Bank of N.T. Butterfield & Son Ltd
Annual Report 2007

Plain-text annual report

One hundred and fifty 00 100 ANNUAL REPORT 2007 1 Who we are. Butterfield Bank Group is a diversified, international financial services company. We were established in Bermuda in 1858, where today we are the largest independent bank. In addition to Bermuda, we operate in nine international financial centres. We have total assets of $11.9 billion, client assets under management of approximately $12 billion and over $145.7 billion of client assets under administration. We employ 1,850 people around the world. Butterfield Bank is a publicly traded corporation with a primary share listing on the Bermuda Stock Exchange and a secondary listing on the Cayman Islands Stock Exchange. 1904 3 What we do. We offer a full range of community banking services in Bermuda, Barbados and the Cayman Islands, encompassing retail and corporate banking and treasury activities. In the wealth management area, we provide private banking, asset management and personal trust services from Bermuda, The Bahamas, the Cayman Islands, Guernsey, Hong Kong, Malta, Switzerland and the United Kingdom. We also provide services to corporate and institutional clients from Bermuda, The Bahamas, Canada, the Cayman Islands and Guernsey, which include investment and pension fund administration, asset management, custody and corporate trust services. 1960 7 9 For Shareholders. ...provide consistent and superior returns to our shareholders... 1968 Non-Bermudian 29.7% Bermudian 70.3% 1 – 999 Shares 0.7% 1,000 – 4,999 Shares 3.3% 5,000 – 9,999 Shares 3.1% 10,000 – 49,000 Shares 13.3% 50,000 – 99,999 Shares 11.7% 100,000 and above Shares 67.9% Share Ownership: Bermudian / Non-Bermudian Distribution of Shares by Number Held Non-Bermudian 29.7% Bermudian 70.3% 1 – 999 Shares 0.7% 1,000 – 4,999 Shares 3.3% 5,000 – 9,999 Shares 3.1% 10,000 – 49,000 Shares 13.3% 50,000 – 99,999 Shares 11.7% 100,000 and above Shares 67.9% Share Ownership: Bermudian / Non-Bermudian Distribution of Shares by Number Held Net Income ($ millions) Earnings Per Share ($) Diluted Return on Equity (%) Return on Assets (%) 146.0 134.1 109.4 90.5 70.8 1.06 0.85 1.68 1.53 1.28 21.2 17.9 24.6 25.2 23.6 1.2 1.3 1.2 1.1 1.0 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 Annual Dividend Declared ($) Market Value & Net Book Value per Share ($) 0.52 0.56 0.48 0.60 0.64 2003 2004 2005 2006 2007 20.00 15.00 10.00 5.00 0 11.02 4.64 11.16 5.19 14.12 5.90 18.75 18.25 6.46 7.44 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Market Value Book Value 21 For Employees. ...offer security and opportunities to our employees... 1981 25 For Communities. ...making a valuable contribution to the communities in which we operate... 1966 29 For Customers. …customer-focused, efficient and ethical delivery of banking and other selected financial services… 1983 35 For Generations. 1986 41 Managements’ Discussion & Analysis of Results of Operations & Financial Condition Results of Operations Shareholder Value Share Purchase Activity Performance Indicators Jurisdiction Overviews Bermuda The Bahamas Barbados Canada Cayman Islands Guernsey Hong Kong Malta Switzerland United Kingdom 43 44 45 45 46 46 47 48 48 49 50 50 51 51 52 1989 53 55 55 56 56 57 58 59 60 61 62 63 64 65 66 67 Financials. Financial Overview Income Expenses Balance Sheet Taxes Capital Selected Quarterly Results of Operations Financial Summary Management’s Financial Reporting Responsibility Independent Auditors’ Report to the Shareholders Consolidated Balance Sheet Consolidated Statement of Income Consolidated Statement of Changes in Shareholders’ Equity and Comprehensive Income Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements 1965 55 55 Financial Overview Income Total revenue for the Group after provisions was $470.0 million for the year ended 31 December 2007, up $54.9 million, or 13.2%, from $415.1 million for the same period a year ago. Net interest income before provisions for credit losses increased by 15.8% to $252.6 million. The increase reflects growth in average interest earning assets, up 14.9% to $11.5 billion, and the Group’s continually successful asset/liability management strategies. As a result, the net interest margin widened by 0.03% to 2.18%. We continue to be appropriately reserved with total provisions of $26.9 million. Non-performing loans totalled $36.8 million as at 31 December 2007, up from $29.1 million a year ago, the increase reflecting loan growth in the commercial loan and mortgage portfolios. They represent 0.9% of the total loan portfolio, compared to 0.8% a year ago. Provisions in respect of credit losses charged to income were $2.0 million, compared to $3.0 million last year. Non-interest income grew by 13.4% to $219.7 million, reflecting business growth, notably from foreign exchange (+17.1%), trust and custody (+16.7%), investment & pension fund administration (+14.2%), and asset management (+10.9%). An unrealised gain of $3.2 million was recorded in respect of trading securities, principally mutual funds managed by the Bank, and there was a $0.2 million gain on sale of an affiliate in respect of a Bermuda based company. Other (losses)/gains netted to a loss of $3.7 million, reflecting gains made from the sale of equity positions in a credit card processing company ($3.4 million) and a fund administration company ($1.0 million), and the sale and lease-back of premises in Cayman ($0.6 million) offset by losses from the write down of an investment in a Bermuda based financial services company ($2.4 million) and an unrealised loss of $6.3 million on a credit derivative transaction entered into with a related party. Changes in Net Interest Income (In $ thousands) For the year ended 31 December 2007 2006 Average balance Interest Rate Average balance Interest Rate Assets Cash and deposits with banks Investments Loans Interest earning assets Other assets Total assets Liabilities Deposits Subordinated capital Interest bearing liabilities 3,005,511 4,569,566 3,922,337 11,497,414 124,609 253,831 282,711 661,151 4.15% 5.55% 7.21% 5.75% 3,308,586 3,317,309 3,384,718 10,010,613 129,908 163,348 234,772 528,028 473,076 11,970,490 - 661,151 - 5.52% 389,083 10,399,696 - 528,028 9,731,178 281,750 10,012,928 395,681 14,853 410,534 4.07% 5.27% 4.10% 8,415,621 278,963 8,694,584 298,254 14,553 312,807 Non-interest bearing current accounts Other liabilities Total liabilities Shareholders’ equity Total liabilities and shareholders’ equity Spread Net interest margin 1,114,722 262,960 11,390,610 579,880 11,970,490 Note: Underlying assets and liabilities are comprised of various currencies. - - - - 410,534 3.60% 964,496 195,115 9,854,195 - - 312,807 545,501 10,399,696 1.65% 2.18% 3.93% 4.92% 6.94% 5.27% - 5.08% 3.54% 5.22% 3.60% - - 3.17% 1.67% 2.15% Annual Report 2007 Expenses The efficiency ratio was 65.7%, compared to 64.8% in 2006, reflecting that growth in the Group’s operating expenses, up 14.4%, was higher than the percentage increase for operating income, up 13.2% year on year. The increase in the operating expense primarily reflected the expanding size of the Group, with salaries and employee benefits up 13.7% to $184.8 million, accounting for 58.3% of total Group operating expenses, compared with 58.6% last year. There was a significant increase in costs relating to professional and outside services, up 48.0% to $22.3 million, reflecting a number of technology, risk management and client services initiatives. Property costs increased year on year by 24.6%, principally reflecting increased depreciation relating to the refurbishment of and improvements made to the Bank’s Rosebank operations centre in Bermuda. As at 31 December 2007 there were 843 employees in Bermuda, down from 845 a year ago. Overseas, the total headcount increased by 122 to 1,007 primarily due to continued growth in Cayman (+23), Guernsey (+14), the acquisition of the Bentley Reid Group (+44) and the establishment of a fund administration operations centre in Halifax, Nova Scotia (+32). Balance Sheet Total assets increased by 7.0% to $11.9 billion, up from $11.1 billion a year ago. This increase reflects the rise in the customer deposit base, up year on year by $0.7 billion, or 7.1%, to $10.4 billion, which included an 8.2% increase in non-interest bearing deposits to $1.0 billion. The increase in the customer deposit base was primarily employed in funding growth in our loan portfolio, up 9.7% to $4.1 billion, and our held to maturity investment portfolio, up year on year by 35.7% to $3.8 billion. Cash and deposits with banks reduced year on year by 20.1% to $2.5 billion, reflecting increased investments in AAA/AA rated floating rate note securities. Available for sale securities; principally bank certificates of deposit, reduced slightly by 3.2% to $0.9 billion whilst trading investments, at $0.1 billion, were at the same level as a year ago. There was no other than temporary impairment recorded in respect of held to maturity investments and the fair value of the portfolio, at $3.6 billion, represented 95.7% of amortised cost. The Balance sheet remains highly liquid with a loans to customer deposits ratio of 39.5% and loans to total assets ratio of 34.6%. Marketing 2.2% Amortisation of intangible assets 2.1% Non-income taxes 4.4% Professional and outside services 6.9% Property 9.5% Technology and Communications 8.9% Other Income 2.0% Net Interest Income 53.3% Distribution of 2007 Total Expense Distribution of 2007 Expenses by Location Other expenses 6.8% Income Taxes 2.2% Salaries and other employee benefits 57.0% Barbados 3.6% Cayman 17.2% Guernsey 14.4% Switzerland 0.4% The Bahamas 2.7% UK 8.6% Distribution of 2007 Total Revenue Distribution of 2007 Total Revenue by Location Trust & Custody 8.1% Asset Management 8.1% Investment & Pension Fund Administration 11.1% The Bahamas 2.5% Barbados 2.5% UK 6.7% Guernsey 13.4% Banking Services 9.2% Cayman 23.9% Foreign Exchange Revenue 8.2% Bermuda 53.1% Switzerland 0.0% Bermuda 51.0% 57 The Bank has previously viewed the mortgage-backed and other asset-backed securities markets as good sources of yield, liquidity and transparency of information on issuers and underlying collateral. Through the ALCO Committee, the Bank monitors its investments with exposure to the US residential market, as well as exposures to other residential and commercial mortgage-backed securities and other forms of asset-backed securities through timely reporting, the use of industry standard models and sources of information and specialists within the Bank to interpret the results of stress testing. The Bank’s policy is to invest in senior tranches of investment grade asset-backed securities. As at 31 December 2007 investments in US residential collateralised mortgage obligations (CMO’s), had a carrying value (amortised cost) of $478.7 million with a fair value of $371.2 million and represented 12.8% of total held to maturity investments. Total holdings of CMO’s as at 31 December 2007, including residential CMO’s, were $828.5 million with a fair value of $713.2 million and represented 22.1% of total held to maturity investments. Investment Portfolio by Long Term Debt Rating Other asset-backed securities had a carrying value (amortised cost) of $632.9 million with a fair value of $593.8 million and represented 16.9% of held to maturity investments. Other 1.2% In light of the market instability and complexity in fair value and other-than-temporary impairment determinations, a large degree of judgement is involved in the assessments. The Bank continues to have exposure to these markets and as such there exists a level of uncertainty as to the impact of future events in these markets and declines in the US economy, that may affect management’s views on other-than-temporary impairment, ultimately resulting in possible write-downs to fair value. However, based on current economic conditions, management believes that the Bank will collect all amounts due according to the contractual terms of the securities. By rating category, holdings of US residential mortgage-backed securities were as follows: AAA: 60.1%; AA: 33.1%; BBB: 2.8%. AA 40.8% A 14.6% BBB 1.0% Taxes AAA 42.4% For the period under review the corporation tax of the Group was $7.0 million compared to $3.8 million for the same period a year ago, reflecting increased taxable earnings in Guernsey and the UK. Corporation taxes of $4.9 million in Guernsey, $2.0 million in the UK and $0.1 million in Barbados were incurred for the year. As a result, the Group’s effective corporation tax rate increased from 2.8% a year ago to 4.6%. Non-income taxes of $14.2 million were also paid across the Group, up 8.5% from $13.0 million the previous year, primarily reflecting an increase in employee related taxes. Other 1.2% BBB 1.0% A 14.6% AAA 42.4% Investment Portfolio by Long Term Debt Rating Lending by Location Barbados 3.6% UK 14.7% The Bahamas 1.0% AA 40.8% Guernsey 11.2% Bermuda 61.0% Cayman 8.5% Group Loans by Type Lending by Location Other Consumer Loans 10.8% Commercial and Industrial 23.8% Barbados 3.6% UK 14.7% The Bahamas 1.0% Residential Mortgages 33.4% Commercial Real Estate 23.8% Guernsey 11.2% Bermuda 61.0% Credit Card 1.8% Financial Institutions and Government 6.4% Cayman 8.5% Annual Report 2007 Capital The Group continues to maintain a strong capital base that ensures stability and allows us to take advantage of opportunities for growth. At 31 December 2007 the risk weighted total capital ratio was 13.0%, compared to the 10.0% minimum requirement of the Bermuda Monetary Authority (BMA). Of the total, the Tier 1 ratio was 8.6%, compared to a 5% minimum requirement. Shareholders’ equity increased by $79.8 million, or 14.5% over a year ago, reflecting the increase in retained earnings offset by share buy-backs. Weighted risk assets rose year on year by 16.0% to $6.3 billion, primarily due to growth in loans and investments. The loan to the Stock Option Trust of $41.6 million is in respect of potential obligations under the Bank’s Stock Option Plan and is deducted from shareholders’ equity as treasury stock. The increase in the loan from $37.0 million the previous year reflects the purchase of 597,818 Bank shares by the Stock Option Trust at a cost of $22.7 million, offset by repayments from cash received on the exercise of stock options by employees. During the period under review, the Bank issued 74,522 new shares and transferred 232,392 treasury shares under the Dividend Re-investment Programme, which represents a cash savings of $12.5 million, or 23.0% of the total dividend paid. As a result of the stock split in August 2007, 59,637,346 new shares were issued. Under the Share Buy-Back Plan, the Bank purchased and cancelled 125,603 shares, at a cost of $7.4 million and purchased and held as treasury stock, 967,119 shares at a cost of $38.1 million. Capital Composition (In $ thousands) For the year ended 31 December 2007 2006 Tier 1 capital Tier 2 capital Deductions * Total capital 547,801 296,922 (21,413 ) 823,310 488,131 266,185 (18,722 ) 735,594 Weighted Risk Assets (In $ thousands) Cash and inter-bank placements Investments Loans Other assets Off-balance sheet items Total weighted risk assets Capital Ratios (%) Tier 1 Tier 2 Deductions * Total * Deductions from capital comprise investments in affiliates. 487,158 1,795,446 3,169,395 360,335 533,420 6,345,754 623,260 1,091,422 2,867,821 285,450 600,715 5,468,668 8.6% 4.7% (0.3% ) 13.0% 8.9% 4.9% (0.3% ) 13.5% 59 Financial Overview Selected Quarterly Results of Operations (Unaudited, in $ thousands except per share data and ratios) Quarter ended 31 December 30 September 30 June 31 March 2007 Net interest income after provision for credit losses Total fees and other income Total revenue Total non-interest expense Net income for the quarter Earnings per share ($) * Basic Diluted Return on shareholders’ equity (%) 65,924 56,121 122,045 87,289 34,756 0.41 0.40 22.9 63,786 57,238 121,024 81,378 39,646 0.47 0.46 27.1 61,649 54,400 116,049 80,140 35,909 0.42 0.41 25.1 59,258 51,587 110,845 75,161 35,684 0.42 0.41 25.8 Quarter ended 31 December 30 September 30 June 31 March 2006 Net interest income after provision for credit losses Total fees and other income Total revenue Total non-interest expense Net income for the quarter Earnings per share ($) * Basic Diluted Return on shareholders’ equity (%) 57,688 49,581 107,269 74,786 32,483 0.38 0.37 22.7 55,058 51,018 106,076 71,424 34,652 0.41 0.39 24.5 53,573 51,078 104,651 70,794 33,857 0.40 0.39 25.0 48,902 48,154 97,056 63,965 33,091 0.39 0.38 26.3 * All prior period per share data have been restated to reflect the three for one stock split in August 2007 and the one for ten stock dividend in August 2006. Annual Report 2007 Financial Summary (In $ thousands, except per share data) Year ended 31 December 2007 2006 2005 2004 2003 At year end Cash and deposits with banks Investments Loans, net of allowance for credit losses Premises, equipment and computer software Total assets Total deposits Subordinated capital and senior debt Shareholders’ equity For the year Net interest income after provision for credit losses Fee and other income Salaries and other employee benefits Other non-interest expenses Net income Dividends paid Financial ratios Return on assets Return on shareholders’ equity Dividend payout ratio Total capital funds to total assets ratio Risk weighted capital ratio Efficiency ratio Per share ($) * Net income (diluted) Dividends declared Net book value Number of employees Bermuda Overseas Total 2,517,012 4,744,989 4,124,764 215,379 11,910,920 10,747,971 284,191 629,330 250,617 219,346 184,751 139,217 145,995 54,366 1.2% 25.2% 37.2% 7.7% 13.0% 65.7% 1.68 0.64 7.44 843 1,007 1,850 3,151,191 3,786,793 3,760,745 171,326 11,132,802 10,042,832 280,168 549,553 215,221 199,831 162,504 118,465 134,083 46,496 1.3% 24.6% 34.7% 7.5% 13.5% 64.8% 1.53 0.60 6.46 845 885 1,730 2,849,920 2,916,399 3,085,594 141,708 9,197,566 8,240,109 278,679 495,226 182,174 172,955 144,331 101,447 109,351 38,504 1.2% 23.6% 35.2% 8.4% 13.1% 66.4% 1.28 0.56 5.90 789 808 1,597 2,396,724 3,266,400 2,645,331 126,031 8,630,383 7,907,450 142,333 428,030 148,075 163,090 127,459 93,240 90,466 32,217 1.1% 21.2% 35.6% 6.6% 10.7% 69.1% 1.06 0.52 5.19 786 766 1,552 Shareholder data Number of shareholders Number of common shares (in thousands) * 4,201 84,553 3,915 28,375 3,878 25,429 3,778 22,745 2,912,383 2,638,253 1,954,716 99,979 7,733,806 7,122,577 122,871 382,095 115,066 118,985 100,104 63,109 70,838 26,809 1.0% 17.9% 37.8% 6.5% 13.0% 67.7% 0.85 0.48 4.64 734 647 1,381 3,581 20,643 * Actual outstanding; excludes common shares held as treasury stock and common shares held by the Bank’s Stock Option Trust. All prior period per share data have been restated to reflect the three for one stock split in August 2007. All prior period per share data, with the exception of dividends, have been restated to reflect the one for ten stock dividends in August 2006, 2005, 2004 and 2003. The number of shares in 2007 increased primarily due to the three for one stock split. The number of shares in 2006, 2005 and 2004 increased primarily due to the issue of the stock dividends. 61 Management’s Financial Reporting Responsibility The Management of The Bank of N.T. Butterfield & Son Limited is responsible for the preparation of the consolidated financial statements contained in this Report, which covers all of the interests of the Bank. Management has fully disclosed its income, assets, liabilities and off balance sheet commitments. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, where appropriate, are based on the best estimates and judgement of Management. Management has established and maintains a system of financial reporting and internal controls to provide reasonable assurance that transactions are properly authorised and recorded, assets are protected against unauthorised use or disposition and liabilities are recognised. These procedures include the careful selection and training of qualified staff, the establishment of organisational structures providing an appropriate and well-defined division of responsibilities, and the communication of policies and standards of business conduct throughout the Bank. The system of internal controls is further supported by a professional staff of internal auditors who conduct periodic inspections of all aspects of the Bank’s operations. In addition, the Bank’s Head of Group Internal Audit has full and free access to the Audit & Compliance Committee of the Board of Directors. The Audit & Compliance Committee, composed entirely of directors who are not employees of the Bank, reviews the financial statements before such statements are approved by the Board of Directors and submitted to the Bank’s shareholders. The Committee meets and consults regularly with Management, the internal auditors and our external independent auditors to review the scope and results of their work. Under the provisions of the Bermuda Monetary Authority Act 1969, the Bermuda Monetary Authority is charged with the supervision of the Bank. Such supervision is in line with international practices and combines a comprehensive system of statistical returns, providing a detailed breakdown of the balance sheet and statement of income accounts of the Bank, and regular meetings with the senior management of the Bank. Such regular reviews are intended to satisfy the Authority that the safety and interests of the depositors, creditors and shareholders of the Bank are being duly observed and that the Bank is in a sound financial condition. The accounting firm of PricewaterhouseCoopers, the shareholders’ independent auditors, has examined the consolidated financial statements of the Bank in accordance with auditing standards generally accepted in the United States of America and have expressed their opinion in their report to the shareholders. The auditors have unrestricted access to, and meet periodically with, the Audit & Compliance Committee to review their findings regarding internal controls over the financial reporting process, auditing matters and financial reporting issues. Management has made available to PricewaterhouseCoopers all of the Bank’s financial records and related data as well as the minutes of shareholders’ and directors’ meetings. Alan R. Thompson President & Chief Executive Officer 29 February 2008 Richard J. Ferrett Executive Vice President & Chief Financial Officer 29 February 2008 Annual Report 2007 Independent Auditors’ Report to the Shareholders 63 Consolidated Balance Sheet As at 31 December (In $ thousands) 2007 2006 Assets Cash and demand deposits with banks Term deposits with banks Total cash and deposits with banks Investments Trading Available for sale Held to maturity Total investments Loans, net of allowance for credit losses Premises, equipment and computer software Accrued interest Goodwill Other intangible assets Other assets Total assets Liabilities Deposits Non-interest bearing Interest bearing Customers Banks Total deposits Employee future benefits Accrued interest Dividend payable Other liabilities Total other liabilities Subordinated capital Total liabilities Shareholders’ equity Common share capital ($1.00 par: Authorised shares 100,000,000) Additional paid in capital Retained earnings Less: treasury common stock Accumulated other comprehensive loss Total shareholders’ equity Total liabilities and shareholders’ equity The accompanying notes are an integral part of these consolidated financial statements. 267,261 2,249,751 2,517,012 58,534 932,238 3,754,217 4,744,989 4,124,764 215,379 68,597 25,260 81,230 133,689 11,910,920 1,042,062 9,399,517 306,392 10,747,971 98,063 34,774 14,081 102,510 249,428 284,191 11,281,590 89,456 455,114 167,607 (71,576 ) (11,271 ) 629,330 11,910,920 341,582 2,809,609 3,151,191 56,471 963,355 2,766,967 3,786,793 3,760,745 171,326 64,163 25,018 69,685 103,881 11,132,802 964,496 8,791,163 287,173 10,042,832 107,191 33,409 13,178 106,471 260,249 280,168 10,583,249 29,870 514,872 76,881 (37,039 ) (35,031 ) 549,553 11,132,802 Robert A. Mulderig Chairman of the Board Robert J. Stewart Vice Chairman Alan R. Thompson President & Chief Executive Officer Annual Report 2007 Consolidated Statement of Income For the year ended 31 December (In $ thousands, except per share data) 2007 2006 Non-interest income Investment and pension fund administration Banking Foreign exchange revenue Asset management Trust and custody Other non-interest income Total non-interest income Interest income Loans Investments Deposits with banks Total interest income Interest expense Deposits Subordinated capital Total interest expense Net interest income before provision for credit losses Provision for credit losses Net interest income after provision for credit losses Realised/unrealised gains on trading securities Gain on sale of affiliates Other (losses) gains Total revenue Non-interest expense Salaries and other employee benefits Property Technology and communications Professional and outside services Non-income taxes Marketing Amortisation of intangible assets Other expenses Total non-interest expense Net income before income taxes Income taxes Net income Earnings per share Basic Diluted Earnings per share comparative figures have been restated for the three for one stock split in August 2007. The accompanying notes are an integral part of these consolidated financial statements. 52,301 43,266 38,717 38,260 38,112 9,026 219,682 284,695 253,831 124,608 663,134 395,681 14,853 410,534 252,600 (1,983 ) 250,617 3,221 170 (3,727 ) 469,963 184,751 30,856 28,741 22,304 14,152 7,131 6,916 22,140 316,991 152,972 (6,977 ) 145,995 1.72 1.68 45,798 41,289 33,053 34,492 32,650 6,372 193,654 237,769 163,348 129,908 531,025 298,254 14,553 312,807 218,218 (2,997 ) 215,221 1,608 2,144 2,425 415,052 162,504 24,770 26,531 15,071 13,045 6,932 6,352 21,972 277,177 137,875 (3,792 ) 134,083 1.58 1.53 65 Consolidated Statement of Changes in Shareholders’ Equity and Comprehensive Income For the year ended 31 December (In $ thousands) Common share capital Authorised: 100,000,000 shares (2006: 100,000,000) of par value $1 each Issued Issued and outstanding at beginning of year (January 2007: 29,869,754 shares; January 2006: 26,947,915 shares) Dividend reinvestment (December 2007: 306,914 shares; December 2006: 263,435 shares) of which issued from treasury common stock (December 2007: 232,392 shares; December 2006: nil shares) Stock dividend (December 2007: nil shares; December 2006: 2,706,063 shares) Stock split (December 2007: 59,637,346 shares; December 2006: nil shares) Shares repurchased and cancelled (December 2007: 125,603 shares; December 2006: 47,659 shares) Issued and outstanding at end of year (December 2007: 89,456,019 shares; December 2006: 29,869,754 shares) Additional paid in capital Balance at beginning of year Dividend reinvestment of which related to treasury common stock Stock split Stock dividend Issued under directors’ and executive officers’ and employees’ stock option plans Common shares repurchased and cancelled Balance at end of year Retained earnings Appropriated - general reserve Unappropriated at beginning of year Net income for year Cash dividends declared Stock dividend Balance at end of year Accumulated other comprehensive loss Balance at beginning of year Net change in unrealised gains and losses on translation of net investment in foreign operations Net change in unrealised gains and losses on available for sale securities Net change in unrealised gains and losses on cash flow hedges Net change in employee future benefits Net change in minimum pension liability Balance at end of year Treasury common stock Balance at beginning of year (January 2007: 1,494,584 shares; January 2006: 1,519,203 shares) Net purchases Balance at end of year (December 2007: 4,903,324 shares; December 2006: 1,494,584 shares) Total shareholders’ equity Comprehensive income Net income Other comprehensive income (loss) Total comprehensive income The accompanying notes are an integral part of these consolidated financial statements. Annual Report 2007 2007 2006 29,870 26,948 307 (232 ) 264 - - 2,706 59,637 (126 ) - (48 ) 89,456 29,870 514,872 12,403 (8,197 ) (59,637 ) - 2,959 (7,286 ) 455,114 100,000 (23,119 ) 145,995 (55,269 ) - 167,607 (35,031 ) 542 (398 ) 38 23,578 - (11,271 ) (37,039 ) (34,537 ) (71,576 ) 341,647 14,804 - - 158,371 2,666 (2,616 ) 514,872 100,000 52,501 134,083 (48,626 ) (161,077 ) 76,881 (322 ) 5,465 (446 ) 1,134 (41,266 ) 404 (35,031 ) (25,548 ) (11,491 ) (37,039 ) 629,330 549,553 145,995 23,760 169,755 134,083 (34,709 ) 99,374 Consolidated Statement of Cash Flows For the year ended 31 December (In $ thousands) Cash flows from operating activities Net income Adjustments to reconcile net income to cash provided by operating activities Depreciation and amortisation Increase in carrying value of investments in affiliates Share-based compensation Gain on sale of affiliate Gain on sale of premises and equipment Gain on sale of private equity investments Provision for credit losses Increase in accrued interest receivable Increase in other assets Increase in accrued interest payable Increase (decrease) in other liabilities Net change in trading account securities Cash provided by operating activities Cash flows from investing activities Net decrease increase in term deposits with banks Net additions to premises, equipment and computer software Net increase in loans Held to maturity securities: proceeds from maturities Held to maturity securities: purchases Available for sale securities: proceeds from sale and maturities Available for sale securities: purchases Net proceeds on sale of private equity investment Net proceeds on sale of affiliate Purchase of subsidiary Cash used in investing activities Cash flows from financing activities Net increase in demand and term deposit liabilities Proceeds from dividend re-investment plan Common shares repurchased Treasury stock Cash dividends paid Cash provided by financing activities Effect of exchange rates on cash and demand deposits with banks Net (decrease) increase in cash and demand deposits with banks Cash and demand deposits with banks: beginning of period Cash and demand deposits with banks: end of period Supplemental disclosure of cash flow information Cash interest paid Cash income tax paid The accompanying notes are an integral part of these consolidated financial statements. 2007 2006 145,995 134,083 27,536 21,009 (1,051 ) (4,204) 2,959 2,328 (170 ) (635) (569 ) (1,509) (4,388 ) (1,501) 1,983 2,997 (4,069 ) (16,708) (15,608 ) (27,521) 1,114 12,724 3,273 (344 ) 120,719 86,758 207,477 157,005 (1,872 ) 155,133 573,681 (59,152 ) (348,491 ) 1,980,152 (2,981,357 ) 4,019,843 (3,964,763 ) 4,388 2,344 (28,353 ) (801,708 ) 664,323 12,478 (45,564 ) (4,582 ) (54,366 ) 572,289 21,486 (42,621 ) (575,187 ) 734,672 (1,240,278 ) 2,685,099 (3,030,445 ) 1,501 635 - (1,445,138 ) 1,470,924 15,066 (2,664 ) (11,491 ) (46,496 ) 1,425,339 (35 ) (794 ) (74,321 ) 186,884 341,582 267,261 154,698 341,582 411,082 5,428 300,956 2,741 67 Notes to Consolidated Financial Statements For the year ended 31 December 2007 (All amounts are expressed in thousands of Bermuda dollars unless otherwise stated) Note 1: Significant Accounting Policies (a) Basis of Presentation and Use of Estimates and Assumptions The accounting and financial reporting policies of The Bank of N.T. Butterfield & Son Limited (the Bank) and its subsidiaries conform to Generally Accepted Accounting Principles in the United States of America (GAAP). The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Such estimates, including the provision for credit losses, the fair value of financial instruments, the fair value of investments, litigation provisions, variable interest entities, pensions and post-retirement medical benefit plan benefits, the carrying value of goodwill and intangible assets require management to make subjective or complex judgments and are subject to change in the future as additional information becomes available or previously existing circumstances are modified. (b) Basis of Consolidation The Bank consolidates subsidiaries where it holds, directly or indirectly, more than 50% of the voting rights or where it exercises control. Entities where the Bank holds 20% to 50% of the voting rights and/or has the ability to exercise significant influence, other than investments in designated variable interest entities (VIEs), are accounted for under the equity method, and the pro rata share of their income (loss) is included in other income. The Bank consolidates entities deemed to be VIEs when the Bank is determined to be the primary beneficiary under the Financial Accounting Standards Board (FASB) interpretation No. 46 (Revised 2003) Consolidation of Variable Interest Entities (FIN 46R). (c) Foreign Currency Translation Assets, liabilities, revenues and expenses denominated in US dollars are translated to Bermuda dollars at par. Assets and liabilities arising from other foreign currency transactions are translated into Bermuda dollars at the rates of exchange prevailing at the balance sheet date. The resulting gains or losses are included in foreign exchange revenue in the Consolidated Statement of Income. The assets and liabilities of foreign currency based subsidiaries are translated at the rate of exchange prevailing on the balance sheet date while associated revenues and expenses are translated to Bermuda dollars at the average rates of exchange prevailing throughout the period. Unrealised translation gains or losses on investments in foreign currency based subsidiaries are recorded as a separate component of shareholders’ equity within accumulated other comprehensive income. Such gains and losses are recorded in the Consolidated Statement of Income only when realised. (d) Assets Held in Trust or Custody Securities and properties (other than cash and deposits held with the Bank and its subsidiaries) held in trust, custody, agency or fiduciary capacity for customers are not included in the Consolidated Balance Sheet because the Bank is not the beneficiary of these assets. (e) Investments Investments include debt and equity securities. Debt securities include bonds, notes, certificates of deposit, redeemable preferred stock, as well as certain loan or asset backed and structured securities subject to prepayment risk. Equity securities include common and non-redeemable preferred stocks. Debt securities classified as “held to maturity” represent securities that the Bank has both the ability and the intent to hold until maturity and are carried at amortised cost adjusted to recognise other than temporary impairment, except for money market mutual funds which are carried at market value, which approximates cost plus accrued and reinvested interest since acquisition. Debt securities and marketable equity securities classified as “available for sale” are carried at fair value, with unrealised gains and losses reported in other comprehensive income, with the exception of other than temporary impairments which are included in net income. Debt and equity securities classified as “trading” securities are carried at fair value, with the unrealised gains and losses included in the Consolidated Statement of Income as gains and losses on trading. Fair value is determined based on the quoted market price or independent pricing services when available, or if quoted market prices or independent pricing services are not available, discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. In respect of held to maturity or available for sale securities, declines in fair value that are determined to be other than temporary are charged to earnings. Accrual of income is suspended in respect of debt securities that are in default, or from which it is unlikely that future interest payments will be received as scheduled. Realised gains and losses on sales of investments are included in earnings on a specific identified cost basis. Venture capital investments are recorded at fair value with adjustments to fair value being recognised in investment income. In assessing fair value, management reviews meaningful third party transactions in the private market and the results of applying acceptable valuation methodologies to current and projected cash flows. In the absence of persuasive evidence to the contrary, management generally considers cost to be the best indicator of fair value. Due to the dynamic nature of assumptions used in establishing fair values, the values reflected in the consolidated financial statements may differ materially from the values that would be determined by negotiations held between parties in a sale transaction. Annual Report 2007 (f) Loans Loans are reported at the principal amount outstanding, net of allowance for credit losses, unearned income and net deferred loan fees. Interest income is recognised over the term of the loan using the interest method, or on a basis approximating a level rate of return over the term of the loan, except for loans classified as non-accrual. Non-accrual loans are those on which the accrual of interest is discontinued. Loans are placed on non-accrual status immediately if, in the opinion of management, full payment of principal or interest is in doubt or when principal or interest is 90 days past due, unless the loan is fully secured and any collection efforts are reasonably expected to result in repayment of all amounts due under the contractual terms of the loan. The entire balance of an account is contractually delinquent if the minimum payment of principal or interest is not received by the specified due date. Delinquency is reported on loans that are 30 days or more past due. Interest accrued but not collected at the date a loan is placed on non-accrual status is reversed against interest income. In addition, the amortisation of net deferred loan fees is suspended. Interest income on non-accrual loans is recognised only to the extent it is received in cash. However, where there is doubt regarding the ultimate collectivity of the loan principal, all cash thereafter received is applied to reduce the carrying value of the loan. Loans are restored to accrual status only when interest and principal payments are brought current and future payments are reasonably assured. Credit card loans that are contractually 180 days past due and consumer loans with an outstanding balance under $100,000 that are contractually 180 days past due are automatically written off. The Bank accounts for and discloses non-accrual commercial loans as impaired loans, and recognises their interest income as previously discussed for non-accrual loans. Accordingly, interest income on these loans is recognised after the entire recorded investment is recovered, and interest is actually received. In addition, the amortisation of net deferred loan fees is suspended. (g) Allowance for Credit Losses The Bank maintains an allowance for credit losses, which in management’s opinion is adequate to absorb all incurred credit related losses in its portfolio relating to on and off balance sheet lending portfolio. The allowance