SYBT 10-K Fiscal year ended Dec. 31, 2013

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-K

Annual Report Pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934

S.Y. BANCORP, INC.

1040 East Main Street
Louisville, Kentucky 40206
(502) 582-2571

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

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

None

Indicate by check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Act). Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

The aggregate market value of registrant’s voting stock (Common Stock, no par value) held by non-affiliates of the registrant as of June 30, 2013 (the last business day of the registrant’s most recently completed second fiscal quarter) was $316,583,000.

The number of shares of the registrant’s Common Stock, no par value, outstanding as of February 24, 2014, was 14,611,849.

Documents Incorporated By Reference

Portions of Registrant’s definitive proxy statement related to Registrant’s Annual Meeting of Shareholders to be held on April 23, 2014 (the “Proxy Statement”), to be filed with the Securities and Exchange Commission, are incorporated by reference into Part III of this Form 10-K.

Table of Contents

S.Y. BANCORP, INC.

Form 10-K

Index

Part I:
Item 1.	Business	3
Item 1A.	Risk Factors	5
Item 1B.	Unresolved Staff Comments	7
Item 2.	Properties	8
Item 3.	Legal Proceedings	8
Item 4.	Mine Safety Disclosures	8
Part II:
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	9
Item 6.	Selected Financial Data	12
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	44
Item 8.	Financial Statements and Supplementary Data	44
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	95
Item 9A.	Controls and Procedures	95
Item 9B.	Other Information	98
Part III:
Item 10.	Directors, Executive Officers and Corporate Governance	98
Item 11.	Executive Compensation	98
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	99
Item 13.	Certain Relationships and Related Transactions, and Director Independence	99
Item 14.	Principal Accounting Fees and Services	99
Part IV:
Item 15.	Exhibits and Financial Statement Schedules	99
Signatures		103
Index to Exhibits		104

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Part I

Item 1. Business

S. Y. Bancorp, Inc. (“Bancorp” or “Company”), headquartered in Louisville, Kentucky, is the holding company for Stock Yards Bank & Trust Company (“Bank”).  Bancorp was incorporated in 1988 in Kentucky is registered with, and subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System. The Bank is wholly owned and is a state chartered bank.  Because Bancorp has no significant operations of its own, its business and that of the Bank are essentially the same.  The operations of the Bank are fully reflected in the consolidated financial statements of Bancorp.  Accordingly, references to “Bancorp” in this document may encompass both the holding company and the Bank.

Stock Yards Bank & Trust Company

Stock Yards Bank & Trust Company is the banking subsidiary of Bancorp and was chartered in 1904.  The Bank is headquartered in Louisville, Kentucky and provides commercial and personal banking services in the Louisville, Kentucky, Indianapolis, Indiana and Cincinnati, Ohio metropolitan markets through 34 full service banking offices.  The Bank is chartered under the laws of the Commonwealth of Kentucky.  In addition to traditional commercial and personal banking activities, the Bank has an investment management and trust department offering a wide range of trust administration, investment management, employee benefit plan and estate administration, and financial planning services.  The Bank also originates and sells single-family residential mortgages. Additionally, the Bank offers securities brokerage services in the name of Stock Yards Financial Services through an arrangement with a third party broker-dealer.  The Bank’s correspondent banking department offers holding company loans and lines of credit, deposit services, international services, investment management and trust services, and other services to community banks across Kentucky and southern Indiana.  See Note 24 to Bancorp’s consolidated financial statements for information relating to the Bank’s business segments and “Item 2. Properties” for information regarding owned and leased properties.

2013 Acquisition

On April 30, 2013, Bancorp completed the acquisition of 100% of the outstanding shares of THE BANCorp, Inc. (“Oldham”), parent company of THE BANK — Oldham County, Inc.  As a result of the transaction, THE BANK — Oldham County merged into Stock Yards Bank & Trust Company.  Since the acquisition date, results of operations acquired in the Oldham transaction have been included in Bancorp’s financial results.  The Oldham transaction has been accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration transferred were recorded at estimated fair value on the acquisition date.  See Note 3 to Bancorp’s consolidated financial statements for information relating to the acquisition.

At December 31, 2013, Stock Yards Bank & Trust had 519 full-time equivalent employees.  Employees of Stock Yards Bank & Trust are entitled to participate in a variety of employee benefit programs including a combined employee profit sharing and stock ownership plan (“KSOP”).  Management of Bancorp strives to be an employer of choice and considers the relationship with employees to be good.

Supervision and Regulation

Bank holding companies and commercial banks are extensively regulated under both federal and state laws. Changes in applicable laws or regulations may have a material effect on the business and prospects of Bancorp.

Bancorp, as a registered bank holding company, is subject to the supervision of and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956. In addition, Bancorp is subject to the provisions of Kentucky’s banking laws regulating bank acquisitions and certain activities of controlling bank shareholders.

Kentucky and federal banking statutes delineate permissible activities for Kentucky state-chartered banks.  Kentucky’s statutes, however, contain a super parity provision for Kentucky banks having a top one or two

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rating in its most recent regulatory examination.  This provision allows a state bank to engage in any banking activity in which a national bank in Kentucky, a state bank operating in any other state, or a federally chartered thrift could engage.  The bank must first obtain a legal opinion specifying the statutory or regulatory provisions that permit the activity.

The Bank is subject to the supervision of the Kentucky Department of Financial Institutions and the Federal Deposit Insurance Corporation. The Federal Deposit Insurance Corporation (FDIC) insures the deposits of the Bank to the current maximums of $250,000 per depositor.

The Gramm-Leach-Bliley Act (the “GLB Act”) allows for affiliations among banks, securities firms and insurance companies by means of a financial holding company (“FHC”). The GLB Act requires that, at the time of establishment of an FHC, all depository institutions within that corporate group must be “well managed” and “well capitalized” and must have received a rating of “satisfactory” or better under its most recent Community Reinvestment Act examination. Further, non-banking financial firms (for example an insurance company or securities firm) may establish an FHC and acquire a depository institution. While the distinction between banks and non-banking financial firms has been blurring over recent years, the GLB Act makes it less cumbersome for banks to offer services “financial in nature” but beyond traditional commercial banking activities. Likewise, non-banking financial firms may find it easier to offer services that had, heretofore, been provided primarily by depository institutions.  In 2012, management of Bancorp chose to become an FHC after evaluating the benefits and costs.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) was signed into law in 2010.  Generally, the Dodd-Frank Act was effective the day after it was signed into law, but different effective dates apply to specific sections of the law.  This new extensive and complex legislation contained many new provisions affecting the banking industry, including:

· Creation of a new Bureau of Consumer Financial Protection overseeing banks with assets totaling $10 billion or greater while writing and maintaining several regulations that apply to all banks

· Determination of debit card interchange rates by the Federal Reserve Board

· New regulation over derivative instruments

· Phase outs of certain forms of trust preferred debt and hybrids previously included as bank capital

· Increases to FDIC deposit coverage, revised calculations for assessing bank premiums, and numerous other provisions affecting financial institution regulation, oversight of certain non-banking organizations, investor protection, etc.

