Bank of N.T. Butterfield & Son Ltd Annual Report 2011

Plain-text annual report

A Foundation for Growth A n n u a l R e p o r t 2 0 1 1 The Bank of N.T. Butterﬁeld & Son Limited Annual Report 2011 Cover: Banyan tree, Hamilton Parish, Bermuda About Butterfield Butterﬁeld is a diversiﬁed ﬁnancial services Group operating in seven jurisdictions. We have total assets of $8.8 billion and $71.7 billion of client assets under administration. We employ over 1,300 people around the world. The parent company, The Bank of N.T. Butterﬁeld & Son Limited, is a publicly traded company with a primary share listing on the Bermuda Stock Exchange and a secondary listing on the Cayman Islands Stock Exchange. Additional information can be obtained from our website, www.butterﬁeldgroup.com. 1 “Butterfield is pursuing a strategy that will continu e to strength en th e company and promote its long-term growth.” 2 CHAIRMAN’S LETTER TO THE SHAREHOLDERS I am pleased to report that Butterﬁeld returned to proﬁtability Subject to his election to the Board, the Directors intend to appoint in 2011, producing net income of $40.5 million and delivering Brendan McDonagh to the position of Executive Chairman of the operating proﬁts in each quarter. The Bank’s 2011 income is modest Bank. Mr. McDonagh is a career banker with more than 30 years of by historical standards, reﬂecting a period of protracted economic international experience in consumer ﬁnance, retail and commercial dislocation and low interest rates. Against that backdrop, the Bank’s banking and wealth management. His knowledge and experience will ﬁnancial performance in 2011 should be viewed as an important be advantageous to the Board as it works to continue to move the accomplishment and evidence that the Bank is on a solid ﬁnancial Bank forward on its current, proﬁtable trajectory. base following an extremely difﬁcult period. Butterﬁeld was adversely impacted during the global ﬁnancial crisis April 2011, ﬁlling the vacancy created by the earlier resignation of by investments in troubled asset-backed securities and the Julian Francis. Additionally, Victor Dodig replaced John Orr as one of non-performance of certain loans. In response, the Bank raised CIBC’s nominees to the Board in August. James Burr, whose term as a $750 million of new capital during 2009 and 2010, and over the past Director expires in 2012, will not stand for re-election. Olivier Sarkozy two years, has deployed that capital to de-risk the Balance Sheet is nominated to replace Mr. Burr as one of Carlyle’s two nominees to The Board transition also saw Barclay Simmons join as a Director in and enhance business systems and structures. The resulting dilutive the Board. impact of the recapitalisation on legacy Shareholders’ ownership was severe, but the actions taken to address underperforming assets, It has been my honour to have been a member of the Board for the improve the Bank’s operating infrastructure and control costs have past 15 years and Chairman since February 2008; unfortunately the created a foundation for rebuilding Shareholder value. Butterﬁeld is beginning of the ﬁnancial crisis and the toughest years in Butterﬁeld’s pursuing a strategy that will continue to strengthen the company and 154-year history. I have had the opportunity to work closely with many promote its long-term growth. talented Directors and the Bank’s dedicated employees. I believe that the Bank, its employees and the communities we serve are in an During 2011, Butterﬁeld paid dividends totalling $16 million on excellent position following the Bank’s recapitalisation. outstanding Preference Shares. Consistent with the Board’s view that the distribution of proﬁts should be suspended until such time as the I extend my sincere best wishes to Mr. McDonagh. I am conﬁdent that, Bank is generating sufﬁcient income to allow for a meaningful under his leadership, the Board will continue to successfully rebuild per-Share dividend, no dividends were declared or paid on Common value for the beneﬁt of Butterﬁeld Shareholders. Shares in 2011. Holders of Contingent Value Convertible Preference Shares (“CVCP Shares”), issued in 2010 as part of our rights offering, were eligible for certain distributions in connection with the sale or public offering of the Bank’s equity interest in fund administrator Butterﬁeld Fulcrum Group Limited (“BFG”). In the second quarter, the Bank completed the sale of its minority interest in BFG, resulting in a distribution of $3.3 million (or $0.42 per CVCP Share). I committed to Shareholders that, following the recapitalisation, we would work to accomplish an orderly transition of the Board to provide continuity of experience. As part of this transition I have advised the Board that I will retire as a member of the Board and Chairman effective at the close of the 2012 Annual General Meeting. Robert Steinhoff, Vice Chairman, has similarly announced his retirement from the Board effective at the close of the 2012 Annual General Meeting. Robert A. Mulderig Chairman of the Board Butterﬁeld Annual Report 2011 3 “We ha ve realigned our resources to areas with greater growth potential…” 4 PRESIDENT & CHIEF EXECUTIVE OFFICER’S REPORT 2011 was a year of transition for Butterﬁeld; one in which we continued to institutions paying higher interest. Average deposits for 2011 to build a foundation for future growth. Our focus was on enhancing decreased by $356 million versus 2010. The Bank’s core deposits, proﬁtability, maintaining and further strengthening our Balance Sheet consisting primarily of demand deposits and savings deposits, and investing in our core businesses of community banking and remained stable. wealth management. ENHANCING PROFITABILITY Despite a difﬁcult operating environment for banks, with low interest rates and depressed demand for some services, Butterﬁeld generated The Bank also remained in a very liquid position, with the percentage of assets held in cash, cash equivalents, short-term investments and investments totalling 46.5% at year end. net income of $40.5 million for the year, with four proﬁtable quarters. Reﬂective of our conservative investment stance, the Bank sought to limit its exposure to the debt crisis in Europe and actively reduced its Revenue was up by $30.5 million versus normalised 2010 ﬁgures. exposure to Continental Europe in the fourth quarter. Contributing substantially to our 2011 earnings was an increase in net interest income before provisions for credit losses of $34.8 million. Although we have seen an increase in the incidence of delinquencies The Bank’s net interest margin increased by 47 basis points to 2.50% in loan and mortgage payments, the increase is commensurate with in 2011. the general economic decline. Non-accrual loans as a percentage of total loans declined to 2.8% at the end of 2011 from 3.9% in 2010, As a result of streamlining certain processes, the introduction of new whilst non-performing assets as a percentage of total assets was technology and a reduced demand for some services, headcount was 1.7%, a reﬂection of the transfer of $27.4 million of non-accrual loans reduced by 135 across the Group. to the “Other Real Estate Owned” category in settlement of certain commercial loans and foreclosed residential property. The Bank Butterﬁeld had no signiﬁcant investment losses and recognised no employs conservative standards in its lending activities and, during other-than-temporary impairments on investments during 2011, having these challenging times, has exercised ﬂexibility with customers who dealt decisively with its problematic assets following the capital raise are experiencing difﬁculty in repaying loans on the original terms. in 2010. Charge-offs against loans were $23.8 million in 2011 amidst ongoing economic challenges (compared to $107.9 million in 2010). Through our private banking businesses in Guernsey and the United STRENGTHENING THE BALANCE SHEET As a result of ongoing diligence with respect to the quality of Kingdom, we began targeting under-served segments of the lending market in 2011, increasing residential lending to high net worth clients who purchased prime Central London properties. The addition investments and loans we make, our Balance Sheet was further strengthened in 2011. of these high quality assets, in combination with the extension of additional credit facilities to the Government of Bermuda, contributed Total assets decreased by $799 million to end the year at $8.8 billion, Loans represented a conservative 48.1% of total assets and 57.4% of to an increase in the loan portfolio of $200 million during the year. the year-on-year decrease owed primarily to ﬂuctuations in hedge customer deposits at year end. fund deposits and some loss of non-core deposits that migrated Butterﬁeld Annual Report 2011 5 CAPITAL During 2011, the Bank’s capital position improved from already-strong Michael Neff, Head of Group Asset Management, who joined 2010 levels. The Tier 1 capital ratio was 17.7% at year end, and the total Butterﬁeld in early 2011, is working to strengthen and grow the asset capital ratio stood at 23.5%, well ahead of both industry norms and management offerings across the Group. Our asset management regulatory minimums. Butterﬁeld’s tangible common equity ratio was strategy involves the rationalisation of the Butterﬁeld Fund line 6.6% and the tangible total equity ratio was 8.9% at 31 December 2011. up, partnering with third-party investment managers to deliver new INVESTING IN OUR CORE BUSINESSES During the year, the Bank completed a three-year project to convert its core banking systems in Bermuda and the Cayman Islands to a new Oracle platform managed by HP. The new systems replace software that was beyond its service life and provide the Bank with a state-of-the-art platform. They allow the Bank to improve stability, risk management and customer service. With the same banking platform in place in our two largest jurisdictions, we also have more opportunities to gain efﬁciencies from the synchronisation of processes and product line ups moving forward. products and tailoring products and services to clients’ life stages and advisory requirements. During the year, we introduced a managed portfolio service and an online brokerage service in Bermuda—the ﬁrst of its kind in the jurisdiction—making a wide range of US exchange-traded securities available to self-directed retail investors. The online brokerage service will continue to be expanded to include third-party funds. For institutional clients, we introduced the BNY Mellon Butterﬁeld Income Advantage Fund, a ﬁxed income fund with a low risk proﬁle that aims to deliver higher returns than money market funds. We realigned our trust businesses across the Group under a centralised reporting structure in 2011. Bob Moore, who was previously Managing Director of our Guernsey bank, took on the role of Head of Group Trust in July and is working to harmonise our offerings and approach to the marketing and delivery of ﬁduciary services across the Group. Work continues on installing new systems for our Group trust businesses in key jurisdictions. SERVING OUR COMMUNITIES Community banking is a core Butterﬁeld business and investing in people and projects that are helping improve the prosperity and well-being of people in our markets is viewed as an important investment for the Bank. To that end, we provided sponsorship, donations and the helping hands of employee volunteers to deserving organisations and events across our jurisdictions in 2011. 6 Working together, the Board, the Bank’s Management team and our instrumental in helping Butterﬁeld secure new sources of capital to employees have made great progress under our strategy to streamline enable the Bank to survive the ﬁnancial crisis and emerge in a position and strengthen our businesses and processes. We have realigned to prosper as the global economy recovers. I would also like to extend our resources to areas with greater growth potential, and trimmed thanks to Director James Burr, who will be leaving the Board in 2012, for underperforming assets and offerings in the interest of fostering his valued contributions to Butterﬁeld. future proﬁtability. Our success in strengthening the Bank ﬁnancially has been recognised we enjoy from our clients and Shareholders. Finally, I would like to express my appreciation for the ongoing support by the rating agencies. In 2011, both Fitch and Standard & Poor’s afﬁrmed our ratings, the latter on more stringent criteria that saw many international banks downgraded during the year. The ﬁnancial press, too, has acknowledged our progress and recognised our people for their expertise. Several of our senior executives in Europe were included among Citywealth’s honoured practitioners in the areas of trust, investment management and private banking. Euromoney recently identiﬁed Butterﬁeld in Bermuda and the Caribbean as providing the “Best Private Banking Services” in a number of key areas. On behalf of the Management team, I would like to thank Chairman Robert Mulderig and Vice Chairman Robert Steinhoff, who will both retire following the 2012 Annual General Meeting, for their many years of service to Butterﬁeld. Both Mr. Mulderig and Mr. Steinhoff were Bradford Kopp President & Chief Executive Ofﬁcer Butterﬁeld Annual Report 2011 7 BOARD OF DIRECTORS & PRINCIPAL BOARD COMMITTEES L to R - Back Row: Richard Venn, Victor G. Dodig, Wolfgang Schoellkopf, Bradford Kopp, Brendan McDonagh, Barclay Simmons, James Burr, Shaun Morris Front Row: Sheila Lines, Robert Steinhoff, Robert A. Mulderig, Pauline Richards, John Wright COMMITTEES INDICATED BY NUMBERS 1,5 CHAIRMAN ROBERT A. MULDERIG* Retired Chariman & Chief Executive Ofﬁcer, Mutual Risk Management Ltd. 1 1,3 BRADFORD KOPP President & Chief Executive Ofﬁcer, WOLFGANG SCHOELLKOPF Managing Partner, The Bank of N.T. Butterﬁeld & Son Limited Lykos Capital Management Chairman, Woodmont Trust Co. Ltd. 2,4,6 1,2,5 VICE CHAIRMAN* ROBERT STEINHOFF Retired Partner, KPMG Director, Argus Insurance Co. Ltd. 2,5,6 JAMES BURR Managing Director, Carlyle Global Financial Services Group SHEILA LINES* Chief Executive Ofﬁcer, KeyTech Limited 1,4 SHAUN MORRIS* Partner, Appleby Bermuda law ﬁrm 2,4,6 PAULINE RICHARDS* Chief Operating Ofﬁcer, 3,4 VICTOR G. DODIG Senior Executive Vice-President Armour Group Holdings Limited Director, Wyndham Worldwide Inc. Director, Apollo Global Management, LLC and Group Head, Wealth Management, CIBC Former Director and Audit Committee Chair, Cendant Corporation 3,5 BARCLAY SIMMONS* Managing Partner, Attride-Stirling & Woloniecki, Barristers & Attorneys 1,3,5 RICHARD VENN Senior Executive Vice-President, Advisor to the CEO Ofﬁce, CIBC 3,6 JOHN WRIGHT* Retired Bank Chief Executive *Independent, Non-Executive Director. On an annual basis, the Corporate Governance Committee ensures the appropriate composition of the Board and its Committees in accordance with the Group’s Corporate Governance Policy. The assessment of the independence of a Director is based upon a number of factors including, but not limited to: whether he or she has been employed by the Group within the last ﬁve years; whether he or she has had, within the last three years, a material relationship with the Group; and whether he or she represents a signiﬁcant Shareholder. 8 PRINCIPAL BOARD COMMITTEES 1. EXECUTIVE COMMITTEE OF THE 3. RISK POLICY & COMPLIANCE BOARD OF DIRECTORS Supports the Board in fulﬁlling its COMMITTEE Focuses on credit, market and 5. COMPENSATION & HUMAN RESOURCES COMMITTEE Focuses on compensation and overall governance responsibilities. operational risk. beneﬁts, employee development and succession. 2. AUDIT COMMITTEE 4. CORPORATE GOVERNANCE Oversees Butterﬁeld’s ﬁnancial reports, internal ﬁnancial controls, COMMITTEE Focuses on Directors’ and Board 6. AD HOC I.T. COMMITTEE Focuses on technology and systems internal audit processes and Committee governance, performance development. compliance. and Directors’ nominations. On 5 January 2012, the Bank announced that Brendan McDonagh, who was previously Chief Executive Ofﬁcer, HSBC North America and Group Managing Director, HSBC Holdings plc, will be nominated for election to its Board of Directors at the 2012 Annual General Meeting of Shareholders. Subject to his election, the Directors intend to appoint Mr. McDonagh to the position of Executive Chairman of the Bank. DIRECTORS’ CODE OF PRACTICE AND GROUP CODE OF CONDUCT The Directors have adopted a Code of Best Practice based upon recommended principles of corporate governance. In implementing the Code, the Board meets regularly, retains full effective control over the Bank, and monitors Executive Management. A Group Code of Conduct applies to Directors and employees and imposes Butterﬁeld’s principles of business, including ethics and conﬂicts of interest. Copies of the Codes can be accessed on www.butterﬁeldgroup.com. Butterﬁeld Annual Report 2011 9 SENIOR MANAGEMENT BRADFORD KOPP* President & Chief Executive Ofﬁcer PHILIP JONES Senior Relationship Manager & MARTIN POLLOCK Managing Director, Deputy Head of Corporate Banking, Butterﬁeld Trust (Bermuda) Limited Bermuda CHARLES LAWRENCE Senior Vice President, Treasury, Bermuda SEAN LEE Executive Vice President, Retail Banking, Bermuda JOHN MARAGLIANO Senior Vice President, Finance JULIEN MARTEL Managing Director, JONATHAN RAYNOR Senior Vice President, Group Head of Compliance & Risk Change JOHN ROBINSON Managing Director, Butterﬁeld Bank (Guernsey) Limited BRADLEY ROWSE* Executive Vice President, Chief Financial Ofﬁcer NIR SADEH Senior Vice President, Private Banking, Bermuda Butterﬁeld Bank (Bahamas) Limited MICHAEL MCWATT Executive Vice President, RICHARD SAUNDERS Head of European Asset Management Banking and Deputy Managing Director, Butterﬁeld Bank (Cayman) Limited W. AARON M. SPENCER Senior Vice President, Operations and Information Technology JAMES MCPHERSON* Senior Vice President, Group Internal Audit ROBERT MOORE* Executive Vice President, Head of Group Trust MICHAEL NEFF* Executive Vice President, Head of Group Asset Management JIM PARKER Managing Director, Butterﬁeld Trust (Switzerland) Limited RAYMOND SYKES Managing Director, Butterﬁeld Bank (UK) Limited LLOYD WIGGAN Managing Director, Butterﬁeld Bank (Barbados) Limited BOB WILSON Executive Vice President, Corporate Banking, Bermuda MICHAEL COLLINS* Senior Executive Vice President, Bermuda CONOR O’DEA* Senior Executive Vice President, International Banking and Managing Director, Butterﬁeld Bank (Cayman) Limited CURTIS BALLANTYNE Senior Vice President, Chief Credit Ofﬁcer SHEILA BROWN Senior Vice President, Investment Services, Bermuda CURTIS DICKINSON Executive Vice President, Group Capital Markets & Treasury ERWIN DIKAU Chief Financial Ofﬁcer, Butterﬁeld Bank (Cayman) Limited WILTON DOLLOFF* Executive Vice President, Chief Operating Ofﬁcer DANIEL FRUMKIN* Executive Vice President, Chief Risk Ofﬁcer DONNA HARVEY MAYBURY* Executive Vice President, Human Resources PAUL HODGSON Managing Director, Butterﬁeld Trust (Guernsey) Limited *Member, Group Executive Committee 10 CONTENTS MANAGEMENT’S DISCUSSION & ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (cid:0) (cid:115)(cid:0) (cid:48)(cid:69)(cid:82)(cid:70)(cid:79)(cid:82)(cid:77)(cid:65)(cid:78)(cid:67)(cid:69)(cid:0)(cid:45)(cid:69)(cid:65)(cid:83)(cid:85)(cid:82)(cid:69)(cid:77)(cid:69)(cid:78)(cid:84)(cid:0) (cid:0) (cid:0) (cid:0) (cid:0) (cid:0) (cid:0) (cid:115)(cid:0) (cid:33)(cid:66)(cid:79)(cid:85)(cid:84)(cid:0)(cid:34)(cid:85)(cid:84)(cid:84)(cid:69)(cid:82)(cid:108)(cid:69)(cid:76)(cid:68)(cid:0) (cid:115)(cid:0) (cid:34)(cid:85)(cid:83)(cid:73)(cid:78)(cid:69)(cid:83)(cid:83)(cid:0)(cid:51)(cid:84)(cid:82)(cid:65)(cid:84)(cid:69)(cid:71)(cid:89)(cid:0) (cid:115)(cid:0) 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(cid:21)(cid:20) (cid:21)(cid:21) (cid:21)(cid:22) (cid:21)(cid:23) (cid:21)(cid:25) (cid:22)(cid:16) 102 Butterﬁeld Annual Report 2011 11 MANAGEMENT’S DISCUSSION & ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The ﬁnancial overview of results of operations and ﬁnancial condition should be read in conjunction with our Consolidated Financial Statements and the related notes. The Financial Statements and notes have been prepared in accordance with generally accepted accounting principles in the United States of America (GAAP). All references to “Butterﬁeld”, the “Group” or the “Bank” refer to The Bank of N.T. Butterﬁeld & Son Limited and its subsidiaries on a consolidated basis. Certain statements in this discussion and analysis may be deemed to include “forward looking statements” and are based on Management’s current expectations and are subject to uncertainty and changes in circumstances. Forward looking statements are not historical facts but instead represent only Management’s belief regarding future events, many of which by their nature are inherently uncertain and outside of Management’s control. Actual results may differ materially from those included in these statements due to a variety of factors, including worldwide economic conditions, success in business retention and obtaining new business and other factors. PERFORMANCE MEASUREMENT We use a number of ﬁnancial measures to assess the performance Total Capital Ratio The Total Capital Ratio measures the amount of the Bank’s capital in of our business lines. Some measures are calculated in accordance relation to the amount of risk it is taking. All banks must ensure that a with GAAP while other measures do not have a standardised meaning reasonable proportion of their risk is covered by permanent capital. under GAAP. Accordingly, these measures, described below, may Under Basel II, Pillar I, banks must maintain a minimum total capital not be comparable with similar measures used by other companies. ratio of 8%. In effect, this means that 8% of RWA must be covered by Investors may, however, ﬁnd these non-GAAP ﬁnancial measures permanent or near permanent capital. At least half of the regulatory useful in analysing ﬁnancial performance. capital must fall into Tier 1, which only takes into account the pure Return on Assets (“ROA”) ROA is an indicator of proﬁtability relative to total assets. ROA process takes into account the relative risk of various types of lending. The higher the capital adequacy ratio a bank has, the greater the level demonstrates how efﬁcient Management is at using assets to of unexpected losses it can absorb before becoming insolvent. equity capital so the Tier 1 ratio must be at least 6%. The risk weighting generate earnings. The ROA ratio is calculated as Annual earnings / Average total assets. Tangible Common Equity / Tangible Asset Ratio (“TCE / TA”) TCE / TA is used to determine how much loss the Bank can take before Return on Common Shareholders’ Equity (“ROE”) ROE measures proﬁtability by revealing how much proﬁt is generated Shareholder equity is impacted. The TCE / TA ratio is calculated as (Common equity - Intangible assets - Goodwill) / Tangible assets. with the money invested by Shareholders. ROE is the amount Common equity is the Bank’s Total Shareholders’ equity less the of net income returned as a percentage of Shareholders’ Equity $200 million liquidation preference on Preference Shares. Tangible and calculated as Net Income / Average Shareholders’ Equity. Net assets are the Bank’s total assets less goodwill and intangibles. income is for the full ﬁscal year (before dividends paid to Common stock holders but after dividends to Preferred stock). Common Shareholders’ Equity does not include the $200 million liquidation Net Interest Margin (“NIM”) NIM is a performance metric that examines how successful the Bank’s preference on Preference Shares. investment decisions are compared to its cost of funding assets and is calculated as (Interest income – Interest expenses) / Average Tier 1 Capital Ratio The Tier 1 Capital Ratio is the ratio of the Bank’s core equity capital, Interest Earning Assets. The daily average was used in calculating the average balance for deposits to avoid any distortion caused by large as measured under Basel II, to its total risk-weighted assets (“RWA”). ﬂuctuations. RWA are the total of all assets held by the Bank weighted by credit risk according to a formula determined by the Regulator. The Bank follows the Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Tier 1 Common Ratio The Tier 1 Common Ratio is the same as the Tier 1 Capital Ratio but only includes Common equity in the numerator and deducts the $200 million liquidation preference on Preference Shares. Efﬁciency Ratio The Efﬁciency Ratio is deﬁned as non-interest expenses before amortisation of intangible assets and income taxes as a percentage of total revenue before gains and losses and provisions for credit losses. 12 ABOUT BUTTERFIELD Established in 1858, Butterﬁeld provides community banking and wealth management in Bermuda and select markets in the Caribbean and Europe. Today we are the largest independent bank in Bermuda and have a signiﬁcant market position in the Cayman Islands. Group-wide, we have over 1,300 employees across seven jurisdictions. Butterﬁeld offers a full range of community banking services in Bermuda, Barbados and the Cayman Islands, consisting of institutional, corporate, commercial and retail banking and treasury activities. In wealth management, we provide private banking, asset management, custody and trust services to individual, family, institutional and corporate clients from our headquarters in Bermuda and subsidiary ofﬁces in The Bahamas, the Cayman Islands, Guernsey, Switzerland and the United Kingdom. BUSINESS STRATEGY Whilst remaining well capitalised with strong liquidity, our strategic Given the large, loyal customer deposit base enjoyed in our main focus is on building Shareholder value by expanding our share of the jurisdictions, and the relatively low volume of lending demand from community and private banking markets in jurisdictions in which we our customer base, our investment strategy is more important than have a meaningful presence and a depth of local market knowledge. to most ﬁnancial institutions. At 31 December 2011, we had $4.1 Our strategy also involves leveraging our multi-jurisdictional trust, billion of cash and investments representing almost 47% of total custody and asset management offerings to build our wealth assets. In recognition of this deﬁning characteristic of Butterﬁeld, we management business from both cross-referrals with existing have adopted a conservative approach to our investments, including customers and new client generation from our core and new growth signiﬁcantly reducing the list of international banks from whom we will markets. We aim to build upon our relationship-based business purchase certiﬁcates of deposit. 2011 also represented a signiﬁcant approach by delivering exceptional client service experiences, advancement in reducing our Interest Rate Risk, which measures the as well as a wide range of products to meet our clients’ ﬁnancial degree to which our proﬁtability is at risk due to changes in interest services needs. rates. This advancement has allowed us to improve the proﬁtability of our investments despite the ongoing challenges of a low and volatile The wide range of products we offer is reﬂective of our strategy of investment climate and without increasing credit risk. Our continued pursuing diversiﬁed business lines, including private banking, asset management of Interest Rate Risk requires us to purchase ﬁxed rate management, custody, corporate trust and personal trust services. investments that, while complying with our credit safety requirements, Those diverse businesses directly contribute to the high level of fee will experience temporary declines in market values when rates income relative to our total income. Despite the current economic start to increase. Rising interest rates will improve the proﬁtability of environment reducing the volume of customer activity, our fee income Butterﬁeld, such that these anticipated negative marks are part of our remains at almost 39% of revenue before provisions and gains strategy—they will not affect earnings, as they are not credit related, or losses. but they will potentially give rise to negative impacts in equity through “Other Comprehensive Income”. To minimise the impact on our equity To build on our community banking and wealth management in such circumstances, while implementing proper management of strategies, we will also leverage our strong and loyal client base. Interest Rate Risk, we have instituted a Held to Maturity (“HTM”) Unlike many banks, Butterﬁeld is almost exclusively funded by our portfolio of $64.8 million at year end. This portfolio is expected to Shareholders and our customers. Our core customer deposits have grow to up to $250 million and the range of permitted investments been remarkably stable throughout the crisis. In 2011, we focused on is very limited to ensure a very high credit quality. Unless modiﬁed these core deposits and pricing discipline to signiﬁcantly improve by the Board of Directors, the HTM investments must be explicitly or their contribution to net interest income. This contribution reﬂects implicitly guaranteed by a G7 nation or supranational, rated AA+ or the strength of being a deposit-led organisation even in times of low better in either case. interest rates. To support our strategy, we have realigned our Management structure to focus on lines of business and central support services with less emphasis on independent management and support teams by jurisdiction. However, we remain ﬂexible and nimble in each jurisdiction, with decision making on client service-related matters based locally. In addition, we have invested heavily—and continue to invest—in new technology that allows for new and ﬂexible products, enhanced customer service and a streamlined, more efﬁcient operation. We expect our recent investment in new core banking systems in our two largest markets—Bermuda and the Cayman Islands—will help drive new revenue opportunities, improved internal control, and operational efﬁciencies. Our strategy of moving to centralised support services and centres of excellence is enhanced by these technological investments and will drive further efﬁciencies. 2011 OVERVIEW During 2011, we continued to build our core infrastructure, made progress in rightsizing our cost base, and generated revenue growth of 9.8%. Overall, we are pleased with the direction of Butterﬁeld’s ﬁnancial performance in 2011, delivering net income of $40.5 million following two years of signiﬁcant losses. However, our goal of returning to a position of greater sustainable proﬁtability remains a work in progress. We are resolute in our commitment to continuing the positive momentum we have developed and to improving Shareholder value. More effective deployment of liquidity, combined with disciplined deposit pricing drove a 19.4% increase in net interest income before credit losses. Cost management objectives established in 2010 were achieved, contributing to a 3.5% decrease in operating costs, a reduction in headcount of 135, and a 10.4% improvement in the Butterﬁeld Annual Report 2011 13 efﬁciency ratio. However, these improvements were partially offset by declines in non-interest income as the recessionary environment MARKET ENVIRONMENT For much of 2011, the impact of the sovereign debt crisis in Europe caused continued declines in transaction volumes with some loss of overshadowed the more encouraging economic news from western business from customers restructuring their own businesses. Our core economies, creating uncertainty and market volatility as market deposits remained stable in all jurisdictions, whilst maturing higher participants attempted to interpret the impact on the near-term priced deposits in Bermuda, Guernsey and the United Kingdom macro economic direction. The fear of a double-dip recession in the migrated to ﬁnancial institutions willing to pay higher deposit rates. United States subsided in the second half of the year, whilst European Key Accomplishments in 2011 were as follows: (cid:115)(cid:0) Systems: We implemented new core banking systems in Bermuda and the Cayman Islands. (cid:115)(cid:0) Capital: We maintained a strong capital position, with over $1.0 billion of regulatory capital, a Tier 1 capital ratio of 17.7% at 31 December 2011, with a TCE / TA ratio of 6.6%, up 13.8% from 5.8% in 2010. (cid:115)(cid:0) Proﬁtability: The Bank delivered four consecutive quarters of political disputes and threats of disruption of oil production in the Middle East violently swayed markets. Consistent with the volatility, the impacts in the economies in which we operate were mixed. Island economies have generally experienced rising unemployment and shrinking populations as companies have downsized and moved central support services to less expensive jurisdictions. This has had a ripple effect as demand for local business services has declined. In Bermuda and the Cayman Islands, the worst impact was felt in the construction and quarrying sectors, as both the number and value of construction projects continued to decline during the year. Tourism proﬁtability; with net income for the year rising from $14.8 million normalised in 2010 to $40.5 million in 2011. continued to struggle, given the high correlation with the United States economy, but some strengthening was seen in 2011 with increases in air arrivals and hotel occupancy levels in both Bermuda and the Cayman Islands, albeit at signiﬁcantly reduced levels from the highs seen in 2007. These factors contributed to a muted business environment in our Bermuda and Caribbean operations with little loan demand and limited growth opportunities. Our customers have not been immune to the economic downturn, and we saw more pressure on their ability to service loan payment obligations during the year. However, our close relationship with our customers and hands-on approach to working with them to address loan servicing challenges has softened the impact on our non-performing assets. Conversely, our private banking business in Europe enjoyed strong loan demand as some European banks withdrew from sectors of the lending market appropriate for our private banking businesses. We were able to advance more quality loans to high net worth customers, improve our low loan-to-deposit ratio and grow our European lending book. Additionally, we have seen increasing demand for wealth management products from high net worth individuals seeking asset protection strategies in defence of uncertainty and volatility. (cid:115)(cid:0) Investment strategy: We implemented a new investment strategy for the deployment of excess liquidity that contributed to our NIM increasing by 47 basis points, from 2.03% in 2010 to 2.50% in 2011, despite an environment of falling interest rates and our dedication to conservative investments. (cid:115)(cid:0) Expenses: We reduced non-interest expenses by $10.9 million, from $309.4 million in 2010, to $298.5 million in 2011. (cid:115)(cid:0) Headcount: Across the Group, headcount was reduced by 135, from 1,519 as at 31 December 2010 to 1,384 by the end of 2011. (cid:115)(cid:0) Deposits: The Bank maintained stable core deposits, whilst decreasing deposit costs by 13 basis points, from 65 basis points in 2010 to 52 basis points in 2011. (cid:115)(cid:0) Loan quality: Gross non-accrual loans as a percentage of gross loans decreased to 2.8% at year-end 2011 from 3.9% at year-end 2010 as certain properties previously used by customers as security for loans are now held directly by the Bank as Other Real Estate Owned. (cid:115)(cid:0) Asset quality: Non-performing assets as a percentage of total assets remained stable at 1.7% at year-end 2011. This ratio is a new measure comprising both non-accrual loans and Other Real Estate Owned. (cid:115)(cid:0) Ratings reafﬁrmed: Standard & Poor’s ratings reafﬁrmed at A- under new ratings methodology; Fitch reafﬁrmed at A-. 14 2012 OUTLOOK Although 2011 provided a difﬁcult economic climate in which to In 2012, we are focusing our attention on product development and customer service, which we expect will drive revenue growth from both operate, Butterﬁeld made progress against our strategic priorities cross selling to our existing client base and winning new business. and emerged proﬁtable. 