for credit losses consists of specific allowances and a general allowance, each of which is reviewed on a regular basis. The allowance for credit losses is included as a reduction of the related asset category. (h) Specific Allowances Specific allowances are determined on an item by item basis and reflect the associated estimated credit loss. The specific allowance for credit loss is computed as the difference between the recorded investment in the loan and present value of expected future cash flows from the loan. The effective rate of return on the loan is used for discounting the cash flows. However, when foreclosure of a collateral-dependent loan is probable, the Bank measures impairment based on the fair value of the collateral. The Bank considers estimated costs to sell, on a discounted basis, in the measurement of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan. If the measurement of an impaired loan is less than the recorded investment in the loan, then the Bank recognises impairment by creating a valuation allowance with a corresponding charge to bad debt expense. (i) General Allowance The allowance for credit losses attributed to the remaining portfolio is established through a process that estimates the probable loss inherent in the portfolio based upon various analyses. These analyses consider historical default rates and loss severities, internal risk ratings, and geographic, industry, and other environmental factors. Management also considers overall portfolio indicators including trends in internally risk rated exposures, cash-basis loans, historical and forecasted write-offs, and a review of industry, geographic and portfolio concentrations, including current developments within those segments. In addition, management considers the current business strategy and credit process, including limit setting and compliance, credit approvals, loan underwriting criteria and loan workout procedures. Each portfolio of smaller balance, homogeneous loans, including consumer mortgage, instalment, revolving credit, and most other consumer loans, is collectively evaluated for impairment. The allowance for credit losses attributed to these loans is established via a process that estimates the probable losses inherent in the portfolio, based upon various analyses. Management considers overall portfolio indicators including historical credit losses; delinquent (defined as loans with payments contractually over 30 days past due), non-performing, and classified loans; trends in volumes and terms of loans; an evaluation of overall credit quality; the credit process, including lending policies and procedures; and economic, geographical, product, and other environmental factors. (j) Business Combinations, Goodwill and Intangible Assets All business combinations are accounted for using the purchase method. Identifiable intangible assets (mostly customer relationships) are recognised separately from goodwill and are initially valued using discounted cash flow calculations and other recognised valuation techniques. Goodwill represents the excess of the price paid for the acquisition of a business over the fair value of the net assets acquired. Goodwill is tested annually for impairment at the reporting unit level, or more frequently if events or circumstances such as adverse changes in the business climate indicate there may be impairment. If the carrying amount of a reporting unit, including the allocated goodwill, exceeds its fair value, goodwill impairment is measured as the excess of the carrying amount of the reporting unit’s allocated goodwill over the implied fair value of the goodwill. Other acquired intangible assets with finite lives are amortised on a straight-line basis over their estimated useful lives, not exceeding 15 years. Intangible assets’ estimated lives are re-evaluated annually and an impairment test is carried out if certain indicators of impairment exist. 69 (k) Premises, Equipment and Computer Software Land, building, equipment and computer software, including leasehold improvements, are carried at cost less accumulated depreciation. The Bank generally computes depreciation using the straight-line method over the estimated useful life of an asset, which is 50 years for buildings, and 3 to 10 years for other equipment. For leasehold improvements the Bank uses the straight-line method over the lesser of the remaining term of the leased facility or the estimated economic life of the improvement. The Bank capitalises certain costs associated with the acquisition or development of internal use software. Once the software is ready for its intended use, these costs are amortised on a straight-line basis over the software’s expected useful life, which is between 5 and 7 years. If deemed significant the Bank will capitalise interest cost in accordance with FAS No. 34 Capitalisation of Interest Cost (FAS 34). (l) Derivatives In accordance with FAS No. 133 Accounting for Derivative Instruments and Hedging Activities (FAS 133), all derivatives are recognised on the Consolidated Balance Sheet at their fair value. FAS 133, as amended by FAS No. 138 Accounting for Certain Derivative Instruments and Certain Hedging Activities (FAS 138) and FAS No. 149 Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149), establishes accounting and reporting standards for financial derivatives, including certain financial derivatives embedded in other contracts and hedging activities. On the date that the Bank enters into a derivative contract, it designates the derivative as either: a hedge of the fair value of a recognised asset or liability (a fair value hedge); a hedge of a forecasted transaction or the variability of cash flows that are to be received or paid in connection with a recognised asset or liability (a cash flow hedge), or an instrument that is held for trading or non-hedging purposes (a trading or non-hedging instrument). Changes in the fair value of a derivative that is highly effective, and that is designated and qualifies as a fair value hedge, along with changes in the fair value of the hedged asset or liability that are attributable to the hedged risk, are recorded in current period earnings. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash flow hedge, to the extent that the hedge is effective, are recorded in other comprehensive income, until earnings are affected by the variability of cash flows of the hedged transaction. Any hedge ineffectiveness is recorded in current period earnings. Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a foreign currency hedge is recorded in either current period earnings or other comprehensive income, depending on whether the hedging relationship satisfies the criteria for a fair value or cash flow hedge. If, however, a derivative is used as a hedge of a net investment in a foreign operation, the changes in the derivative’s fair value, to the extent that the derivative is effective as a hedge, are recorded in the cumulative translation adjustment account within other comprehensive income. Changes in the fair value of derivative trading and non-hedging instruments are reported in current period earnings. The Bank formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value, cash flow, or foreign currency hedges to specific assets and liabilities on the consolidated balance sheet or specific firm commitments or forecasted transactions. The Bank also formally assesses whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. When it is determined that a derivative has ceased to be highly effective as a hedge, the Bank discontinues hedge accounting prospectively. For those hedge relationships that are terminated, hedge designations that are removed, or forecasted transactions that are no longer expected to occur, the hedge accounting treatment described in the paragraphs above is no longer applied and the end-user derivative is terminated or transferred to the trading account. For fair value hedges, any changes to the hedged item remain as part of the basis of the asset or liability and are ultimately reflected as an element of the yield. For cash flow hedges, any changes in fair value of the end-user derivative remain in other comprehensive income and are included in retained earnings of future periods when earnings are also affected by the variability of the hedged cash flows. If the forecasted transaction is no longer likely to occur, any changes in fair value of the end-user derivatives are immediately reflected in other income. (m) Employee Future Benefits The Bank maintains trusteed pension plans for substantially all employees including non-contributory defined benefit plans and a number of defined contribution plans. Benefits under the defined benefit plans are primarily based on the employee’s years of credited service and average annual salary during the final years of employment as defined in the plans. The Bank also provides post-retirement medical benefits for substantially all retired Bermuda-based employees. The Bank’s defined benefit pension plans are accounted for in accordance with FAS No. 87 Employers’ Accounting for Pensions (FAS 87) and FAS No. 88 Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits (FAS 88). Its post-retirement medical and life insurance plans are accounted for in accordance with FAS No. 106 Employers’ Accounting for Post-retirement Benefits Other Than Pensions (FAS 106). Both plans are also accounted for in accordance with FAS No. 158 (FAS 158), Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). Expense for the defined benefit pension plans and the post-retirement medical benefits plan is comprised of (a) the actuarially determined benefits for the current year’s service, (b) imputed interest on the actuarially determined liability of the plan, (c) in the case of the defined benefit pension plans, the expected investment return on the market value of plan assets and (d) amortisation of certain items over the expected average remaining service life of employees in the case of the defined benefit pension plans, and the expected average remaining service life to full eligibility age of employees covered by the plan in the case of the post-retirement medical benefits plan. The items amortised are amounts arising as a result of experience gains and losses, changes in assumptions, plan amendments and the change in the net pension asset or post-retirement medical benefits liability arising on adoption of revised accounting standards. Annual Report 2007 For each of the defined benefit pension plans and for the post-retirement medical benefits plan, the asset (liability) recognised for accounting purposes is reported in other assets and employee future benefits. For the defined contribution pension plans the Bank and participating employees provide an annual contribution based on each participating employee’s pensionable earnings. Amounts paid are expensed in the period. (n) Share-Based Compensation The Bank has a number of share-based compensation plans for eligible employees. In accordance with FAS No. 123R Share-Based Payment (FAS 123R), the Bank follows the fair value method of accounting for share-based compensation plans. The fair value of share-based awards that eventually vest is amortised over the vesting period of the award. (o) Revenue Recognition Trust and investment services fees include fees for private and institutional trust, executorship, and custody services. These fees are recognised as revenue when the Bank has rendered all services to the clients and is entitled to collect the fee from the client, as long as there are no other contingencies associated with the fee. Asset management fees include fees for investment management, investment advice and brokerage services. Investment management fees are recognised over the period in which the related service is provided, on a net asset value basis. Investment advice and brokerage services fees are recognised in the period in which the related service is provided. Investment and pension fund administration fees include fees for pension fund administration, institutional fund administration, registration and transfer agent and corporate services. Pension and institutional fund administration fees are recognised as revenue when the Bank has rendered all services to the clients and is entitled to collect the fee from the client, as long as there are no other contingencies associated with the fee. All other fees are recognised as revenue over the period of the relationship. Banking services fees primarily include fees for certain loan origination, letters of credit, other financial guarantees, compensating balances and other financial services related products. Certain loan origination fees are primarily overdraft and other revolving lines of credit fees. These fees are recognised as revenue over the period of the underlying facilities. Letters of credit fees are recognised as revenue over the period in which the related service is provided. All other fees are recognised as revenue in the period in which the service is provided. Loan interest income includes the amortisation of non-refundable loan origination and commitment fees. These fees are deferred (except for certain retrospectively determined fees meeting specified criteria) and recognised as an adjustment of yield over the life of the related loan. In accordance with FAS No. 91 Accounting for Non-refundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (FAS 91), these loan origination and commitment fees are offset by their related direct cost and only the net amounts are deferred and amortised into interest income. Dividend and interest income on all securities, including amortisation of premiums and discounts on debt securities held for investment, are included in investment income in the Consolidated Statement of Income. (p) Fair Value of Financial Instruments The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The accounting for an asset or liability may differ based on the type of instrument and/or its use in a trading or investing strategy. Generally, the measurement framework recorded in financial statements is based on one of the following: - At fair value on the Consolidated Balance Sheet, with changes in fair value recorded each period in the Consolidated Statement of Income. - At fair value on the Consolidated Balance Sheet, with changes in fair value recorded each period as a separate component of shareholders’ equity and as part of other comprehensive income. - At cost (less other than temporary impairments), with changes in fair value not recorded in the financial statements but disclosed in the notes. - At the lower of cost or fair value. Fair value amounts represent estimates of the consideration that would currently be agreed upon between knowledgeable, willing parties who are under no compulsion to act and is best evidenced by a quoted market price, if one exists. Some of the Bank’s financial instruments lack an available trading market. Therefore, these instruments have been valued using present value or other valuation techniques and may not necessarily be indicative of the amounts realisable in an immediate settlement of the instruments. Had a ready market for the instruments existed, the differences could be material. In addition, the calculation of estimated fair value is based on market conditions at a specific point in time and may not be reflective of future fair values. The book value of financial assets and financial liabilities held for purposes other than trading may exceed their fair value due primarily to changes in interest rates and credit agency ratings and outlooks. The Bank does not reduce the book value of financial assets to their fair values, unless they are other-than-temporarily impaired, as it is the Bank’s intention to hold them until maturity. The fair values disclosed exclude premises and equipment and certain other assets and liabilities as these are not financial instruments. 71 The following methods and assumptions were used in the determination of the fair value of financial instruments: i) Cash and deposits with banks: The fair value of cash and deposits with banks, being short term in nature, is deemed to equate to the carrying value. ii) Investments: The fair values of investments are determined based on the quoted market price or independent pricing services when available, or if quoted market prices or independent pricing services are not available, discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. iii) Loans: The majority of loans are variable rate and re-price in response to changes in market rates and hence the fair value has been estimated as the carrying value. For fixed-rate loans, the fair value has been estimated by performing a discounted cash flow calculation using market rates for similar loans made at the balance sheet date. iv) Accrued interest: The carrying values of accrued interest receivable and payable are assumed to approximate their fair values given their short-term nature. v) Deposits: The fair value of fixed-rate deposits has been estimated by discounting the contractual cash flows, using market interest rates offered at the balance sheet date for deposits of similar terms. The fair value of deposits with no stated maturity date is deemed to equate to the carrying value. vi) Subordinated capital: The fair value of the subordinated capital has been estimated by discounting the contractual cash flows, using current market interest rates. vii) Derivatives: Fair value of exchange traded derivatives is based on quoted market prices. Fair value of over the counter derivatives is calculated as the net present value of contractual cash flows using prevailing market rates. The aggregate of the estimated fair value of amounts presented does not represent management’s estimate of the underlying value to the Bank. (q) Credit Related Arrangements In the normal course of business, the Bank enters into various commitments to meet the credit requirements of its customers. Such commitments, which are not included in the Consolidated Balance Sheet, include: i) Commitments to extend credit which represent undertakings to make credit available in the form of loans or other financing for specific amounts and maturities, subject to certain conditions. ii) Standby letters of credit, which represent irrevocable obligations to make payments to third parties in the event that the customer is unable to meet its financial obligations. iii) Documentary and commercial letters of credit, primarily related to the import of goods by customers, which represent agreements to honour drafts presented by third parties upon completion of specific activities. These credit arrangements are subject to the Bank’s normal credit standards and collateral is obtained where appropriate. The contractual amounts for these commitments set out in the table in Note 11 represent the maximum payments the Bank would have to make should the contracts be fully drawn, the counterparty default, and any collateral held prove to be of no value. As many of these arrangements will expire or terminate without being drawn upon or fully collateralised, the contractual amounts do not necessarily represent future cash requirements. The Bank does not carry any liability for these obligations. (r) Income Taxes The Bank uses the asset and liability method whereby income taxes reflect the expected future tax consequences of temporary differences between the financial statements’ carrying amounts of assets and liabilities and their respective tax bases. Accordingly, a