Uncertainty remains as to the ultimate impact of the Dodd-Frank Act, which could have a continued adverse impact on the financial services industry as a whole and on Bancorp’s business, results of operations and financial condition.

Available Information

Bancorp files reports with the SEC including the Annual Report on Form 10-K, quarterly reports on Form 10-Q, current event reports on Form 8-K, and proxy statements, as well as any amendments to those reports. The public may read and copy any materials the Registrant files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov.  Bancorp’s Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are accessible at no cost on Bancorp’s web site at http://www.syb.com after they are electronically filed with the SEC.

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Item 1A. Risk Factors

Investment in Bancorp’s common stock involves risk, and Bancorp’s profitability and success may be affected by a number of factors including those discussed below.

Financial condition and profitability depend significantly on local and national economic conditions.

Our success depends on general economic conditions both locally and nationally.  Most of Bancorp’s customers are in the Louisville, Indianapolis, and Cincinnati metropolitan areas.  Some of Bancorp’s customers are directly impacted by the local economy while others have more national or global business dealings. Some of the factors influencing general economic conditions include tepid economic recovery, unemployment, and government regulation. Poor economic conditions have an unfavorable impact on the demand of customers for loans and the ability of some borrowers to repay these loans.  Deterioration in the quality of the credit portfolio could have a material adverse effect on financial condition, results of operations, and ultimately capital.

Financial condition and profitability depend on real estate values in our market area.

Bancorp offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Over half of Bancorp’s loans are secured by real estate (both residential and commercial) in Bancorp’s market area. In instances where borrowers are unable to repay their loans from us and there has been deterioration in the value of the loan collateral, Bancorp could experience higher loan losses. Additional increases in loan loss provisions, which may be necessary in the future, could have a material adverse effect on financial condition, results of operations, and ultimately capital.

If actual loan losses are greater than Bancorp’s allowance assumption for loan losses, earnings could decrease.

Bancorp’s loan customers may not repay their loans according to the terms of these loans, the collateral securing the payment of these loans may be insufficient to ensure repayment and the wealth of guarantors providing guarantees to support these loans may be insufficient to aid in the repayment of these loans.  Accordingly, Bancorp may experience significant credit losses which could have a material adverse effect on operating results.  Bancorp makes various assumptions and judgments about the collectability of the loan portfolio, including the creditworthiness of borrowers and the value of real estate and other assets serving as collateral for repayment of many loans.  In determining the adequacy of the allowance for loan losses, Bancorp considers, among other factors, an evaluation of economic conditions and Bancorp’s loan loss experience.  If Bancorp’s assumptions prove to be incorrect or economic problems are worse than projected, the current allowance may not be sufficient to cover loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio.  Such additions to the allowance, if necessary, could have a material adverse impact on financial results.

In addition, federal and state regulators periodically review Bancorp’s allowance for loan losses and may require an increase in the provision for loan losses or loan charge-offs. If the regulatory agencies require any increase in the provision for loan losses or loan charge-offs for which Bancorp had not allocated, it would have a negative effect on net income.

Fluctuations in interest rates could reduce profitability.

Our primary source of income is from the net interest spread, the difference between interest earned on loans and investments and the interest paid on deposits and borrowings.  Bancorp expects to periodically experience “gaps” in the interest rate sensitivities of Bancorp’s assets and liabilities, meaning that either interest-bearing liabilities will be more sensitive to changes in market interest rates than interest-earning assets, or vice versa.  In either event, if market interest rates should move contrary to Bancorp’s position, this “gap” will work against Bancorp and earnings will be negatively affected.

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Many factors affect the fluctuation of market interest rates, including, but not limited to the following:

· Inflation or deflation;

· recession;

· a rise in unemployment;

· tightening money supply;

· international disorder and instability in foreign financial markets; and

· the Federal Reserve’s actions to control interest rates;

Bancorp’s interest rate sensitivity analysis indicates an increase in interest rates of up to 2% would decrease net interest income, primarily because the majority of Bancorp’s variable rate loans have floors of 4% or higher, and are indexed to the prime rate.  Since the prime rate is currently 3.25%, rates would have to increase more than 75 bp before the rates on such loans will rise.  This effect negatively impacts the effect of rising rates.  Deposit rates generally do not reprice as quickly as loans which negatively affects earnings as rates decline.  Bancorp’s asset-liability management strategy, which is designed to mitigate risk from changes in market interest rates, may not be able to prevent changes in interest rates from having a material adverse effect on Bancorp’s results of operations and financial condition.  Bancorp’s most recent earnings simulation model estimating the impact of changing interest rates on earnings indicates net interest income will decrease approximately 2.1% if interest rates immediately decrease 100 basis points for the next 12 months and decrease approximately 3.8% if rates increase 100 basis points.  Prevailing interest rates are at historically low levels, and current indications are that the Federal Reserve will likely maintain the low rates through 2014 and into 2015.

Significant stock market volatility could negatively affect Bancorp’s financial results.

Capital and credit markets experience volatility and disruption from time to time.  These conditions place downward pressure on credit availability, credit worthiness and customers’ inclinations to borrow.  Prolonged volatility or a significant disruption could negatively impact customers’ ability to seek new loans or to repay existing loans.  The personal wealth of many of borrowers and guarantors has historically added a source of financial strength to certain loans and would be negatively impacted by severe market declines.  Sustained reliance on their personal assets to make loan payments would result in deterioration of their liquidity, and could result in loan defaults.

Income from investment management and trust services constitutes an average of 40% of non-interest income. Trust assets under management are expressed in terms of market value, and a significant portion of fee income is based upon those values. While investment management and trust fees are based on market values, they typically do not fluctuate directly with the overall stock market.  Accounts typically contain fixed income and equity asset classes, which generally react to market fluctuations inversely to each other.

Competition with other financial institutions could adversely affect profitability.

Bancorp operates in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Bancorp faces vigorous competition from banks and other financial institutions. A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services. Additionally, Bancorp encounters competition from smaller community banks in Bancorp’s markets.  Bancorp also competes with other non-traditional providers of financial services, such as brokerage firms and insurance companies. This competition may reduce or limit margins on banking services, reduce market share and adversely affect results of operations and financial condition.

