Bank of Marin Bancorp
Annual Report 2004

Plain-text annual report

BANK OF MARIN 2004 ANNUAL REPORT TABLE OF CONTENTS Directors and Executive Officers .................................................. 1 Bank Staff and Corporate Officers ............................................... 2 Message to Shareholders ............................................................. 3 Business of the Bank ................................................................... 4 Management's Discussion and Analysis ....................................... 5 Report of Independent Auditors ................................................. 20 Financial Statements ................................................................. 22 Notes to Financial Statements ................................................... 26 Selected Financial Data ............................................................. 37 Stock Price and Dividend Information ........................................ 37 DIRECTORS AND EXECUTIVE OFFICERS Judith O’Connell Allen, Community volunteer, Chairman, Bank of Marin * Nancy R. Boatright, Vice President & Corp. Sec., Bank of Marin * Russell A. Colombo, Exec. Vice President & Branch Administrator, Bank of Marin * Christina J. Cook, Exec. Vice President & CFO, Bank of Marin James E. Deitz, President, Marin Business Services W. Robert Griswold, Jr., President and CEO, Bank of Marin Ray Hoffman, III, Proprietor, Hoffman Development Co. Norma J. Howard, Business consultant J. Patrick Hunt, Partner, Hunt Investments H. C. Jackson, Retired merchant James D. Kirsner, Business consultant * Larry Klaustermeier, Sr. Exec. Vice President & CCO, Bank of Marin * Patrick J. London, Exec. Vice President & Director of Wealth Management Services, Bank of Marin Stuart D. Lum, Partner, Veracast Communications Joseph D. Martino, Retired banker James L. Placak, Employee Benefits Consultant Joel Sklar, MD, Partner, Cardiology Assoc. of Marin & San Francisco Brian M. Sobel, Partner, Sobel Communications * Alexandra E. Souza, Exec.Vice President & CAO, Bank of Marin J. Dietrich Stroeh, Partner, CSW/Stuber-Stroeh Engineering Group Jan Yanehiro, Owner, Media and Marketing Strategic Planning * These executive officers are not also directors. This annual report serves as the annual disclosure statement for the purposes of part 350 of the Federal Deposit Insurance Corporation rules. It has not been reviewed or confirmed for accuracy or relevance by the FDIC. Annual Report - 1 BANK STAFF Mary Adams Diane Akers Dino Alessio Nova Alexander Terry Aman Joanne Amaral Michele Anderson Natalie Andryushina Tamara Austin Boualay Bala Caroline Barossi Ken Beagle Susan Beaver Robin Bentivegna John Berens Josiane Bougard Arlene Brians Vanessa Camacho Scott Canaan Brian Carlson David Cerejo Gaik Chan Nancy Chapin Angela Colglazier Kay Commins Anooshik Cronin Sarah Dempsey Amra Dizdarevic Barbara Dougherty Sean Dwyer Mary Jayne Elmore Donna Ernst Florette Eugene Brandee Everett Susan Farac Coy Ferini Giuliana Ferrer Gary Ford Craig Fox Vince Franceschi Leslie Fuette Hung Fung Karen Garbarino Judy Grider Helga Gruber Vicki Gruber Sarah Guenther Jessica Gutgsell Sal Gutierrez Victoria Gutierrez Dina Hadzikadunic Jessica Ham Bryan Heagy Viviana Henao Dean Higgins Debbie Higgins Kyle Hixon Helen Hoffmann Josh Iversen Tracy Jerves Kevin Johnson Claudia Just Olsen Merlee Katzman Mindy King Lisa Kleinecke David Kough Van Luu Molly Manisay Connie Marelich Joan Marino Stephanie McLeod Kenny Meligan Mary Melville Victor Mencarelli Edgar Mendoza Pia Mize Marisol Negrete Eric Nelson Linda Nolt Michael Nord Jon O'Halloran Anotinette Oroz Jaime Ortiz Teri Pearson CORPORATE OFFICERS Connie Pedersen John Pedone Irene Pelmear Shirley Pettit Sabrina Randall Nancy Reich Linda Reid Isaias Reyes Penny Reynolds Marie Rieck Mike Roney Stephen Ross Saroj Sachdev Ellie Shattuck Nikki Singh Mari Soria Jamie Thigpen Allison Thornton Kim To Barbara Tolin Cindy Toscanini Ray Vallerga Patty Varela Joe Villaluna Jim Whaley Renee Weaver Danielle Wu Vita Yumanova Kate Albaugh, Asst. Vice President Sue Anderson, Vice President Marshall Appleton, Asst. Vice President Angela Bergamini, Asst. Vice President Gisela Bigden-Fisher, Vice President Boo Boero, Asst. Vice President Karry Bryan, Asst. Vice President Michael Burke, Vice President Fabia Butler, Asst. Vice President Michael Callan, Vice President Joan Capurro, Vice President Megan Carter, Asst. Vice President Sal Catinella, Vice President Douglas Caulfield. Vice President Judi Cole, Vice President Chris Colliver, Asst. Vice President Phyllis Cope, Vice President Richard DeRamon, Vice President Emily Di Laura, Vice President Pat Feingold, Vice President Holly Ford, Vice President Sharon Fox, Vice President Faith Giosso, Asst. Vice President Kevin Gish, Asst. Vice President Robert Gotelli, Asst. Vice President Jeff Graham, Asst. Vice President Janet Hayward, Vice President Karen Hegarty, Vice President Sherri Hendrickson, Vice President Wayne Hoffer, Vice President Fran Hoke, Vice President Deborah Hoke Smith, Vice President Martha Hollenbeck, Vice President Joseph Iacocca, Vice President Annual Report - 2 Donald Jarvis, Vice President Nancy Jones, Vice President Steve Kambur, Vice President James King, Vice President Carol Kneis, Vice President Mae Lacourse, Vice President Carrie Lee, Asst. Vice President Thomas Leong, Asst. Vice President Lynn McHale, Asst. Vice President Jerry Miller, Vice President Bill Montgomery, Vice President Frank Murray, Sr. Vice President Patti O'Brien, Asst. Vice President Elizabeth O'Farrell, Sr. Vice President Peter Pelham, Vice President Frank Perachiotti, Jr., Vice President Carole Reif, Vice President Elizabeth Reizman, Sr. Vice President Lucy Rezendes, Vice President Dan Rheiner, Vice President Robert Rowen, Asst. Vice President Renee Rymer, Vice President David Schmidt, Vice President Mary Ann Shoemaker, Vice President Liza Silva, Vice President Linda Steidle, Vice President Renee Story, Asst. Vice President Rich Ugarte, Vice President Sherry Wallace, Vice President Jackie Williams, Vice President Bonnie Wilson, Asst. Vice President Nicole Young, Asst. Vice President Keith Zimmerman, Sr. Vice President MESSAGE TO OUR SHAREHOLDERS: Bank of Marin reported record earnings in 2004, so it’s tempting, in one sense, to let the numbers speak for themselves. Consider, if you will, these year over year changes: • Net income of $9,518,000, an increase of 27.4% over 2003. • Loan totals of more than $575 million, 28% more than the previous year. • Total deposits of $645 million, an increase of more than 10%. • Total assets of over $737 million, a 15% increase. • Non-interest expense growth limited to just over 10%. • An efficiency ratio of 54.7%. • Non-performing loans in the portfolio: none. While we’re extremely pleased with these outstanding results, we’re even more proud of how we achieved them. We did it without compromising any of the principles our founder, Bill Murray, envisioned when we began 15 years ago: hard work, attention to detail, legendary and personalized service for each of our customers, a dedicated and loyal professional team, a real and meaningful commitment to the many communities we serve, and an on-going pledge to our shareholders to work in your best interests. We’re very proud of what we’ve accomplished during these first 15 years. We’ve grown in size and scope, expanded our customer base, grown capital, and greatly increased and improved our product offerings. At the same time, we have intensified our community support and involvement, and provided our shareholders with solid and impressive results. As a group, our employees are the largest single shareholder of the Bank, with our Employee Stock Ownership Plan (ESOP), holding more than six percent of the outstanding stock. They think and act like shareholders, because they are. They are constantly working with the shareholders’ best interests in mind. And, they’re extremely loyal. Our employee turnover is among the lowest in California for banks our size. In the past year, we’ve made two significant additions to our senior management team. Russ Colombo joined the Bank as Branch Administrator to oversee our branch network and business development activities; and Chris Cook, a CPA, joined the Bank to assume the responsibilities of Chief Financial Officer. Both bring a wealth of experience, and the same dedication we all embrace: putting our customers at the very top of everything we do. In the coming year, we’ll be adding a second branch in Petaluma; and we’re targeting yet another branch at a location we’re now exploring. Our first 15 years have been very rewarding in many ways. And, in view of all we’ve accomplished, we’re very excited about the future. Our message to you, our shareholders, is a simple, but sincere one: thank you. Thanks for your ongoing support. Thanks for your belief in us. We look forward to continuing to partner with you to build an even better, stronger and more productive Bank of Marin. /s/ Judith O'Connell Allen Judith O’Connell Allen Chairman of the Board /s/ W. Robert Griswold, Jr. W. Robert Griswold, Jr. President & Chief Executive Officer Annual Report - 3 BUSINESS OF THE BANK General 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) and commenced operations in January 1990. The Bank is an insured bank under the Federal Deposit Insurance Act and, like most state chartered banks of its size in California, is not a member of the Federal Reserve System. Market Area and Customer Base The Bank’s market area stretches from southern Sonoma county south to the Golden Gate Bridge and lies between the Pacific Ocean on the west and San Pablo Bay to the east. Of this larger market area the Bank has designated the communities of San Rafael, Corte Madera, Greenbrae, Larkspur, Kentfield, Ross, San Anselmo, Tiburon, Belvedere, Mill Valley, Sausalito, Terra Linda, Bel Marin Keys, Novato and Petaluma as its primary market areas. The Bank’s customer base is made up of business and personal banking relationships from the communities near the nine branch office locations. Loans The Bank offers a broad range of commercial and retail lending programs including commercial loans, construction financing, consumer loans including indirect auto, and home equity loans and lines of credit. The Bank also offers a proprietary Visa credit card to its customers, including a Business Visa program for business and professional customers. For reporting purposes these programs are consolidated into the general categories of commercial loans, real estate loans and personal loans. At December 31, 2004, these broad categories totaled $576,957 thousand, and accounted for approximately 21%, 63% and 16%, respectively, of the loan portfolio. The interest rates on most commercial loans are tied to the Wall Street Journal prevailing prime rate and change as rate changes are reported. A majority of these loans have a term of one year or less. Real estate loans include commercial real estate loans, consumer loans and lines of credit secured by real property, and construction financing. Commercial real estate loans are generally written for ten years with fixed rates for the first 5 years and then adjusting to an indexed spread for the remaining 5 years. Consumer real estate secured loans include equity lines of credit and installment loans for various consumer purposes. Generally, equity lines are for a term of ten years or less and are secured by first or second deeds of trust on residential properties and bear interest at a floating rate tied to the Wall Street Journal prevailing prime rate. Usually, home equity installment loans are for a term of 15 years or less and have a fixed rate of interest. The Bank offers construction financing to developers of single-family residences and commercial real estate properties. Construction loans are typically repaid through permanent financing by the Bank or from other financial institutions. Usually these loans have terms of twelve to eighteen months, have fixed rates of interest or floating rates tied to the Wall Street Journal prevailing prime rate, and are secured by first deeds of trust. Deposits The Bank offers a variety of checking and savings accounts, and a number of time deposit alternatives, including interest bearing and non-interest bearing personal and business checking accounts and time certificates of deposit. The Bank also offers direct deposit of payroll, social security and pension checks. Bank of Marin's ATM system is tied into both the STAR and PLUS networks, and the Bank offers a proprietary Visa check card. Bank of Marin attracts deposits from individuals, merchants, small to medium sized businesses and professionals who live and/or work in our market areas. More than 90% of our deposits come from Marin and southern Sonoma counties. Approximately 54% of the Bank’s deposits are from businesses and 46% are from individuals. The Bank as a matter of policy does not accept brokered deposits. Wealth Management Services In 1998, the Bank began to offer investment advisory and personal trust services. The services include customized portfolio management of individual stocks, bonds and cash and retirement assets; professional management of all trust assets including real estate and other specialty assets; tax reporting, safekeeping and accounting of assets; estate settlement and administration of all areas of living, testamentary and charitable trusts. Annual Report - 4 MANAGEMENT’S DISCUSSION AND ANALYSIS The following discussion of the Bank’s financial condition and results of operations for each of the years in the three-year period ended December 31, 2004 should be read in conjunction with the Bank’s financial statements and related notes thereto, located on pages 22 to 36 of this Annual Report. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. On April 15, 2004 the Board of Directors declared a 3-for-2 stock split payable May 24, 2004. In April, 2003 and April, 2002 the Board of Directors declared 5% stock dividends. Earnings per share and book value per share amounts have been restated for prior periods to reflect the stock split and stock dividends. Additionally, the Board of Directors declared a one-time special cash dividend of $.40 per post-split share payable on June 1, 2004. 