THE PNC FINANCIAL SERVICES GROUP, INC. Quarterly Report on Form 10-Q For the quarterly period ended September 30, 2001 Page 1 represents a portion of the third quarter 2001 Financial Review which is not required by the Form 10-Q report and is not "filed" as part of the Form 10-Q. The Quarterly Report on Form 10-Q and cross reference index is on page 41. CONSOLIDATED FINANCIAL HIGHLIGHTS THE PNC FINANCIAL SERVICES GROUP, INC.
Three months ended September 30 Nine months ended September 30 -------------------------------- ------------------------------ Dollars in millions, except per share data 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------- FINANCIAL PERFORMANCE Revenue Net interest income (taxable-equivalent basis) $564 $534 $1,692 $1,644 Noninterest income 789 700 2,210 2,156 -------------------------------- ------------------------------ Total revenue 1,353 1,234 3,902 3,800 Income from continuing operations 298 299 858 900 Discontinued operations 23 40 45 -------------------------------- ------------------------------ Income before cumulative effect of accounting change 298 322 898 945 Cumulative effect of accounting change (5) -------------------------------- ------------------------------ Net income $298 $322 $893 $945 ================================ ============================== CASH EARNINGS (a) Continuing operations $327 $328 $946 $986 Discontinued operations 24 40 46 -------------------------------- ------------------------------ Before cumulative effect of accounting change 327 352 986 1,032 Cumulative effect of accounting change (5) -------------------------------- ------------------------------ Net income from cash earnings $327 $352 $981 $1,032 ================================ ============================== Per common share DILUTED EARNINGS Continuing operations $1.02 $1.01 $2.91 $3.03 Discontinued operations .08 .14 .15 -------------------------------- ------------------------------ Before cumulative effect of accounting change 1.02 1.09 3.05 3.18 Cumulative effect of accounting change (.02) -------------------------------- ------------------------------ Net income $1.02 $1.09 $3.03 $3.18 ================================ ============================== DILUTED CASH EARNINGS (a) Continuing operations $1.12 $1.11 $3.22 $3.32 Discontinued operations .08 .14 .16 -------------------------------- ------------------------------ Before cumulative effect of accounting change 1.12 1.19 3.36 3.48 Cumulative effect of accounting change (.02) -------------------------------- ------------------------------ Net income from cash earnings $1.12 $1.19 $3.34 $3.48 ================================ ============================== Cash dividends declared $.48 $.45 $1.44 $1.35 - ---------------------------------------------------------------------------------------------------------------------------- SELECTED RATIOS FROM CONTINUING OPERATIONS Return on Average common shareholders' equity 17.92% 19.99% 17.55% 20.67% Average assets 1.71 1.72 1.63 1.74 Net interest margin 3.86 3.54 3.76 3.63 Noninterest income to total revenue 58.31 56.73 56.64 56.74 Efficiency (b) 54.70 56.79 56.71 57.32 FROM NET INCOME Return on Average common shareholders' equity 17.92% 21.54% 18.28% 21.72% Average assets 1.71 1.67 1.67 1.67 Net interest margin 3.86 3.27 3.72 3.38 Noninterest income to total revenue 58.31 59.23 57.12 58.82 Efficiency (c) 54.70 54.50 56.13 55.87 =============================================================================================================================
(a) Excludes amortization of goodwill and does not reflect the implementation of Statement of Financial Accounting Standards No. 142. (b) Excludes amortization and distributions on capital securities. (c) Excludes amortization, distributions on capital securities and residential mortgage banking risk management activities. 1
September 30 December 31 September 30 Dollars in millions, except per share data 2001 2000 2000 - --------------------------------------------------------------------------------------------------------------------------------- BALANCE SHEET DATA Assets $71,944 $69,844 $69,884 Earning assets 57,684 59,373 60,142 Loans, net of unearned income 42,140 50,601 49,791 Securities available for sale 11,689 5,902 6,490 Loans held for sale 1,753 1,655 2,127 Deposits 44,995 47,664 47,494 Transaction deposits 30,773 28,771 27,848 Borrowed funds 13,046 11,718 12,299 Shareholders' equity 6,827 6,656 6,383 Common shareholders' equity 6,611 6,344 6,071 Book value per common share 23.28 21.88 21.01 Loans to deposits 94% 106% 105% CAPITAL RATIOS Leverage 8.1% 8.0% 6.9% Common shareholders' equity to total assets 9.19 9.08 8.69 ASSET QUALITY RATIOS Nonperforming assets to total loans, loans held for sale and foreclosed assets .85% .71% .68% Allowance for credit losses to total loans 1.71 1.33 1.36 Allowance for credit losses to nonaccrual loans 199.45 208.98 219.16 Net charge-offs to average loans (For the three months ended) .59 .32 .24 =================================================================================================================================