Credit unions continue to grow in popularity and size, and their expansion into business lending is growing.  Because credit unions are not subject to federal income tax, and Bancorp pays federal income tax at a marginal rate of 35%, these companies have a significant competitive advantage over Bancorp.  This advantage may have a negative impact on Bancorp’s growth and resultant financial results as these credit unions continue to expand.

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Bancorp’s accounting policies and methods are critical to how Bancorp reports its financial condition and results of operations. They require management to make estimates about matters that are uncertain.

Accounting policies and methods are fundamental to how Bancorp records and reports its financial condition and results of operations. Bancorp must exercise judgment in selecting and applying these accounting policies and methods so they comply with United States generally accepted accounting principles (US GAAP).

Bancorp has identified certain accounting policies as being critical because they require management’s judgment to ascertain the valuations of assets, liabilities, commitments and contingencies. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or reducing a liability. Bancorp has established detailed policies and control procedures that are intended to ensure these critical accounting estimates and judgments are well controlled and applied consistently. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. Because of the uncertainty surrounding Bancorp’s judgments and the estimates pertaining to these matters, there can be no assurances that actual results will not differ from those estimates. See the “Critical Accounting Policies” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for more information.

An extended disruption of vital infrastructure or a security breach could negatively impact Bancorp’s business, results of operations, and financial condition.

Bancorp’s operations depend upon, among other things, infrastructure, including equipment and facilities.  Extended disruption of vital infrastructure by fire, power loss, natural disaster, telecommunications failure, information systems breaches, terrorist activity or the domestic and foreign response to such activity, or other events outside of Bancorp’s control could have a material adverse impact on the financial services industry as a whole and on Bancorp’s business, results of operations and financial condition. Bancorp’s business continuity plan may not work as intended or may not prevent significant interruption of operations.  The occurrence of any failures, interruptions, or security breaches of information systems could damage Bancorp’s reputation, result in the loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have an adverse effect on Bancorp’s financial condition and results of operation.

Bancorp’s assets which are at risk for cyber-attacks include financial assets and non-public information belonging to customers. Bancorp utilizes several third-party vendors who have access to our assets via electronic media.  Certain cyber security risks arise due to this access, including cyber espionage, blackmail, ransom, and theft.  Bancorp employs many preventive and detective controls to protect its assets, and provides mandatory recurring information security training to all employees. Bancorp requires third parties to have similar or superior controls in place.  Bancorp did not suffer a material incident in the years reported herein.  Bancorp maintains certain insurance coverage to prevent material financial loss from cyber-attacks.

Bancorp operates in a highly regulated environment and may be adversely affected by changes in federal, state and local laws and regulations.

Bancorp is subject to extensive regulation, supervision and examination by federal and state banking authorities.  Any change in applicable regulations or federal or state legislation could have a substantial impact on Bancorp and its operations.  Additional legislation and regulations may be enacted or adopted in the future that could significantly affect Bancorp’s powers, authority and operations, which could have a material adverse effect on Bancorp’s financial condition and results of operations.  The exercise of regulatory power may have negative impact on Bancorp’s results of operations and financial condition.

Item 1B. Unresolved Staff Comments

Bancorp has no unresolved SEC staff comments.

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Item 2. Properties

The principal offices of Bancorp are located at 1040 East Main Street, Louisville, Kentucky. Bancorp’s operations center is at a separate location. In addition to the main office complex and the operations center, Bancorp owned 19 branch properties at December 31, 2013, two of which are located on leased land.  At that date, Bancorp also leased 15 branch facilities.  Of the 34 banking locations, 28 are located in the Louisville Metropolitan Statistical Area (“MSA”), three are located in the Indianapolis MSA and three are located in the Cincinnati MSA.  See Notes 6 and 18 to Bancorp’s consolidated financial statements for the year ended December 31, 2013, for additional information relating to amounts invested in premises and equipment and lease commitments .

Item 3. Legal Proceedings

See Note 18 to Bancorp’s consolidated financial statements for the year ended December 31, 2013, for information relating to legal proceedings.

Item 4. Mine Safety Disclosures

Not applicable.

Executive Officers of the Registrant

The following table lists the names and ages as of December 31, 2013 of all current executive officers of Bancorp and the Bank. Each executive officer is appointed by Bancorp’s Board of Directors to serve at the discretion of the Board. There is no arrangement or understanding between any executive officer of Bancorp or the Bank and any other person(s) pursuant to which he/she was or is to be selected as an officer.

Name and Age of Executive Officer		Position and Offices with Bancorp and/or the Bank
David P. Heintzman Age 54		Chairman of the Board of Directors and Chief Executive Officer of Bancorp and the Bank
James A. Hillebrand Age 45		President and Director of Bancorp and the Bank
Kathy C. Thompson Age 52		Senior Executive Vice President and Director of Bancorp and the Bank
Nancy B. Davis Age 58		Executive Vice President, Secretary, Treasurer and Chief Financial Officer of Bancorp and the Bank
William M. Dishman III Age 50		Executive Vice President and Chief Risk Officer of the Bank
Gregory A. Hoeck Age 63		Executive Vice President and Director of Retail Banking of the Bank
Philip S. Poindexter Age 47		Executive Vice President and Chief Lending Officer of the Bank
T. Clay Stinnett Age 40		Executive Vice President and Chief Strategic Officer of Bancorp and the Bank

Mr. Heintzman was appointed Chairman and Chief Executive Officer in January 2006.  Prior thereto, he served as President of Bancorp and the Bank since 1992. Mr. Heintzman joined the Bank in 1985.

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Mr. Hillebrand was appointed President in July 2008.  Prior thereto, he served as Executive Vice President and Director of Private Banking of the Bank since 2005. From 2000 to 2004, he served as Senior Vice President of Private Banking.  Mr. Hillebrand joined the Bank in 1996.

Ms. Thompson was appointed Senior Executive Vice President in January 2006.  Prior thereto, she served as Executive Vice President of Bancorp and the Bank. She joined the Bank in 1992 and is Manager of the Investment Management and Trust Department.

Ms. Davis was appointed Executive Vice President of Bancorp and the Bank in 1999 and Chief Financial Officer in 1993.  She joined the Bank in 1991.

Mr. Dishman joined the Bank and was appointed Executive Vice President and Chief Risk Officer in February 2009.  Prior thereto, he served as Executive Vice President and Chief Credit Officer for National City Bank’s Kentucky and Tennessee markets from 2004 to 2009.

Mr. Hoeck joined the Bank and was appointed Executive Vice President in May 1998.  He is the Director of Retail Banking for the Bank.  In January 2014, Mr. Hoeck announced his retirement from the Bank effective June 30, 2014.