deferred income tax asset or liability is determined for each temporary difference based on the enacted tax rates to be in effect on the expected reversal date of the temporary difference. Income taxes on the Consolidated Statement of Income include the current and deferred portions of the income taxes. Income taxes applicable to items charged or credited directly to shareholders’ equity are included in such items. Net deferred income tax assets or liabilities accumulated as a result of temporary differences are included in other assets or other liabilities, respectively. A valuation allowance is established to reduce deferred income tax assets to the amount more likely than not to be realised. (s) Consolidated Statement of Cash Flows For the purposes of the Consolidated Statement of Cash Flows, cash and demand deposits with banks include cash and demand deposits; vault cash and cash in transit where the Bank holds the related assets. (t) Earnings Per Share Earnings per share has been calculated using the weighted average number of common shares outstanding during the year and adjusted for the stock split and the stock dividend declared during the years ended 31 December 2007 and 2006 (see also Notes 18 and 23). The dilutive effect of share-based compensation plans was calculated using the treasury stock method, whereby the proceeds received from the exercise of share-based awards are assumed to be used to repurchase outstanding common shares, using the quarterly average market price of the Bank’s shares for the period. Annual Report 2007 (u) Consolidation of Variable Interest Entities FIN 46R requires beneficiaries of variable interests to consolidate the VIE if that party will absorb a majority of the expected losses of the VIE, receive a majority of residual returns of the VIE, or both. This party is considered the primary beneficiary of the entity. The determination of whether an entity meets the criteria to be considered the primary beneficiary of a VIE requires an evaluation of all transactions (such as investments, loans and fee arrangements) with the entity. (v) Impairment or Disposal of Long-Lived Assets An impairment loss is recognised when the carrying amount of a long-lived asset to be held and used exceeds the sum of the undiscounted cash flows expected from its use and disposal. The impairment recognised is measured as the amount by which the carrying amount of the asset exceeds its fair value. Long-lived assets that are to be disposed of other than by sale are classified and accounted for as held for use until the date of disposal or abandonment. Assets that meet certain criteria are classified as held for sale and are measured at the lower of their carrying amounts or fair value, less costs of sale. Note 2: Significant Acquisitions On 29 October 2007, the Bank acquired all outstanding shares of Bentley Reid Group Limited (Bentley Reid), a privately-held, international wealth management company with offices in Hong Kong, London and Malta for consideration of £13.8 million ($28.4 million) paid in cash. The purchase agreement provides for contingent payments in years 2009 and 2010 of up to £5.3 million ($10.5 million). Management has assessed that the contingency amounts are not probable and therefore have not been accounted for at this time. The payments will be accounted for as and when they are probable and will be recorded as additional goodwill at that time. The following table summarises the total consideration in respect of the acquisition of Bentley Reid: Fair value of assets acquired Cash and deposits with banks Premises, equipment and computer software Intangible assets - customer relationships Other assets Total assets Fair value of liabilities assumed Other liabilities Fair value of identifiable net assets acquired Total purchase consideration Bentley Reid 9,154 2,069 17,705 2,206 31,134 2,781 28,353 28,353 Note 3: Cash and Deposits with Banks 31 December Unrestricted Non-interest earning Cash and demand deposits Bermuda Non-Bermuda Total Bermuda Non-Bermuda Total 2007 2006 56,667 41,622 98,289 27,062 22,955 50,017 Interest earning Deposits maturing within three months and on demand Deposits maturing between three to six months Deposits maturing between six to twelve months Sub-total - Interest earning 255,443 - - 255,443 2,010,071 43,117 64,123 2,117,311 2,265,514 43,117 64,123 2,372,754 183,815 - - 183,815 2,745,502 77,458 78,719 2,901,679 2,929,317 77,458 78,719 3,085,494 Total unrestricted cash and deposits 312,110 2,158,933 2,471,043 210,877 2,924,634 3,135,511 Affected by drawing restrictions related to minimum reserve and derivative margin requirements Non-interest earning Demand deposits - 27,876 27,876 - 12,795 12,795 Interest earning Deposits maturing within three months Total restricted deposits 5,032 5,032 13,061 40,937 18,093 45,969 2,885 2,885 - 12,795 2,885 15,680 Total cash and deposits with banks 317,142 2,199,870 2,517,012 213,762 2,937,429 3,151,191 Restricted cash of $5.032 million in Bermuda reflects collateral posted against interest rate swaps. 73 Note 4: Investments The following table presents securities by remaining term to maturity: 31 December 2007 Trading Debt securities issued by non-US governments Corporate securities and other Total trading Available for sale Certificates of deposit Debt securities issued by non-US governments Corporate debt securities Equity securities Total available for sale Held to maturity US government and federal agencies/corporations Certificates of deposit Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity Total investments Total by currency Bermuda dollars US dollars Other Total investments Remaining term to maturity Within 3 months 3 to 12 months 1 to 5 years Over No specific maturity 5 years Carrying value - - - 731 - 731 4,304 - 4,304 5,572 - 5,572 - - 1,838 - 1,838 - - - - - 4,496 - 87,699 14,395 1,346,894 49,986 1,503,470 136,248 - 740,781 17,827 45,981 473,755 1,414,592 - 47,927 47,927 10,607 47,927 58,534 - - - 331 331 - - - 1,887 - - 1,887 918,073 11,996 1,838 331 932,238 200,731 230,412 828,480 76,311 1,785,376 632,907 3,754,217 669,729 11,996 - - 681,725 - 81,152 - 19,997 186,419 90,831 378,399 248,344 - - - 248,344 59,987 149,260 - 22,205 206,082 18,335 455,869 1,060,124 704,944 1,507,774 1,422,002 50,145 4,744,989 - 270,411 789,713 1,060,124 - 352,388 352,556 704,944 - 1,160,218 347,556 1,507,774 - 1,249,561 172,441 1,422,002 492 45,323 4,330 50,145 492 3,077,901 1,666,596 4,744,989 Annual Report 2007 31 December 2006 Trading Debt securities issued by non-US governments Corporate securities and other Total trading Available for sale Certificates of deposit Debt securities issued by non-US governments Corporate debt securities Equity securities Other, primarily asset-backed securities Total available for sale Held to maturity US government and federal agencies/corporations Certificates of deposit Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity Total investments Total by currency Bermuda dollars US dollars Other Total investments Within 3 months 3 to 12 months Remaining term to maturity Over 5 years 1 to 5 years No specific maturity Carrying value - - - 559 3 562 3,847 - 3,847 6,351 - 6,351 - - 1,650 - - 1,650 - - - - - - 64,645 - - 60,396 1,130,477 44,413 1,299,931 158,977 - 279,393 14,407 113,568 159,142 725,487 - 45,711 45,711 10,757 45,714 56,471 - - - 223 - 223 - - - - - - - 836,285 27,265 1,650 223 97,932 963,355 223,622 217,162 279,393 80,261 1,743,450 223,079 2,766,967 464,226 27,265 - - 97,932 589,423 - 167,162 - - 152,003 - 319,165 372,059 - - - - 372,059 - 50,000 - 5,458 347,402 19,524 422,384 908,588 795,005 1,303,778 733,488 45,934 3,786,793 - 364,042 544,546 908,588 - 393,328 401,677 795,005 - 1,138,242 165,536 1,303,778 - 573,015 160,473 733,488 2,787 40,925 2,222 45,934 2,787 2,509,552 1,274,454 3,786,793 Investments at carrying value includes $3,062 million (2006: $2,159 million) of floating-rate instruments and $1,634 million (2006: $1,582 million) of fixed-rate instruments. The approximate yield on floating-rate securities at 31 December 2007 was 5.22% (2006: 5.61%), while the approximate yield on fixed-rate securities was 5.67% (2006: 5.39%). Certificates of deposit with a carrying value of $50.0 million included in the Held to maturity category are restricted from sale in accordance with a credit enhancement agreement. 75 The cost of available for sale securities, the amortised cost of held to maturity securities and their estimated fair values were as follows: 31 December Available for sale Certificates of deposit Debt securities issued by non-US governments Corporate debt securities Equity securities Other, primarily asset-backed securities Total available for sale 31 December Held to maturity US government and federal agencies/corporations Certificates of deposit Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity 2007 Gross Gross unrealised unrealised losses gains Cost Fair value 2006 Gross Gross unrealised unrealised losses gains Cost Fair value 916,187 11,996 1,838 192 - 930,213 2,004 - - 139 - 2,143 (118 ) - - - - (118 ) 918,073 11,996 1,838 331 - 932,238 836,826 27,265 1,650 223 97,931 963,895 - - - - 1 1 (541 ) - - - - (541 ) 836,285 27,265 1,650 223 97,932 963,355 2007 Gross Gross Amortised unrealised unrealised losses gains Cost 2006 Gross Gross Fair Amortised unrealised unrealised losses gains Cost value Fair value 200,731 230,412 828,480 76,311 1,785,376 632,907 3,754,217 113 133 719 809 853 (821 ) (48 ) (115,976 ) (36 ) 223,622 200,023 217,162 230,497 279,393 713,223 80,261 77,084 (14,317 ) 1,771,912 1,743,450 223,079 599,241 (164,889 ) 3,591,980 2,766,967 25 (33,691) 2,652 397 68 61 125 1,427 337 2,415 (849 ) - (128 ) (543 ) (2,080 ) (9,190 ) (12,790 ) 223,170 217,230 279,326 79,843 1,742,797 214,226 2,756,592 The following table shows the fair value and gross unrealised losses of the Bank’s investments with unrealised losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealised loss position: 31 December 2007 Available for sale Certificates of deposit Held to maturity US government and federal agencies/corporations Certificates of deposit Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity securities with unrealised losses Less than 12 months 12 months or more Gross unrealised losses Fair value Gross Fair unrealised losses value Total Total gross fair unrealised losses value 221,248 (118 ) - - 221,248 (118 ) 95,228 115,108 509,804 - 1,116,584 (553 ) (48 ) (113,931 ) - (12,775 ) 507,628 (24,900) 47,287 - 134,776 40,958 205,356 48,498 (268 ) - (2,045 ) (36 ) (1,542 ) (8,791 ) 142,515 115,108 727,595 40,958 1,321,940 473,111 (821 ) (48 ) (127,702 ) (36 ) (14,317 ) (21,965 ) 2,344,352 (152,207 ) 476,875 (12,682 ) 2,821,227 (164,889 ) Total securities with unrealised losses 2,565,600 (152,325 ) 476,875 (12,682 ) 3,042,475 (165,007 ) Annual Report 2007 31 December 2006 Available for sale Certificates of deposit Held to maturity US government and federal agencies/corporations Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity securities with unrealised losses Less than 12 months 12 months or more Fair value Gross unrealised losses Gross unrealised losses Fair value Total Total gross fair unrealised losses value 831,839 (541 ) - - 831,839 (541 ) 35,162 113,455 - 313,482 39,117 (89 ) (78 ) - (270 ) (53 ) 63,885 35,218 39,399 277,480 64,076 (760 ) (50 ) (543 ) (1,810 ) (9,137 ) 99,047 148,673 39,399 590,962 103,193 (849 ) (128 ) (543 ) (2,080 ) (9,190 ) 501,216 (490 ) 480,058 (12,300 ) 981,274 (12,790 ) Total securities with unrealised losses 1,333,055 (1,031 ) 480,058 (12,300 ) 1,813,113 (13,331 ) Management conducts an ongoing review to identify and evaluate securities that show objective indications of possible impairment. An investment is considered impaired if its unrealised losses represent impairment that is considered to be other-than-temporary. To assess whether an other-than-temporary impairment has occurred, management must make certain judgments and estimates and in determining whether a loss is temporary factors considered include the extent of the unrealised loss, the length of time that the security has been in an unrealised loss position, the financial condition of the issuer, prospects for recovery in fair value, and the Bank’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery. If the decline is considered to be other-than-temporary, a write-down is recorded in the Consolidated Statement of Income. Unrealised losses for US Government and federal agencies/corporations, Collateralised mortgage obligations, Debt securities issued by non-US governments, Corporate debt securities and Other, primarily asset-backed securities, were due to interest rate changes and widening credit spreads caused by the recent disruption in the financial markets, the weakening of the US housing market, and credit rating downgrades of certain securities in the marketplace. However, given that a substantial portion of these securities are investment grade securities, the unrealised losses are primarily in higher rated securities, we believe these losses are a result of technical spread widening rather than fundamental deterioration and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, the Bank believes it is probable that it will be able to collect all amounts due according to the contractual terms of the investments. Accordingly, the Bank does not consider these investments to be other-than-temporarily impaired as at 31 December 2007. The fair value of the Bank’s collateralised mortgage obligations related exposure depends on market conditions and assumptions that are subject to change over time. The Bank expects that market conditions will continue to evolve, and that the fair value of the Bank’s positions will frequently change. The degree of judgement involved in determining the fair value of an investment security is dependent upon the availability of quoted market prices or observable market parameters. When observable market prices and parameters do not exist as was in certain circumstances the case at 31 December 2007, judgement is necessary to estimate fair value which gives rise to added uncertainty in the valuation process and assessment of whether a security is considered other- than-temporarily impaired. The valuation process takes into consideration factors such as interest rate changes, movements in credit spreads, default rate assumptions, prepayment assumptions, type and quality of collateral, and market sentiment. Management has supplemented its fair value and impairment analyses by stress testing collateralised mortgage obligations where the fair value is significantly lower than amortised cost using a widely employed industry modeling and analytics software tool. This analytics software tool provides an extensive, accurate, and timely set of structured securities deal models and data, covering the wide range of asset backed securities, collateralised mortgage obligations, residential collateralised mortgage obligations, and collateralised debt obligations (including collateralised bond obligations and collateralised loan obligations) deals. Investments in collateralised mortgage obligations with fair values significantly lower than amortised cost were stress tested using various loss severity scenarios and based on the results the Bank has concluded that there is no other-than-temporary impairment in the Bank’s portfolio of investments. Specific risk factors of the underlying collateral were considered in other-than-temporary impairment assessments, specifically, the vintage of the underlying loans, the percentage of first lien loan mortgages, home owner/owner occupied properties, geographic location and diversification, loan to value ratios and FICO scores, and seniority of tranche. Stress tests assumed a combination of: slow prepayment rates, high annual default rates, and recovery rates of only 50% on each default. Based on the Bank’s stress testing, which management believes is an extreme scenario, potential principal impairments to these pools is remote. 77 In respect of the following categories, the Bank does not consider those investments to be other-than-temporarily impaired at 31 December 2007: Certificates of deposit The unrealised losses on the Bank’s certificates of deposit were due to interest rate changes. However, given that all of these securities are investment grade securities, and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, the Bank believes that it will collect all amounts due according to the contractual terms of the investments. US Government and federal agencies/corporations The unrealised losses on the Bank’s investments in US Treasury obligations and direct obligations of US government agencies were due to interest rate changes. However, given that all of these securities are investment grade securities, and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, the Bank believes that it will collect all amounts due according to the contractual terms of the investments. Collateralised mortgage obligations The unrealised losses on the Bank’s investments in collateralised mortgage obligations were due to interest rate changes and widening credit spreads caused by the recent disruption in the financial markets, the weakening of the US housing market, and credit rating downgrades of certain securities in the marketplace. However, given that a substantial portion of these securities are investment grade securities, management assesses each security individually for impairment, and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, the Bank believes that a significant deterioration has not occurred as it is not probable that all amounts due (principal and interest) will not be collected. Debt securities issued by non-US governments The unrealised losses on the Bank’s investments in non-US government debt securities obligations and direct obligations of non-US government agencies were due to interest rate changes. Given that these securities are investment grade, and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, the Bank believes that a significant deterioration has not occurred as it is not probable that all amounts due (principal and interest) will not be collected. Corporate debt securities The unrealised losses on the Bank’s investments in corporate bonds were due to interest rate changes and widening credit spreads and credit rating downgrades of certain securities in the marketplace. However, given that these securities are predominantly investment grade, and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, the Bank believes that a significant deterioration has not occurred as it is not probable that all amounts due (principal and interest) will not be collected. Other, primarily asset-backed securities The unrealised losses on the Bank’s other investments, primarily asset-backed securities were due to interest rate changes and widening credit spreads caused by the recent disruption in the financial markets, and credit rating downgrades of certain securities in the marketplace. However, given that a substantial portion of these securities are investment grade securities, management assesses each security individually for impairment, and the Bank has the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, management believes that a significant deterioration has not occurred as it is not probable that all amounts due (principal and interest) will not be collected. In August 2007, the Bank purchased from a related party, namely the AAAm rated Butterfield Money Market Fund Ltd. (BMMFL), $93 million of collateralised mortgage obligations at its best estimate of fair value at the time. The Bank holds the purchased securities in its held to maturity portfolio. The following table presents realised and unrealised gains and losses on trading securities: 31 December Realised/unrealised gains (losses) on trading securities Equities (a) Fixed income and other (b) Total (a) Includes equity securities and equity derivatives. (b) Includes bonds, commercial paper, interest rate and foreign exchange derivatives. 