ANALYSIS OF RESULTS OF OPERATIONS

Net interest income, the “spread” between earnings on interest-earning assets and the interest paid on interest-bearing liabilities, constitutes the largest source of our earnings. Other factors that significantly affect operating results are the provision for loan losses, noninterest income such as service fees and noninterest expenses such as salaries, occupancy expense, equipment expense and other overhead costs, as well as the effects of income taxes.

Net Interest Income

Net interest income on a reported basis amounted to $136.5 million in 2013, $135.2 million in 2012, and $132.2 million in 2011. For internal purposes and in the discussion that follows, we evaluate our net interest income on a tax-equivalent basis by adding the tax benefit realized from tax-exempt securities to reported interest income. Net interest income on a tax-equivalent basis amounted to $138.0 million in 2013, $136.7 million in 2012, and $133.8 million in 2011. Management believes that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods. The following is a reconciliation of reported net interest income to tax-equivalent net interest income.

Table 2 analyzes net interest income on a tax-equivalent basis. Our net interest income on a tax-equivalent basis increased by 1.0% in 2013 and 2.2% in 2012. There are two primary factors that cause changes in the amount of net interest income we record - 1) our net interest margin (tax-equivalent net interest income divided by average interest-earning assets), and 2) changes in our loans and deposits balances.

The minor increases in net interest income over the past two years have been primarily due to an increase in our net interest margin during those periods. “Net interest margin” is a ratio we use to measure the spread between the yield on our earning assets and the cost of our funding and is calculated by taking tax-equivalent net interest income and dividing by average earning assets. Our net interest margin increased from 4.72% in 2011 to 4.78% in 2012 to 4.92% in 2013.

For the past several years, the nation has been in a very low interest rate environment with maturing assets and liabilities originated in prior periods generally repricing at progressively lower interest rates at renewal/maturity. The primary reasons for the increases in our net interest margin has been – 1) yields on our interest-earning assets have declined by a smaller amount than the rates we have paid on our interest bearing liabilities, and 2) favorable changes in the mix of our deposit base. From 2011 to 2013, the yield we earned on our interest-earning assets declined 24 basis points, from 5.55% to 5.31%, while the average rate paid on interest-bearing liabilities declined by 44 basis points, from 0.90% to 0.46%. Positively impacting our yield on assets has been the continued use of interest rate floors on loans, as well as higher levels of loan discount accretion – see below.

As it relates to our interest-bearing liabilities, we have been able to lower interest rates on maturing time deposits that were originated in prior periods, and we have also been able to progressively lower interest rates on various types of interest-bearing checking, savings, and money market accounts. The average interest rate paid on our interest bearing deposits declined from 0.88% in 2011 to 0.43% in 2013. Also, the funding mix of our liabilities had a positive impact on our net interest margin. As calculated from Table 2, the average amount of our lower cost deposits, comprised of checking accounts (non-interest bearing and interest bearing), money market accounts and savings accounts, steadily increased from $1.4 billion in 2011 to $1.7 billion in 2013, an increase of 27%, while the average amount of our higher cost funding, comprised of time deposits and borrowings, declined from $1.6 billion to $1.1 billion over that same period, a change of 29%.

The net interest margin for all periods benefited, by varying amounts, from the net accretion of purchase accounting premiums/discounts associated with the Cooperative Bank acquisition in June 2009 and, to a lesser degree, The Bank of Asheville acquisition in January 2011. As can be seen in the table below, we recorded $19.8 million in 2013, $16.1 million in 2012, and $11.6 million in 2011, in net accretion of purchase accounting premiums/discounts that increased net interest income.

The biggest component of the purchase accounting adjustments was loan discount accretion, which amounted to $20.2 million in 2013, $16.5 million in 2012 and $11.6 million in 2011. The higher amounts of discount accretion are due to payoffs of loans with loan discounts and increased expectations regarding the collectability of other loans.

Table 3 presents additional detail regarding the estimated impact that changes in loan and deposit volumes and changes in the interest rates we earned/paid had on our net interest income in 2012 and 2013. Table 3 indicates that in 2012, changes in interest rates were the primary reason for the increase in net interest income, with the impact of the lower rates reducing interest expense by $5.0 million, while interest income was only reduced by $1.5 million due to rates. Thus, lower interest rates was the primary reason that net interest income increased by $3 million during the year. In 2013, an almost equal combination of changes in the mix of our liability volumes, primarily our deposit mix, and lower interest rates resulted in interest expense declining by $6.3 million. Interest income declined in 2013, primarily due to lower interest rates, by only $5.0 million. This combination of factors resulted in net interest income increasing by $1.3 million in 2013 compared to 2012. As noted previously, for both years, average interest rates on assets benefitted from interest rate floors on loans and higher levels of loan discount accretion, while interest expense benefited from a shifting funding mix and lower rates that we paid on our deposit accounts.

See additional information regarding net interest income in the section entitled “Interest Rate Risk.”

Provision for Loan Losses

The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered appropriate to absorb probable losses inherent in our loan portfolio. Management’s determination of the adequacy of the allowance is based on our level of loan growth, an evaluation of the loan portfolio, current economic conditions, historical loan loss experience and other risk factors.

Our provisions for loan losses and nonperforming assets remain at what we believe to be elevated levels, primarily due to challenging economic conditions, including high unemployment rates that impact borrower repayment ability and lower property values that negatively impact collateral dependent real estate loans. For 2013, 2012, and 2011, our total provisions for loan losses were $30.6 million, $79.7 million, and $41.3 million, respectively. The total provision for loan losses is comprised of provision for loan losses for non-covered loans and provision for loan losses for covered loans, as discussed in the following paragraphs.

We recorded $18.3 million, $70.0 million, and $28.5 million in provisions for loan losses related to non-covered loans for the years ended December 31, 2013, 2012, and 2011, respectively. The lower provision in 2013 compared to the level in 2012 was primarily a result of 1) a $32.9 incremental provision for losses recorded in the fourth quarter of 2012 in connection with a loan sale, and 2) a first quarter of 2012 internal review of non-covered loans that applied more conservative assumptions to estimate the probable losses associated with some of our nonperforming loan relationships. We recorded a provision for loan losses on non-covered loans of $18.6 million in the first quarter of 2012, of which approximately $11 million related specifically to the special internal review.

As it relates to the loan sale, in late 2012, we identified approximately $68 million of non-covered higher-risk loans that we solicited bids for from several third-party investors. Based on an offer to purchase these loans that was received in December, we wrote the loans down by approximately $38 million to their estimated liquidation value of approximately $30 million and reclassified them as “loans held for sale.” The sale of substantially the same pool of loans was completed on January 23, 2013. The incremental provision for loan losses that was necessary as a result of this transaction was approximately $32.9 million, which included the net impact of several factors affecting our calculation of the allowance for loan losses.

The aforementioned special internal review related to non-covered loans and was initiated due to refinements to our loan loss model and internal control changes occurring in the first quarter of 2012 that resulted in a realignment of departmental responsibilities for determining our allowance for loan losses. As a result of the changes, an internal review of selected nonperforming loan relationships was conducted, which applied more conservative assumptions to estimate the probable losses and to allow for a more timely resolution of the related credits. The review identified approximately 30 loan relationships in which additional provisions for loan losses were necessary when more conservative judgments were applied to the repayment assumptions associated with the borrowers. The majority of the additional provision was concentrated in construction and land development real estate, commercial real estate, and residential real estate loan categories. Many of these same loans were included in the loans transferred to the “loans held for sale” category in the fourth quarter of 2012 and were sold in January 2013.