Mr. Poindexter was appointed Chief Lending Officer in July 2008.  Prior thereto, he served as Executive Vice President and Director of Commercial Banking.  Mr. Poindexter joined the Bank in 2004.

Mr. Stinnett was appointed Executive Vice President and Chief Strategic Officer in February 2011.  Prior thereto, he served as Senior Vice President and Chief Strategic Officer since 2005.  Mr. Stinnett joined the Bank in 2000.

Part II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Bancorp’s common stock is traded on the NASDAQ Global Select Market under the ticker symbol SYBT.  The table below sets forth the quarterly high and low market closing prices of Bancorp’s common stock and dividends declared per share. The payment of dividends by the Bank to Bancorp is subject to the restriction described in Note 17 to the consolidated financial statements. Management believes that Bancorp will continue to generate adequate earnings to continue to pay dividends on a quarterly basis.  On December 31, 2013, Bancorp estimates it had a total of approximately 5,600 shareholders, including beneficial owners holding shares in nominee or “street” name.

		2013									2012
								Cash dividends									Cash dividends
Quarter		High			Low			declared			High			Low			declared
First		$	23.29		$	22.10		$	0.20		$	23.65		$	20.60		$	0.19
Second		24.99			21.51			0.20			23.95			21.96			0.19
Third		28.46			24.99			0.20			24.98			22.45			0.19
Fourth		33.77			27.23			0.21			24.12			21.08			0.20

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The following table shows information relating to the repurchase of shares of common stock by Bancorp during the three months ended December 31, 2013.

		Total number of shares purchased (1)		Average price paid per share			Total number of shares purchased as part of publicly announced plan (2)		Maximum number of shares that may yet be purchased under the plan
October 1-October 31		780		$	30.64		—		—
November 1-November 30		2,081		31.61			—		—
December 1-December 31		43		32.13			—		—
Total		2,904		$	31.36		—		—

(1) Activity represents shares of stock withheld to pay the exercise price of stock options or to pay taxes due upon the exercise of stock appreciation rights. This activity has no impact on the number of shares that may be purchased under a Board-approved plan.

(2) Since 2008, there has been no active share buyback plan.

The following performance graph and data shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed soliciting material or subject to Regulation 14A of the Exchange Act or incorporated by reference in any filing under the Exchange Act or the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing.

The first graph below compares the performance of Bancorp Common Stock to the Russell 2000 index, the SNL NASDAQ Bank index and the SNL Midwest Bank index for Bancorp’s last five fiscal years. The graph assumes the value of the investment in Bancorp Common Stock and in each index was $100 at December 31, 2008 and that all dividends were reinvested.

The ten-year period is presented in addition to the five-year period required by the S.E.C. because it provides additional perspective, and Bancorp management believes that longer-term performance is of greater interest to Bancorp shareholders. In 2008 and 2009, Bancorp did not decrease or suspend cash dividends, nor did it experience a decline in value as precipitous as illustrated by the referenced bank indices.  Accordingly, Bancorp’s stock price increases since 2008 have not been as steep as the referenced bank indices. The ten-year graph assumes the value of the investment in Bancorp Common Stock and in each index was $100 at December 31, 2003 and that all dividends were reinvested.

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		Period Ending
Index		12/31/08		12/31/09		12/31/10		12/31/11		12/31/12		12/31/13
S.Y. Bancorp, Inc.		100.00		80.02		94.70		81.85		92.48		135.83
Russell 2000		100.00		127.17		161.32		154.59		179.86		249.69
SNL Midwest Bank		100.00		84.75		105.24		99.40		119.64		163.80
SNL Bank NASDAQ		100.00		81.12		95.71		84.92		101.22		145.48

		Period Ending
Index		12/31/03		12/31/04		12/31/05		12/31/06		12/31/07		12/31/08		12/31/09		12/31/10		12/31/11		12/31/12		12/31/13
S.Y. Bancorp, Inc.		100.00		119.25		126.28		151.62		132.98		156.99		125.61		148.66		128.49		145.18		213.23
Russell 2000		100.00		118.33		123.72		146.44		144.15		95.44		121.38		153.97		147.54		171.67		238.31
SNL Midwest Bank		100.00		112.84		108.73		125.68		97.96		64.44		54.61		67.82		64.06		77.10		105.55
SNL Bank NASDAQ		100.00		114.61		111.12		124.75		97.94		71.13		57.70		68.08		60.40		71.99		103.48

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Item 6. Selected Financial Data

Selected Consolidated Financial Data

(Amounts in thousands except		Years ended December 31
per share data and ratios)		2013			2012			2011			2010			2009
Income statement data
Interest income		$	86,464		$	86,901		$	86,039		$	86,146		$	83,856
Interest expense		9,166			12,951			15,307			19,267			25,181
Net interest income		77,298			73,950			70,732			66,879			58,675
Provision for loan losses		6,550			11,500			12,600			11,469			12,775
Non-interest income		39,002			38,457			33,244			33,739			30,036
Non-interest expenses		71,352			65,472			59,581			57,131			52,695
Income before income taxes		38,398			35,435			31,795			32,018			23,241
Income tax expense		11,228			9,634			8,191			9,065			6,933
Net income		$	27,170		$	25,801		$	23,604		$	22,953		$	16,308
Per share data
Net income, basic		$	1.91		$	1.86		$	1.71		$	1.68		$	1.20
Net income, diluted		1.89			1.85			1.71			1.67			1.19
Cash dividends declared		0.81			0.77			0.72			0.69			0.68
Book value		15.71			14.74			13.58			12.37			11.29
Market value		31.92			22.42			20.53			24.55			21.35
Weighted average common and common equivalent shares - diluted		14,353			13,932			13,834			13,779			13,689
Balance Sheet data
Total assets		$	2,389,262		$	2,148,262		$	2,053,097		$	1,902,945		$	1,791,479
Loans		1,721,350			1,584,594			1,544,845			1,508,425			1,435,462
Allowance for loan losses		28,522			31,881			29,745			25,543			20,000
Available for sale securities		490,031			386,440			352,185			245,352			228,260
Deposits		1,980,937			1,781,693			1,617,739			1,493,468			1,418,184
Federal Home Loan Bank advances		34,329			31,882			60,431			60,442			60,453
Subordinated debentures		—			30,900			40,900			40,900			40,930
Stockholders’ equity		229,444			205,075			187,686			169,861			153,614
Average balances
Stockholders’ equity		$	220,107		$	197,551		$	179,638		$	163,572		$	150,721
Assets		2,232,868			2,070,967			1,959,609			1,847,452			1,717,474
Federal Home Loan Bank advances		32,518			60,113			60,436			69,159			80,904
Long-term debt		30,477			31,474			40,900			40,901			40,930
Selected ratios
Return on average assets		1.22		%	1.25		%	1.20		%	1.24		%	0.95		%
Return on average stockholders’ equity		12.34			13.06			13.14			14.03			10.82
Average stockholders’ equity to average assets		9.86			9.54			9.17			8.85			8.78
Net interest rate spread		3.59			3.74			3.79			3.74			3.43
Net interest rate margin, fully tax-equivalent		3.74			3.94			3.99			3.99			3.74
Efficiency ratio		60.82			57.38			56.47			56.01			58.70
Non-performing loans to total loans		1.33			1.90			1.51			1.28			0.84
Non-performing assets to total assets		1.19			1.74			1.51			1.30			0.77
Net charge offs to average loans		0.60			0.60			0.55			0.40			0.59
Allowance for loan losses to total loans		1.66			2.01			1.93			1.69			1.39