2012 is beginning to show some cause for Business development plans are continually being reﬁned by our optimism, partially as a result of the heightened level of new company Executive Management team and are closely monitored by the Board registrations and levelling off of population declines seen in Bermuda of Directors to ensure targets are being met. Incentive plans have and the Cayman Islands in 2011. In Bermuda, we are seeing strong been more closely aligned with business development targets and political will to make the necessary changes to immigration and land metrics that reﬂect Shareholders’ interests. ownership policies that are expected to attract new international businesses to the island, as well as efforts to reduce deﬁcit levels. On 25 January 2012, ofﬁcials from the United States Federal Reserve This optimism is tempered by the ongoing economic challenges, high announced that they expect interest rates to remain low until at least unemployment and low interest rates. late 2014. We reduced our exposure to declining interest rates in this sustained low-rate environment and have successfully increased In the Cayman Islands, a special economic zone was ofﬁcially our investment returns and net interest margin by employing our launched in 2012 to help attract new businesses to the country, conservative investment strategy and with the help of our investment known as “Cayman Enterprise City”; it is expected to welcome its ﬁrst advisers, building a laddered, high quality securities portfolio. businesses in the ﬁrst quarter. Temporary accommodations have been However, our Balance Sheet will beneﬁt signiﬁcantly from a rising gazetted to allow operations to commence immediately while phase rate environment due to our asset sensitivity. Through the continued one of Cayman Enterprise City’s permanent campus is constructed. employment of this strategy, we expect the returns on our investments In our European operations, we expect that competitive pressures dependent on our ability to purchase qualifying assets as maturities in 2012 will modestly exceed the returns achieved in 2011, but is on deposit pricing will be sustained, but we continue to beneﬁt from fall due. high quality, low loan-to-value lending opportunities to high net worth private clients. We expect to be able to continue to realise cost efﬁciencies in 2012 based on leveraging our previous investments in technology. After several years in ‘rebuilding’ mode, and having completed our The use of common systems, lapsing support contracts on legacy strategy to de-risk the Balance Sheet, and made signiﬁcant progress systems, redesigning processes and centralising support services are in restructuring operations and enhancing our technology, Butterﬁeld anticipated to drive further cost savings in 2012. is well positioned to take advantage of market opportunities as they emerge. With a strong total capital ratio of over 23%, good liquidity versus our peer banks (with a loan-to-asset ratio of only 48%), low cost core deposits (at only 52 basis points), stable loan quality metrics, and new systems in our two largest jurisdictions, we are optimistic about our ability to compete for new business. Butterﬁeld Annual Report 2011 15 FINANCIAL SUMMARY (in $ thousands, except per share data) As at 31 December Cash and cash equivalents Short-term investments Investments in debt and equity securities Loans, net of allowance for credit losses Premises, equipment and computer software Goodwill and intangible assets Total assets Total deposits Subordinated capital Shareholders’ equity Liquidation preference of Preference Shares Common and Contingent Value Preferred equity For the year ended Net interest income before provision for credit losses Provision for credit losses Non-interest income (as reported) Non-interest income (excluding fund administration services business) Salaries and other employee beneﬁts Other non-interest expenses (including income taxes) Net income before gains and losses Gains and losses Net income (loss) Dividends and guarantee fee of Preference Shares Net income (loss) available to Common Shareholders Common dividends paid Financial ratios Return on assets Return on Common Shareholders’ equity (1) Tier 1 capital ratio Total capital ratio Tangible common equity ratio Net interest margin Efﬁciency ratio (3) Per participating Share ($) (1) (2) Net income (diluted) Cash dividends Net book value Number of employees Bermuda Overseas Total 2011 1,979,458 34,814 2,089,726 4,247,260 276,114 49,184 8,824,109 7,525,440 267,755 200,000 629,725 213,735 (14,326) 135,246 135,246 150,752 147,706 36,197 4,275 40,472 21,270 19,202 - 0.4% 3.0% 17.7% 23.5% 6.6% 2.50% 83.9% 0.03 - 1.14 664 720 1,384 2010 2,429,699 26,392 2,629,144 4,043,360 261,955 54,963 9,623,060 8,228,059 282,799 200,000 609,288 178,942 (41,970) 143,420 143,420 159,082 148,408 (27,098) (180,517) (207,615) 18,000 (225,615) - (2.2%) (44.3%) 15.7% 21.6% 5.8% 2.03% 94.3% (0.47) - 1.10 732 787 1,519 2009 1,986,798 N/A 2,926,901 4,218,332 244,242 66,841 9,594,602 8,696,619 283,085 200,000 155,460 186,907 (104,879) 151,705 151,705 156,839 143,351 (66,457) (146,956) (213,413) 9,450 (222,863) 14,938 (2.1%) (47.0%) 7.2% 10.1% 0.9% 1.95% 89.0% (2.34) 0.12 1.64 761 845 1,606 2008 2,221,390 N/A 3,824,079 4,418,277 197,155 71,614 10,911,844 9,801,269 282,296 - 518,440 254,481 (3,045) 212,941 177,358 183,152 167,335 113,890 (109,051) 4,839 - 4,839 57,733 0.0% 0.8% 7.5% 11.2% 4.1% 2.18% 72.8% 0.05 0.52 5.44 803 889 1,692 2007 2,517,012 N/A 4,744,989 4,124,764 215,379 106,490 11,910,920 10,747,971 284,191 - 629,330 252,600 (1,983) 219,682 170,426 184,751 139,217 146,331 (336) 145,995 - 145,995 54,366 1.2% 25.2% 8.6% 13.0% 4.4% 2.20% 65.7% 1.48 0.64 6.53 843 1,007 1,850 Other data Average number of participating Shares on a fully diluted basis 555,615 4,425,639 Risk-weighted assets 477,225 4,934,569 95,065 5,734,096 96,683 6,199,963 98,732 6,345,754 (1) Includes both Common and Contingent Value Convertible Preferred equity. (2) All prior period per Common Share data and number of Common Shares, with the exception of dividends, have been restated to reﬂect the $0.04 stock dividend declared for March, May, August and November 2009 and the one-for-ten stock dividend of February 2008. All prior period per Share data has been restated to reﬂect the three-for-one stock split of August 2007. (3) 2010 & 2009 calculated based on normalised income for comparability purposes. 16 CONSOLIDATED RESULTS OF OPERATIONS AND DISCUSSION FOR FISCAL YEAR ENDED 31 DECEMBER 2011 In 2010, we evaluated our performance on a reported basis (i.e., as reported in our Consolidated Financial Statements prepared in accordance with GAAP) as well as on a normalised basis. In 2011, we discontinued reporting normalised income as we believe our 2011 ﬁnancial results better reﬂect normal ongoing operations. For comparative purposes, we have included comparison to 2010 normalised income as reported in the prior year. For 2010, transactions that were viewed by Management not to be in the normal course of day-to-day business and were unusual in nature were excluded from normalised earnings as they obscure or distort the analysis of trends. Certain earnings measures, such as normalised earnings, do not have standardised meanings as prescribed by GAAP and therefore are unlikely to be comparable to similar measures presented by other companies. Net Income (Loss) The Bank reported net income of $40.5 million for the year ended 31 December 2011, compared to a net loss of $207.6 million in 2010. Results in both years were adversely affected by various non-operating gains and losses. After deduction of dividends ($19.3 million) and the guarantee fee ($2.0 million) on Preference Shares, the net income available to Common Shareholders was $19.2 million ($0.03 per share) in 2011 compared to a reported loss of $225.6 million ($0.47 per Share) in 2010. On a normalised basis, after non-recurring normalisation adjustments, the 2010 loss was $3.2 million ($0.01) per Share. The following table states reported earnings for 2011 compared to normalised 2010 earnings (the Bank discontinued reporting normalised earnings in 2011): (in $ millions) Non-interest income Net interest income before provision for credit losses Total revenue before provision for credit losses and gains and losses Net gains and losses Provision for credit losses Total revenue Total non-interest expenses Net income before taxes Income tax Net income Year ended 31 December 2011 2010 2010 Reported Normalised 139.6 Reported 143.4 $ change (1) % change (1) (3.2%) (4.4) 135.2 213.7 348.9 4.3 (14.3) 338.9 (298.5) 40.4 0.1 40.5 178.9 318.5 0.0 (10.1) 308.4 (292.0) 16.4 (1.6) 14.8 179.0 322.4 (180.5) (42.0) 99.9 (309.5) (209.6) 2.0 (207.6) 34.8 30.4 4.3 (4.2) 30.5 (6.5) 24.0 1.7 25.7 19.4% 9.5% 100.0% 41.6% 9.8% 2.2% 146.3% 106.3% 173.6% Dividends and guarantee fee of Preference Shares (21.3) (18.0) (18.0) (3.3) 18.3% Net income (loss) / earnings attributable to Common Shareholders Net income (loss) / earnings per Common Share Basic Diluted 19.2 (3.2) (225.6) 22.4 700.0% 0.03 0.03 (0.01) (0.01) (0.47) (0.47) 0.04 0.04 133.3% 133.3% (1) Change shown is reported 2011 compared to normalised 2010. Butterﬁeld Annual Report 2011 17 The following table reconciles the Bank’s GAAP reported net income for 2010 with normalised earnings for 2010. There were no normalisation adjustments in 2011. (in $ millions) Net loss as reported Non-core items: Net other gains & losses (1) Investments in afﬁliates Speciﬁc provision for credit losses (2) Legal fees pertaining to liquidity facility Non-recurring organisational change costs (3) Non-recurring taxation credit Net normalised income Year ended 31 December 2010 Net income (loss) (207.6) Diluted EPS (0.47) 172.9 1.5 31.8 7.4 12.4 (3.6) 14.8 0.36 - 0.06 0.02 0.03 (0.01) (0.01) Transactions that are viewed by Management not to be in the normal course of day-to-day business and are unusual in nature are excluded from normalised earnings for the year ended 31 December 2010 as they obscure or distort the analysis of trends. Normalisation adjustments for 2010 include: (1) Net other gains & losses as follows: (cid:115)(cid:0) Net realised losses of $107.0 million, of which $113.8 million relates to realised losses on the sale of asset-backed securities held in the Available For Sale portfolio, partially offset by realised gains of $1.9 million on the disposal of ﬁxed income securities and realised gains of $4.7 million on the disposal of Structured Investment Vehicles (“SIVs”) during 2010. (cid:115)(cid:0) Other-than-temporary impairments of $60.5 million on the Bank’s holdings of SIVs. (cid:115)(cid:0) Realised loss on the sale of the Bank’s subsidiaries in Hong Kong and Malta of $7.4 million. (cid:115)(cid:0) Write-down of $3.8 million of previously capitalised software development no longer in use. (2) Speciﬁc provisions for credit losses of $31.8 million primarily related to commercial mortgage facilities in the hospitality industry in Bermuda and The Bahamas, as well as private banking exposures in the United Kingdom. (3) The organisational change costs are non-recurring expenses incurred, which comprise acceleration of vesting on stock options on change in control, restructuring fees relating to changes to Executive Management and rationalisation of headcount in various jurisdictions. Revenue (Actual 2011 Versus Normalised 2010) Total revenue before provisions for credit losses and gains and losses for 2011 was $348.9 million, up $30.4 million (9.5%) from $318.5 million in 2010. Total non-interest income was down $4.4 million (3.2%) from $139.6 million in 2010 to $135.2 million in 2011; the decrease was primarily attributable to the sale of our Hong Kong and Malta businesses in 2010, which had related revenue of $3.0 million in the prior year. Net interest income before provisions for credit losses rebounded by $34.8 million (19.4%) from $178.9 million in 2010 to $213.7 million in 2011, driven by a 47 basis point increase in the net interest margin from 2.03% in 2010 rising to 2.50% in 2011. The efﬁcient deployment of excess liquidity under our new investment strategy, along with disciplined deposit pricing drove the improvement in the net interest margin, despite the sustained low interest rate environment. 18 DISTRIBUTION OF 2011 TOTAL REVENUES BEFORE PROVISIONS FOR CREDIT LOSSES AND GAINS AND LOSSES DISTRIBUTION OF 2011 TOTAL REVENUES BY LOCATION BEFORE PROVISIONS FOR CREDIT LOSSES AND GAINS AND LOSSES Other Non Interest Income 2% Custody and Other Administration Services 3% Trust 9% Foreign Exchange Revenue 9% Asset Management 7% The Bahamas 2% Barbados 4% United Kingdom 7% Switzerland 1% Bermuda 58% Guernsey 10% Net Interest Income 61% Banking 9% Cayman 18% Non-Interest Income Non-interest income is a function of a number of factors including the composition and value of client assets under management and administration, the volume and nature of clients’ transaction activities, and the types of products and services our clients use. Our fee structure provides for varied pricing that depends on the value of client assets and the nature of services provided. As a result, it is not always possible to draw a direct relationship between the value of client assets and the level of non-interest income, although the trend of non-interest income generally follows the trend in client asset levels. Total non-interest income was down $8.2 million from $143.4 million in 2010 to $135.2 million in 2011 and represents 38.8% of total revenues before provisions for credit losses and gains and losses for 2011, compared to 44.5% in 2010. The following table presents the components of non-interest income for the years ended 31 December 2011 and 2010: (in $ thousands) Asset management Banking Foreign exchange revenue Trust Custody and other administration services Other non-interest income Total non-interest income 2011 22,942 33,302 31,519 29,995 11,780 5,708 135,246 2010 24,544 33,941 32,479 30,534 13,574 8,348 143,420 $ change (1,602) % change (7.0%) (639) (960) (539) (1,794) (2,640) (8,174) (1.9%) (3.0%) (1.8%) (15.2%) (46.3%) (6.0%) Asset Management Asset management revenues are generally based on the market value of assets managed and the volume of transactions and fees for other services rendered. We provide asset management services from our ofﬁces in Bermuda, the Cayman Islands, Guernsey and the United Kingdom. Revenues from asset management were $22.9 million in 2011, down $1.6 million from $24.5 million in 2010; however, excluding the $1.9 million of revenue included in 2010 related to businesses sold in 2010, asset management revenues increased $0.3 million. Assets under management declined $433 million, primarily from redemption in the money market fund due to historically low rates, however a change in product mix to higher margin services increased revenues year on year. The table that follows shows the changes in the year-end values of clients’ assets under management, sub-divided between those managed for clients on a discretionary basis and those client funds invested in mutual funds that Butterﬁeld manages: (in $ millions ) Butterﬁeld Funds Discretionary Total assets under management 2011 3,375 2,269 5,644 2010 3,677 2,400 6,077 $ change (302) % change (8.2%) (131) (433) (5.5%) (7.1%) Butterﬁeld Annual Report 2011 19 Banking During 2011, Butterﬁeld provided a full range of community, commercial and private banking services in select jurisdictions. Retail and community banking services are offered to individuals and small to medium sized businesses through branch locations, telephone banking, Internet banking, automated teller machines and debit cards in Bermuda, the Cayman Islands and Barbados, whilst private banking services were offered in Bermuda, the Cayman Islands, Guernsey and the United Kingdom. Banking fee revenues reﬂect loan, transaction and processing, and other fees earned in these jurisdictions. Banking fee revenues fell by 1.9% in 2011 to $33.3 million, compared to $33.9 million in 2010, mainly due to a one-off fee earned in 2010 and the discontinuation of banking activities in The Bahamas. Foreign Exchange We provide foreign exchange services in the normal course of business in all jurisdictions. The major contributors to foreign exchange revenues are Bermuda and the Cayman Islands, accounting for 77% of the Group’s foreign exchange revenue (2010: 76%). The Bank does not have a proprietary trading book. Foreign exchange income is thus generated from client-driven transactions and totalled $31.5 million in 2011, compared with $32.5 million in 2010. The $1.0 million year-on-year decrease reﬂects declining client volumes, in line with the slowing economic conditions. Trust We provide both personal and institutional trust services from our operations in Bermuda, The Bahamas, the Cayman Islands, Guernsey and Switzerland. Trust revenues are derived from a combination of ﬁxed fees, fees based on the market values of assets held in trust and fees based on time spent in relation to the range of personal trust and company administration services and pension and employee beneﬁt trust services we provide. In 2011, trust revenues totalled $30.0 million, marginally lower than the $30.5 million recorded in 2010; however, prior year included $1.0 million in revenue related to the Malta business that was sold in 2010 and when excluded, trust revenues increased $0.5 million. Trust revenues represented 22% of total non-interest income in 2011, up from 21% in 2010. Revenue increases were seen in four of our ﬁve trust operations: The Bahamas increased by 4.3%, Bermuda increased 3.6% and Guernsey rose 1.7%, while in Switzerland revenues were up 38.2% year on year. In December 2010, a restructuring of our Bahamas operations to focus predominantly on trust activities was announced. In September 2010, the Bank concluded the sale of its trust operations located in Malta, which did not contribute signiﬁcantly to this line of business. Total Trust assets under administration were $40.7 billion as at 31 December 2011 compared to $40.5 billion the prior year. Custody and Other Administration Services Custody fees are generally based on market values of assets in custody, the volume of transactions and ﬂat fees for other services rendered. We provide custody services from our ofﬁces in Bermuda, the Cayman Islands, Guernsey and the United Kingdom, and other administration services—primarily administered banking—in Guernsey. In 2011, revenues were $11.8 million compared to $13.6 million in 2010, down 13.2%, in part due to lower transaction volumes in our custody business, and partly due to a reduction in administered banking mandates as two large mandates wound down their operations. Total custody and other assets under administration (which includes the administered banking services operations provided by our Guernsey business) were $31.0 billion as at 31 December 2011, up $3.2 billion from $27.8 billion the prior year. Other Non-Interest Income The components of other non-interest income are set forth in the following table: (in $ thousands) Net share of earnings (losses) from investments in afﬁliates Rental income Write back of unclaimed balances and dividends Other Total non-interest income Year ended 31 December 2011 884 2,889 - 1,935 5,708 2010 (1,587) 2,779 5,785 1,371 8,348 In 2010, we recorded equity pickup losses of $2.9 million in connection with our minority interest in Butterﬁeld Fulcrum Group Limited (“BFG”), which is reﬂected in the 2010 net loss of $1.6 million from investments in afﬁliates. In the second quarter of 2011, the Bank sold all its remaining shares in BFG. Rental income of $2.9 million in 2011, and $2.8 million in 2010, were received on various premises the Bank owns in Bermuda that are leased to tenants. Included in the “Other” category are maintenance fees from leased premises, Director fee income, and other miscellaneous charges. 20 Net Interest Income Before Provision For Loan Losses Net interest income is the amount of interest earned on our interest-earning assets less interest paid on our interest-bearing liabilities. There are several drivers of the change in net interest income, including changes in the volume and mix of interest-earning assets and interest-bearing liabilities, their relative sensitivity to interest rate movements, and the proportion of non-interest-bearing sources of funds, such as equity and non-interest bearing current accounts. The following table presents the components of net interest income for the years ended 31 December 2011 and 2010: (in $ millions) Assets Cash and cash equivalents and short-term investments Investments Loans Interest-earning assets Other assets Total assets Liabilities Deposits Securities sold under repurchase agreements Subordinated debt Interest-bearing liabilities Non-interest-bearing current accounts Other liabilities Total liabilities Shareholders’ equity Total liabilities and Shareholders’ equity Non-interest-bearing funds net of non-interest-earning assets (free balance) Net interest margin Average balance Interest 1,932.5 2,486.0 4,132.8 8,551.4 466.3 9,017.6 10.8 45.6 202.6 259.0 - 259.0 2011 Average rate 0.56% 1.84% 4.90% 3.03% - 2.87% Average balance Interest 2,107.6 2,595.6 4,119.6 8,822.8 467.8 9,290.6 11.0 28.3 198.1 237.4 - 237.4 2010 Average rate 0.52% 1.09% 4.81% 2.69% - 2.56% 6,720.9 (34.7) (0.52%) 7,103.2 (46.0) (0.65%) - (10.5) (45.2) - - - (3.77%) (0.65%) - - (45.2) (0.55%) - - 3.6 278.4 7,002.9 987.7 192.3 8,182.9 834.7 9,017.6 1,548.4 - 282.7 7,385.9 961.6 243.0 8,581.5 709.1 9,290.6 1,436.9 - (12.5) (58.5) - - - (4.41%) (0.79%) - - (58.5) (0.68%) - - 213.8 2.50% 178.9 2.03% Net interest income before provisions for credit losses increased by 19.4% to $213.7 million in 2011 compared to $178.9 million in 2010, of which 62% (2010: 63%) was generated in Bermuda and 18% (2010: 16%) in the Cayman Islands. Investment yields of 1.84% on $2.5 billion, up from 1.09% in 2010, combined with a 13 basis point decrease in deposit cost, drove a 47 basis point improvement in the net interest margin to 2.50% in 2011 compared to 2.03% in 2010. Although average interest-earning assets decreased by $275.5 million to $8.55 billion in 2011, the decrease had a positive impact on net interest income as the decline was driven by the migration of high-cost deposits which were deployed in lower yielding assets in the cash and cash equivalent category. Free balances of $1.5 billion in 2011 (2010: $1.4 billion) include non-interest-bearing current accounts of $1.0 billion (2010: $1.0 billion) and Shareholders’ equity of $835 million (2010: $709 million) net of other assets and other liabilities. See the Risk Management section for more information on how interest rate risk is managed. Butterﬁeld Annual Report 2011 21 Provision For Credit Losses The Bank’s net provisions for credit losses in 2011 were $14.3 million compared to $42.0 million in 2010. The Bank anticipates the difﬁculties in the local economies, as well as the hospitality sector, will continue for the foreseeable future and has made sufﬁcient provisions in anticipation of a difﬁcult market. The incremental provisions were required principally for the speciﬁc reserves pertaining to commercial and residential exposures as well as enhancements to general provision. Gains and Losses The following table represents the components of gains and losses for the years ended 31 December 2011 and 2010: (in $ thousands) Net realised / unrealised (losses) gains on trading securities Net realised gains (losses) on available for sale securities Other-than-temporary impairment losses on held to maturity and available for sale investments Loss on sale of Malta and Hong Kong located subsidiaries Net other gains (losses) Total gains and losses 2011 (919) 2,059 - - 3,135 4,275 2010 971 (107,047) (60,522) (7,430) (6,489) (180,517) Net Realised / Unrealised (Losses) Gains on Trading Securities A $0.9 million loss was recorded with respect to trading securities in 2011 compared to a gain of $1.0 million in 2010, which primarily relates to the fair value adjustments of the Bank’s seed money in shares of the Butterﬁeld Select Investment Fund, the Butterﬁeld Select Alternative Fund and $50 million in shares of the BNY Mellon Butterﬁeld Income Advantage Fund, which was launched in 2011. During the year, we redeemed $3.8 million of our seed money as it was no longer required. Net Realised Gains (Losses) on Available For Sale Securities Net realised gains of $2.1 million were recorded on securities sold in the normal course of business as part of our asset and liability management strategy. The $107.0 million loss recorded in the prior year was a result of the sale of asset-backed securities as part of the Bank’s Balance Sheet de-risking strategy. Other-Than-Temporary Impairment (“OTTI”) Losses on Held to Maturity and Available For Sale Investments No OTTI losses were recognised in 2011 as Management believes there are no credit losses in the investments, compared to the 2010 OTTI credit loss of $60.5 million recognised. Loss on Sale Of Malta And Hong Kong Located Subsidiaries Consistent with Management’s strategy of focusing resources in jurisdictions where we have a meaningful market presence and a depth of local market knowledge, in September 2010, the Bank sold its trust, wealth management and advisory businesses in Hong Kong and its trust operation in Malta with a resultant net loss of $7.4 million. Net Other Gains (Losses) Net other gains and losses were $3.1 million in 2011 compared to net other losses of $6.5 million in 2010. Net other gains and losses in 2011 include the second quarter of 2011 BFG gain of $3.1 million, the gain on repayment of the subordinated debt of $1.1 million and the $1.4 million equity pick up losses of afﬁliates in the ﬁrst quarter of 2011. During the second quarter, Butterﬁeld completed the sale of its equity interest in BFG for proceeds of $3.3 million, which triggered a dividend of $3.3 million ($0.42 per Share) to holders of Butterﬁeld Contingent Value Convertible Preference Shares (“CVCP Shares”), which was paid on 16 August 2011 to Shareholders of record on 26 July 2011. A realised gain of $1.1 million was recorded during the third quarter of 2011 as a result of the purchase and cancellation of $15.0 million of our own subordinated debt. 22 Net other losses of $6.5 million were recorded in 2010, which included: a write off of $3.8 million in respect of previously capitalised costs for the development of software that would no longer be used, a $1.5 million loss on the write down of an amount receivable from the Bank’s charitable foundation; realised losses of $1.4 million on the Bank’s equity holdings in two credit card companies, which were sold during 2010; losses of $0.7 million on the write down of a private equity investment and an investment in an afﬁliate to reﬂect lower expectations of proceeds on eventual sales; and a $1.2 million gain on interest rate swaps designated as trading instruments, as they did not qualify for hedge accounting but are used as part of the Bank’s overall asset and liability management strategy. Non-Interest Expenses Cost control continued to be a key focus of the Bank in 2011 as the recessionary economic conditions and persistently low interest rate environment challenged the banking business model. Total non-interest expenses in 2011 were $298.5 million compared to $309.5 million recorded in 2010. Salary and employee beneﬁts account for 51% of non-interest expenses with technology, communications and property making up 28% combined. Bermuda expenses (including head ofﬁce costs) represent the majority of the Group costs at 59% of total costs. DISTRIBUTION OF 2011 EXPENSES DISTRIBUTION OF 2011 EXPENSES BY LOCATION Other Expenses 6% Marketing 2% Amortisation of Intangible Assets 2% Non-Income Taxes 5% Professional and Outside Services 6% Property 10% Technology and Communications 18% Salaries and Other Employee Benefits 51% The Bahamas 2% Switzerland 1% Guernsey 10% Cayman 18% Barbados 4% United Kingdom 7% Bermuda 58% The following table presents the components of non-interest expenses for the years ended 31 December 2011 and 2010: (in $ thousands) Salaries and other employee beneﬁts Technology and communications Property Professional and outside services Non-income taxes Amortisation of intangible assets Marketing Other non-interest expenses Total non-interest expenses Income tax beneﬁt Total expenses 2011 Reported 150,752 55,037 29,316 18,762 14,500 5,799 5,257 19,068 298,491 (33) 298,458 2010 2010 $ change vs. % change vs. Reported Normalised Normalised Normalised 2.5% 147,113 159,082 3,639 54,037 27,469 13,811 15,405 5,711 5,002 28,948 309,465 (1,975) 311,440 54,037 28,169 15,411 15,405 5,711 5,002 21,116 291,964 1,960 293,924 1,000 1,147 3,351 (905) 88 255 (2,050) 6,525 (1,993) 4,532 1.9% 4.1% 21.7% (5.9%) 1.5% 5.1% (9.7%) 2.2% (101.7%) 1.5% Butterﬁeld Annual Report 2011 23 Salaries and Other Employee Beneﬁts Salaries and other employee beneﬁts of $150.8 million in 2011 represents a decrease of $8.3 million from 2010. Excluding the $12.0 million of non-recurring costs in 2010, salaries and other employee beneﬁts increased by $3.7 million. However, during 2011, further staff reductions and the implementation of our new core banking system in Bermuda and the Cayman Islands resulted in additional one-off costs of $7.9 million. The 2011 one-off costs are made up of: $3.0 million in overtime and temporary employment services related to the systems implementation projects and $4.9 million in staff termination and redundancy costs. Net of one-off costs, salaries and other employee beneﬁts declined by $4.2 million year over year. Salary cost reductions of $4.1 million, as a result of reduced headcount, which was down 135 from 1,519 at the end of 2010 to 1,384 by 2011, was partially offset by $1.5 million of annual merit increases. A further $7.9 million of savings was realised from reduced staff beneﬁt costs, of which $7.5 million relates to a reduction in post-retirement health care expenses as a result of the changes to the beneﬁt plan made in 2010. These savings were partially offset by a $6.3 million increase in staff incentive expenses, following several years of minimal incentive compensation awards, and also include the amortisation expense related to the previous year’s stock option and Executive long-term Share plan awards. In 2010, salaries and other employee beneﬁts expenses included a charge of $6.2 million in connection with retention and termination payments and other staff-related beneﬁts. These costs were incurred as part of the implementation of non-recurring organisational changes, including changes to Executive Management. Also included in salaries and other employee beneﬁts expense in 2010 is a charge of $5.8 million related to Share-based compensation expenses that occurred as all stock options and deferred incentive shares immediately vested on the equity investment in March 2010. These costs are deducted to arrive at normalised earnings in 2010. Technology and Communications Technology and communication costs were $55.0 million in 2011, up $1.0 million on the $54.0 million recorded in 2010. This reﬂects the ramped-up run rate technology costs as the Bank’s technology platforms have now been fully transitioned to our outsourcing partners, in addition to a partial-year increase of $1.5 million in depreciation from the costs capitalised as part of the new systems implementations in Bermuda and the Cayman Islands during the year. Offsetting these increases were savings of $0.8 million in communication costs from the migration of our traditional land line telephony system to a VOIP phone system. Property Property costs, which reﬂect occupancy expenses, building maintenance, and depreciation of property, plant and equipment, increased by $1.1 million to $29.3 million in 2011 versus the $28.2 million normalised expense of 2010. The increase was due to accelerated depreciation on certain premises totalling $1.6 million per year in additional depreciation. Professional and Outside Services Professional and outside services primarily include consulting, legal, audit, and other professional services. In 2011, the expense was $18.8 million, up $3.4 million compared to $15.4 million incurred in 2010 on a normalised basis; the increase driven mainly by increased investment advisory costs related to our investment advisory agreement with Carlyle Investment Management LLC. The 2011 fees included $1.2 million in consulting fees to assist in the development of future efﬁciencies. Non-Income Taxes These taxes reﬂect non-income-related taxes levied on us in the various jurisdictions in which we operate, including those associated with employee-related costs such as payroll tax, customs duties and business licenses. In 2011, we incurred costs of $14.5 million compared to $15.4 million in 2010, the decrease reﬂecting lower payroll tax in Bermuda due to a decreased number of employees. Amortisation of Intangible Assets Intangible assets relate to client relationships acquired from business acquisitions and are amortised on a straight-line basis over their estimated useful lives, not exceeding 15 years. Acquired intangible assets estimated lives are re-evaluated annually and tested for impairment. The amortisation expense associated with intangible assets was $5.8 million in 2011, compared to $5.7 million in 2010, as the Bank did not acquire or sell intangible assets during 2011. Marketing Marketing expenses reﬂect costs incurred in advertising and promoting our products and services. They totalled $5.3 million in 2011, up $0.3 million from 2010. 24 Other Non-Interest Expenses (in $ thousands) Stationery & supplies Custodian & handling Charitable donations Insurance Other expenses Maintenance fees for liquidity facility Cheque processing Dues and subscriptions Registrar and transfer agent fee Agent commission fees Foreign bank charges Directors’ fees ATM fees General expenses Other Total normalised non-interest expenses Commitment and legal fees to establish a liquidity facility with CIBC Other non-recurring organisational costs Total non-interest expenses 2011 1,945 1,752 1,239 2,944 356 1,615 590 822 639 948 845 426 1,455 3,492 19,068 - - 19,068 2010 2,209 1,810 1,240 3,241 1,765 1,662 676 931 848 755 747 506 1,396 3,330 21,116 7,480 352 28,948 $ change (264) (58) (1) (297) (1,409) (47) (86) (109) (209) 193 98 (80) 59 160 (2,050) (7,480) (352) (9,882) Other expenses were $19.1 million in 2011, a decrease of $2.1 million compared to 2010 normalised, primarily driven by the cancellation of the liquidity facility with CIBC in early 2011. Income Taxes In 2011, income tax expenses associated with our businesses in taxable jurisdictions, namely Barbados, Guernsey, Switzerland and the United Kingdom, were netted to nil compared to a beneﬁt of $2.0 million in 2010. 2011 taxes reﬂect a tax beneﬁt of $1.2 million (2010: $3.3 million) for our UK operation, which recorded a net loss in 2011, offset by income tax expenses of $0.8 million (2010: $0.6 million) in Guernsey and $0.3 million (2010: $0.8 million) in Barbados. Butterﬁeld Annual Report 2011 25 CONSOLIDATED BALANCE SHEET AND DISCUSSION The following table shows the Balance Sheet as reported as at 31 December 2011 and 31 December 2010. (in $ millions) Assets Cash and cash equivalents Short-term investments Investments Loans, net of allowance for credit losses Premises, equipment and computer software Other assets Total assets Liabilities Total deposits Total other liabilities Subordinated capital Total liabilities Liquidation preference of Preference Shares Common equity Total Shareholders’ equity Total liabilities and Shareholders’ equity Capital Ratios Risk weighted assets Tangible Common equity (TCE) Tangible assets (TA) TCE/TA Tier 1 Common ratio Tier 1 ratio Total Capital ratio 2011 1,979 34 2,090 4,247 276 196 8,824 7,525 201 268 7,994 200 630 830 8,824 4,426 581 8,775 6.6% 13.1% 17.7% 23.5% 2010 2,430 26 2,629 4,043 262 233 9,623 8,228 303 283 8,814 200 609 809 9,623 4,935 554 9,568 5.8% 11.6% 15.7% 21.6% The Bank maintains a highly liquid Balance Sheet and is very well capitalised. On 31 December 2011, total assets of the Bank stood at $8.8 billion, down $0.8 billon from year-end 2010, reﬂecting lower year-end customer deposit balances in Bermuda, Guernsey and United Kingdom. At 31 December 2011, the total of cash and cash equivalents, short-term investments and investments represented $4.1 billion, or 46.5% of total assets, down from 52.8% at year-end 2010. At 31 December 2011, Butterﬁeld’s capital ratios were strong, having improved from year-end 2010, with the TCE / TA ratio ending 2011 at 6.6% (2010: 5.8%), whilst the Total Capital ratio and Tier 1 Capital ratios were of 23.5% (2010: 21.6%) and 17.7% (2010: 15.7%) respectively. These ratios are well in excess of regulatory minimums. Cash, Cash Equivalents and Short-Term Investments The Bank only places deposits with highly rated institutions and ensures there is appropriate geographic diversiﬁcation in its exposures. Limits are set for aggregate geographic exposures for each institution and are monitored and reviewed by our Credit Risk Management (“CRM”) division and approved by the Financial Institutions Committee. Effective 1 January 2011, the Bank changed its accounting policy with respect to cash and cash equivalents for the purposes of the Consolidated Statement of Cash Flows. The Bank deﬁnes cash and cash equivalents to include cash on hand, cash items in the process of collection, amounts due from correspondent banks and highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insigniﬁcant risk of change in fair value. Such investments are those with less than three months maturity from the date of acquisition and include unrestricted term deposits, certiﬁcates of deposit, treasury bills and securities purchased under agreements to resell. Investments of a similar nature that are either restricted or have a maturity of more than three months but less that one year are classiﬁed as short-term investments. Previously, cash and demand deposits with banks only included cash and demand deposits, vault cash and cash in transit for the purposes of the Consolidated Statement of Cash Flows. The Bank believes the new policy is preferable as it more closely reﬂects the manner in which the Bank manages its liquid assets. As at 31 December 2011, cash and cash equivalents and short-term investments were $2.0 billion, compared to $2.5 billion as at 31 December 2010. See “Note 3: Change in accounting policy” and “Note 4: Cash and cash equivalents” in the 31 December 2011 audited Financial Statements for additional tables and information. 