2007 2006 3,252 (31 ) 3,221 2,103 (495 ) 1,608 Annual Report 2007 Note 5: Loans The composition of the loan portfolio at each of the indicated dates was as follows: 31 December Bermuda 620,973 Commercial loans Commercial and industrial Commercial real estate 194,911 Commercial mortgage 194,130 Construction 211,596 Financial institutions 15,600 Government 42,758 Overdrafts 1,279,968 Total commercial loans Less allowance for credit losses on commercial loans (12,206 ) Total commercial loans after allowance for credit losses 1,267,762 Consumer loans 59,301 Automobile financing 51,185 Credit card 1,053,387 Mortgages 7,734 Overdrafts 80,580 Other consumer 1,252,187 Total consumer loans Less allowance for credit losses on consumer loans (8,965 ) Total consumer loans after allowance for credit losses 1,243,222 2007 Non- Bermuda Total Bermuda 2006 Non- Bermuda Total 156,245 777,218 467,222 183,749 650,971 588,065 11,351 35,880 3,017 167,701 962,259 (1,757 ) 960,502 782,976 205,481 247,476 18,617 210,459 2,242,227 (13,963 ) 2,228,264 6,106 22,109 333,795 6,447 288,778 657,235 (3,958 ) 653,277 65,407 73,294 1,387,182 14,181 369,359 1,909,423 (12,923 ) 1,896,500 123,123 138,055 422,528 21,600 24,995 1,197,523 (12,734 ) 1,184,789 60,068 42,385 904,339 4,514 76,787 1,088,093 (7,628 ) 1,080,465 485,179 7,920 26,392 - 214,627 917,867 (1,763 ) 916,104 7,419 18,879 352,906 16,254 187,537 582,995 (3,608 ) 579,387 608,302 145,975 448,920 21,600 239,622 2,115,390 (14,497 ) 2,100,893 67,487 61,264 1,257,245 20,768 264,324 1,671,088 (11,236 ) 1,659,852 Total loans Less allowance for credit losses Net loans 2,532,155 (21,171 ) 2,510,984 1,619,494 (5,715 ) 1,613,779 4,151,650 (26,886 ) 4,124,764 2,285,616 (20,362 ) 2,265,254 1,500,862 (5,371 ) 1,495,491 3,786,478 (25,733 ) 3,760,745 The principal means of securing residential mortgages, personal, credit card and business loans are charges over assets and guarantees. Mortgage loans are generally repayable over periods of up to thirty years and personal, credit card, business and government loans are generally repayable over terms not exceeding five years. The effective yield on total loans as at 31 December 2007 is 7.21% (2006: 6.94%). 79 The table below sets forth information about the Bank’s non-accrual loans: 31 December Commercial loans - Bermuda Commercial loans - Non-Bermuda Consumer loans - Bermuda Consumer loans - Non-Bermuda Mortgages - Bermuda Mortgages - Non-Bermuda Total Gross 3,354 12,650 1,416 1,381 11,321 6,628 36,750 2007 Allowance Total Gross 2006 Allowance (2,272 ) (201 ) 1,082 12,449 (179 ) (747 ) (165 ) (300 ) (3,864 ) 1,237 634 11,156 6,328 32,886 5,082 7,201 1,524 1,053 7,714 6,514 29,088 (2,484 ) (226 ) (51 ) (610 ) (165 ) (79 ) (3,615 ) Total 2,598 6,975 1,473 443 7,549 6,435 25,473 For the year ended 31 December 2007, the amount of gross interest income that would have been recorded had impaired loans been current was $3.1 million (2006: $2.8 million). For the year ended 31 December 2007, the Bank recovered overdue interest of $0.4 million (2006: $0.2 million) on impaired loans that were repaid in the year. The average balance of impaired loans during the year ended 31 December 2007 was $34.7 million (2006: $28.5 million). The table below summarises the changes in the allowances for credit losses: Year ended 31 December Allowance for credit losses at beginning of year Provision this year Recoveries Charge-offs Allowance for credit losses at end of year Specific allowances 2007 General allowance 3,615 2,794 316 (2,860 ) 3,865 22,118 (811 ) 2,380 (666 ) 23,021 Specific allowances 2006 General allowances 4,104 1,871 400 (2,760 ) 3,615 20,630 1,126 996 (634 ) 22,118 Total 25,733 1,983 2,696 (3,526 ) 26,886 Total 24,734 2,997 1,396 (3,394 ) 25,733 The table below presents information about the loan delinquencies, and charge-offs: 31 December loans past due Charge-offs 2007 Loans 90 delinquent days or more Total Total 2006 Loans 90 delinquent days or more past due loans Credit card Automobile financing Other consumer and mortgages Consumer loans Commercial loans Total loans reported 6,001 2,563 51,854 60,418 35,694 96,112 788 1,524 19,668 21,980 16,293 38,273 1,534 238 1,126 2,898 628 3,526 4,770 2,513 30,409 37,692 12,165 49,857 502 441 20,001 20,944 8,967 29,911 Annual Report 2007 Charge-offs 1,204 27 188 1,419 310 1,729 Note 6: Credit Risk Concentrations Concentrations of credit risk arise when a number of customers are engaged in similar business activities, are in the same geographic region, or when they have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Bank regularly monitors various segments of its credit risk portfolio to assess potential concentrations of risks and to obtain collateral when deemed necessary. In the Bank’s commercial portfolio, risk concentrations are primarily evaluated by industry and also by geographic region. In the consumer portfolio, concentrations are primarily evaluated by products. Credit exposures include loans, guarantees and acceptances, letters of credit and commitments for undrawn lines of credit. The following table summarises the credit exposure of the Bank by business sector: 31 December Banks and financial services Commercial and merchandising Governments Individuals Primary industry and manufacturing Real estate Transport and communication Sub-total General allowance Total 2007 On-balance Off-balance Total credit exposure sheet sheet 2006 On-balance Off-balance sheet sheet Total credit exposure 482,765 595,596 29,049 1,824,497 57,787 1,132,237 25,855 4,147,786 (23,022 ) 4,124,764 610,577 275,756 - 179,814 37,370 140,681 2,803 1,247,001 - 1,247,001 1,093,342 871,352 29,049 2,004,311 95,157 1,272,918 28,658 5,394,787 (23,022 ) 5,371,765 851,643 444,696 21,600 1,659,580 28,731 755,089 21,524 3,782,863 (22,118 ) 3,760,745 818,742 252,723 2,400 156,834 36,476 156,169 11,731 1,435,075 - 1,435,075 1,670,385 697,419 24,000 1,816,414 65,207 911,258 33,255 5,217,938 (22,118 ) 5,195,820 The following table summarises the credit exposure of the Bank by region: 31 December Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Sub-total General allowance Total 2007 On-balance Off-balance Total credit exposure sheet sheet 2006 On-balance Off-balance sheet sheet Total credit exposure 2,529,540 148,447 351,776 465,663 41,368 610,992 4,147,786 (23,022 ) 4,124,764 661,089 4,091 137,227 333,850 - 110,744 1,247,001 - 1,247,001 3,190,629 152,538 489,003 799,513 41,368 721,736 5,394,787 (23,022 ) 5,371,765 2,282,917 125,044 343,710 451,046 13,598 566,548 3,782,863 (22,118 ) 3,760,745 1,016,157 29,467 110,242 163,940 - 115,269 1,435,075 - 1,435,075 3,299,074 154,511 453,952 614,986 13,598 681,817 5,217,938 (22,118 ) 5,195,820 81 Note 7: Premises, Equipment and Computer Software The following table summarises land, buildings, equipment and computer software: 2007 Accumulated Net carrying value Cost depreciation 2006 Accumulated Cos t depreciation Net carrying value 13,726 154,737 60,332 86,254 315,049 - (34,537 ) (39,033 ) (26,100 ) (99,670 ) 13,571 126,218 50,366 66,055 256,210 - (29,757 ) (30,907 ) (24,220 ) (84,884 ) 13,726 120,200 21,299 60,154 215,379 2007 6,026 3,075 6,803 15,904 31 December Land Buildings Equipment Computer software Total 31 December Depreciation Buildings (included in property expense) Equipment (included in property expense) Computer hardware and software (included in technology expense) Total depreciation charged to operating expenses Note 8: Goodwill and Other Intangible Assets The following table presents goodwill and other intangible assets by business segment: Goodwill Business segment Balance as at 31 December 2005 Foreign exchange translation adjustment Balance as at 31 December 2006 Foreign exchange translation adjustment Balance as at 31 December 2007 Other intangible assets 31 December Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Customer relationships Barbados Guernsey The Bahamas United Kingdom 7,343 1,020 8,363 114 8,477 1,923 - 1,923 - 1,923 5,220 - 5,220 - 5,220 2007 8,354 1,158 9,512 128 9,640 2006 Gross carrying Accumulated amount amortisation 26,063 6,681 1,211 52,504 7,790 20,477 114,726 (2,003 ) (1,816 ) (268 ) (21,147 ) (2,819 ) (5,443 ) (33,496 ) Net carrying amount 24,060 4,865 943 31,357 4,971 15,034 81,230 Gross carrying Accumulated amount amortisation 8,337 6,681 1,211 51,801 7,790 20,219 96,039 (1,250 ) (1,371 ) (188 ) (17,381 ) (2,142 ) (4,022 ) (26,354 ) There have been no impairment losses for the years ended 31 December 2007 and 2006. The estimated aggregate amortisation expense for each of the succeeding years until 31 December 2012 is $7.8 million. Customer relationships are initially valued based on the present value of net cash flows expected to be derived solely from the recurring customer base existing as at the date of acquisition. Customer relationship intangible assets may or may not arise from contracts. During 2007, the Bank acquired new customer relationships for $17.7 million (2006: nil) as a result of the aquisition of Bentley Reid and this has been included in the Bermuda segment based on management reporting lines, the amortisation expense amounted to $6.9 million (2006: $6.3 million) and the foreign exchange translation adjustment increased the net carrying amount by $0.7 million (2006: $6.4 million). Annual Report 2007 13,571 96,461 19,459 41,835 171,326 2006 3,755 3,549 6,552 13,856 Total 22,840 2,178 25,018 242 25,260 Net carrying amount 7,087 5,310 1,023 34,420 5,648 16,197 69,685 Note 9: Customer Deposits and Deposits from Banks (a) By Maturity 31 December Customers Banks Total Customers 2007 2006 Banks Total Demand deposits Demand deposits - Non-interest bearing Demand deposits - Interest bearing Sub-total - demand deposits Term deposits Term deposits maturing within six months Term deposits maturing between six to twelve months Term deposits maturing after twelve months Sub-total - term deposits 1,042,062 4,869,122 5,911,184 - 154,769 154,769 1,042,062 5,023,891 6,065,953 964,496 4,779,115 5,743,611 - 49,248 49,248 964,496 4,828,363 5,792,859 4,153,351 178,814 198,230 4,530,395 147,080 4,543 - 151,623 4,300,431 183,357 198,230 4,682,018 3,594,235 200,471 217,342 4,012,048 233,097 2,995 1,833 237,925 3,827,332 203,466 219,175 4,249,973 Total 10,441,579 306,392 10,747,971 9,755,659 287,173 10,042,832 (b) By Type and Location 31 December Bermuda Customers Banks Barbados Customers Banks Cayman Customers Banks Guernsey Customers Banks The Bahamas Customers Banks United Kingdom Customers Banks Total Customers Total Banks Total 2007 2006 Payable Payable on a fixed date on demand Total Payable Payable on a fixed date on demand Total 2,229,386 86,562 1,626,180 27,078 3,855,566 113,640 2,273,826 - 1,558,952 - 3,832,778 - 165,532 2,566 60,609 20,549 226,141 23,115 123,621 - 45,886 16,156 169,507 16,156 1,518,295 12,848 839,220 98,709 2,357,515 111,557 1,646,663 38,198 727,156 78,782 2,373,819 116,980 962,832 44,649 1,143,182 506 2,106,014 45,155 717,452 8,346 892,275 10,037 1,609,727 18,383 72,393 - 81,967 - 154,360 - 61,444 - 78,454 1,558 139,898 1,558 962,746 8,144 5,911,184 154,769 6,065,953 779,237 4,781 1,741,983 12,925 4,530,395 10,441,579 306,392 4,682,018 10,747,971 151,623 920,605 2,704 5,743,611 49,248 5,792,859 709,325 131,392 4,012,048 237,925 4,249,973 1,629,930 134,096 9,755,659 287,173 10,042,832 83 Note 10: Employee Future Benefits The Bank maintains trusteed pension plans including non-contributory defined benefit plans and a number of defined contribution plans, and provides post-retirement medical benefits to its qualifying retirees. The defined benefit provisions under the pension plans are generally based upon years of service and average salary during the final years of employment. The defined benefit plans are non-contributory and the funding required is provided by the Bank, based upon the advice of an independent actuary. Substantially all of the pension assets are invested in equity, fixed income and other marketable securities. The following table presents the financial position of the Bank’s defined benefit pension plans and the Bank’s post-retirement medical benefit plan. The benefit obligations and plan assets are measured as at 30 November. 2007 Post-retirement medical benefit plan Pension plans Pension plans Accumulated benefit obligation at end of year 109,978 - 112,720 Change in projected benefit obligation Opening projected benefit obligation Service cost Employee contributions Interest cost Benefits paid Settlement of liability Actuarial (gain) loss Foreign exchange translation adjustment Closing projected benefit obligation Change in plan assets Opening fair value of plan assets Actual return on plan assets Employer contribution Employee contributions Benefits paid Cost of settlement Foreign exchange translation adjustment Closing fair value of plan assets Funded status Surplus (deficit) of plan assets over projected benefit obligation at measurement date Employer contribution during the period from measurement date to fiscal year end Net asset (liability) recognised Amounts recognised in the balance sheet consist of: Prepaid benefit cost included in other assets Accrued pension benefit cost included in employee future benefits liability Net asset (liability) recognised in the balance sheet 122,378 3,529 332 6,632 (4,450 ) (2,969 ) (5,982 ) 742 120,212 122,729 6,682 8,541 400 (4,450 ) (2,603 ) 708 132,007 11,795 167 11,962 11,962 - 11,962 106,656 2,612 - 6,192 (1,240 ) - (16,068 ) - 98,152 - - 1,240 - (1,240 ) - - - (98,152 ) 89 (98,063 ) - (98,063 ) (98,063 ) Before-tax amounts recognised in accumulated other comprehensive loss consist of: 3,542 Net actuarial gain (loss) (89 ) Past service cost Net amount recognised in accumulated other comprehensive loss 3,453 (21,141 ) - (21,141 ) 112,228 3,634 386 6,293 (5,079 ) - (1,586 ) 6,502 122,378 97,260 9,853 14,623 386 (5,079 ) - 5,686 122,729 351 161 512 1,130 (618 ) 512 (161 ) (127 ) (288 ) 2006 Post-retirement medical benefit plan - 97,245 2,358 - 5,893 (1,569 ) - 2,729 - 106,656 - - 1,569 - (1,569 ) - - - (106,656 ) 83 (106,573 ) - (106,573 ) (106,573 ) (40,409 ) - (40,409 ) Annual Report 2007 The following table presents the expense constituents of the Bank’s defined benefit pension plans and the Bank’s post-retirement medical benefit plan: Annual benefit expense Service cost Interest cost Expected return on plan assets Amortisation of past service cost Amortisation of net actuarial loss Gain on settlement Defined benefit expense Defined contribution expense Total benefit expense Other changes recognised in other comprehensive income Net gain arising during the period Amortisation of past service cost Amortisation of net actuarial loss Total changes recognised in other comprehensive income 2007 Post-retirement medical benefit plan Pension plans 2006 Post-retirement medical benefit plan Pension plans 3,529 6,632 (8,191 ) 40 578 (366 ) 2,222 5,281 7,503 3,692 40 578 4,310 2,612 6,192 N/A - 3,200 - 12,004 - 12,004 16,068 - 3,200 19,268 3,634 6,293 (6,746 ) 37 (52 ) - 3,166 4,589 7,755 N/A N/A N/A N/A 2,358 5,893 N/A - 3,368 - 11,619 - 11,619 N/A N/A N/A N/A The estimated portions of the net actuarial loss and past service cost for the pension plans that will be amortised from accumulated other comprehensive loss into benefit expense over the next fiscal year are nil. The estimated portion of the net actuarial loss for the post-retirement medical benefit plan that will be amortised from accumulated other comprehensive loss into benefit expense over the next fiscal year is $1.2 million. 31 December Actuarial assumptions used to determine annual benefit expense 2007 Post-retirement medical benefit plan Pension plans 2006 Post-retirement medical benefit plan Pension plans Weighted average discount rate Weighted average rate of compensation increases Weighted average expected long-term rate of return on plan assets Weighted average annual medical cost increase rate 5.35% 3.65% 6.55% N/A 5.75% N/A N/A 10% to 5% in 2013 5.45% 3.80% 6.45% N/A 6.00% N/A N/A 11% to 5% in 2013 Actuarial assumptions used to determine benefit obligations at end of year Weighted average discount rate Weighted average rate of compensation increases Weighted average annual medical cost increase rate 6.25% 4.00% N/A 6.70% N/A 9% to 5% in 2013 5.35% 3.65% N/A 5.75% N/A 10% to 5% in 2013 For 2007, the effect of a one percentage point increase or decrease in the assumed medical cost increase rate on the aggregate of service and interest costs is a $1.9 million increase (2006: $1.7 million) and a $1.5 million decrease (2006: $1.3 million), respectively, and on the benefit obligation a $17.6 million increase (2006: $19.5 million) and a $14.3 million decrease (2006: $15.7 million), respectively. To develop the expected long-term rate of return on the plan assets assumption for each plan, the Bank considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocations of the funds. The weighted average discount rate used to determine benefit obligations at the end of the year is derived from interest rates on high quality corporate bonds with maturities that match the expected benefit payments. 