense from 2010 was primarily due to higher costs associated with an increase in the volume of debit card usage, write-offs of certain assets from the Acquisition, the implementation of a bank-wide customer service training program, higher travel expenses and higher telephone expenses.

2010 Compared with 2009:

The increase in salaries and benefits over 2009 was primarily due to higher personnel-related costs associated with branch expansion, as well as annual merit increases. The number of average FTE totaled 201 and 195 in 2010 and 2009, respectively. In addition, a rise in employee benefit rates contributed to the increase.

The increases in occupancy and equipment expense over 2009 were mainly due to an increase in rent for our Greenbrae branch in its first full-year of service in 2010, and also the new Santa Rosa loan production office, partially offset by cost savings from the relocation of our Corte Madera branch.

The decrease in 2010 FDIC insurance was due to the absence of a special assessment totaling $496 thousand in the second quarter of 2009, partially offset by a higher FDIC assessment rate and higher deposits. Further, we elected to participate in the FDIC Transaction Account Guarantee Program, which provided unlimited insurance coverage on non-interest-bearing transaction accounts defined by the FDIC, on which we paid a 10 basis point surcharge per $100 covered balances in excess of $250 thousand through 2009. The 10 basis point surcharge on non-interest-bearing transaction accounts over $250 thousand increased to 15 basis points from January to December 2010, at which time the program expired.
 
 
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The increase in data processing expense was due to process re-engineering costs, an annual contractual rate increase, as well as the outsourcing of certain trust operations.

The increase in professional service expenses in 2010 when compared to 2009 was mainly due to higher costs associated with strategic expansion initiatives and investment advisory fees.

Advertising expenses decreased in 2010, primarily due to a decrease in the usage of traditional print advertising channels as part of the marketing program.

Director fees increased due to the director compensation rate increase, partially offset by fewer directors.

The increase in other non-interest expense from 2009 was primarily due to a higher provision for losses on off-balance sheet commitments due to a higher commitment amount, operational losses, higher printing and stationery costs, charitable contributions and staff relation costs.

Provision for Income Taxes

We reported a provision for income taxes of $9.2 million, $8.2 million, and $7.8 million for the years ended December 31, 2011, 2010, and 2009, respectively. The effective tax rates were 37.1%, 37.6%, and 37.9% for those same periods.  These provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income, and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities, BOLI and certain tax-exempt loans).  Therefore, there are normal fluctuations in the effective rate from period to period based on the relationship of net permanent differences to income before tax. We have not been subject to an alternative minimum tax (“AMT”) during these periods.

Bancorp and the Bank have entered into a tax allocation agreement which provides that income taxes shall be allocated between the parties on a separate entity basis.  The intent of this agreement is that each member of the consolidated group will incur no greater tax liability than it would have incurred on a stand-alone basis.
 
 
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FINANCIAL CONDITION

Short-term Investment

At December 31, 2011 and 2010, we had $2.0 million and $19.5 million held in money market accounts with our correspondent banks, respectively, which earned interest at rates between 0.15% to 0.50% during 2011 and 0.35% to 0.55% during 2010.

Investment Securities

We maintain an investment securities portfolio to provide liquidity and to generate earnings on funds that have not been loaned to customers.  Management determines the maturities and the types of securities to be purchased based on the liquidity level and the desire to attain a reasonable investment yield balanced with risk exposure.  Table 6 shows the makeup of the securities portfolio by expected maturity at December 31, 2011 and 2010.  Expected maturities differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.  We estimate and update expected maturity dates quarterly based on current prepayment speeds. Equity securities with a zero cost basis and a fair value of $732 thousand are excluded from the following table because they do not have a stated maturity.

Table 6
Investment Securities

   
December 31, 2011
   
December 31, 2010
 
(dollars in thousands)
                   
Weighted
                     
Weighted
 
   
Principal
   
Amortized
   
Fair
   
Average
   
Principal
   
Amortized
   
Fair
   
Average
 
Type and Maturity Grouping
 
Amount
   
Cost1
   
Value
   
Yield2
   
Amount
   
Cost1
   
Value
   
Yield2
 
Held to maturity
                                               
State and municipal
                                               
Due within 1 year
  $ 3,428     $ 3,343     $ 3,367       2.25 %   $ 1,624     $ 1,478     $ 1,500       5.81 %
Due after 1 but within 5 years
    25,006       24,819       24,931       3.73       5,471       5,304       5,440       4.41  
Due after 5 but within 10 years
    22,574       22,145       24,240       5.37       20,905       20,589       20,784       5.11  
Due after 10 years
    4,444       4,431       4,688       6.03       7,561       7,546       7,366       6.01  
Total
    55,452       54,738       57,226       4.49       35,561       34,917       35,090       5.23  
Corporate bonds
                                                               
Due after 1 but within 5 years
    5,000       5,000       4,959       4.00       ---       ---       ---       ---  
Total
    5,000