26 Investments Total investments were $2.1 billion as at 31 December 2011, down $0.5 billion from the prior year-end balance, due primarily to the sale of the majority of our European exposures in the fourth quarter of 2011 and the purchase of treasury securities, which are included in the cash and cash equivalents category. Effective 1 October 2010, the Bank entered into an investment advisory agreement with Carlyle Investment Management LLC, an afﬁliated company of the Carlyle Group. Under the agreement, Carlyle has agreed to provide Balance Sheet management advisory services to the Bank including, but not limited to: development of investment strategies for consideration by the Bank’s Asset and Liability Committee; Balance Sheet simulation analysis, including interest rate sensitivity, economic value at risk, interest at risk and stress testing; detailed investment portfolio reporting; cash ﬂows and net interest income forecasting; deposit behaviour analysis and pricing strategies; and assistance with credit advisory and workout strategies. Our investment policies require Management to maintain a portfolio of securities that will provide the liquidity necessary to facilitate the funding of loans and cover deposit ﬂuctuations, and to mitigate our overall Balance Sheet exposure to interest rate risk, whilst achieving a satisfactory return on the funds invested. The securities in which we may invest are limited to securities that are considered investment grade. Securities in our investment portfolio are accounted for under US GAAP as either Trading, Available For Sale or Held to Maturity. Investment policies are approved by the Board of Directors, governed by The Group Asset and Liability Management Committee and monitored daily by Group Market Risk, a division of Enterprise Risk Management. 31 DECEMBER 2011 INVESTMENT PORTFOLIO BY LONG-TERM DEBT RATING 31 DECEMBER 2011 INVESTMENT PORTFOLIO BY TYPE Other 2% BBB 3% Mutual Funds 3% A 17% Certificates of Deposit 17% Corporate Debt Securities Guaranteed by Non-US Governments 6% AA 9% Pass-Through Note 1% US Government and Federal Agencies 41% AAA 69% Asset-backed Securities- Student Loans 7% Corporate Debt Securities 19% Debt Securities Issued by Non-US Governments 6% Trading securities, consisting of holdings of non-US government securities, corporate equities and seed money invested in mutual funds managed by us, totalled $62.6 million at year-end 2011, compared to $18.1 million at year-end 2010, primarily reﬂecting the $50 million initial seed money invested by the Bank in BNY Mellon Butterﬁeld Income Advantage Fund, which was off set by the disposal of the Butterﬁeld Systematic Equity Fund in 2011. Available for Sale (“AFS”) securities totalled $2.0 billion at year-end 2011, compared to $2.6 billion at year-end 2010. As at 31 December 2011, 40.3% or $790.8 million (2010: 35% or $917.5 million) of AFS securities consisted of holdings of mortgage-backed securities issued by US government agencies. Corporate debt securities, certain of which are guaranteed by non-US governments totalled 27.0%, or $530.6 million (2010: 19.0% or $497.2 million), and certiﬁcates of deposit represented 18.2% or $356.5 million (2010: 33.0% or $859.1 million). The remaining 14.7% AFS securities are comprised primarily of debt securities issued by non-US governments ($113.0 million), government guaranteed student loan-backed securities ($144.3 million) and one pass-through note ($27.0 million), which was formerly a structured investment vehicle (“SIV”). Held to maturity (“HTM”) investments were $64.8 million as at 31 December 2011 (2010: nil) and consisted entirely of mortgage-backed securities issued by US government agencies that Management has no intention to sell before maturity. As at 31 December 2011, 95% (2010: 98.1%) of our total investments were rated investment grade (i.e., rated ‘BBB’ or higher). Butterﬁeld Annual Report 2011 27 The Bank held two SIV-related securities at 31 December 2010. During 2011, a SIV-related security with carrying value of $24.3 million was sold, resulting in a gain of $0.1 million. The following table shows the par value, carrying value and unrealised losses of the Bank’s only remaining SIV-related security (now restructured as a pass-through note) as at 31 December 2011. (in $ millions) Par value Carrying value Unrealised loss in accumulated other comprehensive income Total amortised cost OTTI taken during the year Carrying amount (market value) / Par value Amortised cost / Par value As at 31 December 2011 58.8 27.0 6.7 33.7 - 45.9% 57.3% 2010 122.2 57.6 5.1 62.7 (60.5) 47.1% 51.3% Securities in unrealised loss positions are analysed as part of Management’s ongoing assessment of Other-Than-Temporary Impairment (“OTTI”). When Management intends to sell securities, it recognises an impairment loss equal to the full difference between the amortised cost basis and the fair value of those securities. When Management does not intend to sell equity or debt securities in an unrealised loss position, potential OTTI is considered using a variety of factors, including the length of time and extent to which the market value has been less than cost, adverse conditions speciﬁcally related to the industry, geographic area or ﬁnancial condition of the issuer or underlying collateral of a security, payment structure of the security, changes to the rating of the security by a rating agency, the volatility of the fair value changes, and changes in fair value of the security after the Balance Sheet date. For debt securities, Management estimates cash ﬂows over the remaining lives of the underlying collateral to assess whether credit losses exist and to determine whether any adverse changes in cash ﬂows have occurred. Management’s cash ﬂow estimates take into account expectations of relevant market and economic data, such as gross domestic product (GDP) and unemployment, during the cash ﬂow cycle as of the end of the reporting period and includes, for example, underlying loan-level data, and structural features of securitisation, such as subordination, excess spread, over-collateralisation or other forms of credit enhancement. Management compares the losses projected for the underlying collateral (“pool losses”) against the level of credit enhancement in the securitisation structure to determine whether these features are sufﬁcient to absorb the pool losses, or whether a credit loss on the debt security exists. Management also performs other analyses to support its cash ﬂow projections, such as stress scenarios. For debt securities, Management considers a decline in fair value to be other-than-temporary when it does not expect to recover the entire amortised cost basis of the security. See “Note 6: Investments” in the 31 December 2011 audited Financial Statements for additional tables and information. Loans The loan portfolio stood at $4.2 billion at 31 December 2011, up $0.2 billion from $4.0 billion the year before, due to the net advancement of $196 million to the Government of Bermuda and an increase of $121 million in Guernsey, offset by the partial and full settlement of certain corporate loans. At 31 December 2011, the loan portfolio represented 48.1% of total assets, compared to 42.0% at 31 December 2010, whilst loans as a percentage of customer deposits were 57.4% (2010: 49.6%). Speciﬁc and general allowances for loan losses at 2011 totalled $61.4 million at 31 December 2011, a decrease of $5.4 million from $66.8 million at year-end 2010. The movement in the allowance results from $23.8 million (2010: $107.9 million) of partial charge-offs, primarily on commercial related exposures, which the Bank deemed unrecoverable. This was offset by $4.1 million of recoveries (2010: $2.5 million) and $14.3 million (2010: $42.0 million) of incremental provisions for speciﬁc reserves, as well as enhancements to the general provisions in line with our provisioning policy that incorporates projected losses in changing economic environments. Charge-offs were $23.8 million in 2011 compared to $107.9 million in 2010, whilst recoveries totalled $4.1 million in 2011 compared to $2.5 million in 2010. Total allowance for credit losses was $61.4 million at 31 December 2011, down from $66.8 million at 31 December 2010. Of the total allowance, the general allowance was $35.5 million (2010: $36.5 million) and the speciﬁc allowance was $25.9 million (2010: $30.3 million) and represents a total coverage ratio of 21.2% of gross non-accrual loans at 31 December 2011, compared to 19.0% at 31 December 2010. 28 Gross non-accrual loans totalled $122.5 million at 31 December 2011, down $37.0 million from $159.5 million at 31 December 2010, and represented 2.8% of the total loan portfolio at 31 December 2011, compared to 3.9% in 2010. During 2011 the Bank recorded Other Real Estate Owned properties (“OREO”) amounting to $27.4 million comprising real estate, amounting to $20.8 million, received during 2011 as settlement for a commercial mortgage loan balance and foreclosed residential properties with a fair value less cost to sell of $6.6 million. A signiﬁcant component of our credit risk relates to our loan portfolio. In addition, credit risk is inherent in certain contractual obligations such as legally binding unfunded commitments to extend credit, commercial letters of credit, and standby letters of credit. Our real estate loan portfolio comprises lending secured by commercial and residential real estate. 31 DECEMBER 2011 LENDING BY LOCATION 31 DECEMBER 2011 GROUP LOANS BY TYPE United Kingdom 10% Commercial Mortgages 19% Bermuda 58% Guernsey 11% Other Consumer 5% Credit Cards 2% Automobile Financing 1% Commercial Overdrafts 2% Commercial and Industrial 7% Governments 6% Construction 1% Cayman 17% Barbados 4% Residential Mortgages 57% Commercial and Industrial Government Loans to governments increased by $194.6 million, primarily as a result of the Bank’s continued investment in the Bermuda economy. During 2011, the Bank extended the Government of Bermuda loan facility to $235 million, which was fully drawn down at the end of 2011. Commercial and Industrial The commercial and industrial loan portfolio includes loans and overdraft facilities advanced primarily to corporations and small and medium-sized entities, which are generally not collateralised by mortgages and where loan repayments are expected to ﬂow from the operation of the underlying businesses. Commercial and industrial loans decreased by $134.1 million in 2011 due to the combination of the partial settlement of a loan to BFG in the ﬁrst quarter of 2011 of $40.9 million, and full settlements of corporate loans during 2011. Commercial Mortgages Commercial mortgages are offered to real estate investors, developers and builders domiciled primarily in Bermuda and the United Kingdom. To manage our credit exposure on such loans, the principal collateral is real estate held for commercial purposes and is supported by a registered mortgage. Cash ﬂows from the properties, primarily from rental income, are generally supported by long-term leases to high quality international businesses. These cash ﬂows are principally sufﬁcient to service the loan. Commercial mortgage ﬁnancing decreased by $101.7 million, from $934.1 million at 31 December 2010 to $832.4 million at 31 December 2011, primarily due to increased pay downs, including real estate, amounting to $20.8 million, received during 2011 as settlement for a commercial mortgage loan balance, and managed reductions in commercial mortgage exposures. In addition, the Bank charged off commercial real estate loans, which in the opinion of Management, are considered uncollectible. Butterﬁeld Annual Report 2011 29 Residential The residential mortgage portfolio is comprised of mortgages to clients with whom we are seeking to establish (or already have) a comprehensive ﬁnancial services relationship. It includes mortgages to individuals and corporate loans secured by residential property. At 31 December 2011, residential mortgages totalled $2.4 billion (or 56.4 % of total gross loans), an increase of $0.2 billion from 31 December 2010. The value of residential mortgages in Bermuda decreased slightly during 2011, due to the transfer of foreclosed properties to OREO at a fair value net of selling costs of $6.6 million. Our Guernsey and United Kingdom ofﬁces increased residential mortgage lending to high net worth individuals, secured by high-end properties in the London, UK area during the year, resulting in a signiﬁcant increase in non-Bermuda residential mortgages in the portfolio. All mortgages were underwritten utilising our stringent credit standards. Residential loans consist of conventional home mortgages and equity credit lines. Other Loan Portfolios We provide loans, as part of our normal banking business, in respect of automobile ﬁnancing, consumer ﬁnancing, credit cards, commercial ﬁnancing, loans to ﬁnancial institutions and overdrafts facilities to retail, corporate and private banking clients in the jurisdictions in which we operate. Our loan portfolio and contractual obligations and arrangements are discussed in more detail in the Notes to the Consolidated Financial Statements. See “Note 7: Loans” and “Note 8: Credit Risk Concentration” in the 31 December 2011 audited Financial Statements for additional tables and information. Deposits Deposits are our principal funding source for use in lending, investments and liquidity. Butterﬁeld is a deposit-led Bank and does not require the use of wholesale funding to fund its loan business. During 2011, core deposits remained stable despite reductions in interest rates paid on deposits. Deposit balances at the end of reporting periods, particularly in our Bermuda and Cayman Islands operations, can ﬂuctuate due to signiﬁcant balances that ﬂow in and out from hedge fund clients to meet quarter-end subscriptions and redemptions, and are generally paid out in the ﬁrst few days of the quarter. The Bank views average customer deposits as a more representative measure of customer deposit balances. The table below shows the average customer deposit balances by jurisdiction, comparing 2011 with 2010. (in $ millions) Barbados Bermuda Cayman Islands Guernsey The Bahamas United Kingdom Total average deposits Average balance during 2011 3,340 259 1,732 1,470 92 816 7,709 2010 3,351 240 1,823 1,488 129 1,034 8,065 $ Change (11) 19 (91) (18) (37) (218) (356) Average customer balances were $7.7 billion, down $356 million from the prior year’s average of $8.1 billion. The decrease was primarily in the UK where the Bank made a strategic decision to exit its unproﬁtable Self Invested Personal Pension (“SIPP”) deposit business. In the Cayman Islands, the decrease represents lower cash balances held by institutional hedge fund clients during the year; core deposits were ﬂat. At year-end 2011, total customer deposits were $7.4 billion compared to $8.1 billion at 31 December 2010. The decrease primarily occurred in Bermuda, the Cayman Islands, Guernsey and the United Kingdom. The decrease in comparative year-end balances in Bermuda was primarily a result of lower hedge fund balances at 31 December 2011, as the Bank had experienced a build up of hedge fund deposits to meet the high rate of fund redemptions in the prior year. The $125.8 million decrease in Guernsey was primarily due to attrition as a result of the intense competition by European banks to attract new deposits at very high rates, as other forms of liquidity have dissipated due to the credit crisis. In the United Kingdom, deposits fell $204.1 million, primarily due to our exiting the SIPP deposit business. 30 Demand deposits, which include chequing accounts (both interest-bearing and non-interest-bearing), savings and call accounts, totalled $5.2 billion, or 69.7% of total customer deposits at year-end 2011, compared to $5.5 billion, or 67.9%, at year-end 2010. Term deposits decreased by 14.4% from $2.7 billion at year-end 2010 to $2.2 billion at year-end 2011 as customers moved to demand deposits given the low interest rate spread on longer-term deposits. The cost of funds was 0.52% in 2011, down 13 basis points from the 0.65% paid in 2010, as a result of disciplined deposit pricing that contributed to the improvement in net interest income. See “Note 11: Customer Deposits and Deposits from Banks” in the 31 December 2011 audited Financial Statements for additional tables and information. Borrowings We have no issuances of certiﬁcates of deposit (“CD”), commercial paper (“CP”) or senior notes outstanding and have no CD or CP issuance programmes. The Bank had a $300 million committed line of credit that we cancelled in the second quarter of 2011. We are able to source funding on an uncommitted basis from a number of major banks, including our principal correspondent banks. We use funding from the inter-bank market as part of interest rate and liquidity management. At 31 December 2011, deposits from banks totalled $125.4 million, compared to $79.7 million at 31 December 2010. Employee Future Beneﬁts As at 31 December 2011, the Bank had a substantial obligation for employee future beneﬁts in the amount of $104.9 million, up $19.7 million from $85.2 million at year-end 2010. The increase is primarily the result of lower discount rates used to value the future obligations, in line with the general downward trend in interest rates, as well as lower than expected returns on plan assets. In the second quarter of 2010, Shareholders’ equity was bolstered by a combination of changes to post-retirement health care beneﬁts. Following an independent, tri-annual actuarial review, the healthcare liability was reduced by approximately $27 million, reﬂecting changes in demographics and claims costs. Additionally, the Bank amended the plan for eligibility, beneﬁts and cost sharing criteria, which resulted in a further reduction in the liability of approximately $41 million. See “Note 12: Employee Future Beneﬁts” in the 31 December 2011 audited Financial Statements for additional tables and information. Subordinated Debt, Interest Payments and Maturities We have outstanding issuances of subordinated debt with a carrying value of $267.8 million as at 31 December 2011, of which $260 million is issued in US dollars and £5 million in Great Britain pounds compared to $282.8 million as at 31 December 2010. All but $27.0 million of outstanding subordinated debt is eligible for inclusion in our Tier 2 regulatory capital base and is limited to 50% of Tier 1 capital. During September 2011, the Bank repurchased a portion of the outstanding 5.11% 2005 Series B Subordinated Notes (“the Note”). The face value of the portion of the Note repurchased was $15 million and the purchase price paid for the repurchase was $13.875 million, which realised a gain of $1.125 million. See “Note 19: Subordinated Capital” in the 31 December 2011 audited Financial Statements for additional tables and information. Repurchase Agreements We also obtain funds from time to time from the sale of securities to institutional investors under repurchase agreements. In a repurchase agreement transaction, we will generally sell an investment security, agreeing to repurchase either the same or a substantially identical security on a speciﬁed later date, generally not more than 90 days, at a price greater than the original sales price. The difference in the sale price and repurchase price is the cost of the use of the proceeds, or interest expense. The investment securities underlying these agreements may be delivered to securities dealers who arrange such transactions as collateral for the repurchase obligation. Repurchase agreements represent a cost competitive funding source and also provide liquidity on agency paper for us. However, we are subject to the risk that the borrower of the securities may default at maturity and not return the collateral. In order to minimise this potential risk when entering into such transactions, we generally deal with large, established investment brokerage ﬁrms with whom we have ‘Master Repurchase’ agreements. Repurchase transactions are accounted for as ﬁnancing arrangements rather than as sales of such securities, and the obligation to repurchase such securities is reﬂected as a liability in our consolidated ﬁnancial statements. No repurchase agreements were outstanding as at year-ends 2011 and 2010. Butterﬁeld Annual Report 2011 31 Shareholders’ Equity Shareholders’ equity increased during the year ended 31 December 2011 by $20.4 million to $829.7 million, reﬂecting: (cid:115)(cid:0) $40.5 million net income for the year. (cid:115)(cid:0) $19.8 million from unrealised gains on AFS securities. (cid:115)(cid:0) $3.9 million of Share-based compensation. (cid:115)(cid:0) $0.8 million translation adjustments on foreign operations. These increases were offset by: (cid:115)(cid:0) $23.4 million net increase in employee future beneﬁts from the decline in interest rates used to discount the future cash ﬂows, and lower than expected return on plan assets. (cid:115)(cid:0) $18.0 million Preference Share dividend and guarantee fee. (cid:115)(cid:0) $3.3 million cash dividends on CVCP Shares. Capital Resources One of Management’s primary objectives is to maintain a strong capital base to promote conﬁdence in the Bank among our clients, the investing public, bank regulators, rating agencies, and Shareholders. The Bank manages its capital both on a total Group basis and, where appropriate, on a legal entity basis. The Finance department has the responsibility for measuring, monitoring and reporting capital levels within guidelines and limits established by the Risk Policy & Compliance Committee of the Board. The management of capital will also involve regional Management when appropriate. In establishing the guidelines and limits for capital, a variety of factors are taken into consideration, including the overall risk of the business in stressed scenarios, regulatory requirements, capital levels relative to our peers, and the impact on our credit ratings. The Bank is subject to Basel II, which is a risk-based capital adequacy framework developed by the Basel Committee on Banking Supervision and has been endorsed by the central bank governors and heads of bank supervision of the G10 countries. The Bank calculates its capital requirement on the Standardised approach under Basel II requirements. The Bank does not expect the changes being proposed to the capital adequacy ratios under Basel III to have a material impact on the Bank’s capital ratios. The Bank is fully compliant with all regulatory capital requirements and maintains capital ratios well in excess of regulatory minimums as at 31 December 2011. As at 31 December 2011, the Bank’s regulatory capital stood at $1,041.0 million with the consolidated Tier 1 total and total capital ratios being 17.7% and 23.5%, respectively (31 December 2010: 15.7% and 21.6%, respectively). The following table sets forth our capital adequacy as at 31 December 2011 and 31 December 2010 in accordance with Basel II framework: Year ended 31 December (in $ millions) Capital Tier 1 capital Tier 2 capital Deductions Total capital Weighted Risk Assets Cash and cash equivalents and investments Loans Other assets Off-Balance Sheet items Operational risk charge Total weighted risk assets Capital Ratios ( % ) Tier 1 common Tier 1 total Total capital 32 2011 2010 781.4 276.3 (16.7) 1,041.0 722.7 2,408.7 401.7 320.2 572.3 4,425.6 13.1% 17.7% 23.5% 772.5 310.3 (15.3) 1,067.5 957.6 2,552.2 426.0 372.4 626.4 4,934.6 11.6% 15.7% 21.6% Under Basel II Pillar III (market disclosure) the Bank is required to publish further information about the risks to which it is exposed. The Bank’s Pillar III disclosures for the year ended 31 December 2011 will be published on the corporate website, www.butterﬁeldgroup.com, shortly after the publication of these Financials Statements. Preference Shares In June 2009, the Bank offered 200,000 of 8.00% Non-Cumulative Perpetual Limited Voting Preference Shares, liquidation preference of US $1,000 per share (the “Preference Shares”) and $200,000,000 in the aggregate. The Preference Shares are fully and unconditionally guaranteed, with the full faith and credit of the Government of Bermuda (the “Guarantor”), as to payment of dividends for up to ten years and as to payment of the liquidation preference on, or in certain circumstances prior to, the ten-year anniversary of the date of issuance (the “Guarantee”). Dividends on the Preference Shares are payable quarterly on a non-cumulative basis, only when, as and if declared by our Board of Directors, on 15 March, 15 June, 15 September and 15 December of each year at a ﬁxed rate equal to 8.00% per annum on the liquidation preference, commencing on 15 September 2009. In the event that, during the ten-year term of the Guarantee, the Bank does not pay full dividends in respect of any quarterly dividend period on any Preference Shares that are then issued and outstanding, the Guarantor has agreed to pay to holders of the Preference Shares an amount equal to such unpaid dividends pursuant to the Guarantee. The Bank may redeem the Preference Shares at its option, subject to approval of the Bermuda Monetary Authority (“BMA”), in whole or in part, on the tenth day prior to the ten-year anniversary of the date of issuance (the “Bank Redemption Date”), at a redemption price equal to 100% of the liquidation preference thereof plus any unpaid dividends for the then-current dividend period to the Guarantee End Date, regardless of whether any dividends are actually declared for such dividend period. In addition, the Bank may redeem the Preference Shares prior to the Bank Redemption Date, at its option, subject to approval of the BMA, in whole or in part, at any time and from time to time, at a redemption price equal to the Make-Whole Redemption Price. Unless previously redeemed, the Guarantor has agreed to purchase from the holders thereof, and such holders will be required to transfer to the Guarantor, on the ten-year anniversary of the date of issuance, all Preference Shares then issued and outstanding, at a price per Preference Share equal to the liquidation preference thereof plus any unpaid dividends for the then-current dividend period to the date of such purchase, regardless of whether any dividends are actually declared for such dividend period. In addition, upon the occurrence of a Liquidation Event at any time prior to the ten-year anniversary of the date of issuance of the Preference Shares, the Guarantor has agreed to purchase from the holders thereof, and such holders will be required to transfer to the Guarantor, all Preference Shares then issued and outstanding, at a price per Preference Share equal to the liquidation preference thereof plus any unpaid dividends for the then-current dividend period to the date of payment, regardless of whether any dividends are actually declared for such dividend period. Capital Raise On 2 March 2010, the Bank issued 144.8 million Common Shares of par value $1 per Share, for a consideration of $175.0 million and 281,770 Mandatorily Convertible Preference Shares of par value $0.01 per Share and 93,230 Contingent Convertible Preference Shares of par value $0.01 per Share, for a consideration of $281.8 million and $93.2 million, respectively. Following the Bank’s Annual General Meeting held on 8 April 2010, The Bank of N.T. Butterﬁeld & Son Limited’s Shareholders approved an increase in the authorised share capital to 26,000,000,000 Common Shares of par value BD$0.01. Subsequent to the increase, conversion of 281,770 Mandatorily Convertible Preference Shares into 233,157,035 Common Shares and 93,230 Contingent Convertible Preference Shares into 77,144,993 Common Shares took place. At the Special General Meeting of Shareholders held on 14 April 2009, the Board of Directors were granted the authority to issue, allot or grant options, warrants or similar rights over or otherwise dispose of all the authorised but unissued Share capital of the Bank. Rights Offering (See the Rights Offering Prospectus for details) In March 2010, the Bank offered up to 99.3 million Common Shares and 8.3 million CVCP Shares in the form of up to 107.6 million Rights Units, each Unit consisting of 0.92038 Common Shares and 0.07692 CVCP Shares, for each Common Share held at a price of BD$1.21 per Rights Unit. Each qualifying Shareholder received 1.113 transferable rights to purchase 1 Rights Unit. Unallocated Rights Shares were available to qualifying Shareholders who exercised all the rights issued to them. Any unallocated Rights Shares remaining thereafter were available to qualifying holders of 8.0% Preference Shares. Following the closing of the Rights Offering on 11 May 2010, the gross proceeds of $130 million were used to repurchase 107,571,361 Shares from the 2 March 2010 investors at the same price at which the investors originally subscribed for the Shares. Butterﬁeld Annual Report 2011 33 Contingent Value Convertible Preference Shares (See the Rights Offering Prospectus for details) A holder of CVCP Shares has the option to convert any such Shares to Common Shares at any time. All CVCP Shares outstanding will automatically convert into Common Shares at the earlier of 31 March 2015 or a sale of the Bank. On such conversion, the CVCP Shares will convert into Common Shares at the Conversion Price. The initial Conversion Price shall be US$1.21 subject to any customary anti-dilution adjustments and certain downward notional adjustment based on certain loan recoveries. A holder of CVCP Shares is entitled to certain distributions in connection with certain sales or public offerings of the Bank’s equity interest in BFG. On 9 February 2011, the Bank announced that it has agreed to sell its minority ownership position in BFG to a new company founded by fund industry executives Tim Calveley and Glenn Henderson and private equity ﬁrm, BV Investment Partners. The sale transaction closed during the second quarter of 2011 and generated proceeds of $3.31 million. The completion of the sale triggered a dividend of $3.27 million ($0.42 per Share) to holders of Butterﬁeld CVCP Shares, which was paid on 16 August 2011 to Shareholders of record on 26 July 2011. Through this transaction, the Bank has fully divested itself of its minority ownership stake in BFG. BFG now operates as a subsidiary of the new company. The Bank continues to provide BFG and its clients with commercial banking, foreign exchange and custody services. BFG was originally established in 2008 through the merger of Butterﬁeld Fund Services and the Fulcrum Group. When, as and if declared by the Board, holders of the outstanding CVCP Shares will be entitled to receive dividends based on the number of Common Shares into which the CVCP Shares would be convertible as of the dividend record date. In the event of any voluntary or involuntary liquidation, dissolution or winding up of the affairs of the Bank, the holders of the CVCP Shares will be entitled to receive from its assets legally available for distribution to Shareholders as a liquidation preference before any distribution of assets is made to or set aside for the holders of any junior Shares, such as the Common Shares, the greater of (1) US$1.21 per CVCP Share plus any declared but unpaid dividends with respect to the then-current dividend period and (ii) the amount per CVCP Share that would be received if such CVCP Share had converted into Common Shares immediately prior to such liquidation, dissolution or winding up. The CVCP Shares are issued as perpetual securities subject to conversion to Common Shares and shall not be redeemable by any holders at any time. The holders of the CVCP Shares will vote together with the holders of the Common Shares on all matters upon which the holders of the Common Shares are entitled to vote. The CVCP Shares shall be entitled to such number of votes based on the number of Common Shares into which the CVCP Shares are convertible as of the applicable record date. The class vote of the holders of at least 66.6% of the CVCP Shares shall be required for (i) the creation or issuance of Shares that are senior to liquidation, (ii) an amendment of rights of the CVCP Shares or (iii) a reclassiﬁcation, merger, amalgamation or consolidation where the holders of CVCP Shares would not receive the consideration that would be received if such CVCP Shares had converted into Common Shares immediately prior to such event. The CVCP Shares shall be privately transferable (subject to applicable securities laws and any required regulatory consents) but shall not be listed on the Bermuda Stock Exchange or any other Stock Exchange. The CVCP Shares will not be registered under the securities laws of any jurisdiction. This will result in a limited market for the CVCP Shares. With respect to the 8.0% Preference Shares, the CVCP Shares rank pari passu as to liquidation and pari passu as to dividends and, with respect to Common Shares, the CVCP Shares rank senior as to liquidation and pari passu as to dividends (other than dividends relating to BFG, as to which the CVCP Shares rank senior). As at 31 December 2011, there were 7.46 million CVCP Shares outstanding with 0.325 million Shares converted to Common Shares at the holders’ option during the year ended as at 31 December 2011. As at 31 December 2011 there were no loan recoveries attributable to the CVCP Shares as deﬁned in the certiﬁcate of designation. Consequently, the conversion factor to Common Shares at 31 December 2011 remained one to one (1:1). Loan recoveries mean the amount by which the cumulative amount of collections actually received by the Bank with respect to “Covered Loans” from and after 1 January 2010 and through (and including) the Measurement Date exceeds $102.3 million. In no event shall the loan recoveries exceed US$42.0 million. As at 31 December 2011, the carrying value of the covered loans was $27.9 million (2010: $58.5 million) reﬂecting charge-offs during the year as approved by the Audit Committee and reviewed by an independent committee of the Board of Directors. 34 Warrants Following the Capital Raise on 2 March 2010, the terms of the 4,279,601 warrants with an exercise price of $7.01 previously issued to the Government of Bermuda in conjunction with the issuance of the Preference Shares in 2009 were adjusted in accordance with the terms of the guarantee. Subsequently, the Government of Bermuda now holds 4,150,774 warrants with an exercise price of $3.614. Dividends No Common Share dividends were declared or paid in 2011 or 2010. Preference Share dividends declared and paid were $16.0 million during 2011 (2010: $16.6 million) in relation to the 8% dividends. In 2011, a $3.3 million dividend was paid to holders of CVCP Shares triggered by the sale of the Bank’s minority interest in BFG. Guarantee fees paid to the Government of Bermuda were $2.0 million during each of 2011 and 2010. Cash Flows Cash and cash equivalents were $2.0 billion as at 31 December 2011, compared to $2.4 billion in the prior year. The decrease is described below by category of operating, investing and ﬁnancing activities. For the year ended 31 December 2011, net cash provided by operating activities totalled $43.7 million (2010: $67.0 million). Cash ﬂows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. Cash provided by operating activities decreased by $23.3 million from 2010 to 2011, due primarily from the $50 million investment of seed money in the new BNY Mellon Butterﬁeld Income Advantage Fund, classiﬁed as “trading investments” for accounting purposes. However, cash generated from operating activities before changes in trading investments increased $23.5 million on a rebound of cash earnings compared to the prior year. Our investing activities include capital expenditures, loan activities, investment activities, and divestiture and acquisition activities. We do not own, directly or indirectly, any shares of stock or any other equity interest or long-term debt securities of any company, corporation, ﬁrm, partnership, joint venture, association or other entity, except pursuant to the ordinary course of investment activities, the strategic investment in an associated company or as a result of the ordinary course loan structuring. Net cash provided by investing activities for the year ending 31 December 2011 totalled $235.9 million compared $197.3 million in 2010. The $38.6 million increase in 2011 over 2010 was mainly due to a $594.8 million net cash provided from proceeds from the sale or maturity of AFS investments in 2011, compared to $95.3 million in 2010, offset by the movement in loans year over year (2011: increase of $255.1 million; 2010: decrease of $104.9 million). Net cash used in ﬁnancing activities totalled $736.4 million in 2011, compared to the $121.8 million in 2010. The $858.2 million decrease reﬂects the net cash used to fund deposit decreases of $701.2 million in 2011, compared to the $380.8 million decrease in deposits offset by the $521.0 million net issuance of Shares and rights in 2010. OFF BALANCE SHEET ARRANGEMENTS Assets Under Administration and Assets Under Management The Bank, in the normal course of business, holds assets under administration and assets under management in a ﬁduciary or agency capacity for our clients. In accordance with US GAAP, these assets are not assets of the Bank and are not included in our Consolidated Balance Sheet. Credit-Related Arrangements We enter into standby letters of credit, letters of guarantee and contractual commitments to extend credit in the normal course of business, which are not required to be recorded on the Balance Sheet. Since many commitments expire unused or only partially used, these totals do not necessarily reﬂect future cash requirements. Management believes there are no material commitments to extend credit that represent risks of an unusual nature. Standby letters of credit and letters of guarantee are issued at the request of our clients in order to secure a client’s payment or performance obligations to a third party. These guarantees represent our irrevocable obligation 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 client. Generally, the term of the standby letters of credit does not exceed one year, whilst the term of the letters of guarantee does not exceed four years. Butterﬁeld Annual Report 2011 35 Credit risk is the principal risk associated with these instruments. The contractual amounts of these instruments represent the credit risk should the instrument be fully drawn upon and the client defaults. To control the credit risk associated with issuing letters of credit and letters of guarantee, we subject such activities to the same credit quality and monitoring controls as our lending activities. The types and amounts of collateral security we hold for these standby letters of credit and letters of guarantee is generally represented by our deposits or a charge over assets held in mutual funds. We are obligated to meet the entire ﬁnancial obligation of these agreements and in certain cases are able to recover the amounts paid through recourse against the collateral security. The following table sets forth the outstanding ﬁnancial guarantees with contractual amounts representing credit risk: As at 31 December (in $ millions) Standby letters of credit Letters of guarantee Total Gross Collateral 321.0 13.4 334.4 303.8 9.9 313.7 2011 Net 17.2 3.5 20.7 Gross 386.7 14.1 400.8 Collateral 354.3 8.7 363.0 2010 Net 32.4 5.4 37.8 Collateral is shown at estimated market value less selling cost. Where cash is the collateral, it is shown in gross amounts including interest income. Contractual Obligations (Including Subordinated Debt) We enter into contractual commitments to extend credit, normally with ﬁxed expiration dates or termination clauses, at speciﬁed rates and for speciﬁc purposes. These credit arrangements are subject to our normal credit standards and collateral is obtained where appropriate. Substantially all of our commitments to extend credit are contingent upon clients 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. In the second quarter of 2011, the Bank cancelled its commitment for a $300 million line of credit with CIBC as Management deemed it was no longer necessary. Whilst outstanding, the facility fees were $200,000 per month. In 2010, the Bank had incurred non-recurring fees of $7.48 million to setup the line of credit facility. A committed line of credit to our Bank in the Cayman Islands, from one of its custodians, was allowed to expire on its maturity on 31 December 2011. Both committed lines were exited as they were no longer required as part of the Bank’s liquidity management programme. The Bank entered into an asset liability management agreement with Carlyle Investment Management LLC (“Carlyle”), an afﬁliated company of the Carlyle Group with an effective date of 1 October 2010. Per the agreement Carlyle has agreed to provide Balance Sheet management advisory services to the Bank for an annual fee of $4.0 million until 1 October 2013. The Bank has a facility, by one of its custodians, whereby the Bank may offer up to US$200 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 2011, $137.1 million (2010: $174.5 million) of standby letters of credit were issued under this facility. The contractual amounts for these commitments represent the maximum payments we would have to make should the contracts be fully drawn, the counterparty default, and any collateral held prove to be of no value. Commitments, when drawn, would be funded from our free cash resources. We enter into other contractual obligations in the normal course of business. Certain of these obligations, such as subordinated debt, are recorded as liabilities in our Consolidated Balance Sheet. Other items, such as sourcing agreements, operating leases and other purchase contracts, are not required to be recorded on the Balance Sheet. Expected cash payments associated with subordinated debt are based on principal payment dates. See “Note 19: Subordinated Capital” for terms of subordinated debt arrangements and interest rates. 