85 The weighted average actual and target asset allocations of the pension plans by asset category, are as follows: 31 December Actual allocation Target allocation Actual allocation Target allocation 2007 2006 Asset category Equity securities (including equity mutual funds) Debt securities (including debt mutual funds) Other Total 46% 44% 10% 100% 46% 52% 2% 100% 49% 32% 19% 100% 46% 43% 11% 100% At 31 December 2007, 38.1% (2006: 34.8%) of the assets of the pension plans were mutual funds and alternative investments managed or administered by wholly-owned subsidiaries of the Bank. At 31 December 2007, 3.1% (2006: 3.3%) of the plans’ assets were invested in common shares of the Bank. The investments of the pension funds are diversified across a range of asset classes and are diversified within each asset class. The assets are generally actively managed with the goal of adding some incremental value through security selection and asset allocation. Estimated 2008 Bank contribution to, and estimated benefit payments for the next ten years under, the pension and post-retirement medical benefit plans are as follows: Pension plans Post-retirement medical benefit plan Estimated Bank contributions for 2008 3,300 3,510 Estimated benefit payments by year: 2008 2009 2010 2011 2012 2013-2017 3,600 4,300 4,700 5,000 5,200 30,200 3,510 3,925 4,363 4,773 5,140 31,433 The projected benefit obligation and fair value of plan assets for pension plans with projected benefit obligations in excess of plan assets were nil and nil as at 31 December 2007 ($93.2 million and $92.6 million respectively, as at 31 December 2006). As at 31 December 2007 and 2006 there were no pension plans with an excess of accumulated benefit obligations over the plan assets. Note 11: Commitments, Credit Related Arrangements and Contingencies Commitments The Bank was committed to expenditures under contract for software development and construction of $12.6 million and nil respectively, as at 31 December 2007 (2006: $3.3 million and $23.0 million). Rental expense for premises leased on a long-term basis for the year ended 31 December 2007 amounted to $7.9 million (2006: $5.7 million). The following table summarises the Bank’s commitments for software development and long-term leases: Year 2008 2009 2010 2011 2012 2013 & thereafter 19,559 6,566 5,273 5,081 5,093 7,094 Annual Report 2007 Credit Related Arrangements Standby letters of credit and letters of guarantee are issued at the request of a Bank customer in order to secure the customer’s payment or performance obligations to a third party. These guarantees represent an irrevocable obligation of the Bank to pay the third party beneficiary upon presentation of the guarantee and satisfaction of the documentary requirements stipulated therein, without investigation as to the validity of the beneficiary’s claim against the customer. Generally, the term of the standby letters of credit does not exceed one year, while the term of the guarantees does not exceed four years. The types and amounts of collateral security held by the Bank for these standby letters of credit and guarantees is generally represented by deposits with the Bank or a charge over assets held in mutual funds. The Bank considers the fees collected in connection with the issuance of standby letters of credit to be representative of the fair value of its obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, the Bank defers fees collected in connection with the issuance of standby letters of credit. The fees are then recognised in income proportionately over the life of standby letters of credit agreements. The Bank enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Bank’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for possible loan losses. The following table presents the credit related arrangements with contractual amounts representing credit risk as follows: 31 December Gross 2007 Collateral Net Gross 2006 Collateral Net Commitments to extend credit 1,245,604 511,669 733,935 959,495 182,514 776,981 Letters of credit Standby Documentary and commercial Guarantees Forward guarantees Total 407,656 2,381 16,744 1,527 1,673,912 350,983 2,381 10,283 1,527 876,843 56,673 - 6,461 - 797,069 492,220 2,422 15,667 1,741 1,471,545 443,098 2,422 9,164 1,741 638,939 49,122 - 6,503 - 832,606 Collateral is shown at estimated market value less selling cost. Where cash is the collateral, this is shown gross including interest income. The Bank has a facility by one of its custodians, whereby the Bank may offer up to US$150 million of standby letters of credit to its customers on a fully secured basis. Under the standard terms of the facility, the custodian has the right to set-off against securities held of 110% of the utilised facility. At 31 December 2007, $97.5 million (2006: $27.8 million) of standby letters of credit were issued under this facility. Legal Proceedings There are a number of actions and legal proceedings pending against the Bank and its subsidiaries which arose in the normal course of its business. Management, after reviewing all actions and proceedings, pending against or involving the Bank and its subsidiaries, considers that the resolution of these matters would not be material to the consolidated financial position of the Bank, with the following exception: the Bank has an interest in interpleader proceedings in New York Southern Federal District Court concerning the priority of payments relating to an investment security in which the Bank has an interest in an amount of $13.5 million, which is the carrying value. Given the significant uncertainty surrounding this matter, it is reasonably possible that a loss will arise. However due to the significant uncertainty surrounding this matter an estimate of the potential loss in carrying value cannot be determined and no provision has been made. 87 Note 12: Interest Income Loans The following table presents the components of loan interest income: Year ended 31 December Mortgages Other loans Amortisation of loan origination fees (net of amortised costs) Total loan interest income 2007 144,240 134,190 278,430 6,265 284,695 Balance of unamortised loan fees as at 31 December 13,723 2006 111,783 120,893 232,676 5,093 237,769 12,528 Note 13: Segmented Information (a) Operating Segments For management reporting purposes, the operations of the Bank are grouped into the following nine business segments based upon the geographic location of the Bank’s operations: Bermuda (which is further sub-divided based on products and services into Community Banking, Wealth Management & Fiduciary Services and Investment & Pension Fund Administration, and Real Estate), Barbados, Cayman, Guernsey, Switzerland, The Bahamas, and the United Kingdom. Accounting policies of the reportable segments are the same as those described in Note 1. The Bermuda Community Banking segment provides a full range of community, commercial and private banking services. Retail services are offered to individuals and small to medium sized businesses through five branch locations and through telephone banking, internet banking, Automated Teller Machines (ATMs) and debit cards. Retail services include deposit services, consumer and mortgage lending, credit cards and personal insurance products. Corporate services include commercial lending and mortgages, cash management, payroll services, remote banking, and letters of credit. Treasury services include money market and foreign exchange activities. The Bermuda Wealth Management & Fiduciary Services and Investment & Pension Fund Administration segment consists of Butterfield Asset Management Limited, which provides investment management, advisory and brokerage services, Butterfield Fund Services Limited, which provides valuation, accounting, corporate and shareholder services, and Butterfield Trust (Bermuda) Limited which provides trust, estate, company management and custody services. The Real Estate segment consists of the Bank’s investments in real estate and all related costs. This segment also includes rental revenues from third parties. The Barbados segment provides a range of community and commercial banking services through four branch locations, ATMs and debit cards. Services include deposit services, commercial banking, consumer and mortgage lending, credit cards. The Cayman segment provides a comprehensive range of community and commercial banking services to private and corporate customers through five locations and through internet banking, ATMs and debit cards. Wealth management and fiduciary services and investment and pension fund administration services are also provided. The Guernsey segment provides a broad range of services to private clients and financial institutions including, private banking and treasury services, internet banking, administered bank services, investment and pension fund administration services and wealth management and fiduciary services. The Switzerland segment provides wealth management and fiduciary services. The Bahamas segment provides institutional, corporate and private clients with a range of wealth management & fiduciary services and investment fund administration services. The United Kingdom segment provides a broad range of services including private banking and treasury services, internet banking and wealth management and fiduciary services to high net worth individuals and privately owned businesses. Annual Report 2007 Operating segment information follows: 31 December 2007 2006 Total Assets Bermuda Community Banking Wealth Management & Fiduciary Services and Investment & Pension Fund Administration Real Estate Total Bermuda Barbados Cayman Guernsey Switzerland The Bahamas United Kingdom Total overseas Less: inter-segment eliminations Total Business Area Analysis 5,419,174 4,857,125 38,680 101,913 5,559,767 277,297 2,729,334 2,368,565 537 181,671 1,999,093 7,556,497 (1,205,344 ) 11,910,920 37,532 82,735 4,977,392 213,449 2,792,777 1,809,527 351 155,398 1,985,942 6,957,444 (802,034 ) 11,132,802 Net interest income Year ended 31 December 2007 Customer Intersegment Allowance Fees and for credit other losses Net Income after central income revenue expenses allocations allocations* allocations Net Income before central Central Total Total 146,817 (16,317 ) (2,332 ) 33,282 161,450 120,908 40,542 18,246 58,788 Bermuda Community Banking Wealth Management & Fiduciary Services and Investment & Pension Fund Administration Real Estate Sub-total Bermuda - - 146,817 526 (1,268 ) (17,059 ) - - (2,332 ) 82,922 83,448 47,563 1,119 10,221 118,591 246,017 178,692 2,387 35,885 (18,587 ) 9,102 (9,102 ) 8,761 67,325 1,039 Barbados 13,808 Cayman Guernsey 4,514 Switzerland - (35) 2,981 The Bahamas (5,248 ) United Kingdom 17,059 Sub-total overseas 418 30,850 105,783 7,323 48,603 18,589 42 352 - - - (45 ) 349 3,750 12,154 11,983 52,447 115,210 57,981 41,495 64,598 48,380 1,296 206 8,654 12,053 8,987 6,807 32,364 29,288 113,394 236,585 157,915 241 171 57,229 16,218 (1,090 ) 3,066 3,076 78,670 (30 ) (6,549 ) (1,640 ) - (292 ) (250 ) (8,761 ) 17,298 - 76,086 141 50,680 14,578 (1,090 ) 2,774 2,826 69,909 Total income 252,600 - (1,983 ) 231,985 482,602 336,607 145,995 - 145,995 Less: inter-segment eliminations (principally rent and management fees) - 252,600 - - - (1,983 ) (12,639 ) (12,639 ) (12,639 ) 219,346 469,963 323,968 - 145,995 - - - 145,995 Total *This includes the allocation of property costs to the Bermuda business lines. In addition, it includes the charge out of the central costs across the Group. 89 Net interest income Customer Intersegment Allowance Fees and other income for credit losses Net Income before central Net Income after central allocations allocations* allocations Central Total Total revenue expenses Year ended 31 December 2006 Bermuda Community Banking Wealth Management & Fiduciary Services and Investment & Pension Fund Administration Real Estate Sub-total Bermuda Barbados Cayman Guernsey Switzerland The Bahamas United Kingdom Sub-total overseas 119,740 (2,931 ) (1,902 ) 34,712 149,619 110,660 38,959 - 38,959 - - 119,740 8,785 53,133 15,391 4 (360 ) 21,525 98,478 688 (1,235 ) (3,478 ) 144 2,955 1,728 - 2,535 (3,884 ) 3,478 - - (1,902 ) 75,244 3,811 75,932 2,576 113,767 228,127 42,318 9,050 162,028 (479 ) (615 ) - - (1 ) - (1,095 ) 3,845 43,643 33,250 - 6,907 7,726 12,295 99,116 50,369 4 9,081 25,367 95,371 196,232 11,320 45,724 39,468 244 6,874 24,618 128,248 33,614 (6,474 ) 66,099 975 53,392 10,901 (240 ) 2,207 749 67,984 - - - - - - - - - - 33,614 (6,474 ) 66,099 975 53,392 10,901 (240 ) 2,207 749 67,984 Total income 218,218 - (2,997 ) 209,138 424,359 290,276 134,083 - 134,083 Less: inter-segment eliminations (principally rent and management fees) - 218,218 - - - (2,997 ) (9,307 ) (9,307 ) 199,831 415,052 (9,307 ) 280,969 - 134,083 - - - 134,083 Total For the year ended 31 December 2007, included within other expenses are the following income tax expense amounts: Guernsey $4.9 million (2006: $3.5 million), United Kingdom $2.0 million (2006: $0.1 million) and Barbados $0.1 million (2006: $0.1 million). Transactions between operating segments principally include interbank deposits and rent which are recorded based upon market rates, and management fees, which are recorded based on the cost of the services provided. (b) Revenues by Products and Services The principal sources of revenues by products and services are disclosed separately in the Consolidated Statement of Income. Note 14: Accounting for Derivative Instruments and Risk Management The Bank uses derivatives in the asset and liability management (ALM) of positions and to assist customers with their risk management objectives. The Bank primarily enters into derivative contracts as part of its overall interest rate risk management strategy to minimise significant unplanned fluctuations in earnings that are caused by interest rate volatility. The Bank’s goal is to manage interest rate sensitivity by modifying the repricing or maturity characteristics of certain consolidated balance sheet assets and liabilities so that movements in interest rates do not adversely affect the net interest margin. The Bank’s derivative contracts principally involve over the counter transactions that are privately negotiated between the Bank and the counterparty to the contract. Derivative instruments that are used as part of the Bank’s interest rate risk management strategy include interest rate swaps and option contracts that have indices related to the pricing of specific consolidated balance sheet assets and liabilities. Interest rate swaps generally involve the exchange of fixed and variable-rate interest payments between two parties, based on a common notional principal amount and maturity date. Interest rate options represent contracts that allow the holder of the option to receive cash or purchase, sell, or enter into a financial instrument at a specified price within a specified period. The Bank pursues opportunities to reduce its exposure to credit losses on derivatives by entering into International Swaps and Derivatives Association Master Agreements (ISDAs). Depending on the nature of the derivative transaction, bilateral collateral arrangements may be used as well. When the Bank is engaged in more than one outstanding derivative transaction with the same counterparty, and also has a legally enforceable master netting agreement with that counterparty, the ”net” marked to market exposure represents the netting of the positive and negative exposures with that counterparty. When there is a net negative exposure, the Bank regards its credit exposure to the counterparty as being zero. The net marked to market position with a particular counterparty represents a reasonable measure of credit risk when there is a legally enforceable master netting agreement between the Bank and that counterparty. On 31 October 2007 the Bank provided credit enhancement to a related party, namely BMMFL. Under the credit enhancement agreement (the Agreement), the Bank is committed to compensate BMMFL subject to a maximum of $50.0 million should specific identified investment holdings in BMMFL have a fair value less than their carrying value and BMMFL is required to draw down on the obligation in order to retain its credit rating from the ratings agency. The decision by the ratings agency with regard to the rating requirements is outside the control of the Bank. In consideration, the Bank receives a fee of $1.3 million during the six month period covered by the Agreement ending 30 April 2008. As at 31 December 2007 the Bank has recognised a derivative liability for the fair value of the credit derivative of $6.3 million. The Agreement may be terminated without being drawn down before its term expires in certain circumstances, including if the underlying asset backed commercial paper is sold or restructured into securities at a price equal to or more than its then amortised cost. The value of the Annual Report 2007 derivative liability has been determined based on marked-to-market fair valuation based on the difference between fair market value and the amortised cost of the covered investments. This marked-to-market unrealised loss may be reversed in a subsequent period to the extent that the unrealised loss on the covered investments are reduced due to increases in the market value of the covered investments. Included in other assets (other liabilities) are the reported receivables and unrealised gains (payables and unrealised losses) related to derivatives. These amounts include the effect of netting as permitted under FASB Interpretation No. 39 Offsetting Amounts Related to Certain Contracts (FIN 39). (a) Fair Value Hedges The Bank enters into interest rate swaps to convert its fixed-rate long-term debt to floating-rate debt, and convert fixed-rate deposits to floating-rate deposits. For the year ended 31 December 2007 the Bank recognised a net loss of nil (2006: $0.1 million) reported as other income in the Consolidated Statement of Income, which represented the ineffective portion of all fair value hedges. As of 31 December 2007 the Bank has recorded the fair value of derivative instrument assets of $0.1 million (2006: $1.5 million) in other assets and derivative instrument liabilities of $5.1 million (2006: $6.2 million) in other liabilities. (b) Cash Flow Hedges The Bank uses interest rate swaps to convert floating-rate notes to fixed-rate instruments. These swaps, which qualify for hedge accounting, have the pay rate indexed to the rates received on the Bank’s variable-rate assets and the receive rate indexed to rates paid on the Bank’s various deposit liabilities. For cash flow hedges, gains and losses on derivative contracts that are reclassified from accumulated other comprehensive loss to current period earnings are included in the line item in which the hedged item is recorded in the same period the forecasted transaction affects earnings. As at 31 December 2007 and 2006, there was no hedge ineffectiveness related to cash flow hedges. As of 31 December 2007 and 2006 there was no deferred net gains or losses on derivative instruments accumulated in other comprehensive income that are expected to be reclassified as earnings during the next twelve months. The maximum term over which the Bank is hedging its exposure to the variability of future cash flows is nil months (2006: 2 months). As of 31 December 2007, the Bank has recorded the fair value of derivative instrument of $0.1 million (2006: nil) in other liabilities. (c) Notional Amounts The following table provides the aggregate notional amounts of derivative contracts outstanding listed by type and divided between those used for trading (non-hedging) and those used in hedging activities. The notional amounts are not recorded as assets or liabilities on the Consolidated Balance Sheet as they represent the face amount of the contract to which a rate or price is applied to determine the amount of cash flows to be exchanged. Notional amounts represent the volume of outstanding transactions and do not represent the potential gain or loss associated with market risk or credit risk of such instruments. 31 December Trading ALM Total value Trading ALM Total value 2007 2006 Interest rate contracts Interest rate swaps Interest rate caps and currency options Sub-total Other derivatives Spot and forward foreign exchange Credit derivative Sub-total Total notional amount of financial derivatives outstanding 40,000 38,686 78,686 407,676 - 407,676 447,676 38,686 486,362 2,763 43,810 46,573 476,332 - 476,332 479,095 43,810 522,905 11,826,492 50,000 11,876,492 - - - 11,826,492 50,000 11,876,492 7,369,599 - 7,369,599 - - - 7,369,599 - 7,369,599 11,955,178 407,676 12,362,854 7,416,172 476,332 7,892,504 Included in the notional amounts for cash flow hedges using interest rate swaps for 31 December 2007, are nil (2006: $25.0 million), pertaining to specific floating- rate notes included in the investment portfolio which were classified as held to maturity. Included in the notional amounts for fair value hedges using interest rate swaps for 2007, are $166.0 million (2006: $86.4 million) pertaining to specific loans, $125.0 million (2006: $125.0 million) pertaining to subordinated debt, and $116.6 million (2006: $245.6 million) pertaining to fixed-rate deposits. 