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Financial Section Roadmap

The financial section of this Form 10-K includes management’s discussion and analysis, consolidated financial statements, and the notes to those financial statements. Bancorp has prepared the following summary, or “roadmap,” to assist in your review of the financial section. It is designed to give you an overview of S.Y. Bancorp, Inc. and summarize some of the more important activities and events that occurred during 2013.

The financial section includes the following:

Management’s discussion and analysis, or MD&A (pages 13 through 44) — provides information as to the analysis of the consolidated financial condition and results of operations of Bancorp.  It contains management’s view about industry trends, risks, uncertainties, accounting policies that Bancorp views as critical in light of its business, results of operations including discussion of the key performance drivers, financial position, cash flows, commitments and contingencies, important events, transactions that have occurred over the last three years, and forward-looking information, as appropriate.

Financial statements (pages 45 through 49) — include Consolidated Balance Sheets as of the end of the last two years, and Consolidated Statements of Income, Comprehensive Income, Cash Flows, and Changes in Stockholders’ Equity, for each of the last three years.  Bancorp’s financial statements are prepared in accordance with US GAAP.

Notes to the financial statements (pages 50 through 92) — provide insight into, and are an integral part of, the financial statements. The notes contain explanations of significant accounting policies, details about certain captions on the financial statements, information about significant events or transactions that have occurred, discussions about legal proceedings, commitments and contingencies, and selected financial information relating to business segments. The notes to the financial statements also are prepared in accordance with US GAAP.

Reports related to the financial statements and internal control over financial reporting (pages 93 through 97) — include the following:

· A report from KPMG LLP, an independent registered public accounting firm, which includes their opinion on the presentation of Bancorp’s consolidated financial statements based on their audits;

· A report from management indicating Bancorp’s responsibility for financial reporting and the financial statements;

· A report from management indicating Bancorp’s responsibility for the system of internal control over financial reporting,  including an assessment of the effectiveness of those controls; and

· A report from KPMG LLP, which includes their opinion on the effectiveness of Bancorp’s internal control over financial reporting.

Our Business

S.Y. Bancorp, Inc. (“Bancorp”), incorporated in 1988, and its business is substantially the same as that of its wholly owned subsidiary, Stock Yards Bank & Trust Company (“the Bank”).  The Bank has operated continuously since it opened in 1904. The Bank conducted business at one location for 85 years and began branching in 1989. At December 31, 2013, the Bank had 28 full service banking locations in the Louisville MSA, three full service banking locations in the Indianapolis MSA, and three full service banking locations in the Cincinnati MSA. Bancorp’s focus on flexible, attentive customer service has been key to its growth and profitability. The wide range of services added by investment management and trust, securities brokerage, and mortgage origination helps support the corporate philosophy of capitalizing on full service customer relationships.

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On April 30, 2013, Bancorp completed the acquisition of 100% of the outstanding shares of THE BANCorp, Inc. (“Oldham”), parent company of THE BANK — Oldham County, Inc.  As a result of the transaction, THE BANK — Oldham County merged into Stock Yards Bank & Trust Company.  Since the acquisition date, results of operations acquired in the Oldham transaction have been included in Bancorp’s financial results.

Forward-Looking Statements

This report contains forward-looking statements under the Private Securities Litigation Reform Act that involve risks and uncertainties. These forward-looking statements may be identified by the use of words such as “expect”, “anticipate”, “plan”, “foresee”, “believe” or other words with similar meaning.  Although Bancorp believes the assumptions underlying the forward-looking statements contained herein are reasonable, any of these assumptions could be inaccurate. Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to: economic conditions both generally and more specifically in the markets in which Bancorp and its subsidiaries operate; competition for Bancorp’s customers from other providers of financial services; government legislation and regulation which change from time to time and over which Bancorp has no control; changes in interest rates; material unforeseen changes in liquidity, deterioration in the real estate market, results of operations or financial condition of Bancorp’s customers; or other risks detailed in Bancorp’s filings with the Securities and Exchange Commission and Item 1A of this Form 10-K all of which are difficult to predict and many of which are beyond the control of Bancorp.

Critical Accounting Policies

Bancorp has prepared the consolidated financial information in this report in accordance with US GAAP.  In preparing the consolidated financial statements in accordance with US GAAP, Bancorp makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  There can be no assurances that actual results will not differ from those estimates.

Management has identified the accounting policy related to the allowance and provision for loan losses as critical to the understanding of Bancorp’s results of operations and discussed this conclusion with the Audit Committee of the Board of Directors.  Since the application of this policy requires significant management assumptions and estimates, it could result in materially different amounts to be reported if conditions or underlying circumstances were to change.  Assumptions include many factors such as changes in borrowers’ financial condition which can change quickly or historical loss ratios related to certain loan portfolios which may or may not be indicative of future losses.  To the extent that management’s assumptions prove incorrect, the results from operations could be materially affected.  The impact and any associated risks related to this policy on Bancorp’s business operations are discussed in the “Allowance for Loan Losses” section below.

The allowance for loan losses is management’s estimate of probable losses in the loan portfolio. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

Prior to the third quarter of 2013, management measured the appropriateness of the allowance for loan losses in its entirety using (a) quantitative (historical loss rates) and qualitative factors (management adjustment factors); (b) specific allocations on impaired loans, and (c) an unallocated amount.  The unallocated amount was evaluated on the loan portfolio in its entirety and was based on additional factors, such as national and local economic trends and conditions, changes in volume and severity of past due loans, volume of non-accrual loans, volume and severity of adversely classified or graded loans and other factors and trends that affect specific loans and categories of loans, such as a heightened risk in the commercial and industrial loan portfolios.  Bancorp utilized the sum of all allowance amounts derived as described above, including a reasonable unallocated allowance, as an indicator of the appropriate level of allowance for loan and lease losses.