If not for the impact of the two 2012 events discussed above, our provisions for loan losses on non-covered loans would have been $26-28 million in both 2011 and 2012 compared to $18.3 million in 2013. We believe the lower provision for loan losses in 2013 was largely due to the 2012 loan sale that resulted in the disposition of some of the largest, highest risk loans in our portfolio, many of which would likely have resulted in losses in 2013 had they not been sold. As discussed below in the section “Nonperforming Assets,” despite the loan sale, our classified and nonperforming loans steadily increased in 2013. However, we believe this increase is due partially to recent senior management additions to our credit administration department, who are taking a more conservative approach to assessing loans than had been past practice, as opposed to any significant level of overall credit deterioration. Additionally, based on our review of the underlying classified and nonperforming credits, we believe that, on average, the severity of the loss rate inherent in our classified loans is less than in recent years. Accordingly, at the present time and based on current conditions, we do not expect a material increase in our provision for loan losses in 2014 compared to 2013.

As it relates to covered loans, we recorded $12.4 million, $9.7 million and $12.8 million in provisions for loan losses during 2013, 2012 and 2011, respectively. These provisions were necessary to provide for loans that showed signs of collection problems during the respective periods, as well as to provide for collateral dependent nonaccrual loans for which we received updated appraisals during the year that reflected lower collateral valuations.  The increase in provisions for loan losses on covered loans from 2012 to 2013 was primarily the result of several large credits that deteriorated during the first quarter of 2013 and were placed on nonaccrual status. The decline in the provision for loan losses on covered loans from 2011 to 2012 was primarily due to lower levels of covered nonperforming loans during the period and stabilization in the underlying collateral values of nonperforming loans. Because of the FDIC loss share agreements in place for these loans, the FDIC indemnification asset was adjusted upwards by recording noninterest income of $9.6 million, $6.6 million, and $10.2 million in 2013, 2012, and 2011, respectively, or 80% of the amount of the provisions. For $0.3 million and $1.5 million of the 2013 and 2012 provision for loan losses on covered loans, respectively, we did not record a corresponding increase to the indemnification asset because we believe that the loan losses will occur after the expiration of the Cooperative Bank non-single family loss share agreement that expires in June 2014 and after the expiration of the Bank of Asheville non-single family loss share agreement that expires in January 2016.

Total net charge-offs for the years ended December 31, 2013, 2012, and 2011, were $28.5 million, $74.7 million, and $49.3 million, respectively. These amounts were comprised of net charge-offs on both non-covered loans and on covered loans.

Net-charge offs for non-covered loans were $15.6 million, $64.0 million, and $31.2 million for 2013, 2012, and 2011, respectively. The significant increase in 2012 was due to the loan sale discussed above which resulted in charge-offs of $37.8 million. The ratio of net charge-offs to average non-covered loans was 0.72%, 3.02%, and 1.52% for 2013, 2012, and 2011, respectively. Notwithstanding the impact of the loan sale, the relatively high level of net charge-offs during 2012 and 2011 was primarily a result of unfavorable economic conditions, especially related to real estate, that resulted in higher levels of borrowers not repaying their loans and the corresponding collateral not being sufficient to pay off the balances. Net charge-offs were lower in 2013, which is reflective of improving economic conditions and lower levels of our highest-risk loans.

Net charge-offs for covered loans were $12.9 million, $10.7 million, and $18.1 million in 2013, 2012, and 2011, respectively. The charge-offs of covered loans were primarily a result of declining collateral values on collateral dependent nonaccrual loans. 

As seen in Tables 14 and 14a, in 2013, 2012, and 2011, our provisions for loan losses and net charge-offs for both covered and non-covered loans were concentrated in loans classified as “real estate – construction, land development & other land loans.”  This category of loans is primarily comprised of land acquisition and development loans and other types of lot loans.  These types of loans were particularly hard hit by the decline in real estate development and property values that occurred in the recession.  As can be seen in Table 10, although we have reduced our exposure to this category of loans, we continue to have significant exposure to this sector, and future material losses could result.

See “Nonperforming Assets” below for further discussion of our asset quality, which impacts our provisions for loan losses.

See the section entitled “Allowance for Loan Losses and Loan Loss Experience” below for a more detailed discussion of the allowance for loan losses. The allowance is monitored and analyzed regularly in conjunction with our loan analysis and grading program, and adjustments are made to maintain an adequate allowance for loan losses.

Noninterest Income

Our noninterest income amounted to $23.5 million in 2013, $1.4 million in 2012, and $26.2 million in 2011.

As shown in Table 4, core noninterest income excludes gains from acquisitions, foreclosed property write-downs and losses, indemnification asset income, securities gains or losses, and other miscellaneous gains and losses. Core noninterest income amounted to $28.2 million in 2013, a 10.7% increase from the $25.5 million in 2012. The 2012 core noninterest income of $25.5 million was a 10.0% increase from the $23.2 million recorded in 2011.

See Table 4 and the following discussion for an understanding of the components of noninterest income.

Service charges on deposit accounts amounted to $12.8 million, $11.9 million, and $12.0 million in 2013, 2012 and 2011, respectively. The increase in 2013 was primarily due to higher levels of overdraft fees due to a change in the fee structure for overdrafts. In comparing 2012 to 2011, our level of service charges on deposit accounts was relatively unchanged, which reflected the net impact of 1) a decrease in overdraft fees resulting from regulations that were enacted in the second half of 2011, and 2) the introduction of new fees on deposit accounts, such as fees for customers that elected to receive paper statements.

In December 2013, we introduced a new deposit product line-up. In addition to simplifying our product offering, which was a primary goal, other significant changes included the elimination of our free checking account for customers maintaining low account balances and the elimination of paper statement fees and certain overdraft fees. As a result of these changes, we expect a significant net increase in our service charges on deposits accounts in 2014 over 2013.

Other service charges, commissions and fees amounted to $9.3 million in 2013, a 5.5% increase from the $8.8 million earned in 2012. The 2012 amount of $8.8 million was a 9.5% increase from the $8.1 million earned in 2011. This category of noninterest income includes items such as electronic payment processing revenue (which includes fees related to credit card transactions by merchants and customers and fees earned from debit card transactions), ATM charges, safety deposit box rentals, fees from sales of personalized checks, and check cashing fees. The growth in this category for both years was primarily attributable to increased debit card usage by our customers, as we earn a small fee each time our customers make a debit card transaction. Also, part of the increase in this category is due to the overall growth in our total customer base, including growth achieved from corporate acquisitions.

Fees from presold mortgages amounted to $2.9 million in 2013, $2.4 million in 2012, and $1.6 million in 2011. The increases from 2011 to 2013 were due to high mortgage refinance activity resulting from low interest rates on home mortgages, as well as increased volume resulting from additional mortgage loan personnel we have added since 2012. While mortgage fees increased in 2013, mortgage refinance activity slowed towards the end of 2013 due to increases in interest rates on home mortgages that has persisted in 2014. Accordingly, we are expecting a decline in these fees in 2014.

Commissions from sales of insurance and financial products amounted to $2.1 million in 2013, $1.8 million in 2012, and $1.5 million in 2011. This line item includes commissions we receive from three sources - 1) sales of credit life insurance associated with new loans, 2) commissions from the sales of investment, annuity, and long-term care insurance products, and 3) commissions from the sale of property and casualty insurance. The following table presents the contribution of each of the three sources to the total amount recognized in this line item:

As can be seen in the above table, sales of investments, annuities and long term care insurance have almost doubled from 2011 to 2013. This was the result of an initiative and a renewed emphasis on this line of business that began in 2011. We hired a wealth management executive in 2011 who has steadily built a team of financial advisors that have grown this business.

Table 4 shows earnings from bank owned life insurance income were $1.1 million in 2013, $0.6 million in 2012, and less than $0.1 million in 2011. In the second quarters of 2013 and 2012, we purchased $15.0 million and $25.0 million, respectively, in bank-owned life insurance on certain employees. Income related to the growth of the cash value of the insurance was $1.1 million in 2013 and $0.6 million for 2012. We had minimal amounts of bank-owned life insurance prior to 2012.