2 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. This Financial Review should be read in conjunction with The PNC Financial Services Group, Inc. ("Corporation" or "PNC") unaudited Consolidated Financial Statements and Statistical Information included herein and the Financial Review and audited Consolidated Financial Statements included in the Corporation's 2000 Annual Report. Certain prior-period amounts have been reclassified to conform with the current year presentation. For information regarding certain business risks, see the Risk Management and Risk Factors sections in this Financial Review. Also, see the Forward-Looking Statements section in this Financial Review for certain other factors that could cause actual results to differ materially from forward-looking statements or historical performance. OVERVIEW THE PNC FINANCIAL SERVICES GROUP, INC. The Corporation is one of the largest diversified financial services companies in the United States, operating businesses engaged in regional community banking, corporate banking, real estate finance, asset-based lending, wealth management, asset management and global fund services. The Corporation provides certain products and services nationally and others in PNC's primary geographic markets in Pennsylvania, New Jersey, Delaware, Ohio and Kentucky. The Corporation also provides certain asset management and global fund services internationally. PNC continues to aggressively pursue strategies to create a more diverse and valuable business mix designed to create shareholder value over time. PNC's focus is on increasing the contribution from more highly-valued businesses such as asset management and processing while improving the risk/return characteristics of traditional banking businesses. Earnings from asset management and processing businesses represented 25% of total business earnings for the first nine months of 2001 and consolidated noninterest income was 57% of total revenue for the first nine months of 2001. At the same time, PNC sold its residential mortgage banking business and has been downsizing certain institutional lending portfolios resulting in an improvement of the loan to deposit ratio to 94% at September 30, 2001. Over the past three years, PNC has reduced loans by $15 billion and unfunded commitments by $32 billion. PNC continues to evaluate opportunities to reduce lending exposure and further improve the risk/return characteristics of its lending businesses. All of the actions have strenghtened PNC's position in the most difficult operating environment since the early 1990's. On January 31, 2001, PNC closed the sale of its residential mortgage banking business. The gain on sale and earnings from operations included in the first nine months of 2001 totaled $40 million or $.14 per diluted share. These earnings were partially offset by a $32 million or $.11 per diluted share charge in the first quarter of 2001 related to the charge-off of loans in the communications and energy, metals and mining portfolios that PNC has designated for downsizing and severance costs. Certain closing date adjustments are currently in dispute between PNC and the buyer. The disputed matters will be resolved in accordance with procedures provided for in the purchase agreement. The ultimate financial impact of the sale will not be determined until final settlement is completed. SUMMARY FINANCIAL RESULTS Consolidated net income for the first nine months of 2001 was $893 million or $3.03 per diluted share. Excluding the effect of adopting the new accounting standard for financial derivatives, net income was $898 million or $3.05 per diluted share compared with $945 million or $3.18 per diluted share for the first nine months of 2000. These results include the negative impact of a $59 million or $.20 per diluted share net loss from venture capital activities in 2001. Excluding this loss and the effect of the accounting change, results for the first nine months of 2001 were $957 million or $3.25 per diluted share. Return on average common shareholders' equity was 18.28% and return on average assets was 1.67% for the first nine months of 2001 compared with 21.72% and 1.67%, respectively, for the first nine months of 2000. The residential mortgage banking business is reflected in discontinued operations throughout the Corporation's consolidated financial statements. Accordingly, the earnings and net assets of the residential mortgage banking business are shown separately on one line in the income statement and balance sheet, respectively, for all periods presented. The remainder of the discussion and information in this Financial Review reflects continuing operations, unless otherwise noted. 