During the third quarter of 2013, Bancorp refined its allowance calculation whereby it “allocated” the portion of the allowance that was previously deemed to be unallocated allowance based on management’s determination of the appropriate qualitative adjustment. This refined allowance calculation includes specific

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allowance allocations to loan portfolio segments at December 31, 2013 for qualitative factors including, among other factors, (i) national and local economic and business conditions, (ii) the quality and experience of lending staff and management, (iii) changes in lending policies and procedures, (iv) changes in volume and severity of past due loans, classified loans and non-performing loans, (v) potential impact of any concentrations of credit, (vi) changes in the nature and terms of loans such as growth rates and utilization rates, (vii) changes in the value of underlying collateral for collateral-dependent loans, considering Bancorp’s disposition bias, and (viii) the effect of other external factors such as the legal and regulatory environment.  Bancorp may also consider other qualitative factors in future periods for additional allowance allocations, including, among other factors, changes in Bancorp’s loan review process.  Changes in the criteria used in this evaluation or the availability of new information could cause the allowance to be increased or decreased in future periods. In addition, bank regulatory agencies, as part of their examination process, may require adjustments to the allowance for loan and lease losses based on their judgments and estimates.

Additionally, management has identified the accounting policy related to accounting for income taxes as critical to the understanding of Bancorp’s results of operations and discussed this conclusion with the Audit Committee of the Board of Directors.  The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns.  Judgment is required in assessing the future tax consequences of events that have been recognized in Bancorp’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact Bancorp’s financial position and its results from operations.  Additional information regarding income taxes is discussed in the “Income Taxes” section below.

Overview of 2013

The following discussion should be read in conjunction with Bancorp’s consolidated financial statements and accompanying notes and other schedules presented elsewhere in this report.

In 2013, Bancorp completed a year of asset and deposit growth with net income totaling $27,170,000, an increase of 5% over 2012, and the fourth consecutive year of increased net income.  Increased profitability was primarily due to an increase in net interest income, a decline in the provision for loan losses, an increase in non-interest income, partially offset by higher non-interest expenses and higher income tax expense. Diluted earnings per share for 2013 increased 2% over 2012 to $1.89, exceeding the highest amount recorded in any prior year.  Bancorp’s results for 2013 included the effect of several non-core items.  These items are discussed in the “Non-Interest Income and Non-Interest Expenses” section below.  Excluding these items, net income for 2013, was $28.3 million or $1.97 per diluted share.  See the “Non-GAAP Financial Measures” section for details on reconciliation to US GAAP measures.

On April 30, 2013, Bancorp completed the acquisition of 100% of the outstanding shares of THE BANCorp, Inc. (“Oldham”), parent company of THE BANK — Oldham County, Inc.  As a result of the transaction, THE BANK — Oldham County merged into Stock Yards Bank & Trust Company.  Since the acquisition date, results of operations acquired in the Oldham transaction have been included in Bancorp’s financial results.  The Oldham transaction has been accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration transferred were recorded at estimated fair value on the acquisition date.  The fair value adjustments resulted in net assets acquired in excess of the consideration paid.  Accordingly, a non-taxable gain of $449,000 was recognized.  In connection with the Oldham acquisition, Bancorp incurred expenses totaling $1,548,000 related to executing the transaction and integrating and conforming acquired operations with and into Bancorp.

As is the case with most banks, the primary source of Bancorp’s revenue is net interest income and fees from various financial services provided to customers.  Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities.  Loan volume and the interest rates earned on those loans are critical to overall profitability. Similarly deposit volume is crucial to funding loans and rates paid on deposits directly impact profitability.  Business volumes are influenced by overall economic factors including

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market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.

Bancorp’s loan portfolio increased $137 million, or 9%, during 2013 to $1.7 billion.  Excluding $40 million of loans acquired in the Oldham transaction, core loan growth was 6% for 2013.  Record loan production of approximately $489 million was largely offset by loan payoffs, including the effects of normal payoffs and paydowns and increased competition from banks and non-bank financial firms.  Increased loan volume contributed to higher interest income in 2013, but the increase resulting from volume was more than offset by declining interest rates on loans and investments over the past year. Primarily as a result, interest income for 2013 decreased $437,000 over 2012.  Despite significant deposit growth, interest expense declined due to lower funding costs on deposits and borrowings.  While rates paid on liabilities decreased, rates on earning assets decreased slightly more, resulting in a decreased net interest spread and net interest margin compared to 2012.  Net interest margin in 2013 reflected prepayment fees associated with loan refinancing activity.  Adjusting for these sources of additional income, Bancorp’s more normalized or core net interest margin has trended downward throughout 2013, declining to 3.66% for 2013 from 3.88% for 2012. (See “Non-GAAP Financial Measures” section for reconcilement of non-GAAP measures to US GAAP measures.)

Total non-interest income in 2013 increased $545,000 compared to 2012, and remained consistent at 34% of total revenues, reflecting increases in investment management and trust services, service charges on deposit accounts, bankcard transaction revenue, and the gain on the Oldham acquisition, partially offset by a decrease in mortgage banking revenue and brokerage commissions.

Higher non-interest expenses for 2013 resulted from one-time acquisition costs related to the Oldham transaction, write-off of debt issuance costs related to redemption of trust preferred securities, increases in salaries and benefits and data processing expenses, partially offset by decreases in losses on foreclosed assets, furniture and equipment, and FDIC insurance expense.  Bancorp’s efficiency ratio for 2013 of 60.8% increased from 57.4% in 2012.

Also favorably impacting 2013 results, Bancorp’s provision for loan losses decreased to $6,550,000 compared to $11,500,000 for 2012, in response to Bancorp’s assessment of risk in the loan portfolio.  The provision for loan losses is calculated after considering credit quality factors, and ultimately relies on an overall internal analysis of the risk in the loan portfolio.  Bancorp’s allowance for loan losses was 1.66% of total loans at December 31, 2013, compared with 2.01% of total loans at December 31, 2012.

Bancorp’s effective tax rate increased to 29.2% in 2013 from 27.2% in 2012.  The increase in income tax expense from 2012 to 2013 is the result of reduced tax exempt interest in 2013 as well as the recognition of certain federal historic rehabilitation tax credits related to an investment in redevelopment of a Louisville landmark in 2012.

Tangible common equity (TCE), a non-GAAP measure, is a measure of a company’s capital which is useful in evaluating the quality and adequacy of capital.  It is calculated by subtracting the value of intangible assets and any preferred equity from the book value of Bancorp.

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A summary of Bancorp’s TCE ratios at December 31, 2013 and 2012 is shown in the following table.