36 The $112.5 million contractual obligation in respect of sourcing—for Bermuda and the Cayman Islands—relates to an eight-year agreement entered into in October 2008 with global technology service provider Hewlett Packard (“HP”) (previously EDS) to supply technology infrastructure and application development management, information security and technical support for our locations in Bermuda and the Cayman Islands. In 2011, working with HP, we completed the transition of all our business applications and legacy systems in these locations to a new, common platform that will be centrally managed. Under our agreement with HP, server management and maintenance, technology ﬁeld support, application support and development and help desk functions are managed by HP. In addition, HP managed the installation of and conversion to our new, common core banking system in Bermuda and the Cayman Islands which went live in 2011. The transition of functional responsibility for information technology management and support, and the implementation of a new core banking system were completed in the Cayman Islands in the second quarter and in Bermuda in the fourth quarter. Under the agreement, we have the option to expand HP’s service to our other locations, subject to agreement on an expansion plan and fees. We believe that our arrangement with HP will help us optimise operations, improve productivity and enhance client service. We expect to derive synergies in the form of cost savings over time. The management and coordination of our international information technology functions will continue to be carried out from our head ofﬁce in Bermuda. We have entered into additional contractual obligations in the normal course of business which are not signiﬁcant to the amounts above. RISK MANAGEMENT Risk Governance The Group’s risk governance and management structure is illustrated below: BOARD OF DIRECTORS RISK POLICY & COMPLIANCE COMMITTEE AUDIT COMMITTEE GROUP RISK COMMITTEE GROUP ASSET & LIABILITY COMMITTEE GROUP CREDIT COMMITTEE PROVISION & IMPAIRMENTS COMMITTEE POLICY DEVELOPMENT COMMITTEE JURISDICTIONAL BUSINESS UNITS & OVERSIGHT COMMITTEES The Board of Directors oversees the Group’s risk management programme through the approval of the Risk Appetite Framework and supporting risk management policies. It accomplishes its mandate through the activities of two dedicated Committees: The Risk Policy & Compliance Committee This Committee assists the Board in fulﬁlling its responsibilities by overseeing the Group’s risk proﬁle and its performance against approved risk appetites and tolerance thresholds. Speciﬁcally, the Committee considers the sufﬁciency of the Group’s policies, procedures and limits related to the identiﬁcation, measurement, monitoring and control of activities that give rise to credit, market, liquidity, interest rate, operational and reputational risks, as well as overseeing its compliance with laws, regulations and codes of conduct. The Audit Committee This Committee reviews the overall adequacy and effectiveness of the Group’s system of internal controls and the control environment, including those that are brought to bear in respect of the risk management process. It reviews recommendations arising from internal and independent audit review activities and Management’s response to any ﬁndings raised. Butterﬁeld Annual Report 2011 37 Both the Risk Policy & Compliance Committee and the Audit Committee are supported in the execution of their respective mandates by the dedicated Audit, Compliance & Risk Policy Committees for our UK, Guernsey and Caribbean operations, which oversee the sufﬁciency of local risk management policies and procedures and the effectiveness of the system of internal controls that are in place. These Committees are chaired by Non-Executive Directors drawn from our jurisdictional Boards. The Group Executive Management team, led by the President & Chief Executive Ofﬁcer (“CEO”) and including the members of Executive Management reporting directly to the CEO, is responsible for setting business strategy and for monitoring, evaluating and managing risks across the Group. It is supported by the following committees: The Group Risk Committee (GRC) This is the Senior Management Committee with responsibility for risk governance. It provides a forum for the strategic assessment of risks assumed across the Group as a whole, based on an integrated view of credit, market, liquidity, legal and regulatory compliance, operational, interest rate, investment, capital and reputational risks, ensuring that these exposures are consistent with the risk appetites and tolerances promulgated by the Board. It is responsible for reviewing, evaluating and recommending the Group’s Risk Appetite Framework, the results of the Capital assessment and risk proﬁle (“CARP”) process (including all associated stress testing performed) and the Group’s key risk policies to the Board of Directors for approval, for reviewing and evaluating current and proposed business strategies in the context of our risk appetites and for identifying, reviewing and advising on current and emerging risk issues and associated mitigation plans. Its membership is drawn from the Group Executive Management team, including the CEO. The meeting is chaired by the Chief Risk Ofﬁcer. The Group Asset & Liability Committee This Committee is responsible for liquidity, interest rate and exchange rate risk management and other Balance Sheet issues. It also oversees the execution of the Group’s investment and capital management strategies and monitors the associated risks assumed. It is supported in the execution of its mandate by the work undertaken by the dedicated Asset & Liability Committees in each of the Bank’s jurisdictional business units. Its membership is drawn from the Group Executive and Senior Management teams, including the Chief Risk Ofﬁcer and the CEO. The meeting is chaired by the Chief Financial Ofﬁcer. The Group Credit Committee This Committee is responsible for a broad range of activities relating to the monitoring, evaluation and management of credit risks assumed across the Group, at both transaction and portfolio levels. It is supported in the execution of its mandate by the Financial Institutions Committee, a dedicated Sub-Committee that is responsible for the evaluation and approval of recommended inter-bank and counterparty exposures assumed in the Group’s treasury and investment portfolios, and by the activities of local Credit Committees in the UK, Guernsey, and the Caribbean, which review and approve transactions within delegated authorities and recommend speciﬁc transactions outside of these limits to the Group Credit Committee for approval. Its membership is drawn from the Group Executive and Senior Management teams. The meeting is chaired by the Chief Risk Ofﬁcer. The Provisions & Impairments Committee This Committee is responsible for approving signiﬁcant provisions and other impairment charges. It also oversees the overall credit risk proﬁle of the Group in regard to non-accrual loans and assets. It is supported in the execution of its mandate by local Credit Committees and the Group Credit Committee, which make recommendations to this Committee. Its membership is drawn from the Group Executive Management team, including the CEO. The meeting is chaired by the Chief Risk Ofﬁcer. The Policy Development Committee This Committee is responsible for overseeing the design, development and maintenance of the Group’s framework of operational policies. It develops recommendations regarding policy requirements, engages with nominated members of Executive Management to ensure that policies are drafted or updated on a timely basis and provides a forum through which they are debated Group-wide prior to their adoption, thereby ensuring a consistency of application and interpretation. It also ensures that all policies and any policy exception requests are reviewed and recommended prior to presentation to the Group Risk Committee or Risk Policy & Compliance Committee of the Board for approval. Its membership is drawn from the Senior Management team across the Group. It is chaired by the Group Head of Compliance. Risk Management The Group manages its exposure to risk through a three “lines of defence” model. This may be summarised as follows: 38 The ﬁrst “line of defence” This is provided by our jurisdictional business units, which retain ultimate responsibility for the risks they assume and for bearing the cost of risk associated with these exposures. The second “line of defence” This is provided by the Risk Management group, which works in collaboration with our business units to identify, assess, mitigate and monitor the risks associated with our business activities and strategies. It does this by: (cid:115)(cid:0) Making recommendations to the Group Risk Committee regarding the constitution of the Risk Appetite Framework. (cid:115)(cid:0) Setting risk strategies that are designed to manage risk exposures assumed in the course of pursuing our business strategies and aligning them with agreed appetites. (cid:115)(cid:0) Establishing and communicating policies, procedures and limits to control risks in alignment with these risk strategies. (cid:115)(cid:0) Measuring, monitoring and reporting on risk levels. (cid:115)(cid:0) Opining on speciﬁc transactions that fall outside delegated risk limits. (cid:115)(cid:0) Identifying and assessing emerging risks. The four functions within the Risk Management group that support our risk management activities are outlined below. To ensure a formal separation of duties, each reports directly to the Chief Risk Ofﬁcer. Group Market Risk – This provides independent oversight of the measurement, monitoring and control of liquidity and funding risks, interest rate and foreign exchange risks as well as the market risks associated with the Group’s investment portfolios. It also monitors compliance with both regulatory requirements and the Group’s internal policies and procedures relating to the management of these risks. Credit Risk Management – This unit is responsible for the adjudication and oversight of credit risks associated with our retail and commercial lending activities and the management of risks associated with our investment portfolios and counterparty exposures. It also establishes the parameters and delegated limits within which credit risks may be assumed and promulgates guidelines on how exposures should be managed and monitored. Compliance – This unit provides independent analysis and assurance of the Group’s compliance with applicable laws, regulations, codes of conduct and recommended best practices, including those associated with anti-money laundering/counter terrorist ﬁnancing requirements. It is also responsible for assessing the Group’s potential exposure to upstream risks and for providing guidance on the preparations that should be made in advance of these changes coming into effect. Group Operational Risk – This unit assesses the effectiveness of the Group’s procedures and internal controls in managing its exposure to various forms of operational risk, including those associated with new business activities and processes and the deployment of new technologies. It also oversees the Group’s incident management processes and reviews the effectiveness of its loss data collection activities. The third “line of defence” This is provided by our Group Internal Audit function, which provides ongoing review, oversight and challenge of the effectiveness of the internal controls that are executed by both the business and Risk Management communities in the management, monitoring and measurement of our exposure to risk. This includes the review of the accuracy of the underlying data and appropriateness of the stress testing methodologies that are executed as a part of our CARP process. The Risk Appetite Framework The Risk Appetite Framework is the cornerstone of our approach to risk management. Developed by Executive Management and approved formally by the Board of Directors, it communicates a willingness to take on certain risks in the pursuit of our strategic objectives and deﬁnes those that should be avoided. It also provides Management with a clear mandate regarding the amount and type of risk that it may accept and establishes minimum expectations regarding the practices and behaviours that should be brought to bear in managing the exposures assumed. It is aligned with the interests of our stakeholders, feeds into our business planning processes, and shapes our discussions on risk matters generally. Our framework comprises the following elements: (i). Nine broad categories of risk: Credit; Market; Liquidity; Legal & Regulatory; Governance; Process & Technology; People, Country & Political; and Reputational. These represent the various risks that the Group assumes across the entirety of its operations in the pursuit of its strategic goals. Butterﬁeld Annual Report 2011 39 (ii). For each risk category, there is a declared risk appetite. To ensure consistency in our risk conversations, these have been distilled into the three options set out in the table below, with each appetite designed to convey a clear strategic direction in terms of the risk/reward proﬁle assumed: APPETITE DEFINITION PROFILE Averse The Group will work to avoid exposure to this risk Our processes and controls are defensive and given its potential for ﬁnancial loss, reputational focus on detection and prevention. damage, and/or the loss of customer and/or investor conﬁdence. Cautions Given the potential for ﬁnancial loss, reputational Security is favoured over reward. Exposures are damage, and the loss of customer and/or investor only assumed when the risk can be quantiﬁed conﬁdence, the Group will be very selective in the accurately and is assessed as being acceptable. exposures assumed to this risk and will monitor it closely. Open The Group will consider opportunities to accept Reward is commensurate with the risk assumed. this risk and will accept those that fall within clearly Exposures can be estimated reliably and deﬁned parameters. The risk of loss or reputational structures, systems and processes are in damage is accepted but the exposure can be place to manage it. estimated reliably and can be managed to a tolerable level. (iii). A statement of our governing principles relating to each risk category. This establishes the characteristics of the risks that the Bank is willing to assume and the management behaviours that we should exhibit when doing so. Speciﬁc performance measures and tolerance thresholds in respect of each risk category, combining quantitative and qualitative targets (which are designed to reﬂect both forward looking as well as historical perspectives), are designed to provide Executive Management and the Board with an indication of the “direction” of our exposure relative to our declared risk appetite and an early warning of material adverse developments requiring remedial action. The metrics are monitored independently by the Group Risk function and are measured against actual results. The results of these analyses are reported to Management at all levels of the organisation and are reviewed regularly by both the Group Risk and Risk Policy & Compliance Committees in the performance of their oversight activities. Application Of The Risk Appetite Framework The limits, targets and thresholds used to measure performance continue to be reﬁned by the Group Risk Management function in an effort to express as complete a “picture” as possible of our exposure to a given risk, relative to the stated appetite. All changes proposed pass through a formal review and approval process at both the Executive Management and Board levels prior to their adoption. Through this approach, the Risk Appetite Framework sets the tone for our risk culture across the Group as a whole, inﬂuencing behaviours at all levels of the organisation and reinforcing accountability for decisions taken. Many of our Jurisdictional ofﬁces have developed subsidiary risk appetite frameworks in conjunction with their local Risk Management functions. This ensures appropriate coverage of local risk factors and the establishment of proportional tolerance thresholds. Group Risk has reviewed these frameworks prior to their adoption and has modiﬁed any appetites proposed that are considered to be inconsistent with the overall Group approach. Credit Ratings Our credit ratings are provided in the table below: Short-term deposits Long-term deposits and debt Outlook 40 Standard Moody’s Fitch & Poor’s A-2 A- P-1 A2 F1 A- Negative Negative Stable JURISDICTION AND GROUP BUSINESS OVERVIEWS BARBADOS Total revenues before gains and losses in Barbados were down 6.6% Throughout 2011, tight cost management was a major strategy of year over year, primarily due to lower earnings from net interest Butterﬁeld in Barbados. In line with this strategy, the Bank income offset by reduced credit provisions. There was a weak restructured its operations, resulting in a reduced workforce and an demand for credit in the local market during the year, reﬂective of overall reduction in non-interest expense of 12.5% year over year. continued slowness in the Barbados economy. In terms of community support, the Bank continued its title sponsorship of the Barbados Seniors’ Expo. (in $ thousands) Net interest income Provision for credit losses Non-interest income Revenue before gains and losses Total expenses Net income before gains and losses Net gains (losses) Net income As at 31 December (in $ millions) Customer deposits Loans, net of allowance for credit losses Total assets Number of employees 2011 11,485 (1,156) 2,896 13,225 12,135 1,090 37 1,127 269 178 304 114 2010 12,917 (1,707) 2,948 14,158 13,863 295 (151) 144 240 185 274 138 $ change (1,432) % change (11.1) 551 (52) (933) (1,728) 795 188 983 29 (7) 30 (32.3) (1.8) (6.6) (12.5) 269.5 (124.5) 682.6 12.1 (3.8) 10.9 (24) (17.4) Butterﬁeld Annual Report 2011 41 BERMUDA Bermuda is home to Butterﬁeld’s headquarters and remains the Bank’s Loans secured by commercial ofﬁce buildings continue to perform largest jurisdiction in terms of number of employees, Banking Centre well, whilst residential mortgage delinquencies have risen modestly locations and business volume. The Bank of N.T. Butterﬁeld & Son and remain low by international standards. Limited (“Butterﬁeld”) is Bermuda’s ﬁrst and largest independent bank, offering a full range of community banking services and wealth Credit provisions were $25.6 million in 2010 compared to $1.2 million management, including private banking, asset management and in 2011, primarily due to the release of provisions during the year personal trust services. Butterﬁeld also provides services to corporate relating to real estate received in settlement of loans outstanding. and institutional clients, which include asset management and As a result, net income was up $208.9 million to $25.8 million for the corporate trust services. year ended 31 December 2011. Total assets were $4.6 billion at 31 December 2011, down $0.6 billion from 31 December 2010. Assets Bermuda’s revenue before gains and losses increased year over year under management were $3.4 billion at 31 December 2011, down by $38.8 million, or 24.4%, reﬂecting higher interest income, decreased from $3.6 billion at 31 December 2010, reﬂecting the net redemptions, interest expense, and decreased provisions for credit losses offset whilst assets under administration for our trust and custody against decreased non-interest income. businesses at 31 December 2011 were $24.7 billion and $21.8 billion, respectively, compared to $22.8 billion and $19.6 billion at The Bank has stabilised its exposure to the hospitality industry. The 31 December 2010. Bank has taken action to place two hotel properties in Bermuda in receivership, where it was deemed to be the best course of action to Against a backdrop of economic difﬁculties locally, and despite the protect the value of assets and safeguard the interests of the Bank’s impact they had on the Bank’s performance in 2011, Butterﬁeld has Shareholders. The properties are being managed professionally reafﬁrmed our commitment to supporting the third sector, locally. The with a view to selling them as going concerns as soon as appropriate Bank believes that its long-term success and growth as an organisation arrangements can be reached. depends on the prosperity of the communities it serves. In 2011, the Bank reduced the total amount it donated to local charities in Bermuda, but refocused its giving efforts on human services. 42 (in $ thousands) Net interest income Provision for credit losses Non-interest income Revenue before gains and losses Total expenses Net income before gains and losses Net gains (losses) Net income (loss) As at 31 December (in $ millions) Customer deposits Loans, net of allowance for credit losses Total assets Assets under administration Custody and other administration services Trust Assets under management Butterﬁeld Funds Other assets under management Total assets under management 2011 131,937 (1,202) 67,081 197,816 176,726 21,090 4,754 2010 113,363 $ change 18,574 % change 16.4 (25,650) 24,448 (95.3) 71,325 (4,244) (6.0) 159,038 38,778 24.4 192,174 (15,448) (8.0) (33,136) 54,226 (163.6) (149,940) 154,694 (103.2) 25,844 (183,076) 208,920 (114.1) 3,260 2,507 4,578 3,605 (345) (9.6) 2,505 2 0.1 5,193 (615) (11.8) 21,761 24,735 19,633 2,128 10.8 22,835 1,900 8.3 2,653 752 3,405 2,870 (217) (7.6) 746 6 0.8 3,616 (211) (5.8) Number of employees 664 732 (68) (9.3) Butterﬁeld Annual Report 2011 43 CAYMAN ISLANDS Cayman is Butterﬁeld’s second largest jurisdiction in terms of business increases in professional and outside services costs related to asset and market presence. The Bank offers a full range of personal and liability management services and investment advice, along with corporate ﬁnancial services in the Cayman Islands and is among the additional cost associated with auditing the current year’s system leaders in this highly competitive market. To complement Butterﬁeld’s conversion. Provisions for credit losses were up 4.4% to $4.0 million strong retail banking presence, Butterﬁeld Bank (Cayman) Limited on certain overseas investment mortgages, certain commercial loans continued to focus on developing its wealth management businesses. and overall loan growth year over year. Total assets, at $2.0 billion, For the second year in a row, Butterﬁeld’s private banking service were down $63 million or 3.1%. Client assets under administration in Cayman was named “Best Private Bank in the Cayman Islands” decreased by 25.6% to $3.4 billion, due primarily to declines in the by Euromoney’s Private Banking and Wealth Management Survey, value of assets relating to trust clients. considered the benchmark of excellence in international private wealth management. In April, the Bank implemented its new banking In 2011, Butterﬁeld continued to demonstrate its commitment to the platform providing the basis for future client service offerings. Cayman Islands by supporting high-proﬁle economic development events and charitable causes. The Bank provides ﬁnancial support Net income before gains and losses of $9.0 million improved 28.6%, and board representation to the Cayman Islands Banker’s Association whilst the year-on-year improvement in net income in Cayman was and Cayman Finance, the industry-led organisations that foster the primarily attributable to the realised gains on sale of $2.0 million in ongoing development of ﬁnancial services in the Cayman Islands. the current year compared to realised losses of $11.6 million on the Butterﬁeld also had a prominent showing at the Cayman Captive sale of asset-backed securities in the Available For Sale portfolio in Forum conference. the prior year. Net interest income improved 30.6% year over year, to $37.3 million, whilst non-interest income declined by 5.4% to Butterﬁeld sponsored the nineteenth annual St. Patrick’s Day Irish $30.6 million, resulting from decreases in net banking services Jog, beneﬁting The Lighthouse School, Cayman’s only school for revenues due to increases in credit card servicing costs, reduced special needs children. Butterﬁeld Cayman continues to be a major asset management fees, trust fees and foreign exchange commissions. contributor to organisations such as Cayman Hospice Care, the While Cayman experienced steady growth in residential mortgages in Cayman Heart Fund, the Cancer Society, the Cayman Islands Red 2011, absorbing the Bahamas-based residential mortgage book and Cross, Cayman Islands Little League and Junior Squash. Additionally, participating in several commercial lending deals with its parent led 2011 saw the launch of the Butterﬁeld Education Grant, where schools to an increase in the Bank’s loan book of $114 million, or 18.8% year compete for a grant of $20,000 to fund speciﬁc initiatives. on year. Total expenses were $55.0 million in 2011, up $4.8 million from $50.2 million in 2010, due to increased technology and communication costs driven by the Bank’s outsourced I.T. services model and new operating systems implemented in April, including depreciation of its software ﬁxed asset during the balance of the year. There were 44 (in $ thousands) Net interest income Provision for credit losses Non-interest income Revenue before gains and losses Total expenses Net income before gains and losses Net gains (losses) Net income (loss) As at 31 December (in $ millions) Customer deposits Loans, net of allowance for credit losses Total assets Assets under administration Custody and other administration services Trust Assets under management Butterﬁeld Funds Other assets under management Total assets under management Number of employees 2011 37,325 (3,974) 30,650 64,001 54,988 9,013 1,955 2010 28,571 $ change 8,754 % change 30.6 (3,808) (166) 4.4 32,389 (1,739) (5.4) 57,152 6,849 12.0 50,145 4,843 9.7 7,007 2,006 28.6 (11,600) 13,555 (116.9) 10,968 (4,593) 15,561 (338.8) 1,743 722 1,974 1,226 2,188 211 760 971 308 1,781 (38) (2.1) 608 114 18.8 2,037 (63) (3.1) 1,187 39 3.3 3,401 (1,213) (35.7) 270 837 (59) (21.9) (77) (9.2) 1,107 (136) (12.3) 326 (18) (5.5) Butterﬁeld Annual Report 2011 45 GUERNSEY In Guernsey, Butterﬁeld offers private banking, lending, asset Butterﬁeld in Guernsey has continued to support initiatives and its management, custody, administered banking and ﬁduciary services. proﬁle in the local community through sponsorships of the Guernsey Volleyball Junior Development Programme, the Guernsey Squash Net interest income increased by $6.0 million, from $12.4 million in Rackets Association’s Racketball coaching programme and Guernsey 2010, to $18.4 million in 2011, from the purchase of higher-yielding, Annual Squash Open, The Guernsey Sinfonietta, as well as the Classic longer duration assets, and strong growth in our lending book. Yacht Regatta, which was hosted on the island. Non-interest income decreased by $1.3 million from $23.0 million in 2010 to $21.7 million in 2011, from the loss of two administered bank To build upon the Group’s reputation and proﬁle in the area of mandates and lower foreign exchange revenues, compensated in ﬁduciary services, sponsorship was provided for the Society of Trust part, by increases in asset management revenues. Total expenses and Estate Practitioner’s Asia conference held in Singapore. Support increased by $2.6 million to $30.2 million for the year ended for promotional initiatives led by Guernsey Finance was also provided 31 December 2011, due to increases in professional and advisory with a secondary sponsorship at the 2011 Guernsey Funds Forum held fees in 2011 coupled with a non-recurring expense recovery in in London. 2010. Total assets at 31 December 2011 were $1.5 billion, down from $1.6 billion at 31 December 2010, due to customer deposit balances reducing by $128 million, offset by year-on-year exchange translation variances. Loans increased $120 million to $453 million from $333 million at 31 December 2010 as a direct result of our strategy to increase our lending balances with high net worth clients investing in high end residential prime property. Client assets under administration were $16.7 billion at 31 December 2011, up from $16.4 billion a year earlier. 46 (in $ thousands) Net interest income Non-interest income Revenue before gains and losses Total expenses Net income before gains and losses Net gains (losses) Net income As at 31 December (in $ millions) Customer deposits Loans, net of allowance for credit losses Total assets Assets under administration Custody and other administration services Trust Assets under management Butterﬁeld Funds Other assets under management Total assets under management Number of employees 2011 18,379 21,664 39,406 30,245 9,161 242 9,403 1,334 453 1,480 2010 12,384 $ change 5,995 % change 48.4 23,003 (1,339) (5.8) 35,387 4,019 11.4 27,625 2,620 9.5 7,762 1,399 18.0 (1,433) 1,675 (116.9) 6,329 3,074 48.6 1,462 (128) (8.8) 333 120 36.0 1,618 (138) (8.5) 6,714 9,944 5,694 1,020 17.9 10,754 (810) (7.5) 141 447 588 165 180 512 (39) (21.7) (65) (12.7) 692 (104) (15.0) 166 (1) (0.6) Butterﬁeld Annual Report 2011 47 UNITED KINGDOM In the UK, Butterﬁeld Private Bank provides a range of exclusive During 2011, Butterﬁeld re-focused its business on providing exclusive banking, lending, treasury and investment management services. This private banking and wealth management services to wealthy clients includes family ofﬁce services to high net worth international clients and their families through the exit of non-core business. As part of and their advisers from ofﬁces in London. a re-focused private banking strategy, the Bank enhanced its credit The UK’s net loss of $3.3 million in 2011 was a result of credit relationship managers to meet the demand of its clients. The Bank’s provisions relating to historical non-core private banking business. lending focus is on providing lending services to wealthy clients These speciﬁc loan loss provisions generated a realised loss, net of at modest loan-to-value ratios secured on prime Central London offering through the recruitment of a specialist team of experienced tax, of $4.7 million. Total revenues before gains and losses were residential property. $16.9 million, up $4.6 million from $12.3 million as a result of an increase in UK residential lending and a higher return the Bank The Bank made a number of small donations to a range of charities achieved on its debt securities in 2011. At 31 December 2011, total connected with private clients during the year. assets were $1.0 billion, down $129 million due to the decrease in customer deposits, mainly reﬂecting the strategic decision to exit non-core private banking business. (in $ thousands) Net interest income Provision for credit losses Non-interest income Revenue before gains and losses Total expenses Net income before gains and losses Gains and losses Net loss As at 31 December (in $ millions) Customer deposits Loans, net of allowance for credit losses Total assets Assets under administration Custody and other administration services Assets under management Butterﬁeld Funds Other assets under management Total assets under management Number of employees 48 2011 12,688 (6,724) 10,929 16,893 20,253 (3,360) 45 2010 9,381 $ change 3,307 % change 35.3 (7,136) 412 (5.8) 10,027 902 9.0 12,272 4,621 37.7 16,088 4,165 25.9 (3,816) 456 (11.9) (9,964) 10,009 (100.5) (75.9) (3,315) (13,780) 10,465 735 434 976 939 415 (204) (21.7) 19 4.6 1,105 (129) (11.7) 1,276 1,263 13 1.0 330 309 639 101 331 296 (1) (0.3) 13 4.4 627 12 1.9 109 (8) (7.3) GROUP ASSET MANAGEMENT Butterﬁeld Asset Management focuses on fulﬁlling the ﬁnancial needs mass afﬂuent clients are served out of Bermuda and the Cayman of those who demand the highest level of service and expertise. Islands as part of the Bank’s community banking platform. Clients have direct access to their portfolio managers who are, in turn, supported by a Group investment discipline designed to leverage Group Asset Management revenues increased by $0.3 million in 2011, resources from across the organisation, including a Core Strategy & largely attributable to a change in the mix of services favouring higher Research Team based in London. margin offerings. The Group provides a broad range of investment services to Assets under management decreased by $0.4 billion (7.1%) to institutional and private clients in Bermuda, the Cayman Islands, $5.6 billion in 2011, largely due to a fall in money market balances in Guernsey, and the United Kingdom. Principal services include Cayman and particularly Bermuda as clients sought better yielding discretionary investment management and managed portfolio alternatives for short-term investments. In addition, Cayman services. Advisory and self-directed brokerage offerings are available institutional assets under management declined as insurance captives to clients in Bermuda and the Cayman Islands. The Group also offers moved to manage more of their assets onshore. Private client asset money market and mutual funds to both client bases. Institutional growth was strong in the ﬁrst half of the year, especially in the UK. In clients consist primarily of captive insurance companies in Bermuda the second half of the year, private clients were increasingly reluctant and the Cayman Islands. High net worth private clients and their to invest in correcting and volatile markets and select large trust ﬁduciary vehicles are served from all four jurisdictions. Retail and mandates concluded as scheduled in Guernsey. Non-interest income (in $ thousands) Bermuda Cayman Islands Guernsey UK Total Asset Management 2011 8,858 4,150 4,255 5,679 22,942 2010 9,396 4,407 3,784 5,078 22,665* $ change (538) (257) 471 601 277 *Excludes non-interest income of $1.9 million attributable to the Hong Kong subsidiary disposed on 8 September 2010. Note: the above amounts quoted are net of inter-jurisdiction eliminations. Total assets under management (“AUM”) at 31 December: (in $ millions) Bermuda Cayman Islands Guernsey The Bahamas UK Total Butterﬁeld Funds 2,653 211 141 40 330 2011 Other assets 752 760 447 1 309 Total AUM 3,405 Butterﬁeld Funds 2,870 971 588 41 639 270 180 26 331 2010 Other assets 746 Total AUM 3,616 837 512 9 296 1,107 692 35 627 3,375 2,269 5,644 3,677 2,400 6,077 Butterﬁeld Annual Report 2011 49 GROUP TRUST Our trust and corporate services specialists deliver ﬁduciary solutions Trust revenues are derived from a combination of ﬁxed fees, fees to meet a range of client needs, including estate and succession based on the market values of assets held in trust and fees based planning, administration of complex asset holdings, and tax-efﬁcient on time spent in relation to the range of personal trust and company co-ordination for the affairs of international families, the pension administration services and pension and employee beneﬁt trust and employee beneﬁt planning requirements of multi-national services we provide. corporations and institutions. In 2011, trust revenues totalled $30.0 million, almost 2% higher than We provide both personal and institutional trust services from our the $29.5 million recorded in 2010, excluding $1.0 million in revenue operations in Bermuda, The Bahamas, the Cayman Islands, Guernsey related to the Malta business that was sold in 2010. Revenue and Switzerland, with our multi-jurisdictional capability therefore increases were seen in four of our ﬁve trust operations: The Bahamas spanning the world’s leading international trust and ﬁduciary centres. was up 4.3%, Bermuda increased 3.6% and Guernsey rose 1.7%, while in Alongside our traditional strengths in providing services to families a restructuring of our Bahamas operations to focus predominantly and institutions with links to the United Kingdom, North America and on trust activities was announced. In September 2010, the Bank Europe, our business increasingly supports clients connected to the concluded the sale of its trust operations located in Malta, which did Switzerland revenues were up 38.2% year on year. In December 2010, Asian and Latin American regions. not contribute signiﬁcantly to this line of business. Total Trust assets under administration were $40.7 billion as at 31 December 2011, Our goal is to develop long-term relationships with our clients, based compared to $40.5 billion the prior year. on consistently reliable service and underpinned by the technical expertise and competencies of our team. To this end, training and continual professional development for our staff remained a key priority in 2011. Following our selection as The Society of Trust and Estates Professional’s (STEP) Institutional Trust Company of the Year in 2009/10, we were pleased to be recognised as one of Private Client Practitioner’s Top 25 Trust Companies in 2011. Butterﬁeld Trust (Switzerland) Limited also received a nomination as Swiss Trust Company of the Year for Citywealth’s 2012 Offshore Awards. 