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. The Bank’s forward-looking statements include descriptions of plans or objectives of management for future operations, products or services, and forecasts of its 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 the Bank’s earnings in future periods. A number of factors - many of which are beyond the Bank’s control - could cause future results to vary materially from current management expectations. Such factors include, but are not limited to, general economic conditions, 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 the Bank’s operations, pricing, products and services. These and other important factors are detailed in various Federal Deposit Insurance Corporation filings made periodically by the Bank, copies of which are available from the Bank at no charge. Forward-looking statements speak only as of the date they are made. The Bank does 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. Critical Accounting Policy Allowance for Loan Losses Management has considered the accounting principles upon which the Bank’s financial reporting depends and has determined the allowance for loan losses to be the Bank’s most critical accounting policy. The allowance for loan losses is discussed in further detail beginning on page 13 of this Annual Report. The Bank formally assesses the adequacy of the allowance for loan losses on a quarterly basis. Determination of the adequacy is based on ongoing assessments of the probable risk in the outstanding loan portfolio. 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 re-graded as they are renewed, when there is a new loan to the same borrower, when identified facts Annual Report - 5 demonstrate heightened risk of nonpayment, or if they become delinquent. Re-grading of larger problem loans occurs at least quarterly. Confirmation of the quality of the grading process is obtained by independent credit reviews conducted by consultants specifically hired for this purpose and by various bank regulatory agencies. The Bank’s method for assessing the appropriateness of the allowance includes specific allowances for identified problem loans, an allowance factor for pools of credits, and allowances for changing environmental factors (e.g., portfolio trends, concentration of credit, growth, economic factors, etc.). Allowances for identified problem loans are based on specific analysis of individual credits. Loss estimation factors for loan pools are based on analysis of local economic factors applicable to each loan pool. Due to our minimal historic losses, loss estimation factors are based only in part on the previous historical loss experience for each pool. 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. Future Adoption of Accounting Standard For a discussion of the impact of the adoption of Financial Accounting Standards Board Statement No. 123 (revised 2004), Share-Based Payment, see Note 1 of the Notes to Financial Statements. RESULTS OF OPERATIONS Overview The 2004 financial performance for the Bank produced record levels of deposits, loans, and net income. Total deposits reached $645,079 thousand in 2004, an increase of $60,963 thousand or 10.4% from the prior year. Total gross loans finished the year at $576,957 thousand compared to $450,881 thousand in 2003, representing an increase of $126,076 thousand or 28.0%. Net income for 2004 was $9,518 thousand or $1.94 per share (diluted) compared with $7,473 thousand or $1.59 per share (diluted) in 2003. The year over year change in net income represents an improvement of 27.4%. The Bank’s return on average assets (ROA) and return on average equity (ROE) improved over the prior year. In 2004 the Bank’s ROA and ROE were, respectively, 1.38% and 15.64% compared to 1.28% and 14.46% in 2003. Management continues to balance the desire to increase the return ratios to those of its peers with the desire to increase the Bank’s deposit penetration in Marin and Sonoma Counties. For the twelve-month period from June 2003 to June 2004 (the latest date for which the information is available), the Bank’s market share of total Marin County deposits increased from 8.11% to 8.47%. Net interest income was a principal source of the earnings improvement for the year, as it reached $32,237 thousand, an increase of $4,581 thousand or 16.6% over 2003. The interest income component of net interest income was up 14.5% to $37,589 thousand, and is primarily the result of the increase in the size of the Bank’s loan portfolio and, to a lesser extent, an increase in the average balance of U. S. government agency securities, partially offset by lower average yields on interest-earning assets. Total interest expense of $5,352 thousand was up from 2003 by $183 thousand or 3.5% due to interest expense on a new subordinated debenture, as well as growth in the Bank’s deposit portfolio, partially offset by a lower overall rate on interest- bearing liabilities. The Bank provided $934 thousand to the allowance for loan losses in 2004, and net charge-offs were $282 thousand. This compares to a provision of $686 thousand and net charge-offs of $262 thousand in 2003. At year-end 2004 and 2003, the allowance for loan losses as a percentage of total loans was 1.06% and 1.21%, respectively. Non-interest income is comprised of service charges on deposit accounts, Wealth Management Services (WMS) revenue, and other income. In 2004, total non-interest income was $3,643 thousand, which is an improvement of $683 thousand or 23.1% over 2003. Service charges on deposit accounts increased to $1,137 thousand versus $1,020 thousand one year ago. WMS revenue grew to $922 thousand, an increase of $107 thousand, and other income finished the year at $1,584 thousand compared to $1,125 thousand in the prior year. Annual Report - 6 Non-interest expenses increased from $17,817 thousand in 2003 to $19,620 thousand in 2004, a $1,803 thousand or 10.1% increase and was largely due to the growth in the operations of the Bank. Assets of the Bank totaled $737,094 thousand at December 31, 2004, an increase of $94,487 thousand or 14.7% from 2003 ending balances. Contributing to the growth of assets in 2004 was an increase of $125,424 thousand, or 28.2%, in outstanding loans. The increase in loans was funded in part by a shift of the funds from other earning assets, including Federal funds sold and investment securities, as well as increases in deposits, Federal funds purchased and the issuance of a subordinated debenture. Summary of Quarterly Results of Operations Table 1 sets forth the results of operations for the four quarters of 2004 and 2003. Table 1 Summarized Statement of Operations (Dollars in thousands) 2004 Quarters Ended Dec. 31 Sept. 30 June 30 Mar. 31 2003 Quarters Ended Dec. 31 Sept. 30 June 30 Mar. 31 Interest income ............................................ $10,488 $9,821 $8,855 $8,425 1,243 Interest expense .......................................... 7,182 Net interest income ................................. 100 Provision for loan losses ..................... 1,535 8,953 425 1,200 7,655 105 1,374 8,447 304 $8,157 $8,213 $8,340 $8,115 1,405 6,710 167 1,240 6,917 139 1,285 7,055 205 1,239 6,974 174 Net interest income after provision for loan losses .................................... Non-interest income ...................................... Non-interest expense .................................... Income before provision for income taxes .. Provision for income taxes ...................... Net income ................................................ Net income per common share 8,528 951 5,152 4,327 1,662 $2,665 8,143 906 4,991 4,058 1,551 $2,507 7,550 916 4,745 3,721 1,404 $2,317 7,082 870 4,732 3,220 1,191 $2,029 6,778 816 4,263 3,331 1,247 $2,084 6,800 796 4,482 3,114 1,194 $1,920 6,850 679 4,492 3,037 1,179 6,543 668 4,580 2,631 1,020 $1,858 $1,611 Basic ...................................................... Diluted .................................................. $0.58 $0.53 $0.55 $0.51 $0.51 $0.47 $0.45 $0.42 $ 0.47 $ 0.43 $ 0.43 $ 0.41 $ 0.43 $ 0.39 $ 0.37 $ 0.35 Net Interest Income Net interest income is the Bank’s largest source of income (89.85%). Net interest income is the difference between the interest earned on loans, investments and other interest earning assets, and its interest expense 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. Comparisons of net interest income are frequently made using net interest margin and net interest rate spread. Net interest margin is expressed as net interest income divided by average 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 interest earning assets with interest expense and interest bearing liabilities for the three years 2004, 2003 and 2002. The table also indicates net interest income, net interest margin and net interest rate spread for each year. Annual Report - 7 Table 2 Distribution of Average Statements of Condition and Analysis of Net Interest Income (Dollars in thousands) Assets 2004 Interest Average Income/ Yield/ Balance Expense(1) Rate(1) 2003 Interest Average Income/ Yield/ Balance Expense(1) Rate(1) 2002 Interest Average Income/ Yield/ Balance Expense(1)Rate(1) Federal funds sold ............................ $ 5,410 $ 61 -- Interest-earning deposits ........... -- Investment securities 1.13% $ 23,312 $ 243 -- -- -- U. S. Treasury securities .............. U. S. government agencies ........... Other ........................................... Municipal bonds ......................... Loans and bankers’ acceptances.(2) . Total interest-earning assets ..... Cash and due from banks ................. Bank premises and equipment, net . Interest receivable and other assets . 35,009 4,198 12,702 Total Assets ................................ $691,258 12,265 67,888 11,644 27,843 324 2,257 795 1,012 514,299 33,140 639,349 37,589 2.64 3.32 6.83 5.27 6.44 5.95 11,459 32,672 12,303 23,991 518 1,018 791 954 434,908 29,301 538,645 32,825 33,056 4,361 5,513 $581,575 29,877 4,196 2,090 $494,581 1.04% $13,237 $ 204 1.54% -- 4.52 3.11 6.43 5.72 6.74 6.17 -- -- -- 17,522 21,769 15,201 24,281 1,101 1,009 848 1,027 366,408 27,561 458,418 31,750 6.28 4.64 5.58 6.02 7.52 7.02 Liabilities and Stockholders' Equity Interest-bearing transaction accounts Savings accounts ............................... Time accounts ................................... Federal funds purchased .................. Borrowed funds .................................. Total interest-bearing liabilities .... Demand accounts ............................... Interest payable and other liabilities Stockholders’ equity .......................... 66,084 298,091 93,189 2,805 2,705 462,874 164,881 2,639 60,864 Total Liabilities and Stockholders' Equity .............. $691,258 Net Interest Income .................................. Net Interest Margin .................................. Net Interest Spread .................................. 257 2,961 1,968 49 117 5,352 207 2,426 2,534 2 -- 5,169 0.39 $ 51,664 226,288 0.99 110,740 2.11 91 1.74 4.32 -- 388,783 1.16 138,214 2,890 51,688 0.40 $ 43,188 182,532 1.07 105,409 2.29 333 1.71 -- -- 331,462 1.33 115,983 2,922 44,214 309 2,953 2,960 6 -- 6,228 0.72 1.62 2.81 1.86 -- 1.88 $32,237 $27,656 $25,522 $581,575 $494,581 5.11% 4.79% 5.21% 4.84% 5.66% 5.14% (1) Yields and interest income are presented on a taxable equivalent basis using the Federal statutory rate of 34 percent. (2) Average balances on loans outstanding include non-performing loans, if any. The amortized portion of net loan origination fees (costs) is included in interest income on loans, representing an adjustment to the yield. In 2004, the Bank’s net interest income increased by $4,581 thousand or 16.6% over 2003, and by $2,134 thousand or 8.4% in 2003 over 2002. These increases are attributable to growth in average earning assets of $100,704 thousand in 2004 and $80,227 thousand in 2003. In 2004, net interest income was positively affected by a shift in the mix of asset balances from lower-yielding Federal funds sold to higher-yielding loans and securities. The Bank’s 2004 year-end loan-to-deposit ratio was 89.4% up from 77.2% at December 31, 2003. The Bank’s yield on interest earning assets declined in 2004 by twenty-two basis points to 5.95%, and the yield on its loan portfolio declined from 6.74% in 2003 to 6.44% in 2004. The yield on the Bank’s Federal funds sold increased to 1.13% in 2004 from 1.04% in 2003. The increase in the Federal funds sold yield is the result of interest rate increases implemented by the Federal Reserve Board by increasing the Federal funds interest rate (the interest rate banks charge each other for short-term borrowings). The yield on loans declined in 2004 and did not increase despite rate increases due to the lagged effect of interest rate changes on the loan portfolio. In 2003 there was a twenty-five basis point reduction in the Federal funds rate, and a 125 basis point increase in 2004. The yield on the Bank’s portfolio of Agency Securities increased from 3.11% in 2003 to 3.32% in 2004. The increase in the volume and yield on Agency Securities primarily relates to purchases of securities at higher market rates in a rising rate environment. The Bank’s Agency Securities generally have an average life of less than three years and will mature or be called more quickly than other securities in the Bank’s portfolio. Therefore, their yield is significantly impacted by market rates of interest. Other Securities is largely comprised of corporate bonds and the yield on these instruments improved from 6.43% to 6.83% due to shorter duration rates rising during 2004. The yield on the Bank’s portfolio of Treasury Securities declined from 4.52% in 2003 to 2.64% in 2004 and the yield on Municipal Securities declined from 5.72% in 2003 to 5.27% in 2004 due to maturities of higher yielding securities. Annual Report - 8 The rate paid on interest bearing liabilities declined from 1.33% in 2003 to 1.16% in 2004. This is primarily the result of the lagged effect of the aforementioned changes in market interest rates originating from actions taken by the Federal Reserve in 2003 and 2004. In 2004, the Bank achieved a net interest margin (NIM) of 5.11%, down from the NIM of 5.21% experienced in 2003. The decline in the margin is also affected by the lagged effect of changes to market rates, partially offset by the impact of a higher loan-to-deposit ratio. In 2003 the Bank’s net interest margin decreased by forty-five basis points when compared to 2002. The combination of a lower loan-to-deposit ratio in 2003 and the decline in market rates of interest contributed to this change. Table 3, Analysis of Changes in Net Interest Income, separates the change in the Bank’s 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 shows the impact on income of balance sheet changes and the changes in market interest rate levels which occurred during 2004 and 2003. The increase in net interest income during both years is primarily the result of growth in average earning assets and the decline in the rate paid on interest bearing liabilities. Table 3 Analysis of Changes in Net Interest Income (Dollars in thousands) Assets Year ended December 31, 2004 compared to 2003 Yield/ Rate* Total Volume Year ended December 31, 2003 compared to 2002 Yield/ Rate* Volume Total Federal funds sold ............................ $ (187) $ 5 $ (182) $ 156 Interest-earning deposits ................. -- Investment securities -- -- -- $ (117) $ 39 -- -- U. S. Treasury securities ................. 36 U. S. government agencies ........... 1,096 (42) Other .............................................. 222 Municipal bonds ............................ (230) 143 46 (164) Loans and bankers’ acceptances ...... 5,348 (1,509) Total interest-earning assets ........ 6,473 (1,709) (194) 1,239 4 58 (381) 506 (162) (17) 3,839 5,153 4,764 5,255 (202) (497) 105 (56) (583) 9 (57) (73) (3,413) 1,740 (4,180) 1,075 Liabilities Interest-bearing transaction accounts Savings accounts .............................. Time accounts ................................... Federal funds purchased .................. Borrowed funds ................................ Total interest-bearing liabilities ... 58 770 (402) 46 117 589 (8) (235) (164) 1 -- (406) 50 535 (566) 47 117 183 61 708 150 (4) -- 915 (163) (1,235) (576) -- -- (1,974) (102) (527) (426) (4) -- (1,059) Net Interest Income .............................. $5,884 $(1,303) $4,581 $4,340 $(2,206) $2,134 * Variances due to changes in both yield/rate and volume (mix) are allocated to yield/rate. Provision for Loan Losses The Bank formally assesses the adequacy of the allowance on a quarterly basis. The Bank provides as an expense an amount to bring the allowance for loan losses to a level to provide adequate coverage for probable loan losses. The adequacy of the allowance for loan losses is evaluated based on several factors, including growth of the loan portfolio, analysis of probable losses in the portfolio and recent loss experience. Actual losses on loans are charged against the allowance and the allowance is increased through the provision charged to expense. The Bank’s provision for loan losses in 2004 was $934 thousand versus $686 thousand for 2003 and $577 thousand in 2002. Net charge-offs for 2004 totaled $282 thousand compared with $262 thousand in 2003 and $122 thousand in 2002. Table 4, Non-performing Loans at December 31, shows that there were no non- performing assets at December 31 for the last five years. Annual Report - 9 Table 4 Non-performing Loans at December 31 Non accrual loans ................................................. Accruing loans past due 90 days or more ............ Other real estate owned .......................................... Total non-performing assets .......................... 2004 $ -- -- -- $ 0 2003 $ -- -- -- $ 0 2002 $ -- -- -- $ 0 2001 $ -- -- -- $ 0 2000 $ -- -- -- $ 0 The Bank’s policy is to place loans on non-accrual status when management believes that there is serious doubt as to the collection of principal or interest, or when they become contractually past due by 90 days or more with respect to principal or interest, except for loans that are both well secured and in the process of collection. When loans are placed on nonaccrual status, any accrued but uncollected interest is reversed from current income, and additional income is recorded only as payments are received. Non-interest Income Non-interest income includes service charges on deposit accounts, WMS income and other income. Non- interest income grew to $3,643 thousand in 2004, up from $2,960 thousand in 2003 and $2,318 thousand in 2002. Service charges on deposits in 2004 and in 2003 increased by $117 thousand and $180 thousand, respectively. These increases are generally due to growth in the number of accounts in the Bank. The Bank’s WMS has shown similar results. WMS revenue in 2004 was $922 thousand, an increase of $107 thousand over the prior year. This increase is primarily the result of growth in assets under management. WMS revenue in 2003 showed a $145 thousand increase over 2002. The increases in “other” income in 2004 and 2003 are attributed to growth in other services associated with an expanding customer base, the Bank’s $10 million investment in Bank Owned Life Insurance (BOLI), which occurred in 2003, as well as higher commissions and fees due to increased debit and credit card usage. Non-interest Expense Table 5, Significant Components of Non-interest Expense, summarizes the amounts and changes in dollars and percentages. In 2004 non-interest expense increased 10.1% while average loans and deposits increased 18.3% and 18.1%, respectively. In 2003 non-interest expense increased 4.0%, while average loans and deposits increased 18.7% and 17.8%, respectively. Table 5 Significant Components of Non-Interest Expense (Dollars in Thousands) 2004 Year ended December 31, 2003 2004 compared to 2003 Percent Amount Increase Increase 2 0 0 2(Decrease)(Decrease) 2003 compared to 2002 Percent Amount Increase Increase (Decrease) (Decrease) Salaries and related benefits ...... $11,954 $10,767 $10,446 1,601 Occupancy and equipment .......... 882 Depreciation and amortization .... 953 Data processing fees ................... 3,243 Other expense ............................. 1,676 992 1,039 3,343 1,864 949 1,210 3,643 $1,187 188 (43) 171 300 Total ...................................... $19,620 $17,817 $17,125 $1,803 11.0% 11.2 (4.3) 16.5 9.0 10.1% $321 75 110 86 100 $692 3.1% 4.7 12.5 9.0 3.1 4.0% In 2004 salaries and benefits costs increased by $1,187 thousand or 11.0%, primarily due to regular salary adjustments, increased accruals for bonuses and ESOP contributions, as well as higher medical benefit and workers’ compensation costs. The number of full-time equivalent (FTE) employees increased to 167, up from 161 at year-end 2003. In 2004 there were expenses of $1,056 thousand for the Bank’s Employee Stock Annual Report - 10 Ownership and Savings Plan (ESOP), and $1,233 thousand for staff and officer incentive bonus plans. The increase in ESOP expense for 2004 was $139 thousand or 15.2%. The incentive bonus plans increased by $348 thousand or 28.2% from 2003. In comparing 2003 with 2002, salaries and benefits costs increased by $321 thousand or 3.1%, primarily due to annual merit pay increases. The number of full-time equivalent (FTE) employees increased by two from December 31, 2002 to 161 at December 31, 2003. In 2003 there were expenses of $917 thousand for the Bank’s ESOP and $885 thousand for staff and officer incentive bonus plans. The increase in ESOP expense for 2003 was $38,000 or 4.3%. The increase in salary and ESOP costs were offset by a decrease in incentive bonus plan expense, which decreased by $293 thousand or 24.9% from 2002. The 2004 increase of $188 thousand in occupancy and equipment costs is largely due to annual rent increases in the branch and administration facilities. The 2004 expenses also reflect the effect of the addition of the Bank’s Sausalito branch in November 2003. In 2003, the Bank incurred an increase of $75 thousand, which was largely due to annual increases in branch operating leases. The 2004 decrease of $43 thousand in depreciation and amortization expense is primarily attributable to certain fixed assets becoming fully depreciated during the year. In 2003 the Bank had an increase of $110 thousand in depreciation and amortization expenses , which was primarily related to purchases and leasehold improvements. In 2004 data processing costs were $1,210 thousand, an increase over 2003 of $171 thousand or 16.5%. This increase is largely attributable to the greater number of accounts resulting from the growth of the Bank, the contractually stipulated price increases that are part of the Bank’s long-term agreement with its data processing provider, and the increased use of internet banking and bill pay by the Bank’s customers. In 2003, data processing expense increased by $86 thousand, and is attributable to the increase in the growth in the operations of the Bank. Other non-interest expenses of $3,643 thousand represent a $300 thousand or 9.0% increase over 2003. Generally, this increase is due to the growth in activity of the Bank. In 2003, other non-interest expenses increased by $100 thousand or 3.1%. These increases were due to the growth in activity of the Bank. The Bank’s efficiency ratio (the ratio of non-interest expense divided by the sum of non-interest income and net interest income) improved over the prior year and was at 54.7% for 2004. In 2003, the Bank’s efficiency ratio was 58.1%. Provision for Income Taxes The Bank reported a provision for income taxes of $5,808 thousand, $4,640 thousand and $3,897 thousand for the years 2004, 2003 and 2002, respectively. These provisions reflect accruals for taxes at the applicable rates for Federal and California State income taxes based upon reported pre-tax income, and adjusted for the beneficial effect of the Bank’s investment in qualified municipal securities and life insurance products. The Bank has not been subject to an alternative minimum tax (AMT). See Note 10 of the Notes to Financial Statements for additional discussion of Provision for Income Taxes. FINANCIAL CONDITION Investment Securities The Bank maintains an investment securities portfolio to provide liquidity and earnings on funds that have not been loaned. Management determines the maturities and the types of securities to be purchased based on the need for liquidity to fund loans and the desire to attain a high investment yield. Table 6 shows the makeup of the securities portfolio at December 31, 2004 and 2003. Annual Report - 11 Table 6 Securities Investments Type and Maturity Grouping (Dollars in thousands) Held to maturity U.S. Treasury Principal Amount December 31, 2004 Book Value* Value Market Average Yield Principal Amount December 31, 2003 Market Value Book Value* Average Yield Total ........................................ $ -- $ -- $ -- --% $ -- $ -- $ -- --% U.S. government agencies Total ........................................ -- -- -- -- -- -- -- -- State and municipal Due within 1 year ......................... Due after 1 but within 5 years ..... Due after 5 but within 10 years ... Due after 10 years ......................... Total ........................................ Corporate Bonds Due within 1 year ......................... Due after 1 but within 5 years ..... Due after 5 but within 10 years ... Due after 10 years ......................... Total ........................................ Total held to maturity ........................... Available for sale U.S. Treasury Due within 1 year ......................... Due after 1 but within 5 years ..... Due after 5 but within 10 years ... Due after 10 years .......................... Total ........................................ U. S. government agencies Due within 1 year ......................... Due after 1 but within 5 years ..... Due after 5 but within 10 years .... Due after 10 years ......................... Total ........................................ Total available for sale ......................... 6,645 8,790 6,485 3,595 25,515 7,000 4,500 -- -- 11,500 37,015 6,000 4,000 -- -- 10,000 17,360 44,968 1,274 -- 63,602 73,602 6,688 8,869 6,912 3,780 26,249 7,022 4,572 -- -- 11,594 37,843 6,068 4,283 -- -- 10,351 17,433 45,491 1,279 -- 64,203 74,554 6,662 9,193 7,003 3,602 26,460 7,096 4,700 -- -- 11,796 38,256 6,050 4,230 -- -- 10,280 17,512 45,090 1,258 -- 63,860 74,140 3.30 4.32 3.41 3.41 3.69 6.63 5.26 -- -- 6.09 3.71 2.54 2.28 -- -- 2.44 4.22 3.75 4.93 -- 3.90 4.44 7,320 13,795 6,705 1,890 29,710 -- 11,500 -- -- 11,500 41,210 5,500 7,500 -- -- 13,000 26,794 28,407 10,000 716 65,917 78,917 7,367 14,028 7,205 1,899 30,499 -- 11,691 -- -- 11,691 42,190 5,514 7,802 -- -- 13,316 27,258 28,798 10,012 713 66,781 80,097 7,359 14,797 7,244 1,960 31,360 -- 12,380 -- -- 12,380 43,740 5,572 7,879 -- -- 13,451 27,572 28,919 9,852 742 67,085 80,536 2.94 4.13 3.39 4.69 3.71 -- 6.05 -- -- 6.05 4.36 3.09 2.43 -- -- 2.71 4.69 3.04 4.15 6.13 3.92 3.72 Total ...................................................... $110,617 $112,397 $112,396 3.95% $120,127 $122,287 $124,276 3.94% Interest income and yields on tax-exempt securities are not presented on a tax-equivalent basis. * Book value reflects cost, adjusted for accumulated amortization and accretion. No securities are less than investment grade. The Bank’s investment securities portfolio, consisting primarily of U.S. Treasuries, other U.S. government agencies, state and municipal securities, and corporate bonds, decreased $10,743 thousand or 8.75% in 2004. U.S. Treasuries, representing 9% of the portfolio decreased by $3,171 thousand. U.S. government agency securities made up 58% of the portfolio and decreased by $3,225 thousand. State and municipal securities decreased by $4,250 thousand and represent 23% of the portfolio, and corporate bonds totaling $11,594 thousand or 10% of the portfolio, decreased by $97 thousand in 2004. The weighted average maturity of the portfolio at December 31, 2004 was approximately thirty-eight months. At December 31, 2002, the book value of investments in obligations of U. S. Treasury and other U. S. government agencies and corporations was $27,976 thousand, the book value of investments in obligations of state and municipal subdivisions was $22,598 thousand and the book value of investments in corporate bonds was $12,614. Loans Loans, net, increased by $125,424 thousand, which reflects increases in all loan categories. The Bank seeks to maintain a loan portfolio that is well balanced in terms of borrowers, collateral and maturities. Of the Bank’s outstanding loans at December 31, 2004, 71% are secured by real estate. The Bank’s commercial real estate loan portfolio is composed primarily of term loans for which the primary source of repayment is cash flow from net operating income. Table 7 shows an analysis of loans by type. Annual Report - 12 Table 7 Loans Outstanding by Type at December 31 (Dollars in thousands) 2004 2003 2002 2001 2000 Commercial loans ................................................... Real estate Commercial ......................................................... Construction ....................................................... Residential ......................................................... Installment ............................................................ Total loans ........................................................... Allowance for loan losses ..................................... $120,006 $ 105,847 $ 85,192 $ 68,517 $ 54,030 250,326 81,549 30,692 94,384 576,957 6,110 196,703 44,471 28,052 75,808 450,881 5,458 187,384 41,736 29,824 66,019 410,155 5,035 161,136 27,305 28,363 40,928 326,249 4,580 146,695 17,284 24,114 22,825 264,948 4,213 Net loans ............................................................. $570,847 $445,423 $405,120 $321,669 $260,735 Table 8 shows that both the fixed and variable rate portion of the portfolio in 2004 remained relatively unchanged when compared to 2003. In 2004, the Bank’s fixed rate loans were 40.5% of the portfolio, and the variable portion was 59.5%. The large majority of the variable rate loans are tied to independent indices (such as the Wall Street Journal prime rate or the Treasury Constant Maturities) and the remainder adjusts with changes in the Bank’s reference rate. Many of the fixed rate loans with an original term of more than five years have provisions for the fixed rates to reset, or convert to a variable rate, after five years. Table 8 Loan Portfolio Maturity Distribution and Interest Rate Sensitivity (Dollars in thousands) December 31, 2004 December 31, 2003 Fixed Rate Variable Rate Total Percent Fixed Rate Variable Rate Total Percent Due within 1 year ................................ $ 27,284 $139,083 $166,367 166,726 Due after 1 but within 5 years ............ 243,864 Due after 5 years .................................. 62,992 141,110 103,734 102,754 28.8% $28,498 89,142 28.9 67,620 42.3 $96,309 $124,807 134,814 191,260 45,672 123,640 27.7% 29.9 42.4 Total ............................................... $233,772 $343,185 $576,957 100.0% $185,260 $265,621 $450,881 100.0% Percentage ...................................... 40.5% 59.5% 100.0% 41.1% 58.9% 100.0% Note: The "Due within 1 year" data includes demand loans, overdrafts and past due loans. Allowance for Loan Losses Credit risk is inherent in the business of lending. As a result, the Bank maintains an allowance for loan losses to absorb losses inherent in the Bank’s loan portfolio. This is maintained through periodic charges to earnings. These charges are shown in the Statement of Operations as provision for loan losses. All specifically identifiable and quantifiable losses are immediately charged off against the allowance. The balance of the Bank’s allowance for loan losses is an estimate of the remaining losses inherent in the portfolio. The allowance for loan losses to total loans at December 31, 2004 was 1.06% versus 1.21% at the end of 2003. At December 31, 2002, the allowance for loan losses to total loans was 1.23%. Based on the current conditions of the loan portfolio, management believes that the $6,110 thousand allowance for loan losses at December 31, 2004 is adequate to absorb losses inherent in the Bank’s loan portfolio. No assurance can be given, however, that adverse economic conditions or other circumstances will not result in increased losses in the portfolio. Table 9 shows the activity in the allowance for loan losses for each of the years in the five-year period ended December 31, 2004. At December 31, 2004 and 2003 the Bank had no loans that were past due 90 days or otherwise nonperforming. Annual Report - 13 Table 9 Allowance for Loan Losses at December 31 (Dollars in thousands) 2004 2003 2002 2001 2000 Beginning balance .............................................. Provision charged to expense ............................ Loans charged off Commercial ..................................................... Construction ................................................... Real estate ....................................................... Installment ...................................................... Total ............................................................. Loan loss recoveries Commercial ..................................................... Construction ................................................... Real estate ....................................................... Installment ...................................................... Total ............................................................. Net loans charged off ............................... $5,458 934 $5,035 685 $4,580 577 $4,003 619 $3,179 986 (6) -- -- (421) (427) 1 -- -- 144 145 (282) (146) -- -- (230) (376) 14 -- -- 100 114 (262) (33) -- -- (161) (194) 2 -- -- 70 72 (122) (37) -- -- (15) (52) 1 -- -- 9 10 (42) (182) -- -- (33) (215) 36 -- -- 17 53 (162) Ending balance ................................................... $6,110 $5,458 $5,035 $4,580 $4,003 Total loans outstanding at end of year, before deducting allowance for loan losses .............. $576,957 $450,881 $410,155 $326,249 $264,948 Average total loans outstanding during year ..... $514,299 $434,908 $366,408 $291,717 $232,761 Ratio of allowance for loan losses to total loans at end of year .................................................... 1.06% 1.21% 1.23% 1.40% 1.51% The Components of the Allowance for Loan Losses As stated previously in “Critical Accounting Policies,” the overall allowance consists of a specific allowance, an allowance factor, and an allowance for changing environmental factors. The first component, the specific allowance, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable. Through management’s ongoing loan grading process, individual loans are identified that have conditions that indicate the borrower may be unable to pay all amounts due under the contractual terms. These loans are evaluated individually by management and specified allowances for loan losses established where applicable. The second component, the allowance factor, is an estimate of the probable inherent losses across the major loan categories in the Bank’s loan portfolio. This analysis is based on loan grades by pool and current general economic and business conditions. This analysis covers the Bank’s entire loan portfolio but excludes any loans that were analyzed individually for specific allowances as discussed above. The total amount allocated for this component is determined by applying loss estimation factors to outstanding loans. The third component of the allowance for credit losses is an economic component that is not allocated to specific loans or groups of loans, but rather is intended to absorb losses caused by portfolio trends, concentration of credit, growth, economic trends, etc. There are limitations to any credit risk grading process. The volume of loans makes it impractical to re-grade every loan every quarter. Therefore, it is possible that some currently performing loans not recently graded will not be as strong as their last grading and an insufficient portion of the allowance will have been allocated to them. Grading and loan review often must be done without knowing whether all relevant facts are at hand. Troubled borrowers may deliberately or inadvertently omit important information from reports or conversations with lending officers regarding their financial condition and the diminished strength of repayment sources. At December 31, 2004 the allowance for loan losses was $6,110 thousand consisting of a specific allowance of $971 thousand, an allowance factor of $4,539 thousand, and an economic allowance of $600 thousand. At December 31, 2003 the allowance for loan losses was $5,458 thousand consisting of a specific allowance of $1,110 thousand, an allowance factor of $3,643 thousand, and an economic allowance of $705 thousand. Annual Report - 14 Table 10 shows the allocation of the allowance by loan type as well as showing the percentage of total loans in each of the same loan types. Table 10 Allocation of Allowance for Loan Losses (Dollars in thousands) December 31, 2004 Allowance Loans as balance percent of allocation total loans December 31, 2003 Allowance Loans as balance percent of allocation total loans December 31, 2002 Loan as Allowance balance percent of allocation total loans December 31, 2001 December 31, 2000 Allowance Loans as percent of allocation total loans allocation total loans Loans as Allowance balance balance percent of Commercial .................. $2,320 1,315 Construction ................ 1,260 Real estate ................... 1,215 Installment .................. Total allowance for loan losses ... $6,110 Total percent ........ Deposits 20.8% $2,288 14.1 734 1,319 48.7 1,117 16.4 23.4% $1,584 872 1,577 1,002 9.8 44.2 22.6 20.9% $1,322 662 10.2 1,860 45.9 736 23.0 21.0% $1,405 643 1,263 692 8.4 51.2 19.4 20.4% 6.5 64.5 8.6 $5,458 $5,035 $4,580 $4,003 100.0% 100.0% 100.0% 100.0% 100.0% Deposits increased by $60,963 thousand from December 31, 2004 as compared to 2003. Deposits are used to fund the Bank’s interest earning assets. The Bank does not accept brokered deposits and has only a nominal amount of public funds. Tables 11 and 12 show the relative composition of the Bank’s average deposits for the years 2004, 2003 and 2002, and the maturity groupings for the Bank’s time deposits of $100,000 or more. Table 11 Distribution of Average Deposits (Dollars in thousands) 2004 Amount Percent Year ended December 31, 2003 Amount Percent 2002 Amount Percent Demand ......................................... $164,881 Interest checking ............................ 66,084 Savings ......................................... 98,778 Money market ................................. 199,313 Time deposits 26.5% 10.6 15.9 32.0 $138,214 51,664 84,161 142,128 26.2% 9.8 16.0 27.0 $115,983 43,188 70,502 112,030 25.9% 9.7 15.7 25.1 Less than $100,000 ................. 37,392 $100,000 or more .................... 55,797 Total time deposits ............... 93,189 6.0 9.0 15.0 39,756 70,984 110,740 7.5 13.5 21.0 40,762 64,647 105,409 9.1 14.5 23.6 Total Deposits ............................... $622,245 100.0% $526,907 100.0% $447,112 100.0% Note: Refer to Table 2 for the average amount of and the average rate paid on each deposit category. Table 12 Maturities of Time Deposits of $100,000 or more at December 31 (Dollars in thousands) December 31, 2004 2003 2002 Three months or less ................................................ $30,538 6,193 Over three months through six months .................. 10,849 Over six months through twelve months ................ 21,140 Over twelve months .................................................. $39,276 6,470 8,535 17,239 $31,542 8,840 11,330 27,371 Total ................................................................ $68,720 $71,520 $79,083 Commitments The following is a summary of the Bank’s contractual commitments as of December 31, 2004. Table 13 Contractual Obligations at December 31 (Dollars in thousands) Operating leases .................................................... Subordinated debt .................................................. < 1 year $1,303 -- Payments due by period 4-5 years 1-3 years >5 years $1,854 -- $1,631 -- $2,291 5,000 Total $7,079 5,000 The contract amount of loan commitments not reflected on the statement of condition was $184,598 thousand at December 31, 2004 and $153,695 thousand at December 31, 2003. Annual Report - 15 Capital Adequacy As discussed in Note 14 of the Notes to Financial Statements, the Bank’s capital ratios are above regulatory guidelines to be considered “well capitalized.” In 2004, the Bank’s risk based capital ratio improved from 10.92% to 11.37%. This is primarily due to capital growth from earnings and the addition of $5,000 thousand in subordinated debt. Liquidity The goal of liquidity management is to provide adequate funds to meet both loan demand and unexpected deposit withdrawals. This goal is accomplished by maintaining an appropriate level of liquid assets, consistent with core deposit growth, and informal lines of credit to purchase funds from correspondent banks. At year-end 2004, the Bank had approximately $64,539 thousand in cash and securities maturing within one year. The remainder of the securities portfolio of $77,357 provides additional liquidity. At year-end 2003, the Bank had approximately $105,100 thousand in cash, Federal funds sold and securities maturing within one year. The remainder of the securities portfolio of $70,552 thousand provided additional liquidity. During 2004, loan demand was strong resulting in a modest decline in the Bank’s liquidity. Management expects to be able to meet the liquidity needs of the Bank during 2005 primarily through balancing loan growth with corresponding increases in deposits. See discussion below for additional sources of liquidity for the Bank. The Bank did occasionally utilize borrowings from FHLB and Federal fund lines during 2004. The Bank purchased $17,800 thousand in Federal funds at December 31, 2004, as compared to $0 purchased at December 31, 2003. During the year the combination of 10.4% deposit growth and 28.0% gross loan growth resulted in a year-end loan-to-deposit ratio of 89.4% compared to 77.2% at December 31, 2003. Management monitors the Bank’s liquidity position daily, balancing loan fundings/payments with changes in deposit activity and overnight investments. The Bank’s emphasis on local deposits at competitive rates, combined with its 8.9% average equity capital base, provides a very stable funding base. The Bank also has unsecured lines of credit totaling $35,000 thousand with correspondent banks to purchase Federal funds. The Bank is a member of