Noninterest income not considered to be “core” resulted in a net reduction to total noninterest income of $4.7 million in 2013, a net reduction to noninterest income of $24.1 million in 2012, and a net contribution to total noninterest income of $3.0 million in 2011. The components of non-core noninterest income are shown in Table 4 and the significant components thereof are discussed below.

We recorded net gains on non-covered foreclosed properties of $1.3 million in 2013 compared to net losses on non-covered foreclosed properties of $15.3 million for 2012 and $3.4 million for 2011. As previously discussed, in the fourth quarter of 2012, we recorded write-downs totaling $10.6 million on substantially all of our non-covered foreclosed properties in connection with efforts to accelerate the sale of these assets. On average, the write-downs amounted to 29% of the carrying value of the properties. Stabilization in real estate market values and lower carrying values following the December 2012 write-down impacted the variance in 2013.

We recorded $0.4 million of net gains on covered foreclosed properties in 2013. In the fourth quarter of 2013, we realized several sizeable gains on sales of foreclosed properties, with the largest single gain being approximately $2.7 million. Losses on covered foreclosed properties amounted to $13.0 million and $24.5 million for the years ended December 31, 2012 and 2011, respectively. The lower level of losses on covered properties over the past two years has been primarily a result of lower levels of covered foreclosed properties, as well as stabilization in real estate market values in the coastal region of North Carolina, with some types of properties showing signs of appreciation over the past year. As discussed earlier and illustrated in the table below, there was a corresponding entry to indemnification asset income (expense) amounting to 80% of the losses (gains) recorded, that resulted in the bottom line impact of the covered asset gains or losses being 20% of the gross gains or losses.

Indemnification asset income (expense) for 2013, 2012, and 2011 amounted to ($6.8 million), $4.1 million, and $20.5 million, respectively. In 2013 and 2012, higher loan discount accretion and lower levels of loan and foreclosed property losses on covered assets resulted in less indemnification asset income (expense in 2013) in comparison to prior periods. Indemnification asset income and expense primarily relates to adjustments to the amount expected to be received from the FDIC under loss share agreements as a result of changes in anticipated loan losses and foreclosed property losses and write-downs, as follows:

In 2011, as previously discussed, we realized a gain from the FDIC-assisted acquisition of a failed bank amounting to $10.2 million, which was the amount by which the fair value of the assets purchased exceeded the fair value of liabilities assumed in the transaction.

We recorded $0.5 million, $0.6 million, and $0.1 million in gains on sales of securities during 2013, 2012, and 2011, respectively.

The line item “Other gains (losses)” was negatively impacted in 2012 by $0.5 million in prepayment penalties associated with paying off $65 million in borrowings prior to their maturity dates, while the amounts for the other two years presented were insignificant.

Noninterest Expenses

Total noninterest expenses over each of the past three years have been relatively flat, totaling $96.6 million, $97.3 million and $96.1 million for 2013, 2012 and 2011, respectively. Table 5 presents the components of our noninterest expense during the past three years. Line items with the largest fluctuations are discussed below.

Total personnel expense increased from $53.3 million in 2012 to $54.8 million in 2013, an increase of $1.4 million or 2.7%. Salaries expense increased $3.8 million, which was primarily associated with the hiring of employees in the three loan production offices that we opened in the second half of 2013, as well as additions to the mortgage, wealth management, and credit administration departments of the company. The new employees in mortgage and wealth management were hired in order to grow those lines of business throughout our footprint, while the hiring in our credit administration department was initiated to better manage our loan portfolio and to enhance our loan processes in ways that we believe will be more responsive to our customers and enhance our future growth. The increase in salaries expense in 2013 was largely offset by a decrease in employee benefits expense. Employee benefits expense decreased by $2.4 million, or 19.7%, in comparing 2013 to 2012, which is primarily attributable to the freezing of two pension plans as of December 31, 2012. Pension expense for the year ended December 31, 2012 was $2.6 million in comparison to pension income of $0.6 million recorded in 2013. The pension income we recorded in 2013 relates to investment income from the pension plan’s assets.

For 2012, total personnel expense increased from $51.4 million to $53.3 million, an increase of approximately $1.9 million, or 3.7%, from 2011. Salaries expense totaled $1.5 million of this increase, which was primarily associated with the hiring of additional key employees in order to build our infrastructure and to expand our wealth management capabilities. Employee benefits expense increased by approximately $0.4 million in 2012, which was a 3.4% increase from 2011 and corresponds to the increase in salaries expense.

Net occupancy expenses have remained relatively stable over the past three years, amounting to $7.1 million in 2013, $7.0 million in 2012, and $6.6 million in 2011. The largest component of occupancy expense is depreciation expense for our buildings. Our number of branches grew from 92 at the beginning of 2011 to 97 by the end of 2012, resulting in an increase in occupancy expense from 2011 to 2012.

Equipment related expenses were $4.4 million, $4.8 million, and $4.3 million, in 2013, 2012, and 2011, respectively. The increase in 2012 primarily related to an increase in ATM maintenance expenses, primarily due to additional regulatory requirements for ATMs.

In 2011, we incurred acquisition expenses of approximately $0.6 million in connection with The Bank of Asheville acquisition. These expenses consisted primarily of professional fees.

Collection expenses remain elevated due to relatively high levels of delinquencies, although our collection expenses on both non-covered and covered assets have declined in each of the past two years. Collection expenses on non-covered assets amounted to $2.2 million in 2013, $3.1 million in 2012, and $3.5 million in 2011. The significant decrease in 2013 was primarily a result of the loan sale that eliminated our collection responsibilities for those loans. Collection expenses on covered loans, net of FDIC reimbursement, amounted to $0.7 million in 2013, $1.6 million in 2012, and $2.0 million in 2011. The decreases over each of the past two years are a result of the steady declines in our level of covered assets.

Outside consultant expense increased to $2.5 million in 2013 from approximately $1.9 million in each of the prior two years as a result of a new engagement of a third-party consultant to assist us in many areas of our business.

In the second half of 2012, we began an initiative to review and reduce overhead expenses wherever possible. This included assistance from the consulting firm noted above, which assisted us in negotiating certain contracts. Largely as a result of this expense initiative, we experienced the declines shown in Table 5 in stationery and supplies, telephone, and other operating expenses.

We recorded $1.9 million in severance expenses in 2013 due to the separation from service of several employees during the year, including our former chief executive officer. In 2012, severance expenses amounted to $0.5 million, while we did not record any such expenses in 2011.

Income Taxes

Table 6 presents the components of income tax expense and the related effective tax rates. We recorded income tax expense of $12.1 million in 2013, which resulted in an effective tax rate of 36.9%. Impacting our effective tax rate in 2013 was the recording of incremental tax expense of $0.5 million to reduce the value of our deferred tax asset as a result of statutory decreases in North Carolina’s state income tax rate. We recorded an income tax benefit of $17.0 million for 2012 due to the net loss reported for the period, which was approximately 42.0% of the reported net loss. We recorded income tax expense of $7.4 million in 2011, which resulted in an effective tax rate of 35.1% in 2011. The differences in our effective tax rates from the blended statutory income tax rate of 39% are primarily due to tax-exempt interest income. We expect our effective tax rate to be approximately 35% in 2014.

Stock-Based Compensation

We recorded stock-based compensation expense of $0.2 million, $0.3 million, and $0.9 million for the years ended December 31, 2013, 2012, and 2011, respectively. See Note 15 to the consolidated financial statements for more information regarding stock-based compensation.

ANALYSIS OF FINANCIAL CONDITION AND CHANGES IN FINANCIAL CONDITION

Overview

Over the past three years, our total assets have remained fairly stable at approximately $3.2 billion to $3.3 billion. The following table presents detailed information regarding the nature of changes in our loans and deposits in 2012 and 2013:

In 2013, as derived from the table above, our total loans increased by $87 million, or 3.6%. During that period, we experienced internal growth in our non-covered loan portfolio of $142 million, or 6.8%, while our covered loans declined by $72 million, or 25.5%. Also impacting growth was the March 2013 acquisition of two branches with approximately $16 million in loans (see Note 2 to the consolidated financial statements for more information). In 2013, we charged-off $32 million in total loans and foreclosed on $22 million in loans that reduced our loan balances. We continue to pursue lending opportunities in order to improve our asset yields.