91 (d) Fair Value Derivative instruments, in the absence of any compensating up-front cash payments, generally have no market value at inception. They obtain value, positive or negative, as relevant interest rates, exchange rates, equity or commodity prices or indices change, such that previously contracted derivative transactions have become more or less favourable than what can be negotiated under current market conditions for contracts with the same remaining period to maturity. The potential for derivatives to increase or decrease in value as a result of the foregoing factors is generally referred to as market risk. Market risk is managed within clearly defined parameters as prescribed by senior management of the Bank. The following table shows the marked to market fair value of all derivative contracts outstanding. This is defined as the profit (loss) associated with replacing the derivative contracts at prevailing market prices. 31 December Derivative financial instruments Interest rate swaps Spot and forward foreign exchange Credit derivative Interest rate caps and currency options Total fair value Positive 2007 Negative Net Positive 1,085 71,692 - 1,039 73,816 5,884 77,475 6,250 1,039 90,648 (4,799 ) (5,783 ) (6,250 ) - (16,832 ) 1,485 25,410 - 1,286 28,181 2006 Negative 6,891 27,095 - 1,233 35,219 Net (5,406 ) (1,685 ) - 53 (7,038 ) (e) Remaining Maturity The following table summarises the remaining term to maturity of the notional amounts of the Bank’s derivative instruments by type: 31 December 2007 Interest rate contracts Interest rate swaps Interest rate caps and currency options Sub-total Other derivatives Spot and forward foreign exchange Credit derivative Sub-total Within 6 months 6 to 12 months 1 to 3 years 3 to 5 years After 5 years Total 254,582 3,970 258,552 18,333 - 18,333 84,597 - 84,597 17,073 34,716 51,789 73,091 - 73,091 447,676 38,686 486,362 11,731,335 50,000 11,781,335 84,210 - 84,210 10,947 - 10,947 - - - - - - 11,826,492 50,000 11,876,492 Total notional amount by remaining maturity 12,039,887 102,543 95,544 51,789 73,091 12,362,854 31 December 2006 Interest rate contracts Interest rate swaps Interest rate caps and currency options Sub-total Other derivatives Spot and forward foreign exchange Within 6 months 6 to 12 months 1 to 3 years 3 to 5 years After 5 years Total 196,182 16,750 212,932 47,223 12,250 59,473 102,305 3,917 106,222 58,344 10,893 69,237 75,041 - 75,041 479,095 43,810 522,905 7,325,246 38,760 110 5,483 - 7,369,599 Total notional amount by remaining maturity 7,538,178 98,233 106,332 74,720 75,041 7,892,504 Annual Report 2007 (f) Replacement Cost The following table reflects the replacement cost of all derivative contracts outstanding. This is defined as the cost of replacing, at current market rates, all contracts that have a positive fair value before factoring in the impact of master netting agreements. The replacement cost of an instrument is dependent upon its terms relative to prevailing market prices and will fluctuate as market prices change and as the derivative approaches its scheduled maturity. 31 December Interest rate contracts Interest rate swaps Interest rate caps and currency options Sub-total Other derivatives Spot and forward foreign exchange Trading - 1,039 1,039 2007 ALM 1,085 - 1,085 Total value Trading 1,085 1,039 2,124 5 1,286 1,291 2006 ALM 1,480 - 1,480 Total value 1,485 1,286 2,771 71,692 - 71,692 25,410 - 25,410 Total replacement cost 72,731 1,085 73,816 26,701 1,480 28,181 Note 15: Fair Value of Financial Instruments The following table presents the carrying value and fair value of financial assets and liabilities under FAS No. 107 Disclosures About Fair Value of Financial Instruments (FAS 107). Accordingly, certain amounts which are not considered financial instruments are excluded from the table. For investments with an indicator of impairment, management has considered the available evidence, including discussions with rating agencies. Based on this and because the Bank has the ability and the intent to hold such securities to maturity, the Bank believes it will recover the full carrying value of the security. Should specific circumstances dictate that the Bank may not be able to hold such securities to maturity, such as a significant deterioration of credit worthiness of the issuer, the Bank may reassess whether a market value below carrying value represents an other than temporary impairment. 31 December Carrying value Fair value (depreciation ) Carrying value 2007 Appreciation/ 2006 Appreciation/ (depreciation) Fair value Financial assets Cash and deposits with banks Investments Trading Available for sale Held to maturity Loans Commercial, net of allowance for credit losses Consumer, net of allowance for credit losses Other assets Financial liabilities Customer deposits Demand deposits Term deposits Deposits, financial institutions Other liabilities Subordinated capital 2,517,012 2,517,012 - 3,151,191 3,151,191 - 58,534 932,238 3,754,217 58,534 932,238 3,591,980 - - (162,237 ) 56,471 963,355 2,766,967 56,471 963,355 2,756,592 2,228,264 1,896,500 118,504 2,225,280 1,896,965 118,504 (2,984 ) 465 - 2,100,893 1,659,852 434,073 2,097,201 1,660,992 434,073 5,911,184 4,530,395 306,392 65,741 284,191 5,911,184 4,526,335 306,392 65,741 290,993 - 4,060 - - (6,802 ) 5,743,611 4,012,048 287,173 260,249 280,168 5,743,611 4,015,231 287,173 260,249 274,836 - - (10,375 ) (3,692 ) 1,140 - - (3,183 ) - - 5,332 93 Note 16: Interest Rate Risk The following table sets out the assets, liabilities and shareholders’ equity and off-balance sheet instruments on the date of the earlier of contractual maturity or repricing date. Use of this table to derive information about the Bank’s interest rate risk position is limited by the fact that customers may choose to terminate their financial instruments at a date earlier than the contractual maturity or repricing date. Examples of this include fixed-rate mortgages, which are shown at contractual maturity but which may pre-pay earlier, and certain term deposits, which are shown at contractual maturity but which may be withdrawn before their contractual maturity, and certain investments which have call or pre-payment features. 31 December 2007 (in $ millions) Within 3 months 3 to 6 months 6 to 12 months 1 to 5 years After Non-interest 5 years bearing funds Total Earlier of contractual maturity or repricing date Assets Cash and deposits with banks Investments Loans Premises, equipment and computer software Other assets Total assets Liabilities and shareholders’ equity Shareholders’ equity Deposits Other liabilities Subordinated capital (a) Total liabilities and shareholders’ equity 2,284 3,987 3,478 - - 9,749 - 7,807 - 125 7,932 43 301 215 - - 559 - 1,517 - - 1,517 Interest rate sensitivity gap 1,817 (958) 64 236 52 - - 352 - 183 - - 183 169 126 - - 126 48 47 175 209 (4) 215 - 309 - 694 256 - - 301 - 186 - 100 286 - 13 - 60 73 629 1,042 250 (1 ) 1,920 15 183 (1,226 ) Cumulative interest rate sensitivity gap 1,817 859 1,028 1,043 1,226 - 2,517 4,745 4,125 215 309 11,911 629 10,748 250 284 11,911 - - 31 December 2006 (in $ millions) Within 3 months 3 to 6 months 6 to 12 months 1 to 5 years After 5 years Non-interest bearing funds Total Earlier of contractual maturity or repricing date Assets Cash and deposits with banks Investments Loans Premises, equipment and computer software Other assets Total assets Liabilities and shareholders’ equity Shareholders’ equity Deposits Other liabilities Subordinated capital (a) Total liabilities and shareholders’ equity 2,932 2,886 3,430 - - 9,248 - 8,384 - 125 8,509 77 318 150 - - 545 - 272 - - 272 79 252 28 - - 359 - 203 - - 203 - 216 141 - - 357 - 212 - 90 302 Interest rate sensitivity gap 739 273 156 55 - 69 50 - - 119 - 89 - 70 78 41 63 46 (38 ) 171 263 505 550 64 260 (5 ) 1,769 (1,264 ) Cumulative interest rate sensitivity gap 739 1,012 1,168 1,223 1,264 - (a) Includes interest rate swaps with fair value of $0.7 million (2006: $4.6 million), that are highly effective, designated and qualify as fair value hedges. 3,151 3,787 3,761 171 263 11,133 550 10,043 260 280 11,133 - - Annual Report 2007 Note 17: Subordinated Capital On 28 May 2003, the Bank issued US $125 million of Subordinated Lower Tier II capital notes. The notes were issued at par and in two tranches, namely US $78 million in Series A notes due 2013 and US $47 million in Series B notes due 2018. The issuance was by way of private placement with US institutional investors. The notes are listed on the Bermuda Stock Exchange (BSX) in the specialist debt securities category. Part proceeds of the issue were used to repay the entire amount of the US $75 million outstanding subordinated notes redeemed in July 2003. The notes issued under Series A pays a fixed coupon of 3.94% until 27 May 2008 when they become redeemable in whole at the option of the Bank. The Series B notes pays a fixed coupon of 5.15% until 27 May 2013 when they also become redeemable in whole at the Bank’s option. The Series A notes were priced at a spread of 1.25% over the 5-year US Treasury yield and the Series B notes were priced at a spread of 1.35% over the 10-year US Treasury yield. On 2 April 2004, in conjunction with the acquisition of Leopold Joseph, the Bank assumed a subordinated debt of £5 million which is included in the balance sheet in the amount of $9.9 million. The issuance was by way of private placement in the United Kingdom and pays a fixed coupon of 9.29% until April 2012 when it becomes redeemable in whole at the option of the Bank and 10.29% thereafter until August 2017. On 27 June 2005, the Bank issued US $150 million of Subordinated Lower Tier II capital notes. The notes were issued at par in two tranches, namely US $90 million in Series A notes due 2015 and US $60 million in Series B notes due 2020. The issuance was by way of private placement with US institutional investors. The notes are listed on the BSX in the specialist debt securities category. The notes issued under Series A pays a fixed coupon of 4.81% until 2 July 2010, when they will become redeemable in whole at the Bank’s option. The Series B notes pays a fixed coupon of 5.11% until 2 July 2015 when they also become redeemable in whole at the Bank’s option. The Series A notes were priced at a spread of 1.00% over the 5-year US Treasury yield and the Series B notes were priced at a spread of 1.10% over the 10-year US Treasury yield. Interest capitalised in accordance with FAS 34 during the year amounted to $1.7 million (2006: $1.5 million) and is included in interest expense - subordinated capital in the Consolidated Statement of Income. The following table presents the contractual maturity and interest payments for subordinated capital issued by the Bank as at 31 December 2007: Within 1 year 1 to 5 years After 5 years Carrying value Subordinated capital Bermuda 2003 issuance - Series A 2003 issuance - Series B 2005 issuance - Series A 2005 issuance - Series B Subsidiary Other (a) Total Fixed-rate Fixed-rate Fixed-rate Fixed-rate Fixed-rate 3,621 2,421 4,329 3,066 922 - 14,359 16,547 9,682 18,845 12,264 13,153 - 70,491 78,000 80,050 47,000 62,130 90,000 102,415 60,000 86,076 - 9,926 - (735) 284,191 330,671 (a) Other includes interest rate swaps with notional amount of $125 million, that are highly effective, designated and qualify as fair value hedges. Note 18: Earnings per Share Earnings per share has been calculated using the weighted average number of common shares outstanding during the year after deduction of the shares held as treasury stock and adjusted for the stock split and the stock dividend declared during the years ended 31 December 2007 and 2006 (see also Note 23). The dilutive effect of share-based compensation plans was calculated using the treasury stock method, whereby the proceeds received from the exercise of share-based awards are assumed to be used to repurchase outstanding shares, using the average market price of the Bank’s shares for the period. 31 December Basic earnings per share Net income for the year Weighted average number of common shares issued (in thousands) Weighted average number of common shares held as treasury stock (in thousands) Adjusted weighted average number of common shares (in thousands) 2007 2006 145,995 134,083 89,514 (4,734 ) 84,780 1.72 89,307 (4,440 ) 84,867 1.58 95 31 December Diluted earnings per share Net income for the year Weighted average number of common shares issued (in thousands) Weighted average number of common shares held as treasury stock (in thousands) Stock options (in thousands) Adjusted weighted average number of diluted common shares (in thousands) 2007 2006 145,995 134,083 89,514 (4,734 ) 2,137 86,917 1.68 89,307 (4,440 ) 2,520 87,387 1.53 Note 19: Share-Based Payment As at 31 December 2007, the Bank has three share-based compensation plans, which are described below. The compensation cost that has been charged against net income for those plans for the year ended 31 December 2007 was $5.4 million (2006: $3.7 million). The total income tax benefit recognised in the income statement for share-based compensation arrangements for the year ended 31 December 2007 was $0.1 million (2006: $0.1 million). Stock Option Plan At the Annual General Meeting of Shareholders held on 29 October 1997, the Directors were granted authority to implement a Stock Option Plan for executive officers and employees. Under the Bank’s 1997 Stock Option Plan (the 1997 Plan), options to purchase common shares of the Bank may be granted to employees and directors of the Bank that entitle the holder to purchase one common share at a subscription price equal to the market price on the effective date of the grant. Option exercise prices are stated and payable in Bermuda dollars. Generally, grants vest 25 percent at the end of each year for four years. The committee that administers the 1997 Plan has the discretion to vary the period during which the holder has the right to exercise options and, in certain circumstances, may accelerate the right of the holder to exercise options, but in no case shall the exercise period exceed ten years. The Board of Directors of the Bank has established at 9,000,000 the current maximum number of common shares which may be issued or transferred by the Stock Option Trust pursuant to exercise of options. At 31 December 2007, the Bank held as treasury stock 4,903,324 common shares (2006: 1,494,584) that can be used to satisfy the Bank’s obligations with respect to the Stock Option Plan. Directors’ and Executive Officers’ Stock Option Plan 2007 2006 31 December Number of stock options Weighted Weighted average average life remaining exercise (years) price ($) Aggregate intrinsic Number of value ($) stock options 541,899 Outstanding at beginning of year 80,000 Granted (prior to 2007 stock split) (75,204 ) Exercised (prior to 2007 stock split) - Stock dividend granted Stock split 1,093,390 Exercised (after 2007 stock split) (241,037) 1,399,048 Outstanding at end of year 769,109 Vested and exercisable at end of year 30.96 58.25 19.89 - 12.16 7.80 12.91 10.32 614,698 100,000 (228,517 ) 55,718 - - 541,899 334,303 6.87 5.87 7,752 6,099 Weighted average exercise price ($) 27.82 50.00 23.63 29.22 - - 30.96 25.44 Annual Report 2007 Employees’ Stock Option Plan 31 December Outstanding at beginning of year Granted (prior to 2007 stock split) Exercised (prior to 2007 stock split) Forfeited/cancelled (prior to 2007 stock split) Stock dividend granted Stock split Granted (after 2007 stock split) Exercised (after 2007 stock split) Forfeited/cancelled (after 2007 stock split) Outstanding at end of year Vested and exercisable at end of year Number of shares transferable upon exercise 2007 Weighted Weighted average average life remaining exercise (years) price ($) 2006 Number of shares Aggregate intrinsic transferable value ($) upon exercise Weighted average exercise price ($) 1,705,521 564,455 (291,193 ) (34,439 ) - 3,888,492 6,000 (575,753 ) (88,289 ) 5,174,794 1,836,223 34.87 58.25 27.03 15.56 - 14.24 20.50 9.08 16.59 14.78 11.05 1,407,065 489,471 (345,914 ) (34,894 ) 189,793 - - - - 1,705,521 686,223 30.00 50.12 24.55 37.81 34.16 - - - - 34.87 24.57 7.56 6.19 19,919 13,264 The weighted average fair value of stock options granted in the year ended 31 December 2007 was $6.54 per stock option (2006: $6.53), calculated using the Black-Scholes-Merton option-pricing model with the following weighted average assumptions: Year Ended 31 December 2007 2006 Projected dividend yield Risk-free interest rate Projected volatility Expected life (years) 5.0 5.0 3.70% 4.80% 14% 4.00% 4.60% 16% The projected dividend yield and volatility are based on the historical dividends paid and trading prices of the Bank’s common shares. The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasuries yield curve in effect at the time of grant. The Bank uses historical data to estimate expected option life and employee termination rates; separate groups of employees that have similar historical exercise behaviour are considered separately for valuation purposes. The compensation cost related to the Plan that has been charged against the income for the year ended 31 December 2007 was $2.9 million (2006: $2.4 million). The total intrinsic value of options exercised during the year ended 31 December 2007 was $24.2 million (2006: $13.1 million). As at 31 December 2007, there was $3.5 million of total unrecognised compensation cost related to non-vested options granted under the Plan. That cost is expected to be recognised over a weighted average period of 2.3 years. Deferred Incentive Plan Under its Deferred Incentive Plan as approved by the Board of Directors, the Bank grants restricted common shares to selected members of the management team. Shares are granted fully vested and are affected by transfer restrictions which are lifted at a rate of 33 percent at the end of each year for three years. The fair value of each restricted common share granted under the Deferred Incentive Plan was estimated based on the grant date market price of the Bank’s common shares discounted by 25% for their transfer restrictions. The discount for transfer restrictions was based, among other factors, on published restricted stock studies. During the year ended 31 December 2007, 35,442 restricted shares were granted (2006: 32,569). The fair value of common shares granted during the year ended 31 December 2007 was $1.5 million (2006: $1.3 million). Executive Long-Term Incentive Restricted Shares Plan The purpose of the Executive Long-Term Incentive Restricted Share Plan is to provide to selected executives of the Bank and certain subsidiaries of the Bank compensation opportunities that are compatible with shareholder interests that will encourage share ownership and that will enhance the Bank’s ability to retain key executives. Under its Executive Long-Term Incentive Restricted Share Plan, the Bank grants restricted shares to selected members of the management team. Shares are granted unvested and vest at a rate of 25 percent at the end of each year for four years. In certain circumstances, including retirement, shares vest on an accelerated basis. The fair value of each common share granted under the Executive Long-Term Incentive Restricted Share Plan was based on the grant date market price of the Bank’s common shares. During the year ended 31 December 2007, 23,532 shares were granted (2006: nil). The fair value of common shares granted during the year ended 31 December 2007 was $1.4 million (2006: nil). As at 31 December 2007, there was $0.4 million of total unrecognised compensation cost related to non-vested shares granted under the Plan. That cost is expected to be recognised over a weighted average period of 2.6 years. 