the Federal Home Loan Bank of San Francisco (FHLB), and has a line of credit for advances of $24,448 thousand ($6,648 thousand of which was available at December 31, 2004) at an interest rate that is determined daily. Borrowings under the line are limited to eligible collateral. The Bank had undisbursed loan commitments of $184,598 thousand, including $91,237 thousand under lines of credit (these commitments are contingent upon customers maintaining specific credit standards), $48,428 thousand under revolving home equity lines, and $31,174 thousand under undisbursed construction loans. These commitments, to the extent used, are expected to be funded through repayment of existing loans and normal deposit growth. Market Risk Management Market risk is the risk of loss from adverse changes in market prices and rates. The Bank’s market risk arises primarily from interest rate risk inherent in its loan and deposit functions. The objective for managing the assets and liabilities of the Bank is to maximize earnings while maintaining a high-quality portfolio of loans and investments and assuming only limited interest rate risk. The Loan and Investment Committee of the Board of Directors has overall responsibility for interest rate risk management policies. The Committee establishes and monitors guidelines to control the sensitivity of net interest income (NII) and regulatory Tier 1 capital (Capital) to changes in interest rates. Activities in asset and liability management include, but are not limited to, lending, accepting deposits and investing in securities. Interest rate risk is the primary market risk associated with asset and liability management. Sensitivity of NII and Capital to interest rate changes arises when yields on loans and Annual Report - 16 investments change in a different time frame or amount from that of rates on deposits and other interest- bearing liabilities. To mitigate interest rate risk, the structure of the statement of condition is managed with the objective of correlating the movements of interest rates on loans and investments with those of deposits. The asset and liability policy sets limits on the acceptable amount of change to NII and Capital in changing interest rate environments. The Bank uses simulation models to forecast NII and Capital. Simulation of NII and Capital under various scenarios of increasing or decreasing interest rates is the primary tool used to measure interest rate risk. Using licensed software developed for this purpose, management is able to estimate the potential impact of changing rates. A simplified statement of condition is prepared on a quarterly basis as a starting point, using as inputs, actual loans, investments and deposits. In the simulation of NII and Capital under various interest rate scenarios, the simplified statement of condition is processed against at least six interest rate change scenarios. In addition to a flat rate scenario, which assumes interest rates are unchanged, the six scenarios include three 100 basis point increases and three 100 basis point decreases. Each of these scenarios assumes that the change in interest rates is immediate and remains at the new levels. Table 14 summarizes the effect on NII and Capital due to changing interest rates as measured against the flat rate scenario. Table 14 Effect of Interest Rate Change on Net Interest Income and Capital Changes in Interest Rates (in basis points) up 300 .............................. up 200 .............................. up 100 .............................. unchanged ....................... down 100 ......................... down 200 ......................... down 300 ......................... Estimated change in NII (as percent of flat NII) at December 31, Estimated change in capital (as percent of flat capital) at December 31, 2004 4.6% 3.1% 1.5% -- (2.3%) (4.5%) N / A 2003 5.4% 3.6% 1.8% -- (2.5%) N / A N / A 2004 2.6% 1.7% 0.9% -- (1.3%) (2.5%) N / A 2003 3.3% 2.2% 1.1% -- (1.4%) N / A N / A N/A - Not applicable as Federal funds rates cannot drop below zero. The results in the table indicate that the Bank was modestly asset sensitive since NII increased under the increasing interest rate scenarios. The results are also well within the policy guidelines established by the Committee. Further, the results do not assume nor incorporate any action(s) which management might take to minimize any negative consequences of interest rate changes. Therefore, they are not intended to portray likely results but rather estimates of the impact of interest rate risk. As with any simulation model or other method of measuring interest rate risk, certain limitations are inherent in the process. For example, although certain of the Bank’s assets and liabilities may have similar maturities or repricing time frames, they may react differently to changes in market interest rates. In addition, the changes in interest rates on certain categories of either the Bank’s assets or liabilities may precede or lag changes in market interest rates. Also, the actual rates and timing of prepayments on loans and investment securities could vary significantly from the assumptions used in the various scenarios. Further, changes in US Treasury rates accompanied by a change in the shape of the yield curve could produce different results from those presented in the table. Accordingly, the results presented should not be relied upon as indicative of actual results in the event of changing market interest rates. Interest rate sensitivity is a function of the repricing characteristics of the Bank’s assets and liabilities. One aspect is the time frame within which the interest earning assets and interest bearing liabilities are subject to change in interest rates at repricing or maturity. An analysis of the repricing time frames is called a “gap” analysis because it shows the gap between the amounts of assets and liabilities repricing in each of several periods of time. Another aspect is the relative magnitude of the repricing for each category of interest earning asset and interest bearing liability given various changes in market rates. Gap analysis gives no indication Annual Report - 17 of the relative magnitude of repricing. Interest rate sensitivity management focuses on the maturity of assets and liabilities and their repricing during periods of change in market rates. Interest rate sensitivity gaps are calculated as the difference between the amounts of assets and liabilities that are subject to repricing during various time periods. Table 15 shows the Bank’s repricing gaps as of December 31, 2004. Due to the limitations of gap analysis, as described above, the Bank does not generally use it in managing interest rate risk. Instead the Bank relies on the more sophisticated simulation model described above as its primary tool in measuring and managing interest rate risk. Table 15 Interest Rate Sensitivity (Dollars in thousands) At December 31, 2004 Interest Earning Assets 1-30 Days 31-90 Days Maturing or Repricing 181-365 91-180 Days Days Over one year Total Funds sold ................................... $ -- Investment securities .................. 3,001 201,069 Loans ............................................ 204,070 Total ........................................... $ -- 4,662 4,372 9,034 $ -- 14,978 3,824 18,802 $ -- 14,630 14,541 29,171 $ -- 74,712 347,041 421,753 $ -- 111,983 570,847 682,830 Interest Bearing Liabilities -- Transaction and savings deposits -- Federal funds purchased ............. 6,762 Time deposits less than $100,000 18,407 Time deposits $100,000 or more 25,169 Total ....................................... -- Demand Deposits ............................. Sensitivity for period ........................ (16,135) Sensitivity - cumulative .................... $(204,031) $(220,166) 374,326 17,800 3,845 12,130 408,101 -- (204,031) -- -- 6,469 6,194 12,663 -- 6,139 -- -- 5,298 10,850 16,148 -- 13,023 $(214,027) $(201,004) -- -- 9,275 21,139 30,414 170,385 220,954 $ 19,950 374,326 17,800 31,649 68,720 492,495 170,385 $ 19,950 Deferred Compensation Obligations The Bank maintains a nonqualified, unfunded deferred compensation plan for certain key management personnel. Under this plan, participating employees may defer compensation, which will entitle them to receive certain payments upon retirement, death, or disability. The plan provides for payments for fifteen years commencing upon retirement and reduced benefits upon early retirement, disability, or termination of employment. At December 31, 2004, the Bank’s aggregate payment obligations under this plan totaled $722 thousand. Off Balance Sheet Arrangements The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. For additional information, see Note 15 of the Notes to Financial Statements. Borrowings Federal funds Purchased As of December 31, 2004, short-term borrowings totaled $17,800 thousand as compared to $0 as of December 31, 2003. Short-term borrowings consist primarily of Federal funds purchased and borrowings from Federal Home Loan Bank of San Francisco (FHLB). Based on the FHLB stock requirements at December 31, 2004, the lines provided for maximum borrowings of approximately $24,448 thousand. At December 31, 2004 the Bank had an unused capacity with the FHLB of $6,648 thousand. The Bank also has available unused unsecured formal lines of credit totaling $35,000 thousand for Federal funds transactions at December 31, 2004 with correspondent banks. Annual Report - 18 Subordinated Debt On June 17, 2004, the Bank issued a 15-year, $5 million subordinated debenture through a pooled trust preferred program. The interest rate on the debentures is paid quarterly at the three-month LIBOR plus 2.48%. The debenture is subordinated to the claims of depositors and other creditors of the Bank. The principal is due on June 17, 2019. Related Party Transactions See Notes 3, 7, and 11 of the Notes to Financial Statements for discussion of the Bank’s related party transactions. Code of Ethics Bank of Marin has adopted a Code of Ethics that applies to all employees, directors and officers, including the Bank’s principal executive officer, principal financial officer and principal accounting officer. A copy of the Code of Ethics is available, without charge, upon written request to Corporate Secretary, Bank of Marin, P.O. Box 2039, Novato, CA 94948. Annual Report - 19 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Bank of Marin We have audited the accompanying statement of condition of Bank of Marin (the Bank) as of December 31, 2004 and the related statements of operations, stockholders’ equity and cash flows for the year then ended. These financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bank of Marin as of December 31, 2004 and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. We have also audited the adjustments described in Note 1, Earnings Per Share and Note 13, Stockholders’ Equity that were applied to restate the 2003 and 2002 financial statements resulting from the stock split in 2004. In our opinion, such adjustments are appropriate and have been properly applied. Santa Rosa, California February 18, 2005 /s/ Moss Adams LLP Annual Report - 20 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Bank of Marin Corte Madera, California We have audited the accompanying statement of condition of Bank of Marin (the Bank) as of December 31, 2003, and the related statements of operations, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2003 (prior to the restatement for a stock split, not presented herein). These financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Bank as of December 31, 2003, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. San Francisco, California January 21, 2004 /s/ Deloitte & Touche LLP Annual Report - 21 STATEMENT OF CONDITION (Dollar amounts in thousands) Assets Cash and due from banks Federal funds sold Cash and cash equivalents Investment securities Held to maturity, at amortized cost Available for sale (at fair market value, cost $74,554 in 2004 and $80,097 in 2003) Total investment securities Loans, net of allowance for loan losses of $6,110 in 2004 and $5,458 in 2003 Bank premises and equipment, net Interest receivable and other assets Total assets Liabilities and Stockholders’ Equity Liabilities Deposits Non-interest bearing Interest bearing Transaction accounts Savings Time Total deposits Federal funds purchased Subordinated debenture Interest payable and other liabilities Total liabilities December 31, 2004 2003 $ 29,499 --- 29,499 37,843 74,140 111,983 570,847 3,911 20,854 $ 737,094 $ 36,026 16,900 52,926 42,190 80,536 122,726 445,423 4,508 17,024 $ 642,607 $ 170,385 $ 160,121 68,259 306,067 100,368 645,079 17,800 5,000 3,607 671,486 63,801 255,814 104,380 584,116 --- --- 2,914 587,030 Stockholders' Equity Common stock, no par value Authorized - 15,000,000 shares Issued and outstanding - 4,609,685 shares in 2004 and 2,954,054 shares in 2003 Retained earnings Accumulated other comprehensive income (loss), net Total stockholders’ equity 40,208 25,640 (240) 65,608 37,367 17,955 255 55,577 Total liabilities and stockholders’ equity $ 737,094 $ 642,607 The accompanying notes are an integral part of these financial statements. Annual Report - 22 STATEMENT OF OPERATIONS (In thousands, except per share data) Interest income Interest and fees on loans Interest on investment securities U. S. Treasury securities Securities of U. S. Government agencies Obligations of state and political subdivisions - tax exempt Corporate debt securities and other Interest on Federal funds sold Years ended December 31, 2004 2003 2002 $33,140 $29,301 $27,562 324 2,257 1,012 795 61 518 1,018 954 791 243 1,101 1,009 1,027 848 204 Total interest income 37,589 32,825 31,751 Interest expense Interest on interest bearing transaction deposits Interest on savings deposits Interest on time deposits Interest on borrowed funds 257 2,961 1,968 166 207 2,426 2,534 2 309 2,953 2,960 6 Total interest expense 5,352 5,169 6,228 Net interest income Provision for loan losses Net interest income after provision for loan losses Non-interest income Service charges on deposit accounts Wealth Management Services Other income 32,237 934 27,656 686 25,523 577 31,303 26,970 24,946 1,137 922 1,584 1,020 815 1,125 840 670 808 Total