In 2012, as derived from the table above, our total loans declined $54 million, or 2.2%. We experienced internal growth in our non-covered loan portfolio of $93 million, or 4.5%, during 2012, while our covered loans declined by $79 million, or 21.8%. However, much of our non-covered loan growth was offset by the charge-down and reclassification of approximately $68 million in non-covered higher-risk loans to “loans held for sale” during the fourth quarter of 2012. Also offsetting our internal growth of loans were normal loan pay-downs, foreclosures, and loan charge-offs. In 2012, in addition to the $38 million in charge-offs related to the loan sale, we charged-off an additional $39.3 million in loans (resulting in total charge-offs for the year of $77.3 million) and foreclosed on another $54 million in loans that reduced our loan balances.

During 2013, we experienced a net decline in total deposits of $70.3 million, which was a result of growth in our low-cost core deposits (checking, money market, and savings) that was more than offset by declines in our time deposit accounts. For the year, internal growth of $96 million in our core deposit accounts plus acquired growth of $57 million was more than offset by a $224 million decline in time deposits. The growth in core deposits along with cash we received during the year from FDIC loss-share reimbursements and foreclosed property sales allowed us to lessen our reliance on higher cost time deposits. As previously discussed, our net interest margin benefited from this shift.

For the year ended December 31, 2012, growth in our lower cost core deposit accounts exceeded the decline in our higher cost time deposits, which resulted in a net increase in internally generated deposits of $57 million, or 2.1%. Our lowest cost deposits, noninterest bearing checking accounts and interest bearing checking accounts, experienced positive internal growth of $77 million and $96 million, respectively, which allowed us to continue to lessen our reliance on higher cost sources of funding in 2012, including internet deposits and time deposits, and benefited our net interest margin.

Our overall liquidity remained relatively unchanged in 2013 compared to 2012. Our liquid assets (cash and securities) as a percentage of our total deposits and borrowings decreased from 16.2% at December 31, 2012 to 16.1% at December 31, 2013.

Our capital ratios improved in 2013 due to almost $20 million in earnings for 2013. All of our capital ratios have continually exceeded the regulatory thresholds for “well-capitalized” status for all periods covered by this report. Our tangible common equity ratio was 7.46% at December 31, 2013, compared to 6.81% at December 31, 2012 and 6.58% at December 31, 2011.

At December 31, 2012, our non-covered nonperforming asset ratios included $22 million in nonperforming loans that were sold in January 2013. Upon the sale of those loans, our nonperforming asset quality ratios improved and then remained fairly constant for the remainder of the year. At December 31, 2013, our non-covered nonperforming assets to total non-covered assets was 2.78% compared to 2.79% at March 31, 2013 (after the loan sale) and 3.64% at December 31, 2012.

As it relates to the covered assets, it has now been 4.5 years since we acquired Cooperative Bank and 3 years since we acquired The Bank of Asheville in failed bank acquisitions, and we have worked through many of the problem assets. Our covered nonperforming assets have steadily declined over the past two years from $141 million at December 31, 2011 to $71 million at December 31, 2013.

Distribution of Assets and Liabilities

Table 7 sets forth the percentage relationships of significant components of our balance sheet at December 31, 2013, 2012, and 2011.

Our balance sheet mix has remained relatively stable over the past three years. On the asset side, our loan percentage has increased while the FDIC indemnification asset and foreclosed real estate percentages have decreased.

On the liability side, as previously discussed, we have experienced increases in our checking and other transaction accounts and declines in time deposits.

Securities

Information regarding our securities portfolio as of December 31, 2013, 2012, and 2011 is presented in Tables 8 and 9.

The composition of the investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits. We obtain fair values for the vast majority of our investment securities from a third-party investment recordkeeper, who specializes in securities purchases and sales, recordkeeping, and valuation. This recordkeeper provides us with a third-party report that contains an evaluation of internal controls that includes testwork of securities valuation. We further test the values we receive by comparing the values for a significant sample of securities to another third-party valuation service on a quarterly basis.

Total securities amounted to $227.0 million, $223.4 million, and $240.6 million at December 31, 2013, 2012, and 2011, respectively.

The majority of our “government-sponsored enterprise” securities are issued by the Federal Home Loan Bank and carry one maturity date, often with an issuer call feature. At December 31, 2013, of the $18 million (carrying value) in government-sponsored enterprise securities, $9 million were issued by the Federal Home Loan Bank system and the remaining $9 million were issued by the Federal Farm Credit Bank system.

Our $147 million of mortgage-backed securities have all been issued by either Freddie Mac, Fannie Mae, Ginnie Mae, or the Small Business Administration, each of which are government-sponsored corporations. We have no “private label” mortgage-backed securities. Mortgage-backed securities vary in their repayment in correlation with the underlying pools of mortgage loans.

At December 31, 2013, our $3.6 million investment in corporate bonds was comprised of the following:

We have concluded that the unrealized loss associated with the First Citizens Bancorp trust preferred security is due to liquidity and coupon rate considerations and not due to credit concerns.

Substantially all of our investment in equity securities at each year end was comprised of capital stock in the Federal Home Loan Bank of Atlanta (FHLB). The FHLB requires us to hold their stock as a requirement for membership in the FHLB system. The FHLB also requires us to purchase additional stock when we borrow from them. At December 31, 2013, our investment in capital stock of the FHLB amounted to $3.9 million of our total investment in equity securities of $4.0 million.

The fair value of securities held to maturity, which we carry at amortized cost, was $2.7 million more than the carrying value at December 31, 2013 and $5.4 million more than the carrying value at December 31, 2012. Our $54.0 million in securities held to maturity are comprised almost entirely of municipal bonds issued by state and local governments throughout our market area. We have only two municipal bonds with a denomination of $2 million or greater and we have no significant concentration of bond holdings from one government entity, with the single largest exposure to any one entity being $3.6 million. Management evaluated any unrealized losses on individual securities at each year end and determined them to be of a temporary nature and caused by fluctuations in market interest rates, not by concerns about the ability of the issuers to meet their obligations.

At December 31, 2013, net unrealized losses of $2.0 million were included in the carrying value of securities classified as available for sale. At December 31, 2012 and 2011, net unrealized gains of $3.3 million and $3.9 million, respectively, were included in the carrying value of securities classified as available for sale. During the past three years, interest rates have generally declined, which typically increases the value of our investment securities. However, during the last half of 2013, long-term interest rates began increasing, resulting in losses in our available for sale portfolio. Management evaluated any unrealized losses on individual securities at each year end and determined them to be of a temporary nature and caused by fluctuations in market interest rates and the overall economic environment, not by concerns about the ability of the issuers to meet their obligations. Net unrealized gains (losses), net of applicable deferred income taxes, of ($1.2 million), $2.0 million, and $2.4 million have been reported as part of a separate component of shareholders’ equity (accumulated other comprehensive income) as of December 31, 2013, 2012, and 2011, respectively.

The weighted average taxable-equivalent yield for the securities available for sale portfolio was 2.01% at December 31, 2013. The expected weighted average life of the available for sale portfolio using the call date for above-market callable bonds, the maturity date for all other non-mortgage-backed securities, and the expected life for mortgage-backed securities, was 4.5 years.

The weighted average taxable-equivalent yield for the securities held to maturity portfolio was 5.75% at December 31, 2013. The expected weighted average life of the held to maturity portfolio using the call date for above-market callable bonds and the maturity date for all other securities, was 5.0 years.