(in thousands, except per share data and ratios)		December 31, 2013			December 31, 2012
Total equity		$	229,444		$	205,075
Less core deposit intangible		(2,151		)	—
Less goodwill		(682		)	(682		)
Tangible common equity		$	226,611		$	204,393
Total assets		$	2,389,262		$	2,148,262
Less core deposit intangible		(2,151		)	—
Less goodwill		(682		)	(682		)
Total tangible assets		$	2,386,429		$	2,147,580
Tangible common equity ratio		9.50		%	9.52		%
Number of outstanding shares		14,609			13,915
Tangible common equity per share		$	15.51		$	14.69

See “Non-GAAP Financial Measures” section for reconcilement of TCE to US GAAP measures.

Challenges for 2014 will include, maintaining a stable net interest margin, achieving continued loan growth, managing credit quality and increasing regulatory requirements.

· Bancorp expects net interest margin to improve in 2014 as the interest expense from the redeemed trust preferred securities is eliminated.  Other than this, the margin is expected to remain consistent, as rates are expected to be largely unchanged through the fourth quarter of 2014.  Loan prepayments are expected to diminish while prevailing rates for new loans will likely result in a relatively unchanged net interest margin for 2014.  Considering prevailing rates, management expects little margin compression to continue in 2014.  However, increased deposit and loan rate competition could negatively impact this expectation, as could a decrease in longer term interest rates.

· The Federal Reserve Board lowered its key short term rate in 2008 to unprecedentedly low levels, and rates have remained low through 2013.  Indications are that the Federal Reserve will likely keep short term rates low through 2014 and into 2015.  Approximately 35% of Bancorp’s loans are indexed to the prime interest rate and reprice immediately with Federal Reserve rate changes. However, approximately 55% of variable rate loans have reached their contractual floor of 4% or higher, meaning they will not reprice immediately when the prime rate increases.  Deposit rates generally do not reprice as quickly as loans.  Once rates begin to rise, Bancorp’s net interest margin likely will be negatively affected until the increase in the prime rate exceeds 75 basis points from today’s levels.

· Bancorp’s goals for 2014 include net loan growth at a pace similar to that experienced in 2013, excluding the loans acquired in the Oldham transaction. This will be impacted by competition, prevailing economic conditions, and the impact of prepayments in the loan portfolio.  Bancorp believes there is an opportunity for growth, and Bancorp’s ability to deliver attractive growth over the long-term is linked to Bancorp’s success in each market.

· Management is concerned that the slow economic recovery could still revert back to recessionary conditions which will cause a higher level of non-performing loans and potentially lower loan demand, both of which would negatively impact net income.  Until sustained improvement in the economy is noted, particularly as it relates to housing and employment, certain borrowers will continue to experience stressed financial conditions.

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· Bancorp expects a decrease in non-interest income for 2014 in gains on sales of mortgage loans held for sale, as the volume of refinance activity will not continue at the pace experienced in early 2013.  Bancorp has experienced a larger volume of loans to purchase homes, a sign of improving housing markets, which should partially offset effects of decreased refinance activity.

· Bancorp expects year-over-year increases in non-interest expense including personnel, data processing and occupancy expenses.  Bancorp also anticipates higher non-interest expenses to meet the ongoing and increasing burden of additional regulatory requirements.

The following sections provide more details on subjects presented in this overview.

Results of Operations

Net income was $27,170,000 or $1.89 per share on a diluted basis for 2013 compared to $25,801,000 or $1.85 per share for 2012 and $23,604,000 or $1.71 per share for 2011.  Net income for 2013 was positively impacted by:

· a $3.3 million or 5% increase in net interest income.

· a $5.0 million or 43% decrease in provision for loan losses.

· a $0.5 million or 1% increase in non-interest income.

Net income for 2013 was negatively impacted by:

· a $5.9 million or 9% increase in non-interest expenses.

· a $1.6 million or 17% increase in income tax expense.

The following paragraphs provide a more detailed analysis of the significant factors affecting operating results.

Net Interest Income

Net interest income, the most significant component of Bancorp’s earnings, represents total interest income less total interest expense.  Net interest spread is the difference between the taxable equivalent rate earned on average interest earning assets and the rate expensed on average interest bearing liabilities.  Net interest margin represents net interest income on a taxable equivalent basis as a percentage of average earning assets.  Net interest margin is affected by both the interest rate spread and the level of non-interest bearing sources of funds.  The level of net interest income is determined by the mix and volume of interest earning assets, interest bearing deposits and interest bearing liabilities and by changes in interest rates. The discussion that follows is based on tax-equivalent interest data.

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Comparative information regarding net interest income follows:

											2013/2012		2012/2011
(Dollars in thousands)		2013			2012			2011			Change		Change
Net interest income, tax-equivalent basis		$	78,306		$	75,653		$	72,262		3.5	%	4.7	%
Net interest spread		3.59		%	3.74		%	3.79		%	(15	)bp	(5	)bp
Net interest margin		3.74		%	3.94		%	3.99		%	(20	)bp	(5	)bp
Average earning assets		$	2,096,088		$	1,922,134		$	1,809,043		9.1	%	6.3	%
Five year Treasury bond rate at year end		1.75		%	0.73		%	0.83		%	102	bp	(10	)bp
Average five year Treasury bond rate		1.17		%	0.75		%	1.50		%	42	bp	(75	)bp
Prime rate at year end		3.25		%	3.25		%	3.25		%	0	bp	0	bp
Average prime rate		3.25		%	3.25		%	3.25		%	0	bp	0	bp

bp = basis point = 1/100th of a percent

All references above to net interest margin and net interest spread exclude the sold portion of participation loans from calculations.  Such loans remain on Bancorp’s balance sheet as required by US GAAP principles because Bancorp retains some form of effective control; however, Bancorp receives no interest income on the sold portion of these loans.  These participation loans sold are excluded in the calculation of margins, which Bancorp believes provides a more accurate determination of the performance of its loan portfolio.

Prime rate and the five year Treasury bond rate are included above to provide a general indication of the interest rate environment in which Bancorp operated.  Approximately $598 million, or 35%, of Bancorp’s loans are variable rate; most of these loans are indexed to the prime rate and may reprice as that rate changes.  However, approximately $328 million of variable rate loans, have reached their contractual floor of 4% or higher.  Approximately $112 million of variable rate loans have contractual floors below 4%.  The remaining $158 million of variable rate loans have no contractual floor. Bancorp intends to establish floors whenever possible upon acquisition of new customers.  Bancorp’s variable rate loans are primarily comprised of commercial lines of credit and real estate loans.  At inception, most of Bancorp’s fixed rate loans are priced in relation to the five year Treasury bond.