50 The tables below shows trust revenues by jurisdiction, followed by assets under administration. Non-interest income (in $ thousands) Bermuda Cayman Islands Guernsey Switzerland The Bahamas UK Total 2011 13,166 4,879 6,549 677 4,180 544 Trust 2010 12,704 5,263 6,437 490 4,009 607 29,995 29,510* $ change 462 (384) 112 187 171 (63) 485 *Excludes non-interest income of $1.0 million attributable to the Malta subsidiary disposed on 8 September 2010. Note: the above amounts quoted are net of inter-jurisdiction eliminations. Total Trust assets under administration (“Trust AUA”) at 31 December: (in $ millions) Bermuda Cayman Islands Guernsey Switzerland The Bahamas UK Total 2011 24,735 2,188 9,944 386 3,439 - 2010 22,835 3,401 10,754 349 3,172 - 40,692 40,511 Butterﬁeld Annual Report 2011 51 Financials 52 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 reports to, and has full and free access to the Audit Committee of the Board of Directors. The Audit 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 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. Bradford Kopp President & Chief Executive Ofﬁcer 29 February 2012 Bradley Rowse Executive Vice President & Chief Financial Ofﬁcer 29 February 2012 Butterﬁeld Annual Report 2011 53 54 CONSOLIDATED BALANCE SHEET As at 31 December (in thousands of Bermuda dollars) Assets Cash and demand deposits with banks Cash equivalents Total cash and cash equivalents Short-term investments Debt and equity securities Trading Available for sale Held to maturity Total investments in debt and equity securities Loans, net of allowance for credit losses Premises, equipment and computer software Accrued interest Goodwill Intangible assets Investments in afﬁliates Receivable from investments sold Other real estate owned Other assets Total assets Liabilities Deposits Non-interest bearing Interest bearing Customers Banks Total deposits Employee future beneﬁts Accrued interest Preference Share dividends payable Payable for investments purchased Other liabilities Total other liabilities Subordinated capital Total liabilities Shareholders’ equity Common Share capital (BMD 0.01 par; authorised Shares 26,000,000,000 (2010: BMD 0.01 par; authorised Shares 26,000,000,000) issued and outstanding: 549,468,349 (2010: 549,143,448) Preference Share capital (USD 0.01 par; USD 1,000 liquidation preference) issued and outstanding: 200,000 (2010: 200,000) Contingent Value Convertible Preference Share capital (USD 0.01 par) issued and outstanding: 7,464,186 (2010: 7,789,087) Additional paid-in capital Accumulated deﬁcit Less: Treasury Common Shares: 2,163,958 Shares (2010: 2,401,593 Shares) Accumulated other comprehensive loss Total Shareholders’ equity Total liabilities and Shareholders’ equity The accompanying notes are an integral part of these Consolidated Financial Statements. Robert A. Mulderig Chairman of the Board Robert Steinhoff Vice Chairman 2011 2010 413,213 1,566,245 1,979,458 34,814 62,591 1,962,346 64,789 2,089,726 4,247,260 276,114 25,259 15,937 33,247 32,582 - 27,354 62,358 8,824,109 300,865 2,128,834 2,429,699 26,392 18,088 2,611,056 - 2,629,144 4,043,360 261,955 17,691 16,017 38,946 33,534 50,817 - 75,505 9,623,060 961,002 977,417 6,439,076 125,362 7,525,440 104,913 8,905 715 - 86,656 201,189 267,755 7,994,384 5,494 2 75 1,377,556 (490,377) (21,723) (41,302) 829,725 8,824,109 7,170,963 79,679 8,228,059 85,209 9,647 715 112,663 94,680 302,914 282,799 8,813,772 5,491 2 78 1,376,037 (509,579) (24,127) (38,614) 809,288 9,623,060 Bradford Kopp President & Chief Executive Ofﬁcer Butterﬁeld Annual Report 2011 55 CONSOLIDATED STATEMENTS OF OPERATIONS For the year ended 31 December (in thousands of Bermuda dollars, except per Share data) Non-interest income Asset management Banking Foreign exchange revenue Trust Custody and other administration services Other non-interest income Total non-interest income Interest income Loans Investments Deposits with banks Total interest income Interest expense Deposits Subordinated capital Securities sold under repurchase agreement Total interest expense Net interest income before provision for credit losses Provision for credit losses Net interest income after provision for credit losses Net realised / unrealised (losses) gains on trading investments Net realised gains (losses) on available for sale investments Other-than-temporary impairment losses on available for sale investments Realised loss on disposal of subsidiaries Net other gains (losses) Total net revenue Non-interest expense Salaries and other employee beneﬁts Technology and communications Property Professional and outside services Non-income taxes Amortisation of intangible assets Marketing Other expenses Total non-interest expense Net income (loss) before income taxes Income tax beneﬁt Net income (loss) Cash dividends declared on Contingent Value Convertible Preference Shares Cash dividends declared on Preference Shares Preference Shares guarantee fee Net income (loss) attributable to Common Shareholders Income (loss) per Common Share Basic Diluted The accompanying notes are an integral part of these Consolidated Financial Statements. 56 2011 22,942 33,302 31,519 29,995 11,780 5,708 135,246 202,473 45,640 10,846 258,959 34,736 10,486 2 45,224 213,735 (14,326) 199,409 (919) 2,059 - - 3,135 338,930 150,752 55,037 29,316 18,762 14,500 5,799 5,257 19,068 298,491 40,439 33 40,472 (3,270) (16,000) (2,000) 19,202 0.03 0.03 2010 24,544 33,941 32,479 30,534 13,574 8,348 143,420 198,008 28,330 11,047 237,385 45,988 12,455 - 58,443 178,942 (41,970) 136,972 971 (107,047) (60,522) (7,430) (6,489) 99,875 159,082 54,037 27,469 13,811 15,405 5,711 5,002 28,948 309,465 (209,590) 1,975 (207,615) - (16,000) (2,000) (225,615) (0.47) (0.47) CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) For the year ended 31 December (in thousands of Bermuda dollars) Common Share capital issued and outstanding Balance at beginning of year (2011: 549,143,448 Shares; 2010: 99,060,111 Shares) Issuance (2011: nil Shares; 2010: 147,703,758 Shares) Reduction in par value of Shares Repurchased (2011: nil Shares; 2010: 107,571,361 Shares) Rights conversion (2011: nil Shares; 2010: 99,173,842 Shares) Conversion of Mandatorily and Contingent Convertible Preference Shares (2011: nil Shares; 2010: 310,302,028 Shares) Conversion of Contingent Value Convertible Preference Shares (2011: 324,901 Shares; 2010: 475,070 Shares) Balance at end of year (2011: 549,468,349 Shares; 2010: 549,143,448 Shares) Preference Shares Balance at beginning of year (2011: 200,000 Shares; 2010: 200,000 Shares) Issuance (2011: nil Shares; 2010: nil Shares) Balance at end of year (2011: 200,000 Shares; 2010: 200,000 Shares) Mandatorily Convertible Preference Shares Balance at beginning of year (2011: nil Shares; 2010: nil Shares) Issuance (2011: nil Shares; 2010: 281,770 Shares) Conversion to Common Shares (2011: nil Shares; 2010: 281,770 Shares) Balance at end of year (2011: nil Shares; 2010: nil Shares) Contingent Convertible Preference Shares Balance at beginning of year (2011: nil Shares; 2010: nil Shares) Issuance (2011: nil Shares; 2010: 93,230 Shares) Conversion to Common Shares (2011: nil Shares; 2010: 93,230 Shares) Balance at end of year (2011: nil Shares; 2010: nil Shares) Contingent Value Convertible Preference Shares Balance at beginning of year (2011: 7,789,087 Shares; 2010: nil Shares) Rights conversion (2011: nil Shares; 2010: 8,264,157 Shares) Conversion to Common Shares (2011: 324,901 Shares; 2010: 475,070 Shares) Balance at end of year (2011: 7,464,186 Shares; 2010: 7,789,087 Shares) Additional paid-in capital Balance at beginning of year Stock option plan expense Reduction of additional paid-in capital on transfer and sale of Treasury Shares Issuance of Common Shares Issuance of Mandatorily Convertible Preference Shares Issuance of Contingent Convertible Preference Shares Reduction of par value of Common Shares Conversion of Mandatorily and Contingent Convertible Preference Shares Cost of capital raise and rights offering Balance at end of year Accumulated deﬁcit Balance at beginning of year Net income (loss) for year Cash dividends declared on Contingent Value Convertible Preference Shares Cash dividends declared on Preference Shares Preference Shares guarantee fee Balance at end of year The accompanying notes are an integral part of these Consolidated Financial Statements. 2011 5,491 - - - - - 3 5,494 2 - 2 - - - - - - - - 78 - (3) 75 1,376,037 3,567 (2,048) - - - - - - 1,377,556 (509,579) 40,472 (3,270) (16,000) (2,000) (490,377) 2010 99,060 144,836 (241,429) (1,076) 992 3,103 5 5,491 2 - 2 - 3 (3) - - 1 (1) - - 83 (5) 78 764,206 4,019 (6,939) 30,192 281,767 93,229 241,429 (3,103) (28,763) 1,376,037 (283,964) (207,615) - (16,000) (2,000) (509,579) Butterﬁeld Annual Report 2011 57 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) (Continued) For the year ended 31 December (in thousands of Bermuda dollars) Treasury Common Shares Balance at beginning of year (2011: 2,401,593 Shares; 2010: 3,426,106 Shares) Share-based compensation Net purchases, sales and transfers of Treasury Shares Balance at end of year (2011: 2,163,958 Shares; 2010: 2,401,593 Shares) Accumulated other comprehensive loss Balance at beginning of year Net change in unrealised gains (losses) on translation of net investment in foreign operations Net change in unrealised gains on available for sale investments Net change in unrealised non-credit losses on held to maturity investments Net change in employee future beneﬁts liability Balance at end of year Total Shareholders’ equity Comprehensive income (loss) Net income (loss) Other comprehensive (loss) income Total comprehensive income (loss) Components of accumulated other comprehensive loss Cumulative unrealised losses on translation of investment in foreign operations Cumulative unrealised gains (losses) on available for sale investments Cumulative change in employee future beneﬁts liability Balance at end of year The accompanying notes are an integral part of these Consolidated Financial Statements. 2011 (24,127) 356 2,048 (21,723) (38,614) 823 19,845 - (23,356) (41,302) 829,725 40,472 (2,688) 37,784 (11,321) 1,663 (31,644) (41,302) 2010 (34,660) 3,593 6,940 (24,127) (189,184) (4,494) 38,809 58,557 57,698 (38,614) 809,288 (207,615) 150,570 (57,045) (12,144) (18,182) (8,288) (38,614) 58 CONSOLIDATED STATEMENTS OF CASH FLOWS For the year ended 31 December (in thousands of Bermuda dollars) Cash ﬂows from operating activities Net income (loss) Adjustments to reconcile net income (loss) to operating cash ﬂows: Depreciation and amortisation Write down of computer software in development Decrease in carrying value of investments in afﬁliates Share-based payments Loss on sale of premises and equipment Net (gain) loss on sale of afﬁliate / subsidiaries Net gain on repayment of sub-debt Net realised (gains) losses of available for sale securities Other-than-temporary impairments on available for sale investments Provision for credit losses Changes in operating assets and liabilities: Increase in accrued interest receivable Decrease in other assets Decrease in accrued interest payable Decrease in other liabilities Net change in trading investments Cash provided by operating activities Cash ﬂows from investing activities Net (increase) decrease in short-term investments Net proceeds on sale of afﬁliate Additions to premises, equipment and computer software Net (increase) decrease in loans Held to maturity investments: proceeds from maturities Held to maturity investments: purchases Available for sale investments: proceeds from sale and maturities Available for sale investments: purchases Cash and demand deposits held by subsidiaries at time of sale Cash provided by investing activities Cash ﬂows from ﬁnancing activities Net decrease in demand and term deposit liabilities Repayment of subordinated capital Issuance of Common Share capital Issuance of Preference Share capital Cost of issuing Share capital and rights Common Shares repurchased Cash dividends paid on Contingent Value Convertible Preference Shares Cash dividends paid on Preference Shares Preference Shares guarantee fee paid Cash (used in) provided by ﬁnancing activities Net effect of exchange rates on cash and cash equivalents Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosure of cash ﬂow information Cash interest paid Cash income tax paid Non-cash item Transfer to Other Real Estate Owned and other repossessed assets 2011 40,472 39,084 - 952 3,923 - (3,178) (1,125) (2,059) - 14,326 (7,769) 12,918 (731) (8,716) 88,097 (44,422) 43,675 (8,668) 3,178 (33,476) (255,145) - (64,789) 2,383,659 (1,788,827) - 235,932 (701,240) (13,875) - - - - (3,270) (16,000) (2,000) (736,385) 6,537 (450,241) 2,429,699 1,979,458 47,268 871 27,354 2010 (207,615) 25,216 3,831 1,959 7,612 63 7,430 - 107,047 60,522 41,970 (1,520) 23,259 (2,707) (2,441) 64,626 2,371 66,997 20,802 - (39,611) 104,878 20,584 - 2,181,165 (2,085,825) (4,657) 197,336 (380,828) - 295,000 385,001 (28,763) (130,000) - (16,622) (2,000) 121,788 (21,597) 364,524 2,065,175 2,429,699 58,770 468 - The accompanying notes are an integral part of these Consolidated Financial Statements. Butterﬁeld Annual Report 2011 59 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (in thousands of Bermuda dollars) NOTE 1: NATURE OF BUSINESS The Bank of N.T. Butterﬁeld & Son Limited (“Butterﬁeld”, “Bank” or the “Company”) is incorporated under the laws of Bermuda and has a banking license under the Bank and Deposit Companies Act, 1999 (“the Act”). Butterﬁeld is regulated by the Bermuda Monetary Authority (“BMA”), which operates in accordance with Basel principles. Butterﬁeld is a full service community bank and a provider of specialised wealth management services. Services offered include retail, private & corporate banking, treasury, custody, asset management and personal & institutional trust services. The Bank provides such services from seven jurisdictions: Bermuda, Barbados, Cayman, Guernsey, Switzerland, The Bahamas and the United Kingdom. The Bank holds all applicable licenses required in the jurisdictions in which it operates. NOTE 2: SIGNIFICANT ACCOUNTING POLICIES a. Basis of Presentation and Use of Estimates and Assumptions The accounting and ﬁnancial reporting policies of 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 year, and actual results could differ from those estimates. Critical accounting estimates are those that require Management to make subjective or complex judgments about the effect of matters that are inherently uncertain and may change in subsequent periods. Changes that may be required in the underlying assumptions or estimates in these areas could have a material impact on the future ﬁnancial condition and results of operations. Management believes that the most critical accounting policies upon which the ﬁnancial condition depends, and which involve the most complex or subjective decisions or assessments, are as follows: Allowance for credit losses Fair value of ﬁnancial instruments Impairment of long-lived assets Impairment of goodwill Employee future beneﬁts Share-based payments i. ii. iii. iv. v. vi. vii. Concentrations of credit risk & customers viii. Commitments and contingencies b. Basis of Consolidation The Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries (collectively the “Bank”), and those variable interest entities (“VIEs”) where the Company is the primary beneﬁciary. Intercompany accounts and transactions have been eliminated. The Bank consolidates subsidiaries where it holds, directly or indirectly, more than 50% of the voting rights or where it exercises control. The Bank consolidates VIEs where it is considered to be the primary beneﬁciary. The Bank is deemed to have a controlling ﬁnancial interest and is the primary beneﬁciary of a VIE if it has both the power to direct the activities of the VIE that most signiﬁcantly impact the VIE economic performance and an obligation to absorb losses or the right to receive beneﬁts that could potentially be signiﬁcant to the VIE. The determination of whether the Bank meets the criteria to be considered the primary beneﬁciary of a VIE requires a periodic evaluation of all transactions (such as investments, loans and fee arrangements) with the entity. 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 VIEs, are accounted for under the equity method, and the pro rata share of their income (loss) is included in other non-interest income. c. Foreign Currency Translation Assets, liabilities, revenues and expenses denominated in US dollars are translated to Bermuda dollars at par. Assets and liabilities of the parent company 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 Operations. The assets and liabilities of foreign currency-based subsidiaries are translated at the rate of exchange prevailing on the Balance Sheet date, whilst associated revenues and expenses are translated to Bermuda dollars at the average rates of exchange prevailing throughout the year. 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 (loss) (“AOCI”). Gains and losses on foreign currency-based subsidiaries are recorded in the Consolidated Statement of Operations 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 in debt and equity securities are classiﬁed as trading, available for sale (“AFS”) or held to maturity (“HTM”). 60 Investments are classiﬁed primarily as AFS when used to manage the Bank’s exposure to interest rate and liquidity movements, as well as to make strategic longer-term investments. AFS investments are carried at fair value in the Consolidated Balance Sheet with unrealised gains and losses reported as a net increase or decrease to accumulated other comprehensive income (loss). Debt and equity securities classiﬁed as trading investments are carried at fair value in the Consolidated Balance Sheet, with unrealised gains and losses included in the Consolidated Statement of Operations as net realised / unrealised gains (losses) on trading investments. Investments that the Bank has the positive intent and ability to hold to maturity are classiﬁed as HTM and are carried at amortised cost in the Consolidated Balance Sheet. Unrecognised gains and losses on HTM securities are disclosed in the notes to the ﬁnancial statements. The speciﬁc identiﬁcation method is used to determine realised gains and losses on AFS and HTM investments, which are included in net realised gains and losses on AFS and HTM investments, respectively, in the Consolidated Statement of Operations. Dividend and interest income, including amortisation of premiums and discounts, on securities for which cash ﬂows are not considered uncertain are included in interest income in the Consolidated Statement of Operations. For securities with uncertain cash ﬂows, the investments are accounted for under the cost recovery method, whereby all principal and coupon payments received are applied as a reduction of the amortised cost and carrying amount. 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. Contained within other assets are investments in a closed ended fund and private equity companies for which the Bank does not have sufﬁcient rights or ownership interests to follow the equity method of accounting. With respect to the closed ended fund, the Bank uses the net assets value as a practical expedient for fair value. Unquoted equity investments, which are held directly by the Bank and which do not have readily determinable fair values, are recorded at cost and reviewed for impairment if indicators of impairment exist. Investments in afﬁliates includes investments whereby the Bank has the ability to inﬂuence, but not control, the ﬁnancial or operating policies of such entities, are accounted for using the equity method of accounting. Recognition of other-than-temporary impairments Investments in debt securities in unrealised loss positions are analysed as part of Management’s ongoing assessment of other-than-temporary impairment (“OTTI”). When Management intends to sell such securities or it is more likely than not that the Bank will be required to sell the securities before recovering the amortised cost, it recognises an impairment loss equal to the full difference between the amortised cost basis and the fair value of those securities. When Management does not intend to sell or it is not more likely than not that the Bank will be required to sell such securities before recovering the amortised cost, Management determines whether any credit losses exist to identify any OTTI. Under certain circumstances, Management will perform qualitative determination. Alternatively, Management estimates cash ﬂows over the remaining lives of the underlying security to assess whether credit losses exist. In situations where there is a credit loss, only the amount of impairment relating to credit losses on AFS and HTM investments is recognised in net income and for AFS investments, the decrease in fair value relating to factors other than credit losses are recognised in Other Comprehensive Income (Loss) (“OCI”). In determining whether credit losses exist, Management considers a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions speciﬁcally related to the industry, geographic area or ﬁnancial condition of the issuer or underlying collateral of a security; payment structure of the security; changes to the rating of the security by a rating agency; the volatility of the fair value changes; and changes in fair value of the security after the Balance Sheet date. The degree of judgment involved in determining the recoverable value of an investment security is dependent upon the availability of observable market prices or observable market parameters. When observable market prices and parameters do not exist, judgment is necessary to estimate recoverable value which gives rise to added uncertainty in the valuation process. 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. Cash ﬂow estimates take into account expectations of relevant market and economic data as of the end of the reporting period, including, for example, underlying loan-level data, and structural features of securitisation, such as subordination, excess spread, over collateralisation or other forms of credit enhancement. Losses projected for the underlying collateral (“pool losses”) are compared against the level of credit enhancement in the securitisation structure to determine whether these features are sufﬁcient to absorb the pool losses, or whether a credit loss on the debt security exists. As at 31 December 2011, Management’s cash ﬂow forecasts for its Pass-through note investment (“PTN”) was created in conjunction with a specialist in analytical cash ﬂow modelling. Management also performs other analyses to support its cash ﬂow projections to assess the reasonability. For debt securities, Management considers a decline in fair value to be other-than-temporary when it does not expect to recover the entire amortised cost basis of the security. Management’s valuations may include inputs and assumptions that are less observable or require greater estimation, thereby resulting in values which may be greater or lower than the actual value at which the investments may be ultimately sold or the ultimate cash ﬂows that may be recovered. If the assumptions on which Management based its valuations change, the Bank may experience additional OTTI or realised losses or gains, and the period-to- period changes in value could vary signiﬁcantly. f. Loans Loans are reported as 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 effective 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. Butterﬁeld Annual Report 2011 61 Impaired loans A loan is considered to be impaired when, based on current information and events, the Bank determines that it will not be able to collect all amounts due according to the loan contract, including scheduled interest payments. Impaired loans include all non-accruing loans and all loans modiﬁed in a troubled debt restructuring (‘‘TDR’’) even if full collectability is expected following the restructuring. When a loan is identiﬁed as impaired, the impairment is measured based on the present value of expected future cash ﬂows, discounted at the loan’s effective interest rate, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases, the current fair value of the collateral, less selling costs, is used instead of discounted cash ﬂows. If the Bank determines that the expected realisable value of the impaired loan is less than the recorded investment in the loan (net of previous charge- offs, deferred loan fees or costs and unamortised premium or discount), impairment is recognised through an allowance estimate. If the Bank determines that part of the allowance is uncollectible, that amount is charged off. Non-accrual Commercial, commercial real estate and consumer loans (excluding credit card consumer loans) are placed on non-accrual status immediately if: in the opinion of Management, full payment of principal or interest is in doubt; or (cid:115)(cid:0) (cid:115)(cid:0) principal or interest is 90 days past due. Residential mortgages are placed on non-accrual status immediately if: in the opinion of Management, full payment of principal or interest is in doubt; or (cid:115)(cid:0) (cid:115)(cid:0) when principal or interest is 90 days past due, unless the loan is well secured and any ongoing collection efforts are reasonably expected to result in repayment of all amounts due under the contractual terms of the loan. Interest income on non-accrual loans is recognised only to the extent it is received in cash. Cash received on non-accrual loans where there is no doubt regarding full repayment (no impairment recognised in the form of a speciﬁc allowance) is ﬁrst applied as repayment of the past due principal amount of the loan and secondly to past due interest and fees. Where there is doubt regarding the ultimate full repayment of the non-accrual loan (impairment recognised in the form of a speciﬁc allowance), all cash received is applied to reduce the principal amount of the loan. Interest income on these loans is recognised only after the entire balance receivable is recovered and interest is actually received. Loans are restored to accrual status only when interest and principal payments are brought current and future payments are reasonably assured. Loans Modiﬁed in a Troubled Debt Restructuring A modiﬁcation of a loan constitutes a TDR when a borrower is experiencing ﬁnancial difﬁculty and the modiﬁcation constitutes a concession. If a restructuring is considered a TDR, the Bank is required to make certain disclosures in the notes of the ﬁnancial statements and individually evaluate the restructured loan for impairment. The Bank employs various types of concessions when modifying a loan that it would not otherwise consider, which may include extension of repayment periods, interest rate reductions, principal or interest forgiveness, forbearance, and other actions intended to minimise economic loss and to avoid foreclosure or repossession of collateral. Commercial and industrial loans modiﬁed in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor is often requested. Commercial mortgage and construction loans modiﬁed in a TDR often involve extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modiﬁed in a TDR may also involve extending the interest only payment period. Residential mortgage modiﬁcations generally involve a short-term forbearance period after which the missed payments are added to the end of the loan term, thereby extending the maturity date. Interest continues to accrue on the missed payments and as a result, the effective yield on the mortgage remains unchanged. As the forbearance period usually involves an insigniﬁcant payment delay, they typically do not meet the reporting criteria for a TDR. Automobile loans modiﬁed in a TDR are primarily comprised of loans where the Bank has lowered monthly payments by extending the term. Loans modiﬁed in a TDR are typically already on non-accrual status and partial charge-offs have, in some cases, already been taken against the outstanding loan balance. Loans that have been modiﬁed in a TDR are restored to accrual status only when interest and principal payments are brought current for a continuous period of six months under the modiﬁed terms. However, performance prior to the modiﬁcation, or signiﬁcant events that coincide with the modiﬁcation, are included in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of loan modiﬁcation or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains on non-accrual status. 62 A loan that is modiﬁed in a TDR prior to becoming impaired will be left on accrual status if full collectability in accordance with the restructured terms is expected. The Bank works with its customers in these difﬁcult economic times and may enter into a TDR for loans that are in default, or at risk of defaulting, even if the loan is not impaired. Delinquencies 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. Charge-offs The Bank recognises charge-offs when it determines that loans are uncollectible and this generally occurs when all commercially reasonable means of recovering the loan balance have been exhausted. Commercial and consumer loans are either fully or partially charged off down to the fair value of collateral securing the loans when: (cid:115)(cid:0) Management judges the loan to be uncollectible; (cid:115)(cid:0) (cid:115)(cid:0) (cid:115)(cid:0) repayment is expected to be protracted beyond reasonable time frames; the asset has been classiﬁed as a loss by either the Bank’s internal loan review process or external examiners; or the customer has ﬁled bankruptcy and the loss becomes evident owing to a lack of assets or cash ﬂow. The outstanding balance of commercial and consumer real estate-secured loans and residential mortgages that are in excess of the estimated property value, less costs to sell, is charged off once there is reasonable assurance that such excess outstanding balance is not recoverable. Credit card consumer loans that are contractually 180 days past due and other consumer loans with an outstanding balance under $100,000 that are contractually 180 days past due are written off and reported as charge-offs. g. Allowance for Credit Losses The Bank maintains an allowance for credit losses, which in Management’s opinion is adequate to absorb all estimated credit related losses in its lending and off-Balance Sheet credit related arrangements at the Balance Sheet date. The allowance for credit losses consists of speciﬁc allowances and a general allowance as follows: Speciﬁc Allowances Speciﬁc allowances are determined on an exposure-by-exposure 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 the 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 an allowance with a corresponding charge to provision for credit losses. General Allowance The allowance for credit losses attributed to the remaining portfolio is established through various analyses that estimate the incurred loss at the Balance Sheet date inherent in the lending and off-Balance Sheet credit related arrangements portfolios. 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 installment, 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 and incurred in the portfolio, based upon various analyses. Management considers overall portfolio indicators including historical credit losses; delinquent (deﬁned as loans that are more than 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. h. Cash and Cash Equivalents Cash and cash equivalents include cash on hand, cash items in the process of collection, amounts due from correspondent banks and highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insigniﬁcant risk of change in fair value. Such investments are those with less than three months’ maturity from the date of acquisition and include unrestricted term deposits, certiﬁcates of deposit and treasury bills. See Note 3. i. 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. Butterﬁeld Annual Report 2011 63 Goodwill is tested annually for impairment at the reporting unit level, or more frequently if events or circumstances 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. j. Premises, Equipment and Computer Software Land, buildings, 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, including interest cost incurred during the development phase, 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 10 years. Management reviews the recoverability of the carrying amount of premises, equipment and computer software when indicators of impairment exist and an impairment charge is recorded when the carrying amount of the reviewed asset is deemed not recoverable by future expected cash ﬂows to be derived from the use and disposition of the asset. k. Other Real Estate Owned (“OREO”) OREO comprise commercial and residential real estate properties acquired in partial or total satisfaction of loans acquired through foreclosure proceedings, acceptance of a deed-in-lieu of foreclosure or by taking possession of assets that were used as loan collateral. These properties are recorded at fair value less estimated costs to sell the property. If the recorded investment in the loan exceeds the property’s fair value at the time of acquisition, a charge-off is recorded against the speciﬁc allowance. Subsequent decreases in the property’s fair value and operating expenses of the property are recognised through charges to non-interest expense. l. Derivatives All derivatives are recognised on the Consolidated Balance Sheet at their fair value. On the date that the Bank enters into a derivative contract, it designates the derivative as: 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). The changes in the fair value of a derivative 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 year earnings. When the hedge is highly effective, the changes in the fair value of a derivative 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 year earnings. The changes in the fair value of a derivative that is designated and qualiﬁes as a foreign currency hedge is recorded in either current year earnings or other comprehensive income, depending on whether the hedging relationship satisﬁes the criteria for a fair value or cash ﬂow hedge when the hedge is highly effective. 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 year 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 recognised in net income. m. Employee Future Beneﬁts The Bank maintains trusteed pension plans for substantially all employees as either non-contributory deﬁned beneﬁt plans or 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 certain qualifying active and retired Bermuda-based employees. 