The following table provides the names of issuers for which the Company has investment securities totaling in excess of 10% of shareholders’ equity and the fair value and amortized cost of these investments as of December 31, 2013. All of these securities are issued by government sponsored corporations.

Loans

Table 10 provides a summary of the loan portfolio composition of our total loans at each of the past five year ends.

As previously discussed, in our acquisitions of Cooperative Bank and The Bank of Asheville, we entered into loss share agreements with the FDIC, which afford us significant protection from losses on all loans and other real estate acquired in those acquisitions. Because of the loss protection provided by the FDIC, the financial risk of the Cooperative Bank and The Bank of Asheville loans is significantly different from assets not covered under the loss share agreements. Accordingly, we present separately loans subject to the FDIC loss share agreements as “covered loans” and loans that are not subject to the loss share agreements as “non-covered loans.” Table 10a presents a breakout of covered and non-covered loans as of December 31, 2013.

The loan portfolio is the largest category of our earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans, and consumer loans. We restrict virtually all of our lending to our 37 county market area, which is located in western, central and eastern North Carolina, five counties in southern Virginia and four counties in northeastern South Carolina. The diversity of the region’s economic base has historically provided a stable lending environment.

In 2013, loans outstanding increased $86.7 million, or 3.6% to $2.5 billion, while in 2012, loans outstanding decreased $53.9 million, or 2.2% to $2.38 billion. In 2013, the increase in loans outstanding was due to improved loan demand in our market areas, the effects of which were partially offset by declines in our covered loan portfolio. In 2012, the decline was due to the previously discussed transfer of $68.2 million in loans to a “loans held for sale” category and a decline of $79 million in our covered loans, which more than offset $93 million in non-covered loan growth.

The majority of our loan portfolio over the years has been real estate mortgage loans, with loans secured by real estate consistently comprising 90% to 91% of our outstanding loan balances. Except for real estate construction, land development and other land loans, the majority of our “real estate” loans are personal and commercial loans where cash flow from the borrower’s occupation or business is the primary repayment source, with the real estate pledged providing a secondary repayment source.

Table 10 indicates that the two types of loans that have had the largest variances in the amount outstanding as a percent of total loans have been construction/land development loans, which have decreased, and commercial real estate loans, which have increased. In 2005 we expanded our branch network to what was then the fast-growing southeast coast of North Carolina, which had a high demand for construction and land development loans and resulted in our construction loan mix peaking to 23% at December 31, 2007. In 2008, due to recessionary conditions, particularly in the new housing market, loan demand for these types of loans weakened and we significantly tightened our loan underwriting criteria for these loans and generally did not seek to originate these types of loans. These same conditions and internal directives continued into 2013, which resulted in declines in our construction and land development loans. Additionally, these types of loans had high default rates during the recession, especially those associated with our failed bank acquisitions, thus causing further reductions in balances. These factors led to the mix of this loan type decreasing from their peak of 23% in 2007 to 12% of our total loans at December 31, 2013. In 2013, in connection with signs of economic recovery and continued stabilization of real estate values, we changed our internal directives to be more receptive to originating construction and land development loans, however with more conservative underwriting standards than existed prior to the recession.

As shown in Table 10, our commercial real estate loans have increased from 27% of our portfolio at December 31, 2009 to 35% at December 31, 2013. In 2011, our percentage of commercial real estate loans increased slightly due to The Bank of Asheville acquisition, as that bank’s primary business had been commercial lending. Since 2011, we have placed emphasis on originating small business loans, which we typically secure with real estate collateral. The emphasis on this type of loan is consistent with our community banking strategy and has also assisted us in growing the types of loans that qualified for a reduction in the dividend rate that we pay on preferred stock issued in connection with our participation in the Small Business Lending Fund.

Table 11 provides a summary of scheduled loan maturities over certain time periods, with fixed rate loans and adjustable rate loans shown separately. Approximately 16% of our accruing loans outstanding at December 31, 2013 mature within one year and 60% of total loans mature within five years. As of December 31, 2013, the percentages of variable rate loans and fixed rate loans as compared to total performing loans were 35% and 65%, respectively. We intentionally make a blend of fixed and variable rate loans so as to reduce interest rate risk. The mix of fixed rate loans has steadily increased over the past several years because many borrowers desire to lock in an interest rate during the historically low interest rate environment that has been in effect. While this presents risk to our company if interest rates rise, we measure our interest rate risk closely and, as discussed in the section “Interest Rate Risk” below, we do not believe that an increase in interest rates would materially negatively impact our net interest income.

Nonperforming Assets

Nonperforming assets include nonaccrual loans, troubled debt restructurings, loans past due 90 or more days and still accruing interest, nonperforming loans held for sale, and foreclosed real estate. As a matter of policy we place all loans that are past due 90 or more days on nonaccrual basis, and thus there were no loans at any of the past five year ends that were 90 days past due and still accruing interest.

Nonaccrual loans are loans on which interest income is no longer being recognized or accrued because management has determined that the collection of interest is doubtful. Placing loans on nonaccrual status negatively impacts earnings because (i) interest accrued but unpaid as of the date a loan is placed on nonaccrual status is reversed and deducted from interest income, (ii) future accruals of interest income are not recognized until it becomes probable that both principal and interest will be paid and (iii) principal charged-off, if appropriate, may necessitate additional provisions for loan losses that are charged against earnings. In some cases, where borrowers are experiencing financial difficulties, loans may be restructured to provide terms significantly different from the originally contracted terms.

Table 12 summarizes our nonperforming assets at the dates indicated. Because of the loss protection provided by the FDIC, we present separately nonperforming assets subject to the loss share agreements as “covered” and nonperforming assets that are not subject to the loss share agreements as “non-covered.”

Due largely to the economic downturn that began in late 2007 and continued to worsen over succeeding years, we experienced significant increases in our non-covered nonperforming assets, with total non-covered nonperforming assets rising steadily from $11 million at December 31, 2007 to their peak of $146 million at September 30, 2012.

In order to reduce our level of nonperforming assets and lower our overall risk profile, in the fourth quarter of 2012, we identified approximately $68 million of non-covered higher-risk loans, including both performing and non-performing loans, that we targeted for a sale to a third party investor. Based on an offer to purchase these loans that was received in December 2012, we wrote-down the loans by approximately $38 million to their estimated liquidation value of approximately $30 million and reclassified them as “loans held for sale.” Of the $68 million in loans targeted for sale, approximately $38 million had been classified as nonaccrual loans, $11 million had been classified as accruing troubled debt restructurings and the remaining $19 million performing classified loans. The completion of the sale of these loans occurred in January 2013 with sales proceeds of approximately $30 million being received. In the fourth quarter of 2012, we also recorded write-downs totaling $10.6 million on substantially all of our non-covered foreclosed properties in connection with efforts to accelerate the sale of these assets.

As a result of the above actions, our non-covered nonperforming assets decreased from their peak level of $146 million at September 30, 2012 to $106 million at December 31, 2012, which reflects the write-downs of the loans and foreclosed properties, to $83 million at March 31, 2013, which reflects the completion of the January 2013 loan sale. Since that time, our level of non-covered nonperforming assets has not varied significantly and amounted to $82 million at December 31, 2013. Over the last three quarters of 2013, our nonperforming loans increased by approximately $7 million and our foreclosed properties declined by $8 million as a result of increased sales activity, which was consistent with the intent of the write-downs taken in late 2012. At December 31, 2013, the ratio of non-covered nonperforming assets to total non-covered assets was 2.78% compared to 3.64% and 4.30% at December 31, 2012 and 2011, respectively.

Total covered nonperforming assets have steadily declined during the past two years, amounting to $70.6 million at December 31, 2013 compared to $96.2 million and $141.0 million at December 31, 2012 and 2011, respectively. Within this category, foreclosed real estate has declined to $24.5 million compared to $47.3 million at December 31, 2012 and $85.3 million at December 31, 2011. The Company is experiencing increased property sales activity, particularly along the North Carolina coast, where most of the Company’s covered foreclosed properties are located.