non-interest income 3,643 2,960 2,318 Non-interest expense Salaries and related benefits Occupancy and equipment Depreciation and amortization Data processing Other expense 11,954 1,864 949 1,210 3,643 10,767 1,676 992 1,039 3,343 10,446 1,601 882 953 3,243 Total non-interest expense 19,620 17,817 17,125 Income before provision for income taxes Provision for income taxes Net income Net income per common share* Basic Diluted 15,326 12,113 10,139 5,808 $ 9,518 4,640 $ 7,473 3,897 $ 6,242 $2.09 $1.94 $1.70 $1.59 $1.44 $1.37 * Restated for the 3-for-2 stock split declared in April 2004 and for the 5% stock dividend declared in April 2003. The accompanying notes are an integral part of these financial statements. Annual Report - 23 STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Dollar amounts in thousands) Common Stock Shares Amount Retained Earnings Accumulated Other Comprehensive Income (Loss), Net of taxes Unearned ESOP Shares Total Balance at Dec. 31, 2001 2,590,749 $28,003 $11,838 $810 $(50) $40,601 --- --- 6,242 --- --- 6,242 Balance at Dec. 31, 2002 2,757,393 $31,969 $14,662 $551 $(65) $47,117 --- --- 7,473 --- --- 7,473 Comprehensive income: Net income Other comprehensive income Net change in unrealized gain (loss) on available for sale securities (net of tax benefit of $188) Comprehensive income Stock options exercised Stock issued on 5% stock dividend declared Apr. 11 Stock issued in payment of director fees Change in unearned ESOP shares --- --- 27,160 129,956 9,528 --- Comprehensive income: Net income Other comprehensive income Net change in unrealized gain (loss) on available for sale securities (net of tax benefit of $215) Comprehensive income Stock options exercised Stock issued on 5% stock dividend declared Apr. 10 Stock issued in payment of director fees Change in unearned ESOP shares --- --- 48,958 138,461 9,242 --- Comprehensive income: Net income Other comprehensive income Net change in unrealized gain (loss) on available for sale securities (net of tax benefit of $358) Comprehensive income Stock options exercised 3-for-2 stock split declared April 15 Cash dividend paid June 1 Stock issued in payment of director fees --- --- 126,901 1,519,714 --- 9,016 --- --- 317 --- 6,242 --- 3,405 (3,418) 244 --- --- --- (259) (259) --- --- --- --- --- --- --- --- --- (15) (259) 5,983 317 (13) 244 (15) --- --- 955 --- 7,473 --- 4,162 (4,180) 281 --- --- --- (296) (296) --- --- --- --- --- --- --- --- --- 65 (296) 7,177 955 (18) 281 65 --- --- 2,527 --- --- 314 --- 9,518 --- (9) (1,824) --- (495) (495) --- --- --- --- --- --- --- --- --- --- (495) 9,023 2,527 (9) (1,824) 314 Balance at Dec. 31, 2003 2,954,054 $37,367 $17,955 $255 $--- $55,577 --- --- 9,518 --- --- 9,518 Balance at Dec. 31, 2004 4,609,685 $40,208 $25,640 $(240) $--- $65,608 The accompanying notes are an integral part of these financial statements. Annual Report - 24 STATEMENT OF CASH FLOWS (In thousands) Cash Flows from Operating Activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses Compensation payable in common stock Amortization and accretion of investment security premiums, net Depreciation and amortization Net change in operating assets and liabilities: Interest receivable Interest payable Other assets Other liabilities Total adjustments Years ended December 31, 2004 2003 2002 $ 9,518 $ 7,473 $ 6,242 934 344 1,570 949 686 281 1,107 992 577 243 750 882 (362) (25) (3,468) 1,046 988 19 (81) (495) (2,605) (96) (131) (19) (337) 2,610 4,575 Net cash provided by operating activities 10,506 7,377 10,817 Cash Flows from Investing Activities: Purchase of securities held-to-maturity Purchase of securities available-for-sale Proceeds from paydowns/maturity of: Securities held-to-maturity Securities available-for-sale Purchase of bank owned life insurance policies Loans originated and principal collected, net Additions to premises and equipment (5,363) (38,545) (14,277) (87,479) --- (17,128) 9,350 42,878 --- (126,358) (352) 6,972 34,578 (10,000) (40,989) (949) 2,694 31,672 --- (83,906) (1,320) Net cash used in investing activities (118,390) (112,144) (67,988) Cash Flows from Financing Activities: Net increase in deposits Issuance of common stock Federal funds purchased Cash dividend paid Subordinated debt issued Other 60,963 2,527 17,800 (1,824) 5,000 (9) 98,087 955 --- --- --- (18) 74,212 317 --- --- --- (13) Net cash provided by financing activities 84,457 99,024 74,516 Net (decrease) increase in cash and cash equivalents (23,427) (5,743) 17,345 Cash and cash equivalents at beginning of year 52,926 58,669 41,324 Cash and cash equivalents at end of year $29,499 $52,926 $58,669 Supplemental disclosure of cash flow information: Cash paid for interest Cash paid for income taxes $5,319 $5,599 $5,250 $4,822 $6,248 $3,762 The accompanying notes are an integral part of these financial statements. Annual Report - 25 NOTES TO FINANCIAL STATEMENTS December 31, 2004 (In thousands, except share and per-share data) Note 1: Summary of Significant Accounting Policies Nature of Operations: The Bank of Marin (the Bank) is a California state chartered bank. The Bank operates eight branches in Marin County and one in southern Sonoma County, California. The Bank's primary source of revenue is interest from providing loans to customers, who are predominately professionals, small and middle-market businesses, and middle and high-income individuals who work and/or reside in Marin and southern Sonoma counties. The accounting and reporting policies of the Bank conform with generally accepted accounting principles and general practice within the banking industry. A summary of the more significant policies follows. Investment Securities are classified as "held to maturity," "trading securities" or "available for sale." Investments classified as held to maturity are those that the Bank has the ability and intent to hold until maturity and are reported at cost, adjusted for the amortization or accretion of premiums or discounts. Investments classified as trading securities are reported at fair value, with unrealized gains and losses included in earnings; and investments classified as available for sale are reported at fair value, with unrealized gains and losses, net of related tax, if any, reported as a separate component of comprehensive income and included in stockholders’ equity until realized. For the majority of the Bank’s securities, fair values are determined based upon quoted prices for similar securities. At each financial statement date, management assesses each investment to determine if impaired investments are temporarily impaired or if the impairment is other than temporary based upon the positive and negative evidence available. Evidence evaluated includes, but is not limited to, industry analyst reports, credit market conditions, and interest rate trends. A decline in the market value of any security below cost that is deemed other than temporary results in a charge to earnings and the corresponding establishment of a new cost basis for the security. Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Loans are reported at the principal amount outstanding net of deferred fees and the allowance for loan losses. Interest income is accrued daily using the simple interest method. Loans are placed on nonaccrual status when management believes that there is serious doubt as to the collection of principal or interest, or when they become contractually past due by 90 days or more with respect to principal or interest, except for loans that are both well secured and in the process of collection. When loans are placed on nonaccrual status, any accrued but uncollected interest is reversed from current-period interest income, and additional income is recorded only as payments are received. Loan origination and commitment fees, offset by certain direct loan origination costs, are deferred and amortized as yield adjustments over the contractual lives of the related loans. 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 loan portfolio. The allowance is increased by provisions charged to expense and reduced by net charge-offs. The Bank considers the Bank's past loan loss experience, 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 in periodic evaluations of the adequacy of the allowance balance. The allowance for loan losses is based on estimates, and ultimate losses may vary from current estimates. The Bank’s method for assessing the appropriateness of the allowance includes specific allowances for identified problem loans, an allowance factor for pools of credits, and allowances for changing environmental factors (e.g., portfolio trends, concentration of credit, growth, economic factors, etc.) Annual Report - 26 Allowances for identified problem loans are based on specific analysis of individual credits. Loss estimation factors for loan pools are based on analysis of local economic factors applicable to each loan pool. Due to the Bank’s minimal historic losses, loss estimation factors are based only in part on the previous historical loss experience for each pool. 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. The Bank considers a loan as impaired when it is probable the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's original effective interest rate or based on the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through an allocation of the allowance for loan losses. The Bank’s Directors’ Loan Committee reviews the adequacy of the allowance for loan losses at least quarterly, to include consideration of the relative risks in the portfolio and current economic conditions. The allowance is adjusted based on that review if, in the judgement of the Loan Committee and management, changes are warranted. Bank Premises and Equipment consist of leasehold improvements, furniture, fixtures and equipment and are stated at cost, less accumulated depreciation and amortization, which are calculated on a straight-line basis over the estimated useful life of the property or the term of the lease (if less). Furniture and fixtures are depreciated over 5 to 8 years, and equipment is generally depreciated over 3 to 20 years. Leasehold improvements are amortized over the terms of the leases or their estimated useful lives, whichever is shorter. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to expense as incurred. ESOP and Related Debt Employee Stock Ownership Plan (ESOP) - The Bank accounts for shares acquired by its ESOP in accordance with the guidelines established by the American Institute of Certified Public Accountants Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans.” The Bank recognizes compensation cost equal to the fair value of the ESOP shares during the periods in which they become committed to be released. To the extent that the fair value of the Bank’s ESOP shares committed to be released differ from the cost of those shares, the differential is charged or credited to equity. The ESOP is externally leveraged and, as such, the ESOP debt is recorded as a liability and interest expense is recognized on such debt. The ESOP shares not yet committed to be released are accounted for as a reduction in stockholders’ equity. Income Taxes reported in the financial statements are computed based on an asset and liability approach. The Bank recognizes the amount of taxes payable or refundable for the current year, and deferred tax assets and liabilities for the future tax consequences that have been recognized in the financial statement or tax returns. The measurement of tax assets and liabilities is based on the provisions of enacted tax laws. Cash and Cash Equivalents are classified assuming that cash and cash equivalents includes cash and due from banks and federal funds sold, which have an original maturity of 90 days or less at the time of purchase. The Bank is required to maintain reserves with the Federal Reserve Bank of San Francisco equal to a percentage of its reservable deposits. Reserve balances that were required by the Federal Reserve Bank were $10,466 thousand and $7,819 thousand for December 31, 2004 and 2003, respectively, and are reported in cash and due from banks on the balance sheet. Earnings per share are based upon the weighted average number of common shares outstanding during each year. The following table shows weighted average basic shares, potential common Annual Report - 27 shares related to stock options, and weighted average diluted shares. Basic earnings per share are based upon the weighted average number of common shares outstanding during each period. Diluted earnings per share are based upon the weighted average number of common shares and potential common shares outstanding during each period. Earnings per share and share amounts for all periods have been retroactively adjusted for the 3-for-2 stock split in 2004 and the 5% stock dividend in 2003. 2004 2003 2002 Weighted average basic shares outstanding Add: Potential common shares related to stock options 4,546,834 4,392,962 4,324,202 351,176 315,591 227,439 Weighted average diluted shares outstanding 4,898,010 4,708,553 4,551,641 The number of antidilutive shares not included in the calculation of diluted earnings per shares were 14,250, 17,366 and 36,114 at December 31, 2004, 2003 and 2002, respectively. Stock-Based Compensation In December 2002 the Bank adopted the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 148 - Accounting for Stock-Based Compensation - Transition and Disclosure, which amends SFAS No. 123 - Accounting for Stock- Based Compensation. This Statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure requirements to require prominent disclosure about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Bank accounts for stock-based awards for its plans under APB Opinion No. 25 - Accounting for Stock Issued to Employees - under which no stock-based compensation cost has been recognized in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation cost for these plans been determined in accordance with SFAS No. 123, the Bank’s net income and earnings per share would have been reduced to the pro forma amounts shown in the following table. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. (Dollars in thousands, except per share amounts) Net income as reported Stock-based compensation expense, net of taxes Pro forma net income Earnings per share As reported (basic) As reported (diluted) Pro forma (basic) Pro forma (diluted) Weighted-average fair value of options granted during the year Assumptions used in weighted-average fair value Risk-free interest rate Expected dividend yield Expected life in years Expected price volatility 2004 $9,518 (905) $8,613 2003 $7,473 (959) $6,514 2002 $6,242 (910) $5,332 $2.09 1.94 1.89 1.76 $1.70 1.59 1.48 1.38 $1.44 1.37 1.23 1.17 $12.43 $12.85 $11.87 4.05% 0.12% 8 29.96% 4.00% 0.00% 8 28.83% 4.00% 0.00% 8 30.88% In December 2004, the Financial Accounting Standards Board adopted SFAS No. 123-R, which requires recognition for stock-based compensation expense in the Bank’s financial statements beginning in the third quarter of 2005. The Bank expects to adopt the requirements prospectively in July 2005 and estimates the impact to be a reduction to net income of approximately $105 thousand to $140 thousand per quarter. Comprehensive Income for the Bank includes net income reported on the statement of operations and changes in the fair value of its available for sale investments reported as a component of stockholders’ equity. Annual Report - 28 Segment Information The Bank’s two operating segments include the traditional community banking activities provided through its nine branches and its Wealth Management Services. The activities of these two segments are monitored and reported by Bank management as separate operating segments. The accounting policies of the segments are the same as those described in this note. The Bank evaluates segment performance based on total segment revenue and does not allocate expenses between the segments. Wealth Management Services revenues were $922 thousand in 2004, $815 thousand in 2003, and $670 thousand in 2002, which are included in non- interest income in the statement of operations. The revenues of the community banking segment are reflected in all other income lines in the statement of operations. Reclassifications Certain amounts in prior years' financial statements have been reclassified to conform with the current presentation. These reclassifications have no effect on previously reported net income. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Note 2: Investment Securities The amortized cost and fair market value of investment securities at December 31, 2004 and 2003 consisted of the following: (In thousands) 2004 Held to maturity Oblig. of state & political subdivisions Corporate debt securities and other 2004 Available for sale U. S. Treasury Securities Securities of U.S. Government Agencies Total 2003 Held to maturity Oblig. of state & political subdivisions Corporate debt securities and other 2003 Available for sale U. S. Treasury Securities Securities of U.S. Government Agencies Amortized Cost Gains Losses Market Value Gross Unrealized Fair $26,249 11,594 37,843 10,351 64,203 74,554 $112,397 $30,499 11,691 42,190 13,316 66,781 80,097 $472 213 685 6 130 136 $821 $ 983 689 1,672 135 510 645 $(261) (11) (272) (77) (473) (550) $26,460 11,796 38,256 10,280 63,860 74,140 $(822) $112,396 $ (122) --- (122) ( 1) (205) (206) $31,360 12,380 43,740 13,450 67,086 80,536 Total $122,287 $2,317 $(328) $124,276 The amortized cost and estimated market value of investment securities at December 31, 2004 by contractual maturity are shown below. Expected maturities will 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. (In thousands) Within one year After one but within five years After five years through ten years After ten years December 31, 2004 Held to maturity Fair Market Value Amortized Cost Available for sale Fair Market Value Amortized Cost $13,710 13,441 6,912 3,780 $13,759 13,893 7,003 3,601 $ 21,330 44,556 6,496 2,172 $21,356 44,169 6,410 2,205 Total $37,843 $38,256 $74,554 $74,140 Annual Report - 29 For the years ended December 31, 2004, 2003, and 2002 the Bank did not sell any of its investment securities, and accordingly, did not recognize any gains or losses. At December 31, 2004, investment securities carried at $17,253 thousand were pledged with the Federal Reserve Bank: $3,994 thousand to secure the Bank's Treasury, Tax and Loan account and trust deposits, $4,048 thousand to provide collateral for potential future borrowings to meet unusual short-term liquidity needs, and $9,211 thousand to secure the Bank's public fund deposits. Investment securities with unrealized losses are summarized and classified according to the duration of the loss period as follows: December 31, 2004 (In thousands) Held-to-maturity < 12 continuous months Fair value Unrealized loss > 12 continuous months Unrealized loss Fair value Obligations of state & political subdivisions Corporate debt securities and other Available for sale U. S. Treasury Securities Securities of U. S. Government Agencies $5,634 2,081 7,715 9,272 42,222 51,494 Total temporarily impaired securities $59,209 $(261) (11) (272) (77) (473) (550) $(822) $--- --- --- --- --- --- $--- $ --- --- --- --- --- --- $--- December 31, 2003 (In thousands) Held-to-maturity < 12 continuous months Fair value Unrealized loss > 12 continuous months Unrealized loss Fair value Obligations of state & political subdivisions $ 3,857 $ (122) Available for sale U. S. Treasury Securities Securities of U. S. Government Agencies 1,999 20,053 22,052 (1) (205) (206)) Total temporarily impaired securities $25,909 $(328) --- --- --- --- --- -- --- --- --- --- Management periodically evaluates each investment security in an unrealized loss position to determine if the impairment is temporary or other than temporary. Included are twenty-seven securities at December 31, 2004 and nine securities at December 31, 2003 with fair values of $59,209 thousand and $25,909 thousand, respectively, and unrealized losses of $822 thousand and $328 thousand, respectively. Management has determined that no investment security is other than temporarily impaired. This temporary impairment is attributable to general changes in short- term interest rates as measured by the U.S. Treasury yield curve. The duration of this impairment was for a period of less than twelve months. Note 3: Loans The majority of the Bank’s loan activity is with customers located in California, primarily in the counties of Marin and southern Sonoma. Although the Bank has a diversified loan portfolio, a large portion of the loans are for commercial property, and many of the Bank’s loans are secured by real estate in Marin and Sonoma County. Approximately 71% of the loans are secured by real estate. Outstanding loans by type, net of deferred loan fees of $2,040 thousand and $1,395 thousand at December 31, 2004 and 2003, respectively, are as follows: (In thousands) Commercial loans Real estate Commercial Construction Residential Installment Total loans Less - Allowance for loan losses Net Loans Annual Report - 30 2004 $120,006 2003 $105,847 250,326 81,549 30,692 94,384 576,957 ( 6,110) $570,847 196,703 44,471 28,052 75,808 450,881 (5,458) $445,423 At December 31, 2004 and 2003 the Bank had no loans that were past due greater than 90 days. At December 31, 2004, commercial real estate loans of $56,655 thousand were pledged as collateral for an FHLB line of credit. The Bank has, and expects to have in the future, banking transactions in the ordinary course of its business with directors, officers, principal stockholders and their associates. These transactions, including loans, are granted on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the same time for comparable transactions with others and do not involve more than the normal risk of collectibility or present other unfavorable features. An analysis of net loans to related parties for the year ended December 31, 2004, is as follows: (In thousands) Balance at beginning of year New loans to related parties Repayments Balance at end of year 2004 $1,730 1,044 277 $2,497 The undisbursed commitment to related parties as of December 31, 2004 was $1,992 thousand. Note 4: Allowance for Loan Losses Activity in the allowance for loan losses for the three years in the period ended December 31 follows: (In thousands) Beginning balance Provision for loan loss charged to expense Loans charged off Loan loss recoveries Ending balance Total loans outstanding at end of year, 2004 $5,458 934 (427) 145 $ 6,110 2003 $ 5,035 685 (376) 114 $ 5,458 2002 $ 4,580 577 (194) 72 $ 5,035 before deducting allowance for loan losses $ 576,957 $ 450,881 $ 410,155 Average total loans outstanding during the year Ratio of allowance for loan losses to total loans at end of year $ 514,299 $ 434,908 $ 366,408 1.06% 1.21% 1.23% Loans classified as nonaccrual amounted to $0 at December 31, 2004 and 2003. At December 31, 2004, 2003 and 2002 the Bank had no impaired loans. The average recorded investment in impaired loans was $0 for the years ended December 31, 2004, 2003 and 2002. Note 5: Bank Premises and Equipment A summary of Bank premises and equipment at December 31 follows: (In thousands) Leasehold improvements Furniture and equipment Accumulated depreciation and amortization Bank premises and equipment, net 2004 $5,276 6,038 11,314 (7,403) $3,911 2003 $ 5,214 5,748 10,962 (6,454) $4,508 The amount of depreciation and amortization was $949 thousand, $992 thousand and $882 thousand for the three years in the period ended December 31, 2004, 2003 and 2002, respectively. Note 6: Bank Owned Life Insurance The Bank has purchased life insurance policies on the lives of certain officers in the Bank and intends to use the policies ($10,715 thousand cash surrender value at December 31, 2004 and $10,203 thousand cash surrender value at December 31, 2003) to finance employee benefit programs. The investment in the Bank owned life insurance (BOLI) policies are reported in “interest receivable and other assets” at the cash surrender value of the policies. The carrying value includes both the Bank’s original premiums invested in the life insurance policies and the accumulated accretion of policy income since inception of the policies. Income of $512 thousand in 2004 and Annual Report - 31 $203 thousand in 2003 was recognized on the life insurance policies and is reported in “other non- interest income.” Note 7: Deposits Time deposits in denominations of $100,000 or greater were $68,720 thousand and $71,520 thousand at December 31, 2004 and 2003, respectively. Interest on these deposits was $1,968 thousand, $2,534 thousand and $2,960 thousand in 2004, 2003 and 2002, respectively. Scheduled maturities of these deposits at December 31, 2004 follows: (In thousands) Scheduled maturities of time deposits 2005 2006 2007 2008 2009 Thereafter Total $47,579 $7,937 $3,616 $2,370 $7,218 $--- $68,720 The Bank accepts deposits from shareholders, directors and employees in the normal course of business, and the terms are comparable to those with non-affiliated parties. Note 8: Borrowings Federal funds Purchased Short-term debt at December 31, 2004 and 2003 consisted of overnight Federal funds purchased in the amount of $17,800 thousand and $0 thousand, respectively. Short- term borrowing available to the Bank of $24,448 thousand consists of a line of credit and advances with the Federal Home Loan Bank (“FHLB”) secured under terms of a blanket collateral agreement by a pledge of FHLB stock and certain other qualifying collateral such as investments and loans. At December 31, 2004 the Bank had an unused capacity with the FHLB of $6,648 thousand. The Bank also has unused unsecured formal lines of credit totaling $35,000 thousand with correspondent banks. At December 31, 2004, interest rates on lines of credit with correspondent banks ranged from 2.00% to 3.18%. Subordinated Debt On June 17, 2004 the Bank issued a 15-year, $5 million subordinated debenture through the pooled trust preferred program of FTN Financial Capital market and Keefe, Bruyette and Woods, which matures on June 17, 2017. The Bank has the right to redeem the debenture, in whole or in part, at the redemption price at principal amounts in multiples of $1,000 thousand on any interest payment date on or after June 17, 2009. The interest rate on the debentures changes quarterly and is paid quarterly at the three-month LIBOR plus 2.48%. The rate at December 31, 2004 was 4.98%. The debenture is subordinated to the claims of depositors and other creditors of the Bank. Borrowings at December 31, 2004 and 2003 are summarized as follows: (In thousands) Federal funds purchased Subordinated debenture Carrying Value $17,800 5,000 2004 Average Balance $2,805 2,705 Average Rate 1.74% 4.32 Carrying Value $ --- --- 2003 Average Balance $91 --- Average Rate 1.71% --- The maximum amount outstanding at any month end for Federal funds purchased was $18,800 thousand and $5,300 thousand, during 2004 and 2003, respectively. Note 9: Benefit Plans In 2003 the Bank established an Officer Deferred Compensation Plan, which allows key executive officers designated by the Board of Directors of the Bank to defer up to 80% of their salary and 100% of their annual bonus. Amounts deferred earn interest at a rate set annually by the Board of Directors. The interest rate was set at 7% for 2004 and 6% for the period from September 1, 2003 to December 31, 2003. The Bank’s deferred compensation obligation of $722 thousand and $113 thousand at December 31, 2004 and 2003, respectively, is included in “interest payable and other liabilities.” The Bank also established a Split Dollar Plan and a Survivor Income Plan in 2003 for officers designated by the Board of Directors. Death benefits are provided under the specific terms of these Annual Report - 32 plans. The Bank has purchased life insurance policies on the designated officers in connection with these plans. The expense recognized under this plan totaled $2 thousand and $23 thousand for the years ended December 31, 2004 and 2003, respectively. The Bank's 401(k) Plan commenced in May 1990 and is available to all employees. Under the Plan employees can defer up to 50% of their base pay, up to the maximum amount allowed by the Internal Revenue Code. The Bank will match 50% of each participant's contribution up to a maximum match of $4,000 annually. Employer contributions totaled $306 thousand, $267 thousand and $227 thousand for the years ended December 31, 2004, 2003 and 2002, respectively. In 