3 Taxable-equivalent net interest income of $1.692 billion for the first nine months of 2001 increased 3% compared with the first nine months of 2000. The increase was primarily due to the positive impact of transaction deposit growth and a lower rate environment that was partially offset by the impact of continued downsizing of the loan portfolio. The net interest margin widened 13 basis points to 3.76% for the first nine months of 2001 compared with 3.63% for the first nine months of 2000. The increase was primarily due to the impact of the lower rate environment and the benefit of growth in transaction deposits and downsizing of higher-cost, less valuable retail certificates and wholesale deposits. The provision for credit losses was $235 million for the first nine months of 2001 compared with $96 million for the same period in 2000. The increase was primarily related to loans in the communications and energy, metals and mining portfolios that PNC is downsizing. A $45 million addition to unallocated reserves, given the deterioration in overall economic conditions, also contributed to the increase. Noninterest income was $2.210 billion for the first nine months of 2001 and included $134 million of net securities gains and $82 million of equity management losses related to venture capital activities. Excluding net securities gains and equity management gains and losses from both years, noninterest income increased 7% compared with the first nine months of 2000 primarily due to growth in asset management, fund servicing and consumer services revenue. Noninterest expense was $2.350 billion for the first nine months of 2001 compared with $2.319 billion for the first nine months of 2000 and the efficiency ratio remained essentially flat at 57% during both periods. Total assets were $71.9 billion at September 30, 2001 compared with $69.8 billion at December 31, 2000. Average interest-earning assets were $59.7 billion for the first nine months of 2001 compared with $60.1 billion for the first nine months of 2000. A decline in loans and loans held for sale was partially offset by an increase in securities available for sale that are used for balance sheet and interest rate risk management activities. Shareholders' equity totaled $6.8 billion at September 30, 2001 and the regulatory capital ratios were 8.1% for leverage, 8.4% for tier I risk-based and 12.0% for total risk-based capital. During the first nine months of 2001, PNC repurchased 8.4 million shares of common stock. Nonperforming assets were $374 million at September 30, 2001 compared with $372 million at December 31, 2000. The ratio of nonperforming assets to total loans, loans held for sale and foreclosed assets was .85% at September 30, 2001 compared with .71% at December 31, 2000. This ratio increased as the benefit of essentially flat nonperforming assets was more than offset by a reduction in loans outstanding. The allowance for credit losses was $720 million and represented 1.71% of total loans and 199% of nonaccrual loans at September 30, 2001. The comparable amounts were $675 million, 1.33% and 209%, respectively, at December 31, 2000. Net charge-offs were $190 million or .55% of average loans for the first nine months of 2001 compared with $95 million or .25% for the same period in 2000. The increase was primarily related to commercial loans in portfolios that PNC is downsizing. 4 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. REVIEW OF BUSINESSES PNC operates seven major businesses engaged in regional community banking, corporate banking, real estate finance, asset-based lending, wealth management, asset management and global fund services. Business results are presented based on PNC's management accounting practices and the Corporation's management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to generally accepted accounting principles; therefore, PNC's business results are not necessarily comparable with similar information for any other financial services institution. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. The management accounting process uses various balance sheet and income statement assignments and transfers to measure performance of the businesses. Methodologies change from time to time as management accounting practices are enhanced and businesses change. Securities available for sale or borrowings and related net interest income are assigned based on the net asset or liability position of each business. Capital is assigned based on management's assessment of inherent risks and equity levels at independent companies providing similar products and services. The allowance for credit losses is allocated based on management's assessment of risk inherent in the loan portfolios. Support areas not directly aligned with the businesses are allocated primarily based on the utilization of services. Total business financial results differ from consolidated results from continuing operations primarily due to differences between management accounting practices and generally accepted accounting principles, loan portfolios and businesses that were designated for downsizing during 1999, equity management activities, minority interests, residual asset and liability management activities, eliminations, unallocated reserves and unassigned items, the impact of which is reflected in the "Other" category. The operating results and financial impact of the disposition of the residential mortgage banking business, previously PNC Mortgage, are included in discontinued operations. RESULTS OF BUSINESSES
Revenue Return on Earnings (taxable-equivalent basis) Assigned Capital Average Assets -------------------------------------------------------------