Table 12a presents our nonperforming assets at December 31, 2013 by general geographic region and further segregated into “covered” nonperforming assets and “non-covered” nonperforming assets. The majority of our nonperforming assets are located in the Eastern North Carolina region, which has experienced the most severe effects of the recession of any of our regions.

The following is the composition, by loan type, of all of our nonaccrual loans at each period end, as classified for regulatory purposes:

The following segregates our nonaccrual loans at December 31, 2013 into covered and non-covered loans, as classified for regulatory purposes:

The following segregates our nonaccrual loans at December 31, 2012 into covered and non-covered loans, as classified for regulatory purposes:

Among non-covered loans, the tables above indicate that residential first mortgage loans had the most significant variance, increasing from $5.0 million at December 31, 2012 to $12.3 million at December 31, 2013, which was the primary component in the overall increase in non-covered nonaccrual loans over that same period. This rise was caused by increased efforts to work with home borrowers on repayment plans, increased legal delays in the foreclosure process, and continued challenging economic conditions, especially in some of our more rural market areas.

The tables above indicate that covered nonaccrual loans increased from $33.5 million at December 31, 2012 to $37.2 million at December 31, 2013. This increase was due primarily to several large loans that deteriorated during the first quarter of 2013.

Management routinely monitors the status of certain large loans that, in management’s opinion, have credit weaknesses that could cause them to become nonperforming loans. In addition to the nonperforming loan amounts discussed above, management believes that an estimated $5 million of non-covered loans and $11 million of covered loans that were performing in accordance with their contractual terms at December 31, 2013 have the potential to develop problems depending upon the particular financial situations of the borrowers and economic conditions in general. Management has taken these potential problem loans into consideration when evaluating the adequacy of the allowance for loan losses at December 31, 2013 (see discussion below).

Loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed in the problem loan amounts and the potential problem loan amounts discussed above do not represent or result from trends or uncertainties that management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information that causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

We provide additional information regarding the classification status of our loans in tables contained in Note 4 to our consolidated financial statements. As it relates to non-covered loans, those tables indicate that from December 31, 2012 to December 31, 2013, our special mention loans have increased from $61 million to $93 million, our classified accruing loans have increased from $41 million to $79 million and our nonaccrual loans have increased from $33 million to $42 million. We believe these increases are primarily due to recent senior management additions to our credit administration department, who are taking a more conservative approach to assessing loans than had been past practice, as opposed to any significant deterioration in overall loan quality. We also believe that the severity of the loss rate inherent in our classified loans is less than in recent years. In addition, we believe that our allowance for loan losses on non-covered loans, which amounted to $44.3 million, or 1.96% of total non-covered loans, is sufficient to absorb the probable losses inherent in our loan portfolio at December 31, 2013. Accordingly, we do not believe that the increase in our special mention and classified assets is an indicator that our provision for loan losses will be materially higher in 2014 than it was in 2013.

Foreclosed real estate includes primarily foreclosed properties. Non-covered foreclosed real estate amounted to $12.3 million, $26.3 million, and $37.0 million at December 31, 2013, 2012, and 2011, respectively. The decrease in 2013 was the result of strong sales activity during 2013, which was consistent with our strategy implemented in 2012 to accelerate the disposition of foreclosed properties. The decrease in 2012 was due to write-downs of $10.6 million that were recorded in the fourth quarter of 2012. We recorded write-downs on substantially all of our non-covered foreclosed properties in connection with efforts to accelerate the sale of these assets.

At December 31, 2013, 2012 and 2011, we also held $24.5 million, $47.3 million, and $85.3 million, respectively, in foreclosed real estate that is subject to loss share agreements with the FDIC. The decrease in 2013 was due to increased property sales activity, particularly along the North Carolina coast, where most of our covered foreclosed properties are located. The decrease in 2012 was due to a combination of additional write-downs on foreclosed properties due to falling market prices and the actual sale of the foreclosed properties. During 2013, we sold $39 million of covered foreclosed properties, compared to $60 million in 2012 and $37 million in 2011.

The following table presents the detail of our foreclosed real estate at each of the past two year ends:

The following segregates our foreclosed real estate at December 31, 2013 into covered and non-covered:

The following segregates our foreclosed real estate at December 31, 2012 into covered and non-covered:

Allowance for Loan Losses and Loan Loss Experience

The allowance for loan losses is created by direct charges to operations (known as a “provision for loan losses” for the period in which the charge is taken). Losses on loans are charged against the allowance in the period in which such loans, in management’s opinion, become uncollectible. The recoveries realized during the period are credited to this allowance. We consider our procedures for recording the amount of the allowance for loan losses and the related provision for loan losses to be a critical accounting policy. See the heading “Critical Accounting Policies” above for further discussion.

The factors that influence management’s judgment in determining the amount charged to operating expense include past loan loss experience, composition of the loan portfolio, evaluation of probable inherent losses and current economic conditions.

We use a loan analysis and grading program to facilitate our evaluation of probable inherent loan losses and the adequacy of our allowance for loan losses. In this program, credit risk grades are assigned by management and tested by an independent third party consulting firm. The testing program includes an evaluation of a sample of new loans, loans we identify as having potential credit weaknesses, loans past due 90 days or more, loans originated by new loan officers, nonaccrual loans and any other loans identified during previous regulatory and other examinations.

We strive to maintain our loan portfolio in accordance with what management believes are conservative loan underwriting policies that result in loans specifically tailored to the needs of our market areas. Every effort is made to identify and minimize the credit risks associated with such lending strategies. We have no foreign loans, few agricultural loans and do not engage in significant lease financing or highly leveraged transactions. Commercial loans are diversified among a variety of industries. The majority of loans captioned in the tables discussed below as “real estate” loans are personal and commercial loans where real estate provides additional security for the loan. Collateral for virtually all of these loans is located within our principal market area.

The allowance for loan losses amounted to $48.5 million at December 31, 2013, compared to $46.4 million at December 31, 2012, and $41.4 million at December 31, 2011. At December 31, 2013, 2012, and 2011, $4.2 million, $4.8 million, and $5.8 million, respectively, of the allowance for loan losses is attributable to covered loans that have exhibited credit quality deterioration due to lower collateral valuations, while the allowance for loan losses for non-covered loans amounted to $44.3 million, $41.6 million, and $35.6 million, respectively, at those dates. For periods prior to 2010, the entire allowance for loan losses is attributable to non-covered loans.

The ratio of the allowance for non-covered loan losses to non-covered loans was 1.96%, 1.99%, and 1.72%, as of December 31, 2013, 2012, and 2011, respectively.

Table 13 sets forth the allocation of the allowance for loan losses at the dates indicated. The amount of the unallocated portion of the allowance for loan losses did not vary materially at any of the past three year ends. The allowance for loan losses is available to absorb losses in all categories. Table 13a segregates the allocation of the allowance for loan losses as of December 31, 2013 and 2012 into covered and non-covered categories.

Management considers the allowance for loan losses adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the allowance using our procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that we will not in any particular period sustain loan losses that are sizable in relation to the amount reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and losses on foreclosed real estate. Such agencies may require us to recognize additions to the allowance based on the examiners’ judgments about information available to them at the time of their examinations.

For the years indicated, Table 14 summarizes our balances of loans outstanding, average loans outstanding, and a detailed rollforward of the allowance for loan losses.

Table 14a presents a detailed rollforward of the 2013 and 2012 activity for the allowance for loan losses segregated into covered and non-covered activity.

Net loan charge-offs of non-covered loans amounted to $15.6 million in 2013, $64.0 million in 2012, and $31.2 million in 2011. Net non-covered charge-offs as a percentage of average non-covered loans represented 0.72%, 3.02%, and 1.52% during 2013, 2012, and 2011, respectively. The high amount/ratio in 2012 reflects the impact of the charge-offs we recorded in connection with the planned loan sale discussed earlier, which totaled approximately $37.8 million. The lower amount in 2013 is partially a result of the sale of our highest risk loans, which likely would have resulted in additional charge-offs in 2013, as well as generally lower loss severity rates that are associated with improvements in the economy and real estate prices.