64 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 fair 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. 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, respectively. The actuarial gains and losses, transition obligation and past service costs of the deﬁned pension plans and post-retirement medical beneﬁts plan are recognised in OCI net of tax and amortised to net income over the average service period. 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 engages in equity settled Share-based payment transactions in respect of services received from eligible employees. The fair value of the services received is measured by reference to the fair value of the Shares or Share options granted on the date of the grant. The cost of the employee services received in respect of the Shares or Share options granted is recognised in the Consolidated Statement of Operations over the shorter of the vesting or service period. The fair value of the options granted is determined using option pricing models, which take into account the exercise price of the option, the current Share price, the risk free interest rate, expected dividend rate, the expected volatility of the Share price over the life of the option and other relevant factors. Time vesting conditions are taken into account by adjusting the number of Shares or Share options included in the measurement of the cost of employee services so that ultimately, the amount recognised in the Consolidated Statement of Operations reﬂects the number of vested Shares or Share options. The Bank recognises compensation cost for awards with performance conditions if and when the Bank concludes that it is probable that the performance condition will be achieved, net of an estimate of pre-vesting forfeitures (e.g., due to termination of employment prior to vesting). o. Revenue Recognition Trust and investment services fees include fees for private and institutional trust, executorship, and custody services. Asset management fees include fees for investment management, investment advice and brokerage services. Fees are recognised as revenue over the period of the relationship or 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 contingencies associated with the fee. 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. 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, including amortisation of premiums and discounts, on securities for which cash ﬂows are not considered uncertain are included in interest income in the Consolidated Statement of Operations. Loans placed on non-accrual status and investments with uncertain cash ﬂows are accounted for under the cost recovery method, whereby all principal, dividends, interest and coupon payments received are applied as a reduction of the amortised cost and carrying amount. p. Fair Values Fair value is deﬁned as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Bank determines the fair values of assets and liabilities based on the fair value hierarchy, which requires an entity to maximise the use of observable inputs and minimise the use of unobservable inputs when measuring fair value. The relevant accounting standard describes three levels of inputs that may be used to measure fair value. Investments classiﬁed as trading and available for sale, and derivative assets and liabilities are recognised in the Consolidated Balance Sheet at fair value. Level 1, 2 and 3 valuation inputs Management classiﬁes items that are recognised at fair value on a recurring basis based on the Level of inputs used in their respective fair value determination as described below. Fair value inputs are considered Level 1 when based on unadjusted quoted prices in active markets for identical assets. Butterﬁeld Annual Report 2011 65 Fair value inputs are considered Level 2 when based on internally developed models or based on prices published by independent pricing services using proprietary models. To qualify for Level 2, all signiﬁcant inputs used in these models must be observable in the market place or can be corroborated by observable market data for substantially the full term of the instrument and includes, among others: interest yield curves, credit spreads, prices for similar assets and foreign exchange rates. Level 2 also includes ﬁnancial instruments that are valued using quoted price for identical assets but for which the market is not considered active due to low trading volumes. Fair value inputs are considered Level 3 when based on internally developed models using signiﬁcant unobservable assumptions involving Management’s estimations or non-binding bid quotes from brokers. The following methods and assumptions were used in the determination of the fair value of ﬁnancial instruments: Cash and cash equivalents The carrying amount of cash and demand deposits with banks, being short term in nature, is deemed to equate to the fair value. Cash equivalents include unrestricted term deposits, certiﬁcates of deposit and treasury bills with a maturity of less than three months from the date of acquisition and the carrying value at cost is considered to approximate fair value because they are short term in nature, bear interest rates that approximate market rates, and generally have negligible credit risk. Short-term investments Short-term investments comprise restricted term and demand deposits and the carrying value at cost is considered to approximate fair value because they are short term in nature, bear interest rates that approximate market rates, and generally have negligible credit risk. Investments and employee future beneﬁts plans’ assets The fair values of investments and pension plan assets are determined based on observable quoted prices for identical assets or liabilities in active markets when available. If unavailable, observable inputs from similar items in active markets or identical/similar items with inactive markets are used. In the absence of observable quoted prices, unobservable inputs are used. Loans The majority of loans are variable rate and re-price in response to changes in market rates and hence Management estimates that the fair value of loans is not signiﬁcantly different than their carrying amount. For signiﬁcant ﬁxed-rate loan exposures, fair value is estimated by discounting the future cash ﬂows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities of such loans. Accrued interest The carrying amounts of accrued interest receivable and payable are assumed to approximate their fair values given their short-term nature. Other real estate owned (“OREO”) OREO assets are carried at the lower of cost or fair value less estimated costs to sell. Fair value is based on third-party appraisals adjusted to reﬂect Management’s judgment as to the realisable value of the properties. Appraisals of OREO properties are updated on an annual basis. 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 carrying amount of deposits with no stated maturity date is deemed to equate to the fair value. Subordinated capital The fair value of the subordinated capital has been estimated by discounting the contractual cash ﬂows, using current market interest rates. Derivatives Fair value of exchange-traded derivatives is based on quoted market prices. Over-the-counter (OTC) derivative contracts may include forward, swap and option contracts relating to interest rates or foreign currencies. Depending on the product and the terms of the transaction, the fair value of the OTC derivative products are modelled taking into account the counterparties’ creditworthiness and using a series of techniques. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate signiﬁcant judgements and the pricing inputs are observed from actively quoted markets, as is the case for interest rate swap and option contracts. Reporting units The fair value of reporting units for which goodwill is recognised is determined by discounting estimated future cash ﬂows using discount rates reﬂecting valuation-date market conditions and risks speciﬁc to the reporting unit. 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: (cid:115)(cid:0) 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. 66 (cid:115)(cid:0) 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. (cid:115)(cid:0) 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 13) 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 are 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 Operations 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. The Bank initially recognises the ﬁnancial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The Bank recognises interest accrued and penalties related to unrecognised tax beneﬁts in operating expenses. s. Consolidated Statement of Cash Flows For the purposes of the Consolidated Statement of Cash Flows, cash and cash equivalents include cash on hand, cash items in the process of collection, amounts due from correspondent banks and highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insigniﬁcant risk of change in fair value. t. Earnings Per Share Earnings per Share have been calculated using the weighted average number of Common Shares outstanding during the year (see also Note 20). Dividends declared on Preference Shares and related guarantee fees are deducted from net income to obtain net income available to Common Shareholders. In periods when basic earnings per Share is positive, the dilutive effect of Share-based compensation plans is 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. u. Impairment or Disposal of Long-Lived Assets Impairment losses are recognised when the carrying amount of a long-lived asset 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. v. Charitable Trust In July 2000, the Bank established a charitable trust with the irrevocable purpose to make charitable donations to persons ordinarily resident in Bermuda (the “Charitable Trust”). As a not-for-proﬁt organisation, the Charitable Trust is not consolidated in the Bank’s ﬁnancial statements. As the Charitable Trust’s trustees are representatives of the Bank, the Bank’s endowment donations to the Charitable Trust are recognised at their recoverable amount in Other assets in the Consolidated Balance Sheet until dispersed by the Charitable Trust, at which time donations are recognised in Other expenses in the Consolidated Statement of Operations. w. New Accounting Pronouncements The following accounting developments were issued during the year ending 31 December 2011: Financing receivables and the allowance for credit losses disclosures In July 2010, the Financial Accounting Standards Board (“FASB”) issued an accounting standards update about additional “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”. The new disclosure guidance signiﬁcantly expanded the existing requirements and were effective for the Bank on 1 January 2011. The prior-period ﬁgures for loan disclosures have been reclassiﬁed to conform to the current enhanced note disclosures required by the Standard. The Standard did not affect the Bank’s consolidated ﬁnancial condition or results of operations. Butterﬁeld Annual Report 2011 67 Troubled debt restructurings During March 2011, the FASB issued an accounting standards update, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring” to assist creditors in determining whether a loan modiﬁcation is a TDR. The new guidance was effective for public companies in interim and annual periods beginning on or after 15 June 2011 and must be applied retrospectively to restructurings occurring on or after the beginning of the year. The Bank applied the provisions of this update retrospectively to all modiﬁcations and restructurings occurring on or after 1 January 2011. As a result of the retrospective application, the Bank classiﬁed $33.6 million loan modiﬁcations as TDRs that, in previous periods, had not been classiﬁed as TDRs. These newly identiﬁed TDRs did not have a signiﬁcant impact on the speciﬁc allowance or provision expense. At 31 December 2011, these amounts included $20.9 million of performing loans that were not previously considered to be impaired loans. Fair value measurements In May 2011, the FASB issued accounting standard update, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure requirements in US GAAP and IFRS”. The amendments clarify the application of the highest and best use and valuation premise concepts, preclude the application of blockage factors in the valuation of all ﬁnancial instruments and include criteria for applying the fair value measurement principles to portfolios of ﬁnancial instruments. The amendments additionally prescribe enhanced ﬁnancial statement disclosures for Level 3 fair value measurements. The new amendments will be effective for ﬁrst interim or annual period beginning on or after 15 December 2011. The new guidance will require prospective application. The impact of this additional accounting guidance is expected to be primarily on disclosures. Repurchase agreements During May 2011, the FASB issued an accounting standard update, “Reconsideration of Effective Control for Repurchase Agreements“. The amendments in this update remove from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem ﬁnancial assets on substantially the agreed terms, even in the event of default by the transferee. The amendments in this update also eliminate the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement ﬁnancial assets. The guidance in this update is effective for the ﬁrst interim or annual period beginning on or after 15 December 2011. The guidance should be applied prospectively to transactions or modiﬁcations of existing transactions that occur on or after the effective date. Early adoption is not permitted. Other comprehensive income In June 2011, the FASB issued an accounting standards update, “Presentation of Comprehensive Income”, which eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The amendments are effective for ﬁscal years, and interim periods within those years, beginning after 15 December 2011 and should be applied retrospectively. Early adoption is permitted but the Bank elected not to early adopt. These amendments do not require any transition disclosures. The impact of these amendments is primarily on disclosures on the face of the Consolidated Statement of Operations. Goodwill impairment test During September 2011, the FASB issued an accounting standards update, “Testing Goodwill for Impairment (the revised standard)” that permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. The update is effective for annual and interim goodwill impairment tests performed in ﬁscal years beginning after 15 December 2011. Early adoption is permitted. The Bank is assessing the impact of these amendments. 68 NOTE 3: CHANGE IN ACCOUNTING POLICY Effective 1 January 2011, the Bank changed its accounting policy with respect to cash and cash equivalents for the purposes of the Consolidated Statement of Cash Flows. The Bank deﬁnes cash and cash equivalents to include cash on hand, cash items in the process of collection, amounts due from correspondent banks and highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insigniﬁcant risk of change in fair value. Such investments are those with less than three months maturity from the date of acquisition and include unrestricted term deposits, certiﬁcates of deposit, treasury bills and securities purchased under agreements to resell. Previously cash and demand deposits with banks only included cash and demand deposits, vault cash and cash in transit for the purposes of the Consolidated Statement of Cash Flows. The Bank believes the new policy is preferable as it more closely reﬂects the manner in which the Bank manages its liquid assets. The impact of this voluntary change in accounting policy on the Consolidated Financial Statements since the Bank’s adoption of the change in accounting policy is shown in the table below: Consolidated Balance Sheet Cash and demand deposits with banks As reported 2010 Adjustments 2010 325,367 (24,502) Cash equivalents Term deposits with banks 1,950,179 - Certiﬁcates of deposit and treasury bills 1,950,179 Total cash equivalents (1,890) 180,545 178,655 Total cash and cash equivalents 2,275,546 154,153 Short-term investments - 26,392 Restated 2010 300,865 1,948,289 180,545 2,128,834 2,429,699 26,392 Debt and equity securities Trading Available for sale Total investments in debt and equity securities 18,088 2,791,601 2,809,689 As reported 2010 18,088 - (180,545) 2,611,056 (180,545) 2,629,144 Adjustments 2010 Restated 2010 Extract of Consolidated Cash Flow Statement Cash ﬂows from investing activities Net increase in term deposits with banks Net decrease in short-term investments Available for sale securities: proceeds from sale and maturities Available for sale securities: purchases (536,208) - 6,264,970 (6,224,605) 536,208 20,802 (4,083,805) 4,138,780 - 20,802 2,181,165 (2,085,825) Net effect of exchange rates on cash and cash equivalents (14) (21,583) (21,597) Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year (225,882) 551,249 325,367 590,406 1,513,926 2,104,332 364,524 2,065,175 2,429,699 NOTE 4: CASH AND CASH EQUIVALENTS Unrestricted Non-interest earning Cash and demand deposits Interest earning Demand deposits Cash equivalents Sub-total - Interest earning 2011 Non- Bermuda Bermuda Total Bermuda 2010 Non- Bermuda Total 176,091 30,847 206,938 118,155 42,895 161,050 49 206,226 489,391 1,076,854 489,440 1,283,080 206,275 1,566,245 1,772,520 44 602,135 602,179 139,771 1,526,699 1,666,470 139,815 2,128,834 2,268,649 Total cash and cash equivalents 665,531 1,313,927 1,979,458 720,334 1,709,365 2,429,699 Butterﬁeld Annual Report 2011 69 NOTE 5: SHORT-TERM INVESTMENTS Unrestricted Interest earning Term deposits maturing between three to six months Term deposits maturing between six to twelve months Total unrestricted short-term investments Affected by drawing restrictions related to minimum reserve and derivative margin requirements Non-interest earning Demand deposits Interest earning Demand deposits Total restricted short-term investments 2011 Non- Bermuda Bermuda Total Bermuda - - - 4,630 2,900 7,530 4,630 2,900 7,530 - 12,394 12,394 - - - - 2010 Non- Bermuda 392 1,215 1,607 Total 392 1,215 1,607 6,156 6,156 12,641 12,641 2,249 14,643 14,890 27,284 18,157 18,157 472 6,628 18,629 24,785 Total short-term investments 12,641 22,173 34,814 18,157 8,235 26,392 NOTE 6: INVESTMENTS Amortised cost, carrying amounts and estimated fair value The amortised cost, carrying amounts and fair values are as follows: 2011 2010 Gross Gross Amortised unrealised unrealised losses gains cost Carrying amount / Fair value Gross Amortised unrealised gains cost Gross unrealised losses Carrying amount / Fair value Trading Debt securities issued by non-US governments Mutual funds (1) Total trading 5,788 56,964 62,752 419 224 643 (236) (568) (804) 5,971 56,620 62,591 6,553 11,981 18,534 150 273 423 (192) (677) (869) 6,511 11,577 18,088 Available for sale Certiﬁcates of deposit US government and federal agencies Debt securities issued by non-US governments Corporate debt securities guaranteed by non-US governments Corporate debt securities Asset-backed securities - Student loans Pass-through note Equity securities Total available for sale 354,847 778,387 2,411 14,419 (765) (2,002) 356,493 790,804 854,273 927,598 4,885 398 (12) (10,502) 859,146 917,494 111,172 1,966 (106) 113,032 131,028 1,675 (11) 132,692 122,987 412,285 149,759 33,696 120 1,963,253 38 421 - - - 19,255 (1,377) (3,744) (5,413) (6,705) (50) 121,648 408,962 144,346 26,991 70 (20,162) 1,962,346 149,948 352,960 152,434 62,762 77 2,631,080 76 14 - - - 7,048 (304) (5,504) (5,623) (5,116) - (27,072) 149,720 347,470 146,811 57,646 77 2,611,056 (1) The Bank invested $50 million of seed money in the BNY Mellon Butterﬁeld Income Advantage Fund during September 2011. 70 2011 Held to maturity US government and federal agencies Total held to maturity Non-credit impairments recognised in AOCI Gross Carrying unrecognised gains amount Gross unrecognised losses - - 64,789 64,789 228 228 (429) (429) Amortised cost 64,789 64,789 Fair values 64,588 64,588 There were no held to maturity investments as at 31 December 2010. Unrealised loss positions The following tables show the fair value and gross unrealised losses of the Bank’s available for sale and held to maturity 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. Debt securities are categorised as being in a continuous loss position for “Less than 12 months” or “12 months or more” based on the point in time that the fair value declined below the cost basis. 2011 Available for sale Certiﬁcates of deposit US government and federal agencies Debt securities issued by non-US governments Corporate debt securities guaranteed by non-US governments Corporate debt securities Asset-backed securities - Student loans Pass-through note Equity securities Total available for sale securities with unrealised losses Held to maturity US government and federal agencies Total held to maturity securities with unrealised losses 2010 Available for sale Certiﬁcates of deposit US government and federal agencies Debt securities issued by non-US governments Corporate debt securities guaranteed by non-US governments Corporate debt securities Asset-backed securities - Student loans Pass-through note Total available for sale securities with unrealised losses Less than 12 months Gross unrealised losses Fair value 12 months or more Gross unrealised losses Fair value Total fair value Total gross unrealised losses 48,623 144,364 9,493 30,179 217,612 - - 70 (765) (1,585) (54) (3) (2,859) - - (50) - 72,600 2,198 47,267 125,101 144,346 26,992 - - (417) (52) (1,374) (885) (5,413) (6,705) - 48,623 216,964 11,691 77,446 342,713 144,346 26,992 70 (765) (2,002) (106) (1,377) (3,744) (5,413) (6,705) (50) 450,341 (5,316) 418,504 (14,846) 868,845 (20,162) 30,034 30,034 (429) (429) - - - - 30,034 30,034 (429) (429) Less than 12 months Gross unrealised losses Fair value 12 months or more Gross unrealised losses Fair value 128,619 775,157 3,239 108,611 8,075 - 33,304 (12) (10,459) (11) (304) (46) - (2,589) - 23,337 - - 322,995 146,811 24,342 - (43) - - (5,458) (5,623) (2,527) Total fair value 128,619 798,494 3,239 108,611 331,070 146,811 57,646 Total gross unrealised losses (12) (10,502) (11) (304) (5,504) (5,623) (5,116) 1,057,005 (13,421) 517,485 (13,651) 1,574,490 (27,072) There were no held to maturity investments as at 31 December 2010. Butterﬁeld Annual Report 2011 71 The following is a description of the Bank’s main investments. Certiﬁcates of deposit As of 31 December 2011, gross unrealised losses on the Bank’s holdings of certiﬁcates of deposit (“CDs”) were $0.8 million, all of which related to CDs that have been in an unrealised loss position for less than 12 months. Management assesses the credit quality of the issuers, which includes assessments of credit ratings (the Bank only purchases CDs that are rated investment grade or above) and credit worthiness of the issuer and concluded that the CDs do not have any credit losses. US government and federal agencies As of 31 December 2011, gross unrealised losses on securities related to United States (“US”) government and federal agencies were $2.0 million, $0.4 million of which related to investments that were in an unrealised loss position for longer than 12 months. Overall, Management believes that all the securities in this class do not have any credit losses, given the explicit and implicit guarantees provided by the US federal government. Debt securities issued by non-US governments As of 31 December 2011, gross unrealised losses on debt securities issued by non-US governments were $0.1 million, $0.05 million of which related to investments that were in an unrealised loss position for greater than 12 months. All securities in this category were issued by governments of the United Kingdom and Caribbean jurisdictions. Management believes that these securities do not have any credit losses, given the explicit guarantees provided by the non-US governments. Corporate debt securities guaranteed by non-US governments As of 31 December 2011, gross unrealised losses related to corporate debt securities guaranteed by non-US governments were $1.4 million, all of which related to investments that were in an unrealised loss position for greater than 12 months. All the bank-issued securities acquired are explicitly guaranteed by the following governments: United Kingdom, Australia, Denmark and Germany. One security is jointly and explicitly guaranteed by three European Governments: Belgium, France and Luxembourg. Management believes that these securities do not have any credit losses, given the guarantees provided by the non-US governments. Corporate debt securities As of 31 December 2011, gross unrealised losses related to corporate debt securities were $3.7 million, of which $0.9 million related to investments that were in an unrealised loss position for longer than 12 months. Management estimates of cash ﬂows are based on observable market data, issuer-speciﬁc information and credit ratings. Management believes these securities do not have any credit losses. Asset-backed securities - Student loans As of 31 December 2011, gross unrealised losses on student loan asset-backed securities were $5.4 million, all of which related to securities that have been in an unrealised loss position for longer than 12 months. All of these securities are “AAA” rated and Management believes these securities do not have any credit losses. All student loan asset-backed securities are backed by loans that fall within the US federally guaranteed Federal Family Education Loan Program (“FFELP”). The unrealised losses were due to maturity proﬁles that were longer than was initially estimated. Pass-through note (“PTN”) During 2010, the Bank’s investment in its remaining structured investment vehicle (“SIV”) was legally amended to a pass-through note structure whereby the Bank maintained the identical beneﬁcial interest in the same underlying securities of the SIV. As of 31 December 2011, the PTN was in an unrealised loss position amounting to $6.7 million (2010: $5.1 million) for a period exceeding 12 months. Unrealised losses have increased since 31 December 2010 as a result of general risk aversion in the market with regards to distressed assets. The net present value of expected cash ﬂows, or the intrinsic value, to be generated from the underlying assets of the PTN, calculated on both a stressed and severely-stressed environment, is in excess of the amortised cost of the PTN and Management believes that these securities do not have any credit losses. Residential housing prices in the United States, a key driver of the underlying intrinsic value, have performed better than assumed in the models supporting the intrinsic value, which conﬁrms that the unrealised loss is primarily attributable to market risk appetite and not to fundamental valuations. 72 The following table presents securities by remaining term to earlier of expected or contractual maturity: 2011 Within 3 months Remaining term to earlier of expected or contractual maturity 3 to 12 months Over 10 No speciﬁc years maturity 5 to 10 years 1 to 5 years Trading Debt securities issued by non-US governments Mutual funds Total trading - - - 811 - 811 2,026 - 2,026 2,106 - 2,106 1,028 - 1,028 - 56,620 56,620 Available for sale Certiﬁcates of deposit US government and federal agencies Debt securities issued by non-US governments Corporate debt securities guaranteed by non-US governments Corporate debt securities Asset-backed securities - Student loans Pass-through note Equity securities Total available for sale 105,318 - 7,749 - 27,514 - - - 140,581 174,302 4,740 66,056 90,882 106,639 - - - 442,619 76,873 622,559 17,905 30,766 260,755 58,183 - - 1,067,041 - 149,245 20,349 - 14,054 74,999 26,991 - 285,638 - 14,258 971 - - 11,164 - - 26,393 Held to maturity US government and federal agencies Total held to maturity securities - - - - - - 24,854 24,854 39,935 39,935 - 2 2 - - - - 70 74 - - Carrying amount 5,971 56,620 62,591 356,493 790,804 113,032 121,648 408,962 144,346 26,991 70 1,962,346 64,789 64,789 Total investments 140,581 443,430 1,069,067 312,598 67,356 56,694 2,089,726 Total by currency Bermuda dollars US dollars Other Total investments 2010 - - 140,581 140,581 - 186,614 256,816 443,430 - 990,571 78,496 1,069,067 - 300,714 11,884 312,598 - 65,358 1,998 67,356 181 55,226 1,287 56,694 181 1,598,483 491,062 2,089,726 Within 3 months Remaining term to earlier of expected or contractual maturity 3 to 12 months 5 to 10 years Over 10 No speciﬁc years maturity 1 to 5 years Trading Debt securities issued by non-US governments Mutual funds Total trading - - - 728 - 728 2,968 - 2,968 Available for sale Certiﬁcates of deposit US government and federal agencies Debt securities issued by non-US governments Corporate debt securities guaranteed by non-US governments Corporate debt securities Asset-backed securities - Student loans Pass-through note Equity securities Total available for sale 582,783 660 - - 39,365 - - - 622,808 198,362 23,575 31,770 - 121,878 - - - 375,585 78,001 803,851 80,384 149,720 185,160 5,872 57,646 - 1,360,634 533 - 533 - 67,803 18,298 - 1,067 129,760 - - 216,928 2,282 - 2,282 - 21,605 2,240 - - 11,179 - 3 35,027 - 11,577 11,577 - - - - - - - 74 74 Carrying amount 6,511 11,577 18,088 859,146 917,494 132,692 149,720 347,470 146,811 57,646 77 2,611,056 Total investments 622,808 376,313 1,363,602 217,461 37,309 11,651 2,629,144 Butterﬁeld Annual Report 2011 73 2010 Total by currency Bermuda dollars US dollars Other Total investments Within 3 months - 257,887 364,921 622,808 Remaining term to earlier of expected or contractual maturity 3 to 12 months 5 to 10 years Over 10 No speciﬁc years maturity 1 to 5 years - 112,939 263,374 376,313 - 1,241,066 122,536 1,363,602 - 209,736 7,725 217,461 - 32,786 4,523 37,309 169 5,273 6,209 11,651 Gains and losses on investments The following table presents gains and losses on investments: Year ended 2011 Trading Available Held to for sale maturity Total Trading 2010 Available for sale Held to maturity Gains (losses) other than OTTI recognised in net income (919) 2,059 Total impairment applied against carrying amount Less: change in non-credit related impairments recognised in OCI OTTI impairments recognised in net income - - - - - - Net gains (losses) recognised in net income (919) 2,059 Gross unrealised gains (losses) recorded in OCI Realised (gains) losses transferred to net income Total net gains recognised in OCI Non-credit related impairments recognised in OCI Effect of transfer of HTM to AFS Net change in gains (losses) recognised in AOCI - - - - - - 21,904 (2,059) 19,845 - - 19,845 Sale proceeds and realised gains (losses) During the year ended 31 December 2011, the Bank disposed of: - - - - - - - - - - - 1,140 971 (107,047) - - - - - - 36,844 (97,366) (60,522) 1,140 971 (167,569) 21,904 (2,059) 19,845 - - 19,845 - - - - - - (70,203) 167,569 97,366 - (58,557) 38,809 - - - - - - - - - 58,557 58,557 Carrying amount 169 1,859,687 769,288 2,629,144 Total (106,076) 36,844 (97,366) (60,522) (166,598) (70,203) 167,569 97,366 - - 97,366 (cid:115)(cid:0) Certiﬁcates of deposit totalling $580.2 million in sale proceeds, resulting in a gross realised gain of $0.8 million and a gross realised loss of $0.4 million; US agency securities totalling $302.8 million in sale proceeds, resulting in a gross realised gain of $1.8 million; and (cid:115)(cid:0) (cid:115)(cid:0) Corporate bonds totalling $88.3 million in sale proceeds, resulting in a gross realised loss of $0.2 million. During the year ended 31 December 2010, the Bank disposed of: (cid:115)(cid:0) (cid:115)(cid:0) SIV investments totalling $87.0 million in sale proceeds, resulting in a gross realised gain of $4.7 million; and Asset-backed securities totalling $820.1 million in sale proceeds, resulting in a gross realised loss of $113.8 million. 74 NOTE 7: LOANS The composition of the loan portfolio by collateral exposure at each of the indicated dates was as follows: Commercial loans Banks Government Commercial and industrial Commercial overdrafts Total commercial loans Less speciﬁc allowance for credit losses on commercial loans Total commercial loans after speciﬁc allowance for credit losses Commercial real estate loans Commercial mortgage Construction Total commercial real estate loans Less speciﬁc allowance for credit losses on commercial real estate loans Total commercial real estate loans after speciﬁc allowance for credit losses Consumer loans Automobile ﬁnancing Credit card Overdrafts Other consumer Total consumer loans Less speciﬁc allowance for credit losses on consumer loans Total consumer loans after speciﬁc allowance for credit losses Residential mortgage loans Less speciﬁc allowance for credit losses on residential mortgage loans Total residential mortgage loans after speciﬁc allowance for credit losses 2011 Non- Bermuda Bermuda - 256,442 103,922 64,733 425,097 (1,222) 423,875 - 4,230 186,715 28,209 219,154 (1,655) 217,499 Total - 260,672 290,637 92,942 644,251 (2,877) 641,374 2010 Non- Bermuda Bermuda Total 276 61,739 249,965 35,539 347,519 (313) 347,206 81 4,365 357 66,104 191,699 441,664 76,030 40,491 584,155 236,636 (577) (264) 236,372 583,578 502,110 37,178 539,288 (9,225) 330,286 2,814 333,100 (2,829) 832,396 39,992 872,388 (12,054) 567,776 44,093 611,869 (16,400) 366,366 13,047 379,413 (5,134) 934,142 57,140 991,282 (21,534) 530,063 330,271 860,334 595,469 374,279 969,748 23,964 59,469 9,147 87,889 180,469 (160) 180,309 5,862 25,073 5,731 144,002 180,668 (388) 180,280 29,826 84,542 14,878 231,891 361,137 (548) 360,589 37,296 58,582 4,995 94,756 195,629 (118) 195,511 6,025 25,035 5,241 43,321 83,617 10,236 139,450 234,206 371,380 175,751 (1,529) (1,411) 369,851 174,340 1,348,606 1,082,308 2,430,914 (10,446) (3,184) (7,262) 1,341,461 (1,710) 821,857 2,163,318 (6,672) (4,962) 1,345,422 1,075,046 2,420,468 1,339,751 816,895 2,156,646 Total gross loans Less speciﬁc allowance for credit losses Less general allowance for credit losses Net loans 2,493,460 1,815,230 4,308,690 (25,925) (12,134) (35,505) (12,031) 2,456,194 1,791,066 4,247,260 (13,791) (23,474) 2,496,478 1,613,657 4,110,135 (30,312) (36,463) 2,451,899 1,591,461 4,043,360 (18,541) (26,038) (11,771) (10,425) 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 2011 is 4.90% (2010: 4.81%). Butterﬁeld Annual Report 2011 75 The table below presents information about the loan delinquencies: Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Commercial mortgage Construction Total commercial real estate loans Consumer loans Automobile ﬁnancing Credit card Overdrafts Other consumer Total consumer loans 30-59 days 60-89 days 2,297 - 2,297 9,866 16,680 26,546 611 3,944 6 2,776 7,337 210 26 236 1,280 1,629 2,909 299 1,722 9 839 2,869 2011 90 days or more 6,136 4,810 10,946 47,032 - 47,032 633 1,272 76 3,351 5,332 Residential mortgage loans 68,173 37,238 52,983 158,394 Total loans 104,353 43,252 116,293 263,898 30-59 days 60-89 days Total delinquent loans Loans past due 90 days and still accruing interest Total delinquent loans Loans past due 90 days and still accruing interest 8,643 4,836 13,479 58,178 18,309 76,487 1,543 6,938 91 6,966 15,538 8,063 8,709 16,772 90,978 8,068 99,046 859 4,779 400 10,169 16,207 93,349 2010 90 days or more 6,639 8,660 15,299 87,908 - 87,908 340 659 390 6,762 8,151 205 49 254 99 8,068 8,167 322 400 - 1,689 2,411 10,966 61,098 21,798 172,456 225,374 - - - 8 - 8 - 1,272 11 173 1,456 17,589 19,053 - 5 5 - - - - 659 8 104 771 29,361 30,137 1,219 - 1,219 2,971 - 2,971 197 3,720 10 1,718 5,645 21,285 31,120 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Commercial mortgage Construction Total commercial real estate loans Consumer loans Automobile ﬁnancing Credit card Overdrafts Other consumer Total consumer loans Residential mortgage loans Total loans 76 The table below sets forth information about the Bank’s non-accrual loans: 2011 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Consumer loans Automobile ﬁnancing Overdrafts Other consumer Total consumer loans Current 30-90 days past due Non-accrual 90 days gross recorded investments past due 1,590 873 2,463 8,148 89 - 46 135 45 - 45 - 261 - 144 405 6,136 4,810 10,946 7,771 5,683 13,454 47,024 55,172 633 65 3,178 3,876 983 65 3,368 4,416 Residential mortgage loans 3,149 10,907 35,394 49,450 Total loans 2010 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Consumer loans Automobile ﬁnancing Overdrafts Other consumer Total consumer loans Residential mortgage loans Total loans 13,895 11,357 97,240 122,492 Current 30-90 days past due Non-accrual 90 days gross recorded investments past due - - - - 130 - 164 294 - 22 22 6,639 8,655 15,294 6,639 8,677 15,316 2,151 87,908 90,059 519 - 843 1,362 340 382 6,658 7,380 989 382 7,665 9,036 2,483 10,870 31,737 45,090 2,777 14,405 142,319 159,501 Butterﬁeld Annual Report 2011 77 The table below presents information about the credit quality of the Bank’s loan portfolio: 31 December 2011 Pass Special mention Substandard Non-accrual 31 December 2010 Pass Special mention Substandard Non-accrual Commercial loans Banks Government Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Commercial mortgage Construction Total commercial real estate loans Consumer loans Automobile ﬁnancing Credit card Overdrafts Other consumer Total consumer loans - 260,672 267,499 84,131 612,302 625,770 38,363 664,133 28,843 83,159 14,741 219,959 346,702 - - 10,716 3,128 13,844 109,678 1,629 111,307 - - 72 987 1,059 Residential mortgage loans 2,293,083 46,087 Total loans 3,916,220 172,297 - - 4,651 - 4,651 41,766 - 41,776 - 1,383 - 7,577 8,960 42,294 97,681 Commercial loans Banks Government Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Commercial mortgage Construction Total commercial real estate loans Consumer loans Automobile ﬁnancing Credit card Overdrafts Other consumer Total consumer loans 357 66,104 421,306 58,704 546,471 773,351 40,549 813,900 42,095 83,079 9,286 215,087 349,547 Residential mortgage loans 2,071,185 Total loans 3,781,103 - - 12,929 8,311 21,240 59,905 16,591 76,496 159 - 437 11,375 11,971 38,260 147,967 - - 790 338 1,128 10,827 - 10,827 78 538 131 79 826 8,783 21,564 78 49,450 2,430,914 122,492 4,308,690 Total gross recorded investments - 260,672 290,637 92,942 644,251 832,396 39,992 872,388 29,826 84,542 14,878 231,891 361,137 Total gross recorded investments 357 66,104 441,664 76,030 584,155 934,142 57,140 991,282 43,321 83,617 10,236 234,206 371,380 - - 7,771 5,683 13,454 55,172 - 55,172 983 - 65 3,368 4,416 - - 6,639 8,677 15,316 90,059 - 90,059 989 - 382 7,665 9,036 45,090 2,163,318 159,501 4,110,135 The four credit quality classiﬁcations set out above are deﬁned below and describe the credit quality of the Group’s lending portfolio. These classiﬁcations each encompass a range of more granular, internal credit rating grades assigned. Quality classiﬁcation deﬁnitions Pass: A pass loan shall mean a loan that is expected to be repaid as agreed. A loan is classiﬁed as pass where the Bank is not expected to face repayment difﬁculties because the present and projected cash ﬂows are sufﬁcient to repay the debt and the repayment schedule as established by the agreement is being followed. Special Mention: A special mention loan shall mean a loan under close monitoring by the Bank’s Management. Loans in this category are currently protected and still performing (current with respect to interest and principal payments), but are potentially weak and present an undue credit risk exposure, but not to the point of justifying a classiﬁcation of substandard. Substandard: A substandard loan shall mean a loan whose evident unreliability makes repayment doubtful and there is a threat of loss to the Bank unless the unreliability is averted. Non-accrual: Either where Management is of the opinion full payment of principal or interest is in doubt or when principal or interest is 90 days past due and for residential loans which are not well secured and in the process of collection. The table below presents the impairment methodology applied to the Bank’s loan portfolio: Total gross loans evaluated for impairment Commercial loans Commercial real estate loans Consumer loans Residential mortgage loans Total gross loans 2011 2010 Individually evaluated 644,251 872,388 4,416 56,832 1,577,887 Collectively evaluated - - 356,721 2,374,082 2,730,803 Individually evaluated 583,080 991,849 9,035 45,598 1,629,562 Collectivelly evaluated - - 362,345 2,118,228 2,480,573 The table below presents the changes in the allowance for credit loan losses: Loan Allowances Allowances at beginning of year Provision taken during the year Recoveries Charge-offs Other Allowances at end of year Commercial loans 7,725 2,259 546 (1,360) 11 9,181 Commercial real estate loans 28,099 1,482 634 (12,280) (10) 17,925 2011 Consumer loans 9,120 3,882 2,890 (6,730) 6 9,168 Residential mortgage loans 21,831 6,703 13 (3,412) 21 25,156 2010 Total 130,317 41,970 2,456 (107,935) (33) 66,775 Total 66,775 14,326 4,083 (23,782) 28 61,430 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment 2,877 6,304 12,054 5,871 548 8,620 10,446 14,710 25,925 35,505 30,312 36,463 Butterﬁeld Annual Report 2011 79 The table below presents information about the Bank’s impaired loans: 2011 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Consumer loans Automobile ﬁnancing Credit cards Overdrafts Other consumer Total consumer loans Residential mortgage loans Total impaired loans 2010 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Consumer loans Automobile ﬁnancing Overdrafts Other consumer Total consumer loans Residential mortgage loans Total impaired loans 2011 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Consumer loans Automobile ﬁnancing Credit cards Overdrafts Other consumer Total consumer loans Residential mortgage loans Total impaired loans Gross recorded investments Impaired loans with an allowance Net loans Speciﬁc allowance Gross recorded investments Impaired loans without an allowance Net Speciﬁc loans allowance 4,007 669 4,676 41,697 (2,208) (669) (2,877) (12,054) 1,799 - 1,799 29,643 240 - - 861 1,101 30,206 77,680 (75) - - (473) (548) (10,446) (25,925) 165 - - 388 553 19,760 51,755 6,611 6,056 12,667 23,178 743 - 65 2,507 3,315 26,626 65,786 - - - - 6,611 6,056 12,667 23,178 - - - - - - - 743 - 65 2,507 3,315 26,626 65,786 Gross recorded investments Impaired loans with an allowance Net loans Speciﬁc allowance 2,730 57 2,787 53,849 - 314 3,807 4,121 18,372 79,129 (520) (57) (577) (21,534) - (314) (1,215) (1,529) (6,672) (30,312) 2,210 - 2,210 32,315 - - 2,592 2,592 11,700 48,817 Gross recorded investments Impaired loans without an allowance Net loans Speciﬁc allowance 3,909 8,620 12,529 36,210 989 68 3,858 4,915 26,718 80,372 - - - - - - - - - - 3,909 8,620 12,529 36,210 989 68 3,858 4,915 26,718 80,372 Average recorded investment Interest income recognised Impaired loans 9,284 7,314 16,598 79,801 1,167 78 95 4,273 5,613 36,359 138,371 86 5 91 520 - - - - - 273 884 During the year ended 31 December 2011, the amount of gross interest income that would have been recorded had impaired loans been current was $6.9 million (2010: $10.8 million). 