97 Note 20: Share Buy-Back Plan During the year, 125,603 common shares (2006: 47,659) were purchased and cancelled at a cost of $7.4 million (2006: $2.7 million) and 967,119 common shares were purchased to be held as treasury stock at a cost of $38.1 million (2006: nil shares at a cost of nil). During the same period, the Bank’s Stock Option Trust bought 597,818 common shares at a cost of $22.7 million (2006: 431,132 common shares at a cost of $25.1 million) and the Bank’s Charitable Foundation bought nil common shares at a cost of nil (2006: 192,899 common shares at a cost of $11.0 million). The Bank has the present intention to repurchase over the twelve month period commencing 1 January 2008, up to 3,000,000 of its common shares of par value $1 each, pursuant to its share repurchase programme authorised by shareholders on 29 October 1997. This intention is subject to appropriate market conditions and repurchases will only be made in the best interest of the Bank. From time to time the Bank’s associates, insiders and insiders’ associates as defined by the BSX regulations may sell shares which may result in such shares being repurchased pursuant to the programme, but under BSX regulations such trades must not be pre-arranged and all repurchases must be made in the open market. Prices paid by the Bank must not, according to BSX regulations, be higher than the last independent trade for a ‘round lot’, defined as 100 shares or more. The BSX is advised monthly of shares repurchased and cancelled by the Bank and shares purchased by both the Stock Option Trust and the Charitable Foundation. Note 21: Dividend Re-Investment and Employee Common Stock Purchase Plans The Bank’s dividend re-investment and employee common stock direct purchase plans permit participants to purchase, at market value, shares of the Bank’s common stock by re-investment of dividends and/or optional cash payments, subject to the terms of each plan. Note 22: Capital Structure The Bank’s authorised common share capital is $100,000,000 (par value: $1.00). At the Annual General Meeting of Shareholders held on 18 April 2007, the Directors were granted authority to issue redeemable preference share capital of US $1,000,000 (par value US $0.01) and £500,000 (par value of £0.01). The redeemable preference share capital is issuable with such powers, preferences and other rights, limitations and restrictions as may be determined appropriate by the Directors. Note 23: Stock Split and Stock Dividend Shareholders of record at the close of business on 17 August 2007 were issued two additional shares of Butterfield Bank common stock on 31 August 2007 for each one share held as of the record date. All prior period per share data have been restated to reflect the three for one stock split. In August 2006, the Bank distributed a 10% stock dividend to shareholders of record on 7 August 2006. All prior period per share data have been restated to reflect the stock dividend. Note 24: Variable Interest Entities The effect of FIN 46R was a decrease in the Bank’s net assets of approximately $1.9 million for the year ended 31 December 2007 (2006: increase of $1.4 million). The change primarily relates to the Bank’s venture capital investment subsidiary (Butterfield Vencap Limited). Butterfield Vencap Limited holds investments in private companies where the nature of the investment relationship is such that the Bank, through Butterfield Vencap Limited, may absorb a majority of the expected losses or receive a majority of the residual returns of these companies. As at 31 December 2007 the total assets of variable interest entities consolidated in the balance sheet is $31.4 million (2006: $40.2 million). Note 25: Income Taxes The Bank is not subject to any taxes in Bermuda, The Bahamas and Cayman on either income or capital gains under current laws in those jurisdictions. The Bank’s income tax expense for all periods presented relates to income from operations and is attributable to subsidiaries and offices in various other jurisdictions that are subject to the relevant taxes in those jurisdictions. Annual Report 2007 31 December Income taxes in Consolidated Statement of Income Current Deferred Total tax expense Deferred income tax asset Tax loss carried forward General bad debt allowance Pension liability Allowance for compensated absence Onerous leases Other Total asset Deferred income tax liability Net deferred income tax asset 2007 6,977 - 6,977 444 - 707 31 147 2,831 4,160 1,338 2,822 2006 3,061 731 3,792 3,953 20 912 34 145 704 5,768 266 5,502 For the years ended 31 December 2007 and 2006, there were no unrecognised tax benefits and the tax related interest and penalties recognised in net income were nil. The Bank is no longer subject to federal, state and local income tax examinations by tax authorities for years before 1998. Note 26: Future Accounting Developments (a) Fair Value Measurement In September 2006, the Financial Accounting Standards Board issued FAS No. 157, Fair Value Measurement (FAS 157), which addresses how companies should measure fair value when required for recognition or disclosure purposes under US generally accepted accounting principles. Specifically, FAS 157 creates a common definition of fair value and will require expanded disclosures about fair value measurements. FAS 157 will be effective for fiscal years beginning after 15 November 2007 and, therefore, effective from the Bank’s first quarter in 2008. The effect of adoption will not be material. In February 2007, the Financial Accounting Standards Board issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159), which permits companies to choose to measure many financial instruments and certain other items at fair value which are not currently required to be measured at fair value. FAS 159 is effective for financial statements issued for fiscal years beginning after 15 November 2007, and therefore, effective from the Bank’s first quarter in 2008. Management is currently evaluating the effect of adoption. (b) Business Combinations In December 2007, the Financial Accounting Standards Board issued FAS No. 141 (Revised), Business Combinations (FAS 141R), which addresses how companies should recognise and measure assets and liabilities acquired through business combinations. FAS 141R is designed to improve the relevance and comparability of financial information relating to business combinations. FAS 141R will be effective for fiscal years beginning after 15 December 2008 and therefore, effective from the Bank’s first quarter in 2009. Management is currently evaluating the effect of adoption. (c) Non-controlling Interests in Consolidated Financial Statements In December 2007, the Financial Accounting Standards Board issued FAS No. 160, Non-controlling Interest in Consolidated Financial Statements (FAS 160), which addresses how companies should measure and present non-controlling interests. FAS 160 is designed to improve the relevance, comparability, and transparency of financial information relating to non-controlling interests. FAS 160 will be effective for fiscal years beginning after 15 December 2008 and therefore, effective from the Bank’s first quarter in 2009. Management is currently evaluating the effect of adoption. Note 27: Subsequent Events On 15 January 2008 the Bank provided credit enhancement to BMMFL. Under the credit enhancement agreement (the Agreement), the Bank is committed to compensate BMMFL subject to a maximum of $51.0 million should specific identified investment holdings in BMMFL have a fair value less than their carrying value and BMMFL is required to draw down on the obligation in order to retain its credit rating from the ratings agency. The decision by the ratings agency with regard to the rating requirements is outside the control of the Bank. In consideration, the Bank is entitled to receive a fee of $1.5 million during the six month period covered by the Agreement. The Agreement may be terminated without being drawn down before its term expires in certain circumstances, including if the underlying asset backed commercial paper is sold or restructured into securities at a price equal to or more than its then amortised cost. On 25 February 2008 the Bank purchased from BMMFL $75.0 million of asset backed security for fair market value of $73.565 million, and placed these securities into the held to maturity portfolio. The holdings of the asset backed security are high quality with no direct exposure to sub-prime, mid-prime, or second lien mortgages. 99 Directory. Shareholders’ Information Principal Offices & Subsidiaries 101 103 2007 101 Shareholders’ Information Directors’ and Executive Officers’ Share Interests and Directors’ Service Contracts Pursuant to Regulation 6.8(3) of section IIA of the Bermuda Stock Exchange Listing Regulations, the total interests of all Directors Exchange Listing and Executive Officers of the Bank in the shares of the Bank as at The Bank’s shares are listed on the Bermuda Stock Exchange (BSX) 31 December 2007 were 1,441,125 shares. With the exception of and the Cayman Islands Stock Exchange (CSX), located at: those participating in the Shareholders’ Dividend Reinvestment Plan or the Stock Option Plan, no rights to subscribe for shares in the Bank have been granted to or exercised by any Director or Officer. None of the Directors or Executive Officers had any interest in any debt securities issued by the Bank or its subsidiaries. There are no service contracts with Directors, except for Alan R. Thompson, President & Chief Executive Officer, whose Bermuda Stock Exchange (Primary Listing) Phase 1 – 3rd Floor, Washington Mall Church Street Hamilton HM 11 Bermuda Tel: (441) 292 7212 or (441) 292 7213 Fax: (441) 292 7619 www.bsx.com contract expires on 30 June 2009. Dividend Payment Cayman Islands Stock Exchange (Secondary Listing) Elizabethan Square, 4th Floor Dividends approved by the Board are paid quarterly, normally occurring in November, March, May and August. P.O. Box 2408 GT, Grand Cayman Cayman Islands Tel: (345) 945 6060 Fax: (345) 945 6061 www.csx.com.ky Annual Report 2007 Share Dealing Service Butterfield Securities (Bermuda) Limited 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3972 Fax: (441) 292 9947 E-mail: contact@bntb.bm Share Price Published daily in The Royal Gazette in Bermuda and available on Bloomberg Financial Markets (symbol: NTB BH). Written Notice of Share Repurchase Programme — BSX Regulation 6.38 The Board of Directors of the Bank announced the intention to repurchase over the 12 month period commencing 1 January 2008, up to 3,000,000 of its ordinary shares of par value $1 each pursuant to its share repurchase programme authorised by shareholders on 29 October 1997. As at 31 December 2007, 3,000,000 shares represented 3.4% of total issued shares of the Bank. This intention is subject to appropriate market conditions and repurchases will only be made in the best Also available on the BSX and CSX websites. interests of the Bank. The Directors consider that share repurchase Dividend Reinvestment Plan Details are available from Butterfield Fund Services (Bermuda) Limited (E-mail: contact@bntb.bm) and on our website, is an excellent means of enhancing shareholder value while increasing earnings per share. In the 12 months to 31 December 2007, shares repurchased and cancelled totalled* 376,809 shares at an average price of $19.65 and www.butterfieldbank.com, under “About Us | Shareholder Information.” aggregate cost of $7.4 million while shares repurchased and held Certain restrictions apply. Registrar and Transfer Agent Butterfield Fund Services (Bermuda) Limited Rosebank Centre 11 Bermudiana Road Pembroke, HM 11 Bermuda Tel: (441) 299 3882 Fax: (441) 295 6759 E-mail: contact@bntb.bm Head Office The Bank of N.T. Butterfield & Son Limited 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 295 1111 Fax: (441) 292 4365 E-mail: contact@bntb.bm Media Relations & Publication Requests Marketing & Communications Tel: (441) 299 1624 or (441) 298 4610 E-mail: markjohnson@bntb.bm or stuartroberts@bntb.bm Investor Relations Chief Financial Officer Tel: (441) 299 1643 E-mail: richardferrett@bntb.bm as treasury shares totalled 1,907,119 shares at an average price of $20.00 and aggregate cost of $38.1 million. From time to time the Bank’s associates, insiders, and insiders’ associates as defined in the BSX Regulations may sell shares which may result in being repurchased pursuant to the programme, but under BSX Regulations such trades must not be prearranged and all repurchases must be made in the open market. Prices paid by the Bank must not, according to BSX Regulations, be higher than the last independent trade. The Bank will continue to advise the BSX monthly of shares repurchased, and those cancelled or held as treasury shares. In addition and separate to the above, the Bank’s Stock Option Trust may from time to time purchase shares of the Bank through the BSX to satisfy the Bank’s obligations with respect to the Stock Option Plan, and such purchases will likewise be advised to the BSX monthly. Shares purchased in this way in the 12 months to 31 December 2007 totalled* 1,094,354 shares at on average price of $20.73 and aggregate cost of $22.7 million. (*Numbers have been adjusted to reflect the stock split during 2007 of two new shares issued for each share held.) Large Shareholders The following professional nominees at 31 December 2007 were registered holders of 5% or more of the issued share capital: Harcourt & Co. (15.8%), Palmar Limited (6.2%), Wilson & Co. (5.1%). Known beneficial holdings of 5% or more of issued share capital at that date were: Bermuda Life Insurance Company Limited (7.1%). 103 Principal Offices & Subsidiaries Field Real Estate Holdings Limited Real Estate Holding This list does not include all companies in the Group. The Bank of N.T. Butterfield & Son Limited Holding Company, Community Banking, Private Banking, Credit, Treasury Services 65 Front Street, Hamilton, HM 12 Bermuda Tel: (441) 295 1111 Fax: (441) 292 4365 Head Office 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 295 1111 Fax: (441) 292 4365 S.W.I.F.T. BNTB BM HM E-mail: contact@bntb.bm Mailing Address: P.O. Box HM 195 Hamilton, HM AX Bermuda Bermuda Butterfield Asset Management Limited Investment Management, Brokerage Services Managing Director: Ian Coulman 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3817 Fax: (441) 292 9947 E-mail: contact@bntb.bm Butterfield Fund Services (Bermuda) Limited Investment & Pension Fund Administration Managing Director: Douglas Lang Rosebank Centre 11 Bermudiana Road Pembroke, HM 11 Bermuda Tel: (441) 299 3882 Fax: (441) 295 6759 E-mail: contact@bntb.bm Butterfield Trust (Bermuda) Limited Grosvenor Trust Company Limited Personal Trust, Corporate Trust Managing Director: Michelle Wolfe 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3980 Fax: (441) 292 1258 E-mail: contact@bntb.bm The Bahamas Butterfield Bank (Bahamas) Limited Private Banking, Personal Trust, Corporate Trust Managing Director: Robert Lotmore 3rd floor, Montague Sterling Centre, East Bay Street P.O. Box N-3242 Nassau, N.P. The Bahamas Tel: (242) 393 8622 Fax: (242) 393 3772 E-mail: info@butterfieldbank.bs Butterfield Fund Services (Bahamas) Limited Investment & Pension Fund Administration Managing Director: Heather Bellot 2nd floor, Montague Sterling Centre, East Bay Street P.O. Box N-674 Nassau, N.P. The Bahamas Tel: (242) 393 8622 Fax: (242) 393 3772 E-mail: info@butterfieldbank.bs Barbados Butterfield Bank (Barbados) Limited Community Banking Director: Lloyd Wiggan 1st Floor, Carlisle House Hincks Street Bridgetown, Barbados Tel: (246) 431 4500 Fax: (246) 430 0221 E-mail: contact@butterfieldbank.bb Butterfield Asset Management (Barbados) Limited Representative Office Vice President: Caroline Prow Belleville Corporate Centre 38 Pine Road Belleville, St Michael Barbados Tel: (246) 430 1650 Fax: (246) 436 7999 E-mail: carolineprow@butterfield.bb Annual Report 2007 Canada Butterfield Fund Services (Canada) Limited Fund Administration Managing Director: Sylvain Lacoursière 2nd Floor, Summit Place 1601 Lower Water Street Halifax, Nova Scotia Canada B3J 3P6 Tel: (902) 493 7601 Fax: (902) 493 7630 E-mail: sylvainlacoursiere@bntb.bm Cayman Islands Butterfield Bank (Cayman) Limited Community Banking, Private Banking, Asset Management, Personal Trust, Corporate Trust Managing Director: Conor O’Dea Butterfield House 68 Fort Street P.O. Box 705 Grand Cayman KY1-1107 Cayman Islands Tel: (345) 949 7055 Fax: (345) 949 7004 E-mail: info@butterfieldbank.ky Butterfield Fund Services (Cayman) Limited Investment & Pension Fund Administration Managing Director: John Lewis Butterfield House 68 Fort Street P.O. Box 705 Grand Cayman KY1-1107 Cayman Islands Tel: (345) 949 7055 Fax: (345) 949 7004 E-mail: fund.admin@butterfieldbank.ky Guernsey Butterfield Bank (Guernsey) Limited Private Client and Institutional Banking and Credit, Investment Management, Custody and Custodian Trustee Services Managing Director: Robert Moore P.O. Box 25 Regency Court Glategny Esplanade St Peter Port, Guernsey GY1 3AP Channel Islands Tel: (44) 1481 711 521 Fax: (44) 1481 714 533 E-mail: info@butterfield.gg Butterfield Trust (Guernsey) Limited Fiduciary Services Managing Director: Paul Hodgson P.O. Box 25 Regency Court Glategny Esplanade St Peter Port, Guernsey GY1 3AP Channel Islands Tel: (44) 1481 711 521 Fax: (44) 1481 714 533 E-mail: info@butterfield.gg Butterfield Fund Services (Guernsey) Limited Investment & Pension Fund Administration Managing Director: Patrick Firth P.O. Box 25 Regency Court Glategny Esplanade St Peter Port, Guernsey GY1 3AP Channel Islands Tel: (44) 1481 720 321 Fax: (44) 1481 716 117 E-mail: info@butterfield.gg Hong Kong Bentley Asia Limited Personal Trust Bentley Capital (Pacific) Ltd Asset Management Bentley Reid & Co. (Pacific) Ltd Wealth Advisory and Management Deputy Chairman: Nic Bentley 24th Floor, Diamond Exchange Building 8-10 Duddell Street Central Hong Kong Tel: (852) 2810 1233 Fax: (852) 2810 0849 E-mail: admin@bentleyreid.com.hk Malta Bentley Trust Limited Personal Trust, Company Administration Managing Director: Malcolm Becker Level 7, Portomaso Tower St Julians PTM 01 Malta Tel: (356) 21 37 8828 Fax: (356) 21 37 8383 E-mail: admin@bentleytrust.com.mt Switzerland Butterfield Trust (Switzerland) Limited Trust and Company Services Country Head, Managing Director: Jim Parker Boulevard des Tranchées 16 1206 Geneva, Switzerland Tel: (41) 22 839 0000 Fax: (41) 22 830 0099 E-mail: info@butterfield.ch Butterfield Asset Management (Switzerland) Limited Asset Management, Funds Advisory Managing Director: Iain Little Talstrasse 37 CH-8022 Zurich, Switzerland Tel: (41) 43 888 6488 Fax: (41) 43 888 6489 E-mail: info@butterfield.ch United Kingdom Butterfield Bank (UK) Limited Private Banking, Credit, Treasury Services Managing Director: George Bogucki 99 Gresham Street London, EC2V 7NG United Kingdom Tel: (44) 207 776 6700 Fax: (44) 207 776 6701 E-mail: info@butterfieldprivatebank.co.uk Butterfield International Private Office Limited Global and Independent Asset Structuring Services Managing Director: Katie Booth 99 Gresham Street London, EC2V 7NG United Kingdom Tel: (44) 207 776 6700 Fax: (44) 207 776 6701 E-mail: info@butterfieldprivatebank.co.uk Bentley Capital (Europe) Ltd Asset Management Bentley Reid & Co. (Europe) Ltd Wealth Advisory and Management Managing Director: Rupert Bentley 99 Gresham Street London, EC2V 7NG United Kingdom Tel: (44) 207 776 6700 Fax: (44) 207 776 6701 E-mail: administrator@bentleycapital.co.uk 

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