We recorded $12.9 million, $10.7 million, and $18.1 million in net charge-offs of covered loans during 2013, 2012, and 2011, respectively, primarily related to collateral dependent nonaccrual loans for which we received updated appraisals that reflected lower valuations.

Deposits

At December 31, 2013, deposits outstanding amounted to $2.751 billion, a decrease of $70 million from the $2.821 billion at December 31, 2012. During 2013, we experienced strong growth in our noninterest-bearing and interest-bearing checking accounts, and an increase of $57 million in deposits acquired from two branch acquisitions. However, these increases were offset by declines in our higher cost time deposits, including brokered time deposits and internet time deposits. We have been able to lessen our reliance on higher-cost time deposits due to the continued growth in our transaction accounts and cash generated from our FDIC loss-share reimbursements and sales of foreclosed properties.

In 2012, deposits increased from $2.755 billion to $2.821 billion, an increase of $66 million, from December 31, 2011. We experienced significant growth in our noninterest-bearing and interest-bearing checking accounts during 2012. These increases were partially offset by declines in our higher cost time deposits, including brokered time deposits and internet time deposits.

The nature of our deposit growth is illustrated in the table on page 54. The following table reflects the mix of our deposits at each of the past three year ends:

Our deposit mix has shifted over the past few years to a heavier concentration in transaction accounts and less concentration in time deposits. The percentages for retail time deposits have declined because of a combination of 1) customers shifting their matured time deposits into checking accounts because of a steadily shrinking gap between the interest rates that the two products pay and 2) because of satisfactory levels of liquidity, we have chosen not to match certain promotional time deposit interest rates being offered by local competitors.

We routinely engage in activities designed to grow and retain deposits, such as (1) emphasizing relationship banking to new and existing customers, where borrowers are encouraged and normally expected to maintain deposit accounts with us, (2) pricing deposits at rate levels that will attract and/or retain deposits, and (3) continually working to identify and introduce new products that will attract customers or enhance our appeal as a primary provider of financial services.

In December 2013, we rolled out a new deposit product line-up. In addition to simplifying our product offering, which was a primary goal, other significant changes included the elimination of our free checking account for customers maintaining low account balances and the elimination of paper statement fees and certain overdraft fees. We do not expect these changes to have a material impact on our deposit balances in the short-term. In the long-term, we believe the simplified offering will enhance deposit growth.

Table 15 presents the average amounts of our deposits and the average yield paid for those deposits for the years ended December 31, 2013, 2012, and 2011.

As of December 31, 2013, we held approximately $564.5 million in time deposits of $100,000 or more. Table 16 is a maturity schedule of time deposits of $100,000 or more as of December 31, 2013. This table shows that 69% of our time deposits greater than $100,000 mature within one year.

At each of the past three year ends, we have no deposits issued through foreign offices, nor do we believe that we held any deposits by foreign depositors.

Borrowings

Our borrowings outstanding totaled $46.4 million at both December 31, 2013 and December 31, 2012, compared to $133.9 million at December 31, 2011. The decrease from 2011 to 2012 was primarily a result of a $65 million prepayment of FHLB borrowings we completed in the fourth quarter 2012 in order to reduce excess liquidity. The prepayment resulted in a penalty of $0.5 million that is included in the line item “other gains (losses), net” in Table 4.

Table 2 shows that average borrowings were $46.4 million in 2013, compared to $119.5 million in 2012 and $122.7 million in 2011.

At December 31, 2013, the Company had three sources of readily available borrowing capacity – 1) an approximately $312 million line of credit with the FHLB, of which none was outstanding at December 31, 2013 or 2012, 2) a $50 million overnight federal funds line of credit with a correspondent bank, of which none was outstanding at December 31, 2013 or 2012, and 3) an approximately $85 million line of credit through the Federal Reserve Bank of Richmond’s (FRB) discount window, of which none was outstanding at December 31, 2013 or 2012.

Our line of credit with the FHLB can be structured as either short-term or long-term borrowings, depending on the particular funding or liquidity need, and is secured by our FHLB stock and a blanket lien on most of our real estate loan portfolio. There were no borrowings under the FHLB line of credit at any month-end during 2013.

In addition to any outstanding borrowings from the FHLB that reduce the available borrowing capacity of the line of credit, our borrowing capacity was further reduced by $193 million and $143 million at December 31, 2013 and 2012, respectively, as a result of our pledging letters of credit backed by the FHLB for public deposits at each of those dates.

Our correspondent bank relationship allows us to purchase up to $50 million in federal funds on an overnight, unsecured basis (federal funds purchased). We had no borrowings under this line at December 31, 2013 or 2012. There were no federal funds purchased outstanding at any month-end during 2013.

We also have a line of credit with the FRB discount window. This line is secured by a blanket lien on a portion of our commercial and consumer loan portfolio (excluding real estate loans). Based on the collateral that we owned as of December 31, 2013, the available line of credit was approximately $85 million. At December 31, 2013 and 2012, we had no borrowings outstanding under this line. There were no FRB borrowings outstanding at any month-end during 2013.

Our outstanding borrowings at December 31, 2013 and 2012 were comprised entirely of $46.4 million in trust preferred security debt. We have initiated three trust preferred security issuances since 2002 totaling $67.0 million, with one of those issuances for $20.6 million being redeemed in 2007. These borrowings each have 30 year final maturities and were structured in a manner that allows them to qualify as capital for regulatory capital adequacy requirements. We may call these debt securities at par on any quarterly interest payment date five years after their issue date. We issued $20.6 million of this debt on October 29, 2002 (which we called in 2007), an additional $20.6 million on December 19, 2003, and $25.8 million on April 13, 2006. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 2.70% for the securities issued in 2003, and three-month LIBOR plus 1.39% for the securities issued in 2006.

Liquidity, Commitments, and Contingencies

Our liquidity is determined by our ability to convert assets to cash or to acquire alternative sources of funds to meet the needs of our customers who are withdrawing or borrowing funds, and our ability to maintain required reserve levels, pay expenses and operate the Company on an ongoing basis. Our primary liquidity sources are net income from operations, cash and due from banks, federal funds sold and other short-term investments. Our securities portfolio is comprised almost entirely of readily marketable securities which could also be sold to provide cash.

As noted above, in addition to internally generated liquidity sources, we currently (March 2014) have the ability to obtain borrowings from the following three sources – 1) an approximately $312 million line of credit with the FHLB, 2) a $50 million overnight federal funds line of credit with a correspondent bank, and 3) an approximately $85 million line of credit through the FRB’s discount window.

Our overall liquidity remained relatively unchanged from December 31, 2012 to December 31, 2013. Our liquid assets (cash and securities) as a percentage of our total deposits and borrowings decreased from 16.2% at December 31, 2012 to 16.1% at December 31, 2013.

We continue to believe our liquidity sources, including unused lines of credit, are at an acceptable level and remain adequate to meet our operating needs in the foreseeable future. We will continue to monitor our liquidity position carefully and will explore and implement strategies to increase liquidity if deemed appropriate.

In the normal course of business we have various outstanding contractual obligations that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows.

Table 18 reflects our contractual obligations and other commercial commitments outstanding as of December 31, 2013. All of our borrowings at December 31, 2013 consisted of trust preferred securities.