80 The table below presents information about the Bank’s loans modiﬁed in a troubled debt restructuring as of 31 December 2011: Effect of modiﬁcation on recorded investment 2011 Commercial loans Commercial and industrial Commercial overdrafts Total commercial loans Commercial real estate loans Residential mortgage loans Total loans Number of contracts 4 1 5 5 11 21 Pre-modiﬁcation Post-modiﬁcation outstanding recorded outstanding recorded investment Recorded investment Changes in the timing of principal or Interest investment interest payments capitalisation 2,847 1,042 3,889 22,279 7,382 33,550 (1) 2,777 1,142 3,919 23,121 7,146 34,186 2,777 1,142 3,919 23,183 7,336 34,438 - - - - 9 9 - - - 61 180 241 (1) The amount comprised $12.6 million of non-accrual loans and $20.9 million of loans on accrual status. The table below presents information about the Bank’s loans modiﬁed in a troubled debt restructuring from 1 January 2011 to 31 December 2011 that subsequently became 90 days or more past due following a modiﬁcation: Commercial real estate loans Number of contracts 1 Recorded investment 1,519 NOTE 8: CREDIT RISK CONCENTRATIONS Concentrations of credit risk in the lending and off-Balance Sheet credit related arrangements portfolios 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. Unconditionally cancellable credit cards, overdrafts and lines of credit are excluded from the tables below. The following table summarises the credit exposure of the Bank by business sector. The on-Balance Sheet exposure amounts disclosed are net of speciﬁc allowances and the off-Balance Sheet exposure amounts disclosed are gross of collateral held as disclosed in Note 13: Commitments and Credit Related Arrangements. Banks and ﬁnancial services Commercial and merchandising Governments Individuals Primary industry and manufacturing Real estate Hospitality industry Transport and communication Sub-total General allowance Total On-Balance Sheet 331,726 278,614 258,479 2,301,823 226,030 779,450 97,340 9,303 4,282,765 (35,505) 4,247,260 2011 Off-Balance Sheet 496,753 137,023 - 100,500 2,692 94,029 - - 830,997 - 830,997 Total credit exposure 828,479 415,637 258,479 2,402,323 228,722 873,479 97,340 9,303 5,113,762 (35,505) 5,078,257 On-Balance Sheet 355,215 439,429 68,250 2,218,136 70,212 789,155 128,724 10,702 4,079,823 (36,463) 4,043,360 2010 Off-Balance Sheet 423,295 250,927 - 59,979 42,376 25,960 2,804 200 805,541 - 805,541 Total credit exposure 778,510 690,356 68,250 2,278,115 112,588 815,115 131,528 10,902 4,885,364 (36,463) 4,848,901 Butterﬁeld Annual Report 2011 81 The following table summarises the credit exposure of the Bank by region: Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Sub-total General allowance Total On-Balance Sheet 2,479,669 181,325 728,572 454,039 4,742 434,418 4,282,765 (35,505) 4,247,260 2011 Off-Balance Sheet 406,094 8,563 177,846 149,387 90 89,017 830,997 - 830,997 Total credit exposure 2,885,763 189,888 906,418 603,426 4,832 523,435 5,113,762 (35,505) 5,078,257 On-Balance Sheet 2,477,937 188,938 595,425 332,827 69,321 415,375 4,079,823 (36,463) 4,043,360 2010 Off-Balance Sheet 441,485 8,127 227,023 106,556 1,734 20,616 805,541 - 805,541 Total credit exposure 2,919,422 197,065 822,448 439,383 71,055 435,991 4,885,364 (36,463) 4,848,901 NOTE 9: PREMISES, EQUIPMENT AND COMPUTER SOFTWARE The following table summarises land, buildings, equipment and computer software: Land Buildings Equipment Computer software in use Computer software in development Total 2011 Accumulated depreciation - (53,306) (44,545) (52,525) - (150,376) Cost 13,371 184,943 56,585 168,738 2,853 426,490 Net carrying amount 13,371 131,637 12,040 116,213 2,853 276,114 2010 Accumulated depreciation - (46,524) (41,588) (43,796) - (131,908) Net carrying amount 13,371 138,811 13,795 16,406 79,572 261,955 Cost 13,371 185,335 55,383 60,202 79,572 393,863 Depreciation Buildings (included in property expense) Equipment (included in property expense) Computer hardware and software (included in technology & communications expense) Total depreciation charged to non-interest expense Impairment Write off of computer software in development (included in net other losses) 2011 2010 6,819 2,876 9,559 19,254 5,257 3,207 8,070 16,534 - 3,831 82 NOTE 10: 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 2009 Foreign exchange translation adjustment Balance as at 31 December 2010 Foreign exchange translation adjustment Balance as at 31 December 2011 Guernsey 6,917 (245) 6,672 (38) 6,634 United Kingdom 9,795 (450) 9,345 (42) 9,303 Customer relationship intangible assets 2011 2010 Accumulated Accumulated impairment amortisation Cost Bermuda - Wealth Management Barbados Cayman Guernsey The Bahamas United Kingdom Total 8,342 6,681 1,211 41,010 5,234 19,036 81,514 - - (180) - - - (180) (4,034) (3,597) (593) (27,542) (2,867) (9,454) (48,087) Net carrying amount 4,308 3,084 438 13,468 2,367 9,582 33,247 Accumulated Accumulated amortisation impairment Cost 8,342 6,681 1,211 41,242 5,204 19,153 81,833 - - - - - - - (3,479) (3,152) (511) (24,924) (2,517) (8,304) (42,887) Total 16,712 (695) 16,017 (80) 15,937 Net carrying amount 4,863 3,529 700 16,318 2,687 10,849 38,946 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. The 31 December 2011 fair value of customer relationship intangible assets is based on the present value of net cash ﬂows expected to be derived solely from the recurring customer base existing as at 31 December 2011. The discount rate used for testing is the discount rate implied in the initial purchase price acquisition. During 2011 and 2010, the Bank did not acquire new customer relationship intangible assets. Intangible asset impairment loss for the year ended 31 December 2011 of $0.02 million was recognised. During 2011, the amortisation expense amounted to $5.8 million (2010: $5.7 million) and the foreign exchange translation adjustment increased the net carrying amount by $0.07 million (2010: increased by $0.05 million). The estimated aggregate amortisation expense for each of the succeeding ﬁve years (until 31 December 2016) is $5.5 million. NOTE 11: CUSTOMER DEPOSITS AND DEPOSITS FROM BANKS a) By Maturity 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 Customers 2011 Banks Total Customers 961,002 4,202,728 5,163,730 - 118,449 118,449 961,002 4,321,177 5,282,179 977,417 4,558,249 5,535,666 2010 Banks - 10,793 10,793 Total 977,417 4,569,042 5,546,459 2,005,446 131,932 98,970 2,236,348 6,410 382 121 6,913 2,011,856 132,314 99,091 2,243,261 2,353,217 132,359 127,138 2,612,714 64,133 4,753 - 68,886 2,417,350 137,112 127,138 2,681,600 Total 7,400,078 125,362 7,525,440 8,148,380 79,679 8,228,059 Butterﬁeld Annual Report 2011 83 b) By Type and Location Bermuda Customers Banks Barbados Customers Cayman Customers Banks Guernsey Customers Banks The Bahamas Customers United Kingdom Customers Banks Total Customers Total Banks Total Payable on demand 31 December 2011 Payable on a ﬁxed date Total Payable on demand 31 December 2010 Payable on a ﬁxed date Total 2,237,849 109,923 1,021,747 - 3,259,596 109,923 2,458,003 - 1,146,796 44,988 3,604,799 44,988 171,705 97,378 269,083 159,255 80,686 239,941 1,319,357 5,692 1,018,084 2,834 423,436 6,074 1,742,793 11,766 1,348,636 8,587 316,172 388 1,334,256 3,222 1,010,897 1,516 432,140 22,387 450,895 - 1,780,776 30,974 1,461,792 1,516 55,350 3,968 59,318 84,357 37,606 121,963 361,385 - 5,163,730 118,449 5,282,179 373,647 451 2,236,348 6,913 2,243,261 735,032 451 7,400,078 125,362 7,525,440 474,518 690 5,535,666 10,793 5,546,459 464,591 1,511 2,612,714 68,886 2,681,600 939,109 2,201 8,148,380 79,679 8,228,059 NOTE 12: 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 and post-retirement medical plans are not open to new participants and are non-contributory and the funding required is provided by the Bank, based upon the advice of an independent actuary. The following table presents the expense constituents of the Bank’s deﬁned beneﬁt pension plans and the Bank’s post-retirement medical beneﬁts: For the year ended 2011 2010 Pension Post- retirement medical plans beneﬁt plan - 146,897 140,874 2,638 245 7,355 (9,377) (1,800) - 13,124 (587) 152,472 143,978 5,458 5,559 245 (9,377) (540) 145,323 81,114 740 - 4,428 (2,047) - (3,704) 11,349 - 91,880 - - 2,047 - (2,047) - - Post- retirement medical beneﬁt plan - 141,645 2,466 - 6,521 (2,452) - (40,641) (26,425) - 81,114 - - 2,452 - (2,452) - - Pension plans 131,177 125,470 2,366 248 7,424 (5,727) - - 12,959 (1,866) 140,874 135,986 10,931 4,557 248 (5,727) (2,017) 143,978 Accumulated beneﬁt obligation at year end Change in projected beneﬁt obligation Opening projected beneﬁt obligation Service cost Employee contributions Interest cost Beneﬁts paid Settlement and curtailment of liability Plan amendment Actuarial loss (gain) 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 Foreign exchange translation adjustment Closing fair value of plan assets 84 For the year ended 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 (Deﬁcit) surplus of plan assets over projected beneﬁt obligation at measurement date 2011 Post- retirement medical plans beneﬁt plan Pension 5,861 (13,010) - (91,880) 2010 Post- retirement medical beneﬁt plan - (81,114) Pension plans 7,199 (4,095) (7,149) (91,880) 3,104 (81,114) Amounts recognised in accumulated other comprehensive income (loss) consist of: Net actuarial loss Past service credit Net amount recognised in accumulated other comprehensive income (loss) (40,460) - (40,460) (26,195) 35,066 8,871 (29,405) - (29,405) (15,781) 37,520 21,739 Effective 31 December 2011, the Bank’s post-retirement medical beneﬁts were amended to freeze credited service and ﬁnal average earnings for remaining active members. The beneﬁts amendment resulted in a further reduction in the post-retirement medical liability of $1.8 million as at 31 July 2011. The beneﬁts amendment is being amortised to the Statement of Operations over the expected average remaining service lifetime of the active employees in the plan. The following table presents the expense constituents of the Bank’s deﬁned beneﬁt pension plans and the Bank’s post-retirement medical beneﬁt plan: For the year ended 2011 2010 Post-retirement Pension plans medical beneﬁt plan Post-retirement Pension plans medical beneﬁt plan Annual beneﬁt expense Service cost Interest cost Expected return on plan assets Amortisation of past service credit Amortisation of net actuarial loss Deﬁned beneﬁt expense Deﬁned contribution expense Total beneﬁt expense 2,638 7,355 (9,173) - 4,027 4,847 5,496 10,343 Other changes recognised in other comprehensive income (loss) Net (loss) gain arising during the year Past service credit arising during the year Amortisation of past service credit Amortisation of net actuarial loss Total changes recognised in other comprehensive income (loss) (15,082) - - 4,027 (11,055) 740 4,428 - (6,158) 935 (55) - (55) (11,349) 3,704 (6,158) 935 (12,868) 2,366 7,424 (8,617) - 3,386 4,559 5,043 9,602 (10,645) - - 3,386 (7,259) 2,466 6,521 N/A (3,121) 1,634 7,500 - 7,500 26,425 40,641 (3,121) 1,634 65,579 The estimated portion of the net actuarial loss for the pension plans that will be amortised from accumulated other comprehensive loss into beneﬁt expense over the next ﬁscal year is $5.8 million. The estimated portion of the net actuarial loss and the past service credit 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 $2.1 million for the net actuarial loss and a credit of $6.7 million for the past service credit. Butterﬁeld Annual Report 2011 85 Pension plans 2011 Post-retirement medical beneﬁt plan 2010 Pension plans Post-retirement medical beneﬁt plan Actuarial assumptions used to determine annual beneﬁt expense 5.30% Weighted average discount rate 3.75% Weighted average rate of compensation increases Weighted average expected long-term rate of return on plan assets 6.35% N/A Weighted average annual medical cost increase rate 5.50% N/A N/A 7.5% to 4.5% in 2027 5.85% 3.80% 6.45% N/A 6.10% N/A N/A 7.5% to 4.5% in 2027 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 4.65% 1.70% N/A 4.60% N/A 7.5% to 4.5% in 2027 5.30% 3.75% N/A 5.50% N/A 7.5% to 4.5% in 2027 For 2011, 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 $1.0 million increase (2010: $2.1 million) and a $0.8 million decrease (2010: $1.6 million), respectively, and on the beneﬁt obligation a $17.2 million increase (2010: $13.7 million) and a $13.8 million decrease (2010: $11.1 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. The weighted average annual medical cost increase rate remained unchanged in 2011 at 7.5% to 4.5%. Investments policies and strategies The pension plans’ assets are managed according to each plan’s Investment Policy Statement which outlines the Purpose of the Plan, Statement of Objectives and Guidelines & Investment Policy. The asset allocation is diversiﬁed and any use of derivatives is limited to hedging purposes only. The weighted average actual and target asset allocations of the pension plans by asset category are as follows: Asset category Debt securities (including debt mutual funds) Equity securities (including equity mutual funds) Other Total 2011 2010 Actual allocation Target allocation Actual allocation Target allocation 45% 50% 5% 100% 40% 47% 13% 100% 46% 52% 2% 100% 46% 47% 7% 100% Fair value measurements of pension plans’ assets The following table presents the fair value of plans’ assets by category and Level of Inputs used in their respective fair value determination as described in Note 2. 2011 Fair value determination 2010 Fair value determination US government and federal agencies Corporate debt securities Debt securities issued by non-US governments Equity securities and mutual funds Other Total fair value of plans’ assets Level 1 - - - - - - Level 2 5,890 51,295 10,143 74,089 3,521 144,938 Level 3 - - - 385 - 385 Total fair value 5,890 51,295 10,143 74,474 3,521 145,323 Level 1 - - - - - - Level 2 8,242 47,912 9,696 74,794 2,957 143,601 Total fair value 8,242 47,912 9,696 75,171 2,957 143,978 Level 3 - - - 377 - 377 At 31 December 2011, 26.3% (2010: 28.7%) of the assets of the pension plans were mutual funds and equity securities managed or administered by wholly-owned subsidiaries of the Bank. At 31 December 2011, 0.2% and 1.6% (2010: 0.4% and 1.6%) of the plans’ assets were invested in Common and Preference Shares of the Bank, respectively. 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. 86 Estimated 2011 Bank contribution to, and estimated beneﬁt payments for the next ten years under, the pension and post-retirement medical beneﬁt plans are as follows: 2011 Estimated Bank contributions for 2012 Estimated beneﬁt payments by year: 2012 2013 2014 2015 2016 2017 - 2021 Pension Plans 3,588 5,700 6,000 6,400 7,000 6,900 35,600 Post-retirement medical beneﬁt plan 2,807 2,807 3,034 3,271 3,555 3,791 22,876 The projected beneﬁt obligation and fair value of plan assets for pension plans with projected beneﬁt obligations in excess of plan assets were $127.5 million and $114.5 million as at 31 December 2011. NOTE 13: CREDIT RELATED ARRANGEMENTS AND COMMITMENTS Commitments The Bank was committed to expenditures under contract for sourcing and leases of $112.5 million and $30.2 million, respectively, as at 31 December 2011 (2010: $133.2 million and $29.5 million, respectively). Rental expense for premises leased on a long-term basis for the year ended 31 December 2011 amounted to $5.7 million (2010: $5.8 million). The expenditures committed under the other agreements relate to the Balance Sheet Management Advisory Agreement entered into with Carlyle as disclosed in Note 26: Related Party transactions. The following table summarises the Bank’s commitments for sourcing, long-term leases and other agreements: 2011 2012 2013 2014 2015 2016 2017 & thereafter Total commitments Sourcing 24,886 23,665 22,746 22,566 18,671 - 112,534 Leases 5,971 5,030 4,941 4,424 3,645 6,210 30,221 Other agreements 4,000 3,000 - - - - 7,000 Total 34,857 31,695 27,687 26,990 22,316 6,210 149,755 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, whilst the term of the letters of guarantee does not exceed four years. The types and amounts of collateral security held by the Bank for these standby letters of credit and letters of guarantee 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 and letters of guarantee 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 and letters of guarantee. The fees are then recognised in income proportionately over the life of the credit agreements. The following table presents the outstanding ﬁnancial guarantees with contractual amounts representing credit risk as follows: Standby letters of credit Letters of guarantee Total Gross 321,059 13,388 334,447 2011 Collateral 303,769 9,876 313,645 Net 17,290 3,512 20,802 Gross 386,728 14,115 400,843 2010 Collateral 354,310 8,655 362,965 Net 32,418 5,460 37,878 Collateral is shown at estimated market value less selling cost. Where cash is the collateral, this is shown gross including interest income. 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. Butterﬁeld Annual Report 2011 87 The following table presents the unfunded, legally binding commitments to extend credit with contractual amounts representing credit risk as follows: Commitments to extend credit Commitments to extend credit with terms modiﬁed by troubled debt restructuring Documentary and commercial letters of credit Total 2011 491,251 779 4,520 496,550 2010 402,567 - 2,131 404,698 The Bank has a facility by one of its custodians, whereby the Bank may offer up to US$200 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 2011, $137.1 million (2010: $174.5 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. NOTE 14: INTEREST INCOME Loans The following table presents the components of loan interest income: Mortgages Other loans Amortisation of loan premium / discount Amortisation of fair value hedge Amortisation of loan origination fees (net of amortised costs) Total loan interest income Balance of unamortised fair value hedge as at 31 December Balance of unamortised loan fees as at 31 December 2011 95,885 104,393 200,278 - (2,498) 4,693 202,473 (11,656) 7,951 2010 97,667 93,958 191,625 53 - 6,330 198,008 - 7,764 NOTE 15: SEGMENTED INFORMATION At 31 December 2011, for management reporting purposes, the operations of the Bank are grouped into the following seven business segments based upon the geographic location of the Bank’s operations: Bermuda, Barbados, Cayman, Guernsey, Switzerland, The Bahamas and the United Kingdom. Accounting policies of the reportable segments are the same as those described in Note 2. Bermuda provides a full range of retail, 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. Commercial banking includes commercial lending and mortgages, cash management, payroll services, remote banking and letters of credit. Treasury services include money market and foreign exchange activities. Bermuda’s wealth management offering consists of Butterﬁeld Asset Management Limited, which provides investment management, advisory and brokerage services and Butterﬁeld Trust (Bermuda) Limited, which provides trust, estate, company management and custody services. 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 and credit cards. The Cayman Islands 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 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, wealth management and ﬁduciary services. The Switzerland segment provides ﬁduciary services. The Bahamas segment provides institutional, corporate and private clients with a range of wealth management & ﬁduciary 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. 88 88 Total Assets by Segment Bermuda Barbados Cayman Guernsey Switzerland The Bahamas United Kingdom Less: inter-segment eliminations Total 2011 4,577,775 303,960 1,974,338 1,479,901 1,118 77,565 976,451 9,391,108 (566,999) 8,824,109 2010 5,192,585 273,797 2,036,512 1,617,976 1,191 146,069 1,104,946 10,373,076 (750,016) 9,623,060 For the year ended 2011 Net interest income Inter- Customer segment 881 - 757 (17) - 264 (1,885) - 131,056 11,485 36,568 18,396 1 1,041 14,573 213,120 Provision for credit losses (1,202) (1,156) (3,974) (637) - (633) (6,724) (14,326) Revenue before Non- gains interest income and losses 197,816 67,081 13,225 2,896 64,001 30,650 39,406 21,664 664 663 5,786 5,114 16,893 10,929 337,791 138,997 Total Net income (loss) before gains expense and losses 21,090 176,726 1,090 12,135 9,013 54,988 30,245 9,161 (1,411) 2,075 (1) 5,787 (3,360) 20,253 35,582 302,209 Gains and losses 4,754 37 1,955 242 - 3 45 7,036 Net income (loss) 25,844 1,127 10,968 9,403 (1,411) 2 (3,315) 42,618 615 213,735 - - - (14,326) (3,751) 135,246 (3,136) 334,655 (3,751) 298,458 615 36,197 (2,761) 4,275 (2,146) 40,472 Bermuda Barbados Cayman Guernsey Switzerland The Bahamas United Kingdom Total before eliminations Add / (less) inter-segment eliminations / transactions Total For the year ended 2010 Net interest income Bermuda Barbados Cayman Guernsey Hong Kong* Malta* Switzerland The Bahamas United Kingdom Total before eliminations Add / (less) inter-segment eliminations / transactions Total Customer 113,259 12,921 26,590 12,521 1 5 2 2,270 11,373 178,942 - 178,942 Provision for credit losses (25,650) (1,707) (3,808) - - - - (3,669) (7,136) (41,970) Non- interest income 71,325 2,948 32,389 23,003 2,119 886 489 5,201 10,027 148,387 Revenue before gains and losses 159,038 14,158 57,152 35,387 2,120 891 491 3,850 12,272 285,359 Inter- segment 104 (4) 1,981 (137) - - - 48 (1,992) - Net income (loss) before gains and losses (33,136) 295 7,007 7,762 390 30 (1,668) (3,962) (3,816) (27,098) Total expense 192,174 13,863 50,145 27,625 1,730 861 2,159 7,812 16,088 312,457 Gains and losses (149,940) (151) (11,600) (1,433) (3,639) (3,790) - - (9,964) (180,517) Net income (loss) (183,076) 144 (4,593) 6,329 (3,249) (3,760) (1,668) (3,962) (13,780) (207,615) - - - (41,970) (4,967) 143,420 (4,967) 280,392 (4,967) 307,490 - (27,098) - (180,517) - (207,615) * Disposed of the subsidiaries on 8 September 2010; disclosed in the 2010 annual ﬁnancial statements. Butterﬁeld Annual Report 2011 89 Butterﬁeld Annual Report 2011 89 NOTE 16: ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT The Bank uses derivatives in the asset and liability management (“ALM”) of positions and to meet the needs of its customers with their risk management objectives. The Bank’s derivative contracts principally involve over the counter transactions that are privately negotiated between the Bank and the counterparty to the contract and include interest rate contracts and foreign exchange contracts. The Bank may pursue 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. Certain of these agreements contain credit-risk-related contingent features in which the counterparty has the option to accelerate cash settlement of the Bank’s net derivative liabilities with the counterparty in the event the Bank’s credit rating falls below speciﬁed levels or the liabilities reach certain levels. All derivative ﬁnancial instruments, whether designated as hedges or not, are recorded on the Consolidated Balance Sheet at fair value within Other assets or Other liabilities. These amounts include the effect of netting. The accounting for changes in the fair value of a derivative in the Consolidated Statement of Operations depends on whether the contract has been designated as a hedge and qualiﬁes for hedge accounting. Notional amounts 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. Credit risk is limited to the positive fair value of the derivative instrument, which is signiﬁcantly less than the notional amount. 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 fair value is deﬁned as the proﬁt or loss associated with replacing the derivative contracts at prevailing market prices. Risk management derivatives 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. Derivative instruments that are used as part of the Bank’s interest rate risk management strategy include interest rate swap 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. The Bank uses derivative instruments to hedge its exposure to interest rate risk and foreign currency risk. Certain hedging relationships are formally designated and qualify for hedge accounting as fair value or cash ﬂow hedges. Other derivatives that are entered into for risk management purposes as economic hedges are not formally designated as hedges and, therefore, are accounted for as if they were trading instruments. In order to qualify for hedge accounting, a formal assessment is performed on a calendar quarter basis to verify that derivatives used in designated hedging transactions continue to be highly effective as offsets to changes in fair value or cash ﬂows of the hedged item. If a derivative ceases to be highly effective, or if the hedged item matures, is sold, or is terminated, hedge accounting is terminated and the derivative is treated as if it were a trading instrument. Fair value hedges Derivatives are designated as fair value hedges to minimise the Bank’s exposure to changes in the fair value of assets and liabilities due to movements in interest rates. The Bank enters into interest rate swaps to convert its ﬁxed-rate long-term loans to ﬂoating-rate loans, and convert ﬁxed-rate deposits to ﬂoating-rate deposits. Changes in fair value of these derivatives are recognised in income. For fair value hedges, the Bank applies the “shortcut” method of accounting, which assumes there is no ineffectiveness in a hedge. As a result, changes recorded in the fair value of the hedged item are equal to the offsetting gain or loss on the derivative and are reﬂected in the same line item. During the six months ended 30 June 2011, the Bank cancelled its Interest Rate Swaps designated as fair value hedges of loans receivable and therefore discontinued hedge accounting for these ﬁnancial instruments. The fair value attributable to the hedged loans are accounted for prospectively and will be amortised to net income over the remaining life of each individual loan using the effective interest method. 90 Cash ﬂow hedges Derivatives are designated as cash ﬂow hedges in order to minimise the variability in cash ﬂows of interest earning assets caused by movements in interest rates. The effective portion of changes in the fair value of such derivatives is recognised in accumulated other comprehensive income, a component of Shareholders’ equity. When the hedged item impacts earnings, balances in other comprehensive income are reclassiﬁed to the same income or expense classiﬁcation as the hedged item. The Bank applies the “shortcut” method of accounting for cash ﬂow hedges of held to maturity investments, in assessing whether these hedging relationships are highly effective at inception and on an ongoing basis. Any ineffectiveness in cash ﬂow hedge is recognised in earnings. As of 31 December 2011 and 2010, there were no cash ﬂow hedges in place and there were no deferred net gains or losses on derivative instruments accumulated in other comprehensive income in relation with cash ﬂow hedges. Derivatives not formally designated as hedges Derivatives not formally designated as hedges are entered into to manage the interest rate risk of ﬁxed-rate deposits with banks and foreign exchange risk of the Bank’s non-USD investments in subsidiaries. Changes in the fair value of derivative instruments not formally designated as hedges are recognised in income. Client service derivatives The Bank enters into foreign exchange contracts and interest rate caps primarily to meet the foreign exchange needs of its customers. Foreign exchange contracts are agreements to exchange speciﬁc amounts of currencies at a future date at a speciﬁed rate of exchange. Changes in the fair value of client services derivative instruments are recognised in income. The following table shows the aggregate notional amounts of derivative contracts outstanding listed by type and respective gross positive or negative fair values and divided by those used for risk management (sub-classiﬁed as hedging and those that do not qualify for hedge accounting), client services and credit derivatives. Fair value of derivatives is recorded in the Consolidated Balance Sheet in Other assets and Other liabilities. Gross positive fair values are recorded in Other assets and gross negative fair values are recorded in Other liabilities, subject to netting when master netting agreements are in place. 2011 Risk management derivatives Fair value hedges Fixed-rate loans Investments Sub-total fair value hedges Not designated as hedging instruments Sub-total not designated as hedges Sub-total risk management derivatives Client services derivatives Sub-total client services derivatives Total derivative instruments Derivative instrument Notional amounts Positive fair value Negative fair value Net fair value Interest rate swaps Interest rate swaps Currency swaps Foreign currency options Spot and forward foreign exchange Interest rate caps 11,436 18,613 30,049 346,453 65,335 411,788 441,837 5,775,477 37,225 5,812,702 6,254,539 - 18 18 1,031 3,160 4,191 4,209 44,207 89 44,296 48,505 (227) - (227) (105) (651) (756) (983) (43,756) (89) (43,845) (44,828) (227) 18 (209) 926 2,509 3,435 3,226 451 - 451 3,677 Butterﬁeld Annual Report 2011 91 2010 Risk management derivatives Fair value hedges Fixed-rate loans Investments Customer deposits Sub-total fair value hedges Not designated as hedging instruments Sub-total not designated as hedges Sub-total risk management derivatives Client services derivatives Sub-total client services derivatives Derivative instrument Notional amounts Positive fair value Negative fair value Net fair value Interest rate swaps Interest rate swaps Interest rate swaps Interest rate swaps Currency swaps Spot and forward foreign exchange Interest rate caps 175,858 34,316 5,447 215,621 360,000 264,843 624,843 840,464 4,842,989 37,435 4,880,424 47 228 - 275 1,481 4,028 5,509 5,784 39,774 389 40,163 (17,151) - (26) (17,177) (555) (1) (556) (17,104) 228 (26) (16,902) 926 4,027 4,953 (17,733) (11,949) (39,755) (389) (40,144) 19 - 19 Total derivative instruments 5,720,888 45,947 (57,877) (11,930) The following table shows the location and amount of gains (losses) recorded in the Consolidated Statement of Operations. Derivative Instrument Interest rate swaps Forward foreign exchange Foreign currency options Total net gains recognised in net income Consolidated Statement of Operations line item Net other gains (losses) Foreign exchange revenue Foreign exchange revenue For the year ended 2011 (906) 699 1,092 885 2010 1,154 1,076 - 2,230 NOTE 17: FAIR VALUE OF FINANCIAL INSTRUMENTS The following table presents the ﬁnancial assets and liabilities that are measured at fair value on a recurring basis and classiﬁes such fair value based on the type of input used in the related valuations, as described in Note 2. Management classiﬁes items that are recognised at fair value on a recurring basis based on the Level of Inputs used in their respective fair value determination, as described in Note 2. Financial instruments in Level 1 include listed equity shares and actively traded redeemable mutual funds. Financial instruments in Level 2 include equity securities not actively traded, certiﬁcates of deposit, corporate bonds, mortgage-backed securities and other asset-backed securities, interest rate swaps and caps and forward foreign exchange contracts, and mutual funds not actively traded. Financial instruments in Level 3 include non-redeemable private equity shares, corporate bonds, mortgage-backed securities and other asset-backed securities for which the market is relatively illiquid and for which information about actual trading prices is not readily available. 