Average loan balances increased $110 million or 7.2% in 2013; however, the declining interest rate environment drove average loan yields lower by 43 basis points.  Bancorp grew average interest bearing deposits $121 million or 9.2%.  Average interest costs on interest bearing deposits decreased 19 basis points, again reflecting the declining interest rate market and a more favorable mix of deposits. Average Federal Home Loan Bank (“FHLB”) advances decreased by $27.6 million or 45.9%, with average rates decreasing by 136 basis points.  In the fourth quarter of 2012, Bancorp prepaid $30 million of fixed rate advances, incurring $1.06 million in prepayment penalties, which were recorded as interest expense.  Rate changes, combined with volume changes on loans, deposits and FHLB advances, resulted in higher net interest income, but a lower net interest margin for 2013 compared to 2012.

Management anticipates a stable prime rate for 2014.  Time deposit maturities of approximately $111 million, or 32% of total time deposits, in the first two quarters are not likely to spark improvement in interest expense as prevailing market rates are similar to existing rates on those deposits.  The redemption of the $30 million trust preferred securities, which paid 10%, will provide an improvement in interest expense.  This will be somewhat offset by declining overall rates in the loan portfolio as persistent low prevailing rates are expected to continue to erode the overall yield on loans.  The margin could be further affected negatively if competition causes increases in deposit rates or a greater than expected decline in loan pricing in Bancorp’s markets.

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Net interest margin in 2013 reflected a higher amount of prepayment fees associated with loan refinancing activity.  Adjusting for these sources of additional income, Bancorp’s more normalized or core net interest margin has trended downward throughout 2013, declining to 3.66% for 2013 from 3.88% for 2012. (See “Non-GAAP Financial Measures” section for reconcilement of non-GAAP measures to US GAAP measures.)  Management believes these core margins better reveal the pressure of a low interest rate environment and a highly competitive loan market, and it expects margin compression to diminish in 2013.

Asset/Liability Management and Interest Rate Risk

Managing interest rate risk is fundamental for the financial services industry. The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity while attempting to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.

Interest Rate Simulation Sensitivity Analysis

Bancorp uses an earnings simulation model to estimate and evaluate the impact of an immediate change in interest rates on earnings in a one year forecast. The simulation model is designed to reflect the dynamics of interest earning assets, interest bearing liabilities and off-balance sheet financial instruments. By estimating the effects of interest rate increases and decreases, the model can reveal approximate interest rate risk exposure. The simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time.  The model is therefore a tool to indicate earnings trends in given interest rate scenarios and does not indicate actual expected results.

The December 31, 2013 simulation analysis, which shows very little interest rate sensitivity, indicates that an increase in interest rates of 100 to 200 basis points would have a negative effect on net interest income, and a decrease of 100 basis points in interest rates would also have a slightly negative effect on net interest income.  These estimates are summarized below.

		Net interest income % change
Increase 200 bp		(5.48	)
Increase 100 bp		(3.84	)
Decrease 100 bp		(2.08	)
Decrease 200 bp		N/A

Loans indexed to the prime rate, with floors of 4% or higher, comprise approximately 19% of total loans.  Since the prime rate is currently 3.25%, rates would have to increase more than 75 bp before the rates on such loans will rise.  This effect, captured in the simulation analysis above, negatively impacts the effect of rising rates.

The scenario of rates decreasing 200 bp is not reasonably possible given current low rates for short-term instruments and most deposits.

Undesignated derivative instruments described in Note 21 to Bancorp’s consolidated financial statements are recognized on the consolidated balance sheet at fair value, with changes in fair value, due to changes in prevailing interest rates, recorded in other non-interest income. Because of matching terms of offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings, and are therefore not included in the simulation analysis results above.

Derivatives designated as cash flow hedges described in Note 21 to Bancorp’s consolidated financial statements are recognized on the consolidated balance sheet at fair value, with changes in fair value, due to changes in prevailing interest rates, recorded net of tax in other comprehensive income.

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The following table presents the increases in net interest income due to changes in rate and volume computed on a tax-equivalent basis and indicates how net interest income in 2013 and 2012 was impacted by volume increases and the lower average interest rate environment. The tax-equivalent adjustments are based on a 35% federal tax rate. The change in interest due to both rate and volume has been allocated to the change due to rate and the change due to volume in proportion to the relationship of the absolute dollar amounts of the change in each.

Taxable Equivalent Rate/Volume Analysis

		2013/2012									2012/2011
		Increase (decrease)									Increase (decrease)
					due to									due to
(In thousands)		Net change			Rate			Volume			Net change			Rate			Volume
Interest income
Loans		$	(1,376	)	$	(6,932	)	$	5,556		$	586		$	(1,494	)	$	2,080
Federal funds sold		(25		)	3			(28		)	65			—			65
Mortgage loans held for sale		(125		)	(2		)	(123		)	113			(32		)	145
Securities
Taxable		442			(1,199		)	1,641			483			(841		)	1,324
Tax-exempt		(48		)	(205		)	157			(212		)	(204		)	(8		)
Total interest income		(1,132		)	(8,335		)	7,203			1,035			(2,571		)	3,606
Interest expense
Deposits
Interest bearing demand deposits		(126		)	(231		)	105			(86		)	(155		)	69
Savings deposits		(22		)	(34		)	12			(48		)	(60		)	12
Money market deposits		(569		)	(712		)	143			(804		)	(987		)	183
Time deposits		(1,438		)	(1,214		)	(224		)	(2,001		)	(1,457		)	(544		)
Securities sold under agreements to repurchase		(34		)	(37		)	3			(73		)	(66		)	(7		)
Federal funds purchased and other short-term borrowings		1			1			—			(7		)	(3		)	(4		)
Federal Home Loan
Bank advances		(1,574		)	(663		)	(911		)	1,001			1,009			(8		)
Long-term debt		(23		)	77			(100		)	(338		)	536			(874		)
Total interest expense		(3,785		)	(2,813		)	(972		)	(2,356		)	(1,183		)	(1,173		)
Net interest income		$	2,653		$	(5,522	)	$	8,175		$	3,391		$	(1,388	)	$	4,779

Bancorp’s tax equivalent net interest income increased $2.7 million for the year ended December 31, 2013 compared to the same period of 2012 while 2012 increased $3.4 million compared to 2011.  Net interest income for 2013 compared to 2012 was positively impacted by an increase in loan and securities volume and a decrease in deposit rates, a more favorable mix of deposits, and decreases in volume and rates of FHLB advances.  Net interest income was negatively impacted by a decline in the average rate earned on assets.  Volume increases of loans and securities boosted net interest income by $7.2 million and declining rates on deposits, particularly time deposits, contributed $2.2 million to the increase of net interest income.  Partially

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