In the normal course of business there are various outstanding commitments and contingent liabilities such as commitments to extend credit, which are not reflected in the financial statements. The following table presents a summary of our outstanding loan commitments as of December 31, 2013:

At December 31, 2013 and 2012, we also had $14.5 million and $12.8 million, respectively, in standby letters of credit outstanding. We had no carrying amount for these standby letters of credit at either of those dates. The nature of the standby letters of credit is that of a guarantee made on behalf of our customers to suppliers of the customers to guarantee payments owed to the supplier by the customer. The standby letters of credit are generally for terms of one year, at which time they may be renewed for another year if both parties agree. The payment of the guarantees would generally be triggered by a continued nonpayment of an obligation owed by the customer to the supplier. The maximum potential amount of future payments (undiscounted) we could be required to make under the guarantees in the event of nonperformance by the parties to whom credit or financial guarantees have been extended is represented by the contractual amount of the financial instruments discussed above. In the event that we are required to honor a standby letter of credit, a note, already executed by the customer, becomes effective providing repayment terms and any collateral. Over the past two years, we have had to honor only a few standby letters of credit, which involved insignificant amounts of funds and without any loss to us. We expect any draws under existing commitments to be funded through normal operations.

It has been our experience that deposit withdrawals are generally able to be replaced with new deposits when needed. Based on that assumption, management believes that it can meet its contractual cash obligations and existing commitments from normal operations.

We are not involved in any legal proceedings that, in management’s opinion, are likely to have a material effect on the consolidated financial position of the Company.

Capital Resources and Shareholders’ Equity

Shareholders’ equity at December 31, 2013 amounted to $371.9 million compared to $356.1 million at December 31, 2012 and $345.2 million at December 31, 2011. The two basic components that typically have the largest impact on our shareholders’ equity are net income (loss), which increases (decreases) shareholders’ equity, and dividends declared, which decreases shareholders’ equity. Additionally, any stock issuances can significantly increase shareholders’ equity.

In 2013, the most significant factors that impacted our equity were 1) the $20.7 million net income reported for 2013, which increased equity, 2) common stock dividends declared of $6.3 million, which reduced equity, 3) preferred stock dividends declared of $0.9 million, which reduced equity, and 4) a $3.1 million increase in equity primarily related to unrealized gains experienced in our two pension plans (see Note 12 to the consolidated financial statements), which was offset by a $1.0 million decrease in equity related to unrealized losses in our securities portfolio. See the Consolidated Statements of Shareholders’ Equity within the consolidated financial statements for disclosure of other less significant items affecting shareholders’ equity.

In 2012, the most significant factors that impacted our equity were 1) the $23.4 million net loss reported for 2012, which reduced equity, 2) a $33.7 million capital raise comprised of a combination of preferred and common stock (see Note 19 to our consolidated financial statements), which increased equity, 3) an $8.5 adjustment related to the freezing of our two pension plans (see Note 12), which increased equity, 4) common stock dividends declared of $5.6 million, which reduced equity, and 5) preferred stock dividends declared of $2.8 million, which reduced equity.

In 2011, the most significant factors that impacted our equity were the redemption of $65.0 million of our Series A Preferred Stock issued under the U.S. Treasury’s Capital Purchase Program (also known as TARP) and the simultaneous issuance of $63.5 million of Series B Preferred Stock under the Treasury’s Small Business Lending Fund (SBLF). Net income of $13.6 million for 2011 increased equity, while common stock dividends declared of $5.4 million and preferred stock dividends declared of $3.2 million reduced equity. We also recorded accretion of the discount on preferred stock of $2.9 million due to the redemption of the Series A Preferred Stock. (See Note 19 to the consolidated financial statements for further information on these transactions.) Another significant factor negatively impacting equity in 2011 was a $4.5 million increase in accumulated other comprehensive loss that was caused by an increase in our pension liability. The increase in the pension liability was primarily due to the impact of lower interest rates on the actuarial calculations involved in determining the liability. Our policy is to use the Citigroup Pension Index yield curve in the computation of the pension liability. At December 31, 2011, that index had a weighted average rate of 4.39%, which was a decline from the rate of 5.59% at December 31, 2010.

We are not aware of any recommendations of regulatory authorities or otherwise which, if they were to be implemented, would have a material effect on our liquidity, capital resources, or operations.

The Company and the Bank must comply with regulatory capital requirements established by the FRB and the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. These capital standards require the Company and the Bank to maintain minimum ratios of “Tier I” capital to total risk-weighted assets (“Tier I Capital Ratio”) and total capital to risk-weighted assets (“Total Capital Ratio”) of 4.00% and 8.00%, respectively. Tier I capital is comprised of total shareholders’ equity, excluding unrealized gains or losses from the securities available for sale, less intangible assets, and total capital is comprised of Tier I capital plus certain adjustments, the largest of which for the Company and the Bank is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company and the Bank, adjusted for their related risk levels using formulas set forth in FRB and FDIC regulations.

In addition to the risk-based capital requirements described above, the Company and the Bank are subject to a leverage capital requirement, which calls for a minimum ratio of Tier I capital (as defined above) to quarterly average total assets (“Leverage Ratio) of 3.00% to 5.00%, depending upon the institution’s composite ratings as determined by its regulators. The FRB has not advised us of any requirement specifically applicable to the Company.

Table 21 presents our regulatory capital ratios as of December 31, 2013, 2012, and 2011. All of our capital ratios have significantly exceeded the minimum regulatory thresholds for all periods covered by this report.

In addition to the minimum capital requirements described above, the regulatory framework for prompt corrective action also contains specific capital guidelines for a bank’s classification as “well capitalized.” The specific guidelines are as follows – Tier I Capital Ratio of at least 6.00%, Total Capital Ratio of at least 10.00%, and a Leverage Ratio of at least 5.00%. If a bank falls below “well capitalized” status in any of these three ratios, it must ask for FDIC permission to originate or renew brokered deposits. The Bank’s regulatory ratios exceeded the threshold for “well-capitalized” status at December 31, 2013, 2012, and 2011 – see Note 16 to the consolidated financial statements for a table that presents the Bank’s regulatory ratios.

In addition to shareholders’ equity, we have supplemented our capital in past years with trust preferred security debt issuances, which because of their structure qualify as regulatory capital. This was necessary in past years because our balance sheet growth outpaced the growth rate of our capital. Additionally, we have frequently purchased bank branches over the years that resulted in our recording intangible assets, which negatively impacted regulatory capital ratios. As discussed in “Borrowings” above, we have issued a total of $67.0 million in trust preferred securities since 2002, with the most recent issuance being a $25.8 million issuance that occurred in April 2006. We currently have $46.4 million in trust preferred securities outstanding.

In this economic environment, our goal is to maintain our capital ratios at levels at least 200 basis points higher than the “well-capitalized” thresholds set for banks. At December 31, 2013, our total risk-based capital ratio was 16.80% compared to the 10.00% “well-capitalized” threshold.

In addition to regulatory capital ratios, we also closely monitor our ratio of tangible common equity to tangible assets (“TCE Ratio”). Our TCE ratio was 7.46% at December 31, 2013 compared to 6.81% at December 31, 2012.

See “Supervision and Regulation” under “Business” above and Note 16 to the consolidated financial statements for discussion of other matters that may affect our capital resources.

Off-Balance Sheet Arrangements and Derivative Financial Instruments

Off-balance sheet arrangements include transactions, agreements, or other contractual arrangements pursuant to which we have obligations or provide guarantees on behalf of an unconsolidated entity. We have no off-balance sheet arrangements of this kind other than letters of credit and repayment guarantees associated with our trust preferred securities.

Derivative financial instruments include futures, forwards, interest rate swaps, options contracts, and other financial instruments with similar characteristics. We have not engaged in significant derivatives activities through December 31, 2013 and have no current plans to do so.

Return on Assets and Equity

Table 20 shows return on average assets (net income available to common shareholders divided by average total assets), return on average common equity (net income available to common shareholders divided by average common shareholders’ equity), dividend payout ratio (dividends per share divided by net income per common share) and shareholders’ equity to assets ratio (average total shareholders’ equity divided by average total assets) for each of the years in the three-year period ended December 31, 2013.