92 Items that are recognised at fair value on a recurring basis 2011 Fair value 2010 Fair value Financial assets Level 1 Level 2 Level 3 Total carrying amount / Fair value Level 1 Level 2 Total carrying amount / Level 3 Fair value Trading Debt securities issued by non-US governments Mutual funds Total Trading - 5,368 5,368 5,971 51,252 57,223 Available for sale Certiﬁcates of deposit US government and federal agencies Debt securities issued by non-US governments Corporate debt securities guaranteed by non-US governments Corporate debt securities Asset-backed securities - Student loans Pass-through note Equity securities Total Available for sale - - - 356,493 790,804 113,032 121,648 - 408,962 - 133,182 - - - - 70 - 1,924,191 - - - - - - 5,971 56,620 62,591 - 10,021 10,021 6,511 1,556 8,067 356,493 790,804 113,032 - - 11,164 26,991 - 38,155 121,648 408,962 144,346 26,991 70 1,962,346 - - - 859,146 917,494 132,692 149,720 - 347,470 - 135,632 - 24,342 - - 77 - 2,566,573 - - - - - - 6,511 11,577 18,088 859,146 917,494 132,692 - - 11,179 33,304 - 149,720 347,470 146,811 57,646 77 44,483 2,611,056 Other assets - Derivatives Other assets - Closed ended real estate fund - - 48,505 - - 6,199 48,505 6,199 Financial liabilities Other liabilities – Derivatives - (44,828) - (44,828) - - - 45,947 - - 9,044 45,947 9,044 57,877 - 57,877 Consistent with the signiﬁcant accounting policy in Note 2, the current carrying value of other real estate owned will be adjusted to fair value only when there is a devaluation below cost. Transfers of securities 2011 2010 Transfers out of Level 1 Transfers into Level 2 Trading investments (50,035) 50,035 Available for sale investments - - Trading investments - - Available for sale investments - 1,002,803 The transfer out of Level 1 and into Level 2 represents transfers of mutal funds classiﬁed at measurement date based on the level of trading. Level 3 reconciliation 2011 Carrying amount at beginning of year Purchases Proceeds from sale / Capital distributions Accretion recognised in net income Realised and unrealised losses recognised in other comprehensive income Transfers in and out of Level 3 Foreign exchange translation adjustment Carrying amount at end of year Available for sale investments 44,483 290 (3,973) 1,776 (4,421) - - 38,155 Closed ended property fund 9,044 1,185 (3,765) - (251) - (14) 6,199 2010 Available for sale investments 382,452 - (103,064) (3,245) Closed ended property fund 8,307 - - 1,020 Trading investments 296 151 (447) - - - - - (137,093) (94,567) - 44,483 - - (283) 9,044 Butterﬁeld Annual Report 2011 93 Items other than those recognised at fair value on a recurring basis Financial assets Cash and cash equivalents Short-term investments Investments held to maturity Loans, net of allowance for credit losses Financial liabilities Customer deposits Demand deposits Term deposits Deposits from banks Subordinated capital 2011 2010 Carrying amount Fair Appreciation / (depreciation) value Carrying amount Fair Appreciation / (depreciation) value 1,979,458 34,814 64,789 4,247,260 1,979,458 34,814 64,588 4,241,040 5,163,730 2,236,348 125,362 267,755 5,163,730 2,232,570 125,362 225,019 - - (201) (6,220) - 3,778 - 42,736 2,429,699 26,392 - 4,043,360 2,429,699 26,392 - 4,043,360 - - - - 5,535,666 2,612,714 79,679 282,799 5,535,666 2,621,188 79,679 244,606 - (8,474) - 38,193 NOTE 18: 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, expected 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. Investments are shown based on expected duration, which the Bank believes is more representative of maturity date than actual contractual maturity. 2011 Earlier of maturity or repricing date (in $ millions) Assets Cash and cash equivalents Short-term investments Investments Loans Premises, equipment and computer software Other assets Total assets Liabilities and Shareholders’ equity Shareholders’ equity Demand deposits Term deposits Other liabilities Subordinated capital Total liabilities and Shareholders’ equity Interest rate swaps Interest rate sensitivity gap Cumulative interest rate sensitivity gap Within 3 months 3 to 6 months 6 to 12 months 1 to 5 years After 5 years Non-interest bearing funds 1,772 15 450 3,534 - - 5,771 - 4,321 1,712 - 98 6,131 2 (358) (358) - 5 209 121 - - 335 - - 300 - - 300 8 43 (315) - 3 128 53 - - 184 - - 132 - - 132 (2) 50 (265) - - 993 368 - - 1,361 - - 99 - 145 244 (8) 1,109 844 - - 253 117 - - 370 - - - - 25 25 - 345 1,189 207 12 57 54 276 197 803 830 961 - 201 - 1,992 - (1,189) - Total 1,979 35 2,090 4,247 276 197 8,824 830 5,282 2,243 201 268 8,824 - - - 94 94 2010 Earlier of maturity or repricing date (in $ millions) Assets Cash and cash equivalents Short-term investments Investments Loans Premises, equipment and computer software Other assets Total assets Liabilities and Shareholders’ equity Shareholders’ equity Demand deposits Term deposits Other liabilities Subordinated capital Total liabilities and Shareholders’ equity Interest rate swaps Interest rate sensitivity gap Cumulative interest rate sensitivity gap Within 3 months 3 to 6 months 6 to 12 months 1 to 5 years After 5 years Non-interest bearing funds 2,269 19 1,139 3,588 - - 7,015 - 4,569 2,042 - 90 6,701 448 762 762 - - 14 63 - - 77 - - 376 - - 376 - 1 200 48 - - 249 - - 137 - - 137 - (299) 463 (339) (227) 236 - - 1,115 138 - - 1,253 - - 126 - 168 294 (48) 911 1,147 - - 92 109 - - 201 - - 1 - 25 26 (61) 114 1,261 161 6 69 97 262 233 828 809 977 - 303 - 2,089 - (1,261) - Total 2,430 26 2,629 4,043 262 233 9,623 809 5,546 2,682 303 283 9,623 - - - NOTE 19: 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 paid a ﬁxed coupon of 3.94% until 27 May 2008 when it was redeemed in whole by the Bank. The Series B notes pay a ﬁxed coupon of 5.15% until 27 May 2013 when they become redeemable in whole at the Bank’s option. 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 $7.8 million. The issuance was by way of private placement in the United Kingdom and pays a ﬁxed coupon of 9.29% until February 2012 when it becomes redeemable in whole at the option of the Bank and 10.29% thereafter until February 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 $60 million in Series B notes due 2020. The issuance was by way of private placement with US institutional investors. The notes are listed on the BSX in the specialist debt securities category. The notes issued under Series A paid a ﬁxed coupon of 4.81% until 2 July 2010 after which the coupon rate became ﬂoating and the principal became redeemable in whole at the Bank’s option. At 31 December 2011, the Bank has not redeemed any of the Notes issues under Series A and effective 2 July 2010 the coupon rate became ﬂoating at 3 months US$ LIBOR + 1.095%. The Series B notes pay 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. During September 2011, the Bank repurchased a portion of the outstanding 5.11% 2005 Series B Subordinated Notes (“the Note”). The face value of the portion of the Note repurchased was $15 million and the purchase price paid for the repurchase was $13.875 million, which realised a gain of $1.125 million. On 27 May 2008, the Bank issued US $78 million of Subordinated Lower Tier II capital notes. The notes were issued at par and in two tranches, namely US $53 million in Series A notes due 2018 and US $25 million in Series B notes due 2023. 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 proceeds of the issue were used to repay the entire amount of the US $78 million outstanding subordinated notes redeemed in May 2008. The notes issued under Series A pay a ﬁxed coupon of 7.59% until 27 May 2013 when they become redeemable in whole at the option of the Bank. The Series B notes pay a ﬁxed coupon of 8.44% until 27 May 2018 when they also become redeemable in whole at the Bank’s option. The Series A notes were priced at a spread of 4.34% over the 5-year US Treasury yield and the Series B notes were priced at a spread of 4.51% over the 10-year US Treasury yield. Interest capitalised during 2011 amounted to $2.8 million (2010: $3.0 million) and is excluded from interest expense in the Consolidated Statement of Operations. The following table presents the contractual maturity and interest payments for subordinated capital issued by the Bank as at 31 December 2011. The interest payments are calculated until contractual maturity using the current LIBOR rates. Butterﬁeld Annual Report 2011 95 Butterﬁeld Annual Report 2011 95 The following table presents for the remaining subordinated capital issued by the Bank as at 31 December 2011. Interest rate until date Earliest date redeemable maturity date redeemable Contractual Interest payments until contractual maturity Interest rate from earliest date Principal Within 1 to 5 After redeemable to contractual maturity outstanding 1 year years 5 years Subordinated capital Bermuda 2003 issuance - Series B 27 May 2013 2 July 2010 2005 issuance - Series A 2005 issuance - Series B 2 July 2015 2008 issuance - Series A 27 May 2013 2008 issuance - Series B 27 May 2018 Subsidiary Total 27 May 2018 2 July 2015 2 July 2020 27 May 2018 27 May 2023 8 February 2012 8 February 2017 5.15% 3 months US$ LIBOR + 2.000% 4.81% 3 months US$ LIBOR + 1.095% 5.11% 3 months US$ LIBOR + 1.695% 7.59% 3 months US$ LIBOR + 4.185% 8.44% 3 months US$ LIBOR + 4.929% 9.29% 10.29% 1,815 47,000 2,421 5,464 - 90,000 1,470 4,029 45,000 2,300 8,184 3,841 53,000 4,023 10,870 3,779 25,000 2,110 8,440 10,056 399 267,755 13,083 40,179 19,890 759 3,192 7,755 NOTE 20: 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. 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 year. Diluted earnings per Common Share include the dilutive effect resulting from the conversion of Treasury stock. Numbers of Shares are expressed in thousands. Basic earnings per Share Net income (loss) for the year Less: Preference dividends declared and guarantee fee Net income (loss) attributable to Common Shareholders Weighted average number of participating Shares(1) Weighted average number of Common Shares held as Treasury stock Adjusted weighted average number of Common Shares Diluted earnings per Share Net income (loss) attributable to Common Shareholders Weighted average number of participating Shares (1) Weighted average number of Common Shares held as Treasury stock Weighted average number of dilutive Share-based awards Adjusted weighted average number of diluted Common Shares 2011 2010 40,472 (21,270) 19,202 556,933 (2,283) 554,650 0.03 (207,615) (18,000) (225,615) 479,882 (2,657) 477,225 (0.47) 19,202 (225,615) 556,933 (2,283) 965 555,615 0.03 479,882 (2,657) - 477,225 (0.47) (1) The Contingent Value Convertible Preference Shares are classiﬁed as participating securities as they are entitled to dividends declared to Common Shareholders on a 1:1 basis and are therefore included in the basic earnings per Share calculation. During 2011, weighted-average options to purchase 34.5 million (2010: 26.5 million) Shares of Common stock (see Note 21), were outstanding but were anti-dilutive and, therefore, not included in the computation of diluted earnings per Share. Each of these options was considered anti-dilutive because the sum of the option’s expense that will be recognised in the future and its exercise price was greater than the average market price of the Bank‘s Common stock. During 2011, the weighted-average number of outstanding awards of unvested Common Shares (see Note 21) was 3.28 million (2010: nil). All unvested awards of Common Shares were considered dilutive because each award’s unrecognised expense was lower than the average market price of the Bank‘s Common stock. The awards’ yet unrecognised expense is considered to be the proceeds the employees would need to pay to purchase accelerated vesting of the awards. For purpose of calculating dilution, such proceeds are assumed to be used by the Bank to buy-back Shares at the average market price. The weighted-average number of outstanding awards net of the assumed weighted-average number of Shares bought-back is included in the number of diluted participating Shares. Warrants issued to the Government of Bermuda in exchange for the Government’s guarantee of the Preference Shares, with an exercise price of $3.61 for 4.15 million Shares of Common stock were not included in the computation of earnings per Share in 2011 and 2010 because the exercise price was greater than the average market price of the Bank‘s Common stock. 96 NOTE 21: SHARE-BASED PAYMENTS The following table presents the Share-based compensation cost that has been charged against net income and the value of Share-based settlements. Share-based compensation plans Awards granted in years 2009 and prior Awards granted in years 2010 and 2011 Total Share-based compensation Share-based settlement plans Directors Shares and retainers settlement plans Total Share-based payments Unrecognised expense 2010 Stock Option Plan Time Vesting Options Performance Vesting Options 2011 EDIP 2011 ELTIP Time Vesting Shares Performance Vesting Shares For the year ended 2011 2010 Stock option plans EDIP and ELTIP Stock option plans Total EDIP and ELTIP 1,703 1,703 1,876 1,876 3,579 3,579 344 3,923 2,655 1,305 3,960 3,381 - 3,381 Total 6,036 1,305 7,341 271 7,612 For the year ended 2011 5,731 9,169 915 952 961 17,728 On 22 February 2011, the Board approved the 2010 Employee deferred incentive plan and the 2011 Executive long-term incentive Share plan. 2010 Employee Deferred Incentive Plan (“EDIP”) Under the Bank’s 2010 EDIP Plan, Shares were awarded to Bank employees and Executive Management based on time vesting condition, which states that the Shares will vest equally over a three-year period from the effective grant date, subject to the employee’s continued employment. Outstanding at beginning of year Granted Vested Forfeited / cancelled Outstanding unvested at end of year 2011 Number of Shares transferable upon vesting (thousands) - 1,361 (11) (74) 1,276 2011 Executive long-term incentive Share plan (“ELTIP”) Under the Bank’s 2011 ELTIP Plan, Shares were awarded to Bank employees and Executive Management, based on predetermined vesting conditions. The ELTIP Plan comprises two types of vesting conditions upon which the Shares will be awarded, i.e.,: Time Vesting Condition – 50% of each Share award is granted in the form of Time Vested Shares, vesting over a three-year period from the effective grant date, subject to the employee’s continued employment; and Performance Vesting Condition – 50% of each Share award is granted in the form of Performance Shares, vesting upon the achievement of certain performance targets. Outstanding at beginning of year Granted Vested Forfeited / cancelled Outstanding unvested at end of year 2011 Number of Shares transferable upon vesting (thousands) - 2,560 (10) (35) 2,515 Butterﬁeld Annual Report 2011 97 2010 Stock Option Plan Under the Bank’s 2010 Plan, options are awarded to Bank employees and Executive Management, based on predetermined vesting conditions that entitle the holder to purchase one Common Share at a subscription price usually equal to the last traded Common Share price when granted and have a term of 10 years. The Plan comprises two types of vesting conditions upon which the options will be awarded, i.e.,: Time Vesting Condition – 50% of each option award is granted in the form of Time Vested Options and vests 25% on the 2nd, 3rd, 4th and 5th anniversary of the effective grant date, subject to the employee’s continued employment; and Performance Vesting Condition – 50% of each option award is granted in the form of Performance Options and vests on a “Valuation Event” date (date any of the 2 March 2010 Investors transfers at least 5% of total number of Shares or the date that there is a change in control) and any of the New Investors achieve a Multiple of Invested Capital (“MOIC”) based on predetermined MOICs. In the event of a Valuation Event and the MOIC reaching 200%, all options would vest. No options were exercised during the year ended 31 December 2011. Weighted average fair value of stock options granted in the year ended 31 December 2011 Weighted average fair value of stock options granted in the year ended 31 December 2010 Time Vested Options $0.41 $0.62 Performance Options $0.43 $0.66 The weighted average fair value of stock options granted in the year ended 31 December 2011 was calculated using the Black-Scholes-Merton option-pricing model for the Time Vested Options and the Monte Carlo method for the Performance Options using the following weighted average assumptions: Projected dividend yield Risk-free interest rate Projected volatility Expected life (years) Time Vested Options 0% for 2010-2012 1.0% for 2013 2.0% for 2014 3.5% for 2015 and later years 2.0% to 2.2% 36% 6.75 years Performance Options 0% for 2010-2012 1.0% for 2013 2.0% for 2014 3.5% for 2015 and later years 0.0% to 3.6% 36% 8 to 9 years The projected dividend yield is based on the Bank’s estimate, as the Bank has suspended dividend payments, but expects to start paying dividends in 2013. The projected volatilities are based on the historical trading prices of the Bank’s Common Shares. The risk-free interest rate for periods within the expected life of the option is based on the US Treasuries yield curve in effect at the time of grant. As the time vested options granted are “plain vanilla” options, the Bank uses one-half of the time between the average vesting date and the full option term to estimate the expected option life; separate groups of employees that have similar historical exercise behaviour are considered separately for valuation purposes. Number of Shares transferable upon exercise (thousands) 34,308 1,260 (1,936) 33,632 5,431 Number of Shares transferable upon exercise (thousands) 12,428 28,137 (6,257) 34,308 6,275 2011 Weighted average exercise price ($) 3.26 1.24 6.79 3.02 12.41 2010 Weighted average exercise price ($) 11.72 1.21 11.04 3.26 12.38 Weighted average life remaining (years) Aggregate intrinsic value ($ thousands) 5.91 4.95 - Weighted average life remaining (years) Aggregate intrinsic value ($ thousands) 8.68 5.61 1,069 Outstanding at beginning of year Granted Forfeited / cancelled Outstanding at end of year Vested and exercisable at end of year Outstanding at beginning of year Granted Forfeited / cancelled Outstanding at end of year Vested and exercisable at end of year 98 Directors’ Compensation The Bank’s Non-Executive Directors received their annual retainer compensation in the form of cash or fully vested and unrestricted Bank Shares, or a combination of the two. During 2010, a Bank Non-Executive Director received additional compensation in the form of a one-time Shares grant vesting over a two-year period amounting to $0.25 million. The Bank has recognised $0.2 million compensation expense for the year ended 31 December 2011 related to the time vesting Shares granted. NOTE 22: SHARE BUY-BACK PLANS During the years 2011 and 2010, no Common Shares were purchased. 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 must be advised monthly of Shares repurchased and cancelled by the Bank and Shares purchased by both the Bank’s Stock Option Trust and the Bank’s Charitable Trust. NOTE 23: CAPITAL STRUCTURE Authorised capital The Bank’s total authorised Share capital as of 31 December 2011 consisted of (i) 26 billion Ordinary Shares of par value BD$0.01, (ii) 100,200,001 Preference Shares of par value US$0.01 and (iii) 50 million Preference Shares of par value £0.01. On 2 March 2010, the Bank issued 144.8 million Common Shares of par value $1 per Share, for a consideration of $175 million. Following the Bank’s Annual General Meeting held on 8 April 2010, The Bank of N.T. Butterﬁeld & Son Limited’s Shareholders approved an increase in the authorised Share capital to 26,000,000,000 Common Shares of par value BD$0.01. Subsequent to the increase, conversion of 281,770 Mandatorily Convertible Preference Shares into 233,157,035 Common Shares and 93,230 Contingent Convertible Preference Shares into 77,144,993 Common Shares took place. At the Special General Meeting of Shareholders held on 14 April 2009, the Board of Directors were granted the authority to issue, allot or grant options, warrants or similar rights over or otherwise dispose of all the authorised but unissued Share capital of the Bank. On 11 May 2010, the rights were over subscribed with the maximum allowable number of rights of 107,438,016 were exercised and subsequently converted on the ratio of 0.92308 Common Shares for each right unit exercised, amounting to 99,173,842 Common Shares issued. Following the closing of the Rights Offering on 11 May 2010, the gross proceeds of $130 million were used to repurchase 107,571,361 Shares from the 2 March 2010 investors at the same price at which the investors originally subscribed for the Shares. As part of the cost of the Capital Raise, the Bank’s investment adviser was compensated $10 million in cash and $3.5 million in Common Shares at the same prices as the New Investors. On 12 May 2010, in settlement of the aforementioned, the Bank issued 2,896,152 Common Shares to the Bank’s investment adviser. Preference Shares On 22 June 2009, the Bank issued 200,000 Government guaranteed, 8.00% Non-Cumulative Perpetual Limited Voting Preference Shares (the “Preference Shares”). The issuance price was US$1,000 per Share. The Preference Share principal and dividend payments are guaranteed by the Government of Bermuda. Holders of Preference Shares will be entitled to receive, on each Preference Share only when, as and if declared by the Board of Directors, non- cumulative cash dividends at a rate per annum equal to 8.00% on the liquidation preference of $1,000 per Preference Share payable quarterly in arrears. At any time after the expiry of the guarantee offered by the Government of Bermuda, and subject to the approval of the Bermuda Monetary Authority, the Bank may redeem, in whole or in part, any Preference Shares at the time issued and outstanding, at a redemption price equal to the liquidation preference plus any unpaid dividends at the time. In exchange for the Government’s commitment, the Bank issued to the Government 4,279,601 warrants to purchase Common Shares of the Bank at an exercise price of $7.01. The warrants expire on 22 June 2019. On 2 March 2010, the Bank issued 281,770 Mandatorily Convertible Preference Shares of par value $0.01 per Share and 93,230 Contingent Convertible Preference Shares of par value $0.01 per Share, for a consideration of $281.8 million and $93.2 million, respectively. Subsequent to the Bank’s Annual General Meeting held on 8 April 2010, the 281,770 Mandatorily Convertible Preference Shares and 93,230 Contingent Convertible Preference Shares were converted into 233,157,035 and 77,144,993 Common Shares, respectively. Butterﬁeld Annual Report 2011 99 As stated above, on 11 May 2010, 107,438,016 rights were exercised and subsequently converted on the ratio of 0.07692 Contingent Value Convertible Preference Share for each right unit exercised amounting to 8,264,157 Contingent Value Convertible Preference Shares (“CVCP”) issued. The Contingent Value Preference Shares have speciﬁc rights and conditions attached which is explained in detail in the Prospectus of The Rights Offering. Following the Capital Raise on 2 March 2010 under the terms of the 4,279,601 warrants with an exercise price of $7.01 previously issued to the Government of Bermuda in conjunction with the issuance of 200,000 Government guaranteed 8% Non-Cumulative Perpetual Limited Voting Preference Shares in 2009 were adjusted in accordance with the terms of the guarantee. Subsequently, the Government of Bermuda now holds 4,150,774 warrants with an exercise price of $3.61. Regulatory capital The Bank is subject to Basel II which is a risk-based capital adequacy framework developed by the Basel Committee on Banking Supervision (the “Basel Committee”) and has been endorsed by the central bank governors and heads of bank supervision of the G10 countries. In December 2008, the Bermuda Monetary Authority published ﬁnal rules, effective 1 January 2009, with respect to the implementation of the Basel II framework. From this date, the Bank has calculated its capital requirement on the Standardised approach under Basel II requirements. The Bank is fully compliant with all regulatory capital requirements and maintains capital ratios well in excess of regulatory minimums as at 31 December 2011. As at 31 December 2011, the Bank’s regulatory capital stood at $1,041 million (2010: $1,067 million) with the consolidated Tier 1 total and Total Capital ratios being 17.7% and 23.5%, respectively (2010: 15.7% and 21.6%, respectively). NOTE 24: VARIABLE INTEREST ENTITIES The Bank had no investments in variable interest entities for which it was deemed the primary beneﬁciary for the years ended 31 December 2011 and 2010. The Bank has an equitable mortgage in a hospitality related company that has been placed under Receivership and as the Bank is an equity holder at risk, the hospitality related company was considered to be a variable interest entity. As the Bank did not have the legal power to direct the activities of the company that most signiﬁcantly impact the company’s economic performance it was considered not to be the primary beneﬁciary. NOTE 25: INCOME TAXES The Bank is incorporated in Bermuda, and pursuant to Bermuda law, is not taxed on either income or capital gains. The Bank’s subsidiaries in the Cayman Islands and The Bahamas are not subject to any taxes in their respective jurisdictions on either income or capital gains under current law applicable in the respective jurisdictions. The Bank’s subsidiaries in the United Kingdom, Guernsey, Barbados and Switzerland are subject to the tax laws of those jurisdictions and the jurisdictions in which they operate. For the years ended 31 December 2011 and 2010, the Bank did not record any unrecognised tax beneﬁts or expenses and has no uncertain tax positions as at 31 December 2011. The Bank records income taxes based on the enacted tax laws and rates applicable in the relevant jurisdictions for each of the years ended 31 December 2011 and 2010. For the year ended 31 December 2011, the Bank recorded net interest received of $0.03 million and penalties payable of $0.02 million. The components of income taxes attributable to the Bank’s subsidiaries’ operations for the years ended 31 December 2011 and 2010 were as follows: 31 December Income taxes in Consolidated Statement of Operations Current Deferred Total tax (beneﬁt) expense Deferred income tax asset Tax loss carried forward Pension liability Fixed assets Allowance for compensated absence Onerous leases Other Total asset Deferred income tax liability Other Net deferred income tax asset 2011 1,006 (1,039) (33) 6,755 747 738 27 11 532 8,810 (444) 8,366 2010 (3,676) 1,701 (1,975) 5,797 515 676 30 115 490 7,623 - 7,623 Management believes it is more likely than not that the tax beneﬁt of the remaining net deferred tax assets will be realised. 100 NOTE 26: RELATED PARTY TRANSACTIONS Butterﬁeld Fulcrum Group Limited (“BFG”) On 8 February 2011, the Bank entered into an agreement with an investor group (comprised of BV Investor Partners, Glen Henderson and Tim Calveley, (the “BV Investor Group”)) to dispose of its 36% equity interest on a diluted basis in BFG. The sale was completed in the second quarter of 2011 and resulted in a gain on sale of $3.1 million. Under the terms of the agreement, the BV Investor Group paid down BFG’s existing debt and revolving credit facility with the Bank and combined their overall funding requirements with another related entity, FORS Limited (“FORS”), whereby the total loan facilities post-disposition, on commercial market terms as to interest rate, repayment terms and security, is $45.1 million. A Bank Non-Executive Director is a minority shareholder of less than 1% of BFG. As a result of the sale, the Bank paid a dividend of $3.3 million during the third quarter to Contingent Value Convertible Preference Shareholders of record on 26 July 2011. In addition, the Bank has guaranteed to purchase services from BFG, on normal commercial market terms, for three years at minimum agreed revenue levels of $5.5 million, $5.0 million and $4.5 million per annum. In the event there is a shortfall, the Bank is required to pay 38% of the shortfall. Renegotiations of agreements occurred during the third and fourth quarter of 2011, resulting in an expected shortfall from the revenue guarantees over the three-year period, whereby the resultant fair value of the liability is estimated at approximately $0.5 million as at 31 December 2011. Employee loan programme As of 17 May 2005, the Bank established a programme to offer loans with preferential rates to eligible Bank employees, subject to certain conditions set by the Bank and provided that such employees meet certain credit criteria. Loan payments are serviced by automatically debiting the employee’s chequing or savings account with the Bank. Applications for loans are handled according to the same policies as those for the Bank’s regular retail banking clients. The Bank’s ability to offer preferential rates on loans depends upon a number of factors, including market conditions, regulations and the Bank’s overall proﬁtability. The Bank has the right to change its employee loan policy at any time after notifying participants. The staff loans outstanding at 31 December 2011 amount to $251.9 million (2010: $219.0 million) resulting in an interest rate beneﬁt to employees of $6.5 million (2010: $6.2 million). Interested and Director transactions The Bank provides loans and other banking services to the Bank’s Directors, as well as their immediate family members and companies with which they are afﬁliated, as described in Section 96 of the Companies Act 1981, in the ordinary course of business the Bank provides these services on normal commercial terms in respect of interest rates, repayment terms and security. During the third quarter of 2011, the Bank provided a loan to a trust company controlled by a Bank Non-Executive Director, amounting to $2.45 million. The terms of the loan are market related including comprehensive security provided. Charitable Trust The Bank has historically provided a loan facility to the Charitable Trust. At 31 December 2011 and 2010, the carrying value of the loan was $1.2 million. The Charitable Trust used the Loan to purchase Shares in the Bank: 772,971 of the Bank’s Common Shares and 6,223 of the Bank’s Contingent Value Preference Shares at 31 December 2011 and 2010. Financing transactions Capital transaction Canadian Imperial Bank of Commerce (“CIBC”) and funds associated with the Carlyle Group each hold approximately 18% of the Bank’s equity voting power, along with the right to each designate two persons for nomination for election by the Shareholders as member of the Bank’s Board of Directors. Liquidity Facility Agreement During 2010, the Bank entered into a commitment letter for a $500 million line of credit at market rates with CIBC, which was subsequently reduced to $300 million. The Bank cancelled the credit facility effective 1 March 2011. Balance Sheet Management Advisory Agreement The Bank entered into a Balance Sheet management advisory agreement with Carlyle Investment Management LLC, an afﬁliated company of the Carlyle Group with an effective date of 1 October 2010. Per the agreement the Carlyle Group has agreed to provide Balance Sheet management advisory services to the Bank, including advisory services on valuation assessments, for an annual fee of $4 million for a three-year period. Financial instruments with related parties At 31 December 2011, the Bank held $15.9 million in cash and cash equivalents with CIBC and CIBC held $1 million in deposits with the Bank. For the year ended 31 December 2011, the Bank held forward exchange contracts with CIBC with a notional amount of $295.8 million and a net realised loss amount of $5.7 million. As noted in Note 16, the Bank enters into client service forward exchange contracts to meet the foreign exchange needs of its customers. NOTE 27: COMPARATIVE INFORMATION Certain prior period ﬁgures have been reclassiﬁed to conform to current period presentation. NOTE 28: SUBSEQUENT EVENTS The Financial Statements were available to be issued and subsequent events have been evaluated up to 29 February 2012. Butterﬁeld Annual Report 2011 101 SHAREHOLDER INFORMATION DIRECTORS’ AND EXECUTIVE OFFICERS’ SHARE INTERESTS AND DIRECTORS’ SERVICE CONTRACTS SHARE DEALING SERVICE Pursuant to Regulation 6.8(3) of Section IIA of the Bermuda Stock Exchange Listing regulations, the ownership of Common Shares and Contingent Value Convertible Preference Shares of the Bank by all Directors and Executive Ofﬁcers as at 31 December 2011 was 7,750,255 Shares. In addition, this group owns 140 Non-Cumulative Perpetual Limited Voting Preference Shares. As of 31 December 2011, Executive Ofﬁcers also owned 23,470,000 stock options pursuant to the 2010 Stock Option Plan to vest in accordance with timelines established by the Plan. In 2010, a Non-Executive Director received additional compensation in the form of a one-time Share grant of 172,413 Shares to vest over a two-year period. None of the Directors or Executive Ofﬁcers had any interest in any debt securities issued by the Bank or its subsidiaries as at 31 December 2011. There are no service contracts with Directors, except for that of Bradford Kopp, President & Chief Executive Ofﬁcer, whose contract expires on 1 March 2013. Save for the foregoing contract, and those arrangements described in Note 26 to the Bank’s Financial Statements, there are no other contracts of signiﬁcance subsisting during or at the end of the ﬁnancial year ended 31 December 2011 in which a Director of the Bank is or was materially interested, either directly or indirectly. EXCHANGE LISTING The Bank’s Shares are listed on the Bermuda Stock Exchange (BSX) and the Cayman Islands Stock Exchange (CSX), which are located at: BERMUDA STOCK EXCHANGE (Primary Listing) 30 Victoria Street Hamilton, HM 12 P.O. Box HM 1369 Hamilton HM FX Bermuda Tel: (441) 292 7212 Fax: (441) 292 7619 www.bsx.com CAYMAN ISLANDS STOCK EXCHANGE (Secondary Listing) Elizabethan Square, 4th Floor P.O. Box 2408 George Town, Grand Cayman Cayman Islands Tel: (345) 945 6060 Fax: (345) 945 6061 www.csx.com.ky 102 Butterﬁeld Securities (Bermuda) Limited 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3972 Fax: (441) 292 9947 E-mail: info@butterﬁeldgroup.com SHARE PRICE Published daily in The Royal Gazette in Bermuda and available on Bloomberg Financial Markets (symbol: NTB BH). Also available on the BSX and CSX websites. REGISTRAR AND TRANSFER AGENT Butterﬁeld Fulcrum Group (Bermuda) Limited Rosebank Centre 11 Bermudiana Road Pembroke, HM 11 Bermuda Tel: (441) 299 3882 Fax: (441) 295 6759 E-mail: bntbshareholders@bfgl.com MEDIA RELATIONS / PUBLICATION REQUESTS Marketing & Corporate Communications Tel: (441) 299 1624 E-mail: mark.johnson@butterﬁeldgroup.com INVESTOR RELATIONS Senior Vice President, Finance Tel: (441) 298 4758 E-mail: john.maragliano@butterﬁeldgroup.com WRITTEN NOTICE OF SHARE REPURCHASE PROGRAMME — BSX REGULATION 6.38 No Shares were purchased under any Share repurchase programme in 2011. LARGE SHAREHOLDERS At 31 December 2011, the following were registered holders of 5% or more of the issued Share capital: Canadian Imperial Bank of Commerce, 18.64% Carlyle Global Financial Services Partners LP, 18.64% Wellcome Trust Investments, 6.88% Ithan Creek Master Investor (Cayman) LP, 6.71% Rosebowl Western, 6.71% PRINCIPAL OFFICES & SUBSIDIARIES THE BAHAMAS This list does not include all companies in the Group. The Bank of N.T. Butterﬁeld & Son Limited Group Parent Company, Community Banking, Private Banking, Credit and Treasury Services Head Ofﬁce 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 295 1111 Fax: (441) 292 4365 SWIFT: BNTB BM HM E-mail: info@butterﬁeldgroup.com Mailing Address: P.O. Box HM 195 Hamilton, HM AX Bermuda BERMUDA Country Head: Michael Collins, Senior Executive Vice President Butterﬁeld Asset Management Limited Investment Management Managing Director: Michael Neff 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3817 Fax: (441) 292 9947 E-mail: info@butterﬁeldgroup.com Butterﬁeld Securities (Bermuda) Limited Brokerage Services 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3972 Fax: (441) 292 9947 E-mail: info@butterﬁeldgroup.com Butterﬁeld Trust (Bermuda) Limited Grosvenor Trust Company Limited Personal Trust and Corporate Trust Managing Director: Martin Pollock 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3980 Fax: (441) 292 1258 E-mail: info@butterﬁeldgroup.com Butterﬁeld Bank (Bahamas) Limited Trust & Fiduciary Services, Wealth Management Managing Director: Julien Martel Third 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: bahamas@butterﬁeldgroup.com BARBADOS Butterﬁeld Bank (Barbados) Limited Community Banking Managing Director: Lloyd Wiggan 1st Floor, Carlisle House Hincks Street Bridgetown, BB11000 Barbados Tel: (246) 431 4500 Fax: (246) 429 2428 E-mail: barbados@butterﬁeldgroup.com CAYMAN ISLANDS Butterﬁeld Bank (Cayman) Limited Community Banking, Private Banking, Asset Management, Personal Trust and 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: cayman@butterﬁeldgroup.com Butterﬁeld Annual Report 2010 103 GUERNSEY SWITZERLAND Butterﬁeld Bank (Guernsey) Limited Private Client and Institutional Banking, Credit, Investment Management, Custody and Custodian Trustee Services, Administered Banking Managing Director: John Robinson 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: guernsey@butterﬁeldgroup.com 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 728 665 E-mail: guernsey@butterﬁeldgroup.com Butterﬁeld Trust (Switzerland) Limited Trust and Company Services Managing Director: Jim Parker Boulevard des Tranchées 16 1206 Geneva, Switzerland Tel: (41) 22 839 0000 Fax: (41) 22 839 0099 E-mail: switzerland@butterﬁeldgroup.com UNITED KINGDOM Butterﬁeld Bank (UK) Limited Private Banking, Asset Management, Wealth Management, Credit and Treasury Services Managing Director: Raymond Sykes 99 Gresham Street London, EC2V 7NG United Kingdom Tel: (44) 207 776 6700 Fax: (44) 207 776 6701 E-mail: uk@butterﬁeldgroup.com 104

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