1995 the Plan was amended to include an employee stock ownership component and was renamed the Bank of Marin Employee Stock Ownership and Savings Plan. Under the terms of the Plan, as amended, a portion of the Bank's profits, as determined by the Board of Directors, is contributed to the Plan each year either in common stock or in cash for the purchase of Bank of Marin stock. For the years ended December 31, 2004, 2003 and 2002 the Bank contributed $754 thousand, $653 thousand and $652 thousand, respectively. In December 2003 the Plan's trustees arranged for a $1,000 thousand 26-month revolving line of credit at prime plus 1/4% from an unaffiliated community bank. At December 31, 2004 the balance on the line was $0. Contributions to the Plan for both the matching contribution and for the purchase of Bank of Marin stock are included in "salaries and benefits." Employer contributions vest at a rate of 20% per year over a five-year period. Note 10: Income Taxes The current and deferred components of the income tax provision for each of the three years ended December 31, 2004 are as follows: In thousands Current tax provision Federal State Total current Deferred tax( benefit)/liability Federal State Total deferred Total income tax provision 2004 2003 2002 $3,553 1,444 4,997 619 192 811 $5,808 $3,175 1,235 4,410 145 85 230 $4,640 $ 2,866 1,137 4,003 (96) (10) (106) $3,897 Income taxes recorded directly to comprehensive income are not included above. These income tax benefits relating to changes in the unrealized gains and losses on available for sale investment securities amounted to $358 thousand, $215 thousand and $188 thousand in 2004, 2003 and 2002, respectively. The following table shows the tax effect of the Bank's cumulative temporary differences as of December 31: (In thousands) Deferred tax assets: Allowance for loan losses Depreciation State franchise tax Deferred compensation Net unrealized loss on securities available for sale Deferred tax liabilities: Net unrealized gain on securities available for sale Depreciation Loan origination costs Net deferred tax asset 2004 2003 $2,895 304 123 423 174 3,919 --- --- (179) (179) $3,740 $2,310 --- 481 148 --- 2,939 (180) (184) --- (364) $2,575 Annual Report - 33 Based upon the level of historical taxable income and projections for further taxable income over the periods during which the deferred tax assets are deductible, management believes it is more likely than not the Bank will realize the benefit of the deferred tax assets. The effective tax rate of the Bank for 2004, 2003 and 2002 differs from the current Federal statutory income tax rate as follows: Federal statutory income tax rate Increase (decrease) due to: California franchise tax, net of federal tax benefit Tax exempt interest on municipal securities Other 2004 35.0% 6.9 (2.3) (1.7) 37.9% 2003 34.0% 7.2 (2.8) (0.1) 38.3% 2002 34.0% 7.3 (3.3) 0.4 38.4% Note 11: Commitments and Contingencies The Bank rents certain premises and equipment under long-term non-cancellable operating leases expiring at various dates through the year 2019. At December 31, 2004 the approximate minimum future commitments payable under non-cancellable contracts for leased premises are as follows: (In thousands) Operating leases 2005 $1,303 2006 $980 2007 $874 2008 $874 2009 $757 Thereafter $2,291 Total $7,079 Rent expense included in “occupancy” totaled $1,344 thousand, $1,178 thousand and $1,134 thousand in 2004, 2003 and 2002, respectively. The Bank leases one branch facility from a current member of the Bank’s Board of Directors at current market prices. Rental payment to the Director totaled $120 thousand, $116 thousand and $113 thousand for the years ended December 31, 2004, 2003 and 2002, respectively. The Bank is party to legal actions which arise from time to time as part of the normal course of its business. The Bank believes, after consultation with legal counsel, that it has meritorious defenses in these actions, and that the liability, if any, will not have a material adverse effect on the financial position, results of operations, or cash flows of the Bank. Note 12: Fair Value of Financial Instruments The carrying amounts and fair values of the Bank's financial instruments at December 31, 2004 and 2003 follows: (In thousands) Financial assets Cash and cash equivalents Investment securities Loans, net Accrued interest receivable Financial liabilities Deposits Federal funds purchased Subordinated debenture Accrued interest payable 2004 2003 Carrying Amounts $29,499 111,983 570,847 3,312 645,079 17,800 5,000 307 Fair Value $ 29,499 112,396 574,016 3,312 645,109 17,800 5,000 307 Carrying Amounts $ 52,926 122,726 445,423 2,960 584,116 --- --- 322 Fair Value $ 52,926 124,276 452,490 2,960 584,970 --- --- 322 The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents - Cash and cash equivalents are valued at their carrying amounts because of the short-term nature of these instruments. Investment Securities - Investment securities are valued at the quoted market prices. See Note 2 for further analysis. Loans - Loans with variable interest rates are valued at the current carrying value, because these loans are regularly adjusted to market rates. The fair value of fixed rate loans with remaining maturities in excess of one year is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities. Annual Report - 34 Accrued Interest Receivable and Payable - The accrued interest receivable and payable balance approximates its fair value. Deposits - The fair value of non-interest bearing deposits, interest bearing transaction accounts and savings accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using current rates offered for deposits of similar remaining maturities. Borrowings - The balance represents its fair value due to the short-term nature of these borrowings and the long-term borrowing has a variable interest rate. Commitments - The fair value of commitments is not material. Note 13: Stockholders’ Equity On April 15, 2004, the Board of Directors declared a 3-for-2 stock split contingent upon approval of an increase in the number of authorized common shares by the shareholders and the California Department of Financial Institutions (“CDFI”). Shareholders approved the increase to 15 million common shares at their May 4, 2004 Annual Meeting and subsequently the CDFI approved that amendment to the Articles of Incorporation. The stock split was payable on May 24, 2004 to shareholders of record on May 19, 2004. Additionally, the Board declared a one-time special cash dividend of $.40 per post-split share payable on June 1, 2004 to shareholders of record on May 27, 2004, which was also subject to the approvals just noted. On April 10, 2003 and April 11, 2002, the Board of Directors declared 5% stock dividends. Cash was paid in lieu of issuing fractional shares. Earnings per share amounts and information with respect to stock options have been restated for all years presented to reflect the stock dividends and stock split. The Bank has stock option plans for full-time, salaried officers and employees who have substantial responsibility for the successful operation of the Bank. Terms of the plans provide for the issuance of up to 674,606 shares of common stock for these officers and employees. Options are issued at the fair market value of the stock at the date of grant. Options expire ten years from the grant date, and vest over a four year period. Terms of the plans also provide for the issuance of up to 115,473 shares for non-employee directors. These options expire seven years from the grant date, and vest over a four year period. A summary of the status of the Bank's stock option plans at December 31, 2004, 2003 and 2002 and changes for the years then ended is presented in the following table. The 2003 and 2002 information has been restated to reflect the 3-for-2 stock split that occurred in 2004. Outstanding at beg. of year Granted Exercised Cancelled/forfeited Outstanding at end of year Shares 835,880 100,279 (168,015) (15,955) 752,189 2004 Weighted Avg. Exercise Price $13.24 $29.85 $11.16 $19.98 $15.78 2003 2002 Weighted Avg. Shares Exercise Price 849,941 78,395 (74,844) (17,612) 835,880 Shares 777,152 124,596 (43,857) (7,950) 849,941 $12.37 $20.06 $10.11 $14.57 $13.24 Weighted Avg. Exercise Price $11.38 $16.53 $6.48 $14.14 $12.37 Exercisable at end of year 562,883 $13.63 593,538 $12.28 521,220 $11.51 A summary of the options outstanding and exercisable by price range as of December 31, 2004 is presented in the following table. Range of Exercise Prices $0.00 - $5.00 $5.01 - $10.00 $10.01 - $15.00 $15.01 - $20.00 $20.01 - $25.00 $25.01 - $30.00 $30.01 - $35.00 $35.01 - $40.00 Options Outstanding Options Exercisable Outstanding Weighted Avg. Remaining Contractual Life 8,355 24,520 454,071 143,099 27,266 57,678 31,200 6,000 752,189 0.9 1.8 4.4 7.1 7.2 9.2 9.4 9.9 5.5 Weighted Avg. Exercise Price $4.61 $6.24 $12.70 $17.28 $22.06 $28.29 $31.51 $36.84 $15.78 Weighted Avg. Exercisable Exercise Price $4.61 $6.24 $12.66 $17.11 $22.03 $28.29 $31.51 $36.84 $13.63 8,355 24,520 425,033 74,194 11,446 11,535 6,600 1,200 562,883 Annual Report - 35 Under California state banking laws, payment of dividends is restricted to the lesser of retained earnings or the amount of undistributed net profits from the three most recent fiscal years. Under this restriction, the balance of retained earnings equalling approximately $21,409 thousand was available for payment of dividends as of December 31, 2004. Note 14: Regulatory Matters The Bank is subject to various regulatory capital requirements administered by the federal and California banking agencies. The Federal Deposit Insurance Corporation (FDIC) has adopted risk- based capital regulations, which assign risk weightings to bank assets and “off-balance sheet” items (such as loan commitments). Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by the FDIC that, if undertaken, could have a material effect on the Bank’s financial statements. The regulations require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2004 and 2003, that the Bank met all capital adequacy requirements to which it is subject. As of December 31, 2004, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and ratios as of December 31, 2004 and 2003 are presented in the table. (In thousands) As of December 31, 2004 Total Capital (to risk-weighted assets) Tier 1 Capital (to risk-weighted assets) Tier 1 Capital (to average assets) As of December 31, 2003 Total Capital (to risk-weighted assets) Tier 1 Capital (to risk-weighted assets) Tier 1 Capital (to average assets) Actual Amount Ratio For Capital Adequacy Purposes Amount Ratio To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio $77,328 11.37% $65,849 9.69% $65,849 8.98% >$54,388 >8.0% >$27,194 >4.0% >$29,332 >4.0% >$67,986 >10.0% >$40,791 > 6.0% >$36,665 > 5.0% $61,164 10.92% $55,322 9.88% $55,322 8.80% >$44,795 >8.0% >$22,398 >4.0% >$23,263 >4.0% >$55,994 >10.0% >$33,596 > 6.0% >$29,079 > 5.0% Note 15: Financial Instruments with Off-Balance Sheet Risk The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Bank is exposed to credit loss, in the event of nonperformance by the borrower, in the contract amount of the commitment. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments and evaluates each customer’s creditworthiness on a case- by-case basis. The amount of collateral obtained if deemed necessary by the Bank is based on management’s credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and real property. The contract amount of loan commitments not reflected on the statement of condition was $184,598 thousand at December 31, 2004 at rates ranging from 3.04% to 18%. The Bank has set aside an allowance in the amount of $369 thousand for these commitments, which is recorded in “interest payable and other liabilities.” Approximately 62% of the commitments expire in 2005 with approximately 38% expiring between 2006 and 2015. Annual Report - 36 SELECTED FINANCIAL DATA (in thousands except per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31 Total assets Total loans Total deposits Total stockholders’ equity Equity-to-assets ratio For year ended December 31 Net interest income Provision for possible loan losses Non-interest income Non-interest expense Net income Net income per share (diluted)* Dividend payout ratio 2000 $ 379,096 264,948 341,711 34,352 9.1% 2000 $ 19,271 986 1,638 12,675 4,523 1.05 0% 2001 $ 455,417 326,249 411,818 40,601 8.9% 2001 $ 21,456 619 1,873 14,428 5,148 1.17 0% 2002 $ 539,025 410,155 486,029 47,117 8.7% 2002 $ 25,522 577 2,318 17,125 6,242 1.37 0% 2003 $ 642,607 450,881 584,116 55,577 8.6% 2003 $ 27,656 686 2,960 17,817 7,473 1.59 0% 2004 $ 737,094 576,957 645,079 65,608 8.9% 2004 $ 32,237 934 3,643 19,620 9,518 1.94 19.1% 03/04 % change 14.7% 28.0% 10.4% 18.0% 03/04 % change 16.6% 36.2% 23.1% 10.1% 27.4% 22.0% . 1 7 3 7 $ . 6 2 4 6 $ . 0 9 3 5 $ . 4 5 5 4 $ . 1 9 7 3 $ % 2 2 1 . % 4 2 1 . % 6 2 1 . % 8 2 1 . % 8 3 1 . % 4 2 4 1 . % 9 5 3 1 . % 2 1 4 1 . % 6 4 4 1 . % 4 6 5 1 . 00 01 02 03 04 00 01 02 03 04 00 01 02 03 04 Total Assets (in millions) Return on Assets Return on Equity 4 9 1 $ . . 9 5 1 $ 7 3 1 $ . . 7 1 1 $ 5 0 1 $ . . 3 2 4 1 $ . 4 5 2 1 $ . 5 8 0 1 $ . 8 4 9 $ . 3 1 8 $ 00 01 02 03 04 00 01 02 03 04 Total Assets (in millions) Net Income Per Share (diluted)* Book Value Per Share* *Restated for stock dividends declared April 2000, 2001, 2002, 2003 and a 3-for-2 stock split declared April 2004. DIVIDEND INFORMATION, STOCK PRICE AND MARKETPLACE DESIGNATION On April 15, 2004 the Board of Directors declared a 3-for-2 stock split payable May 24, 2004 to shareholders of record on May 19, 2004. Additionally, the Board declared a one-time special cash dividend of $0.40 per post-split share payable on June 1, 2004 to shareholders of record on May 27, 2004. During 2004 there were 1,999 trades at prices ranging from a high of $40.70 to a low of $26.57. In 2003 there were 919 trades at prices ranging from a high of $33.49 to a low of $17.79. Bank of Marin common stock trades on the NASDAQ SmallCap Market under the symbol BMRC. There were 792 holders of record of the Bank’s common stock as of February 1, 2005. Annual Report - 37 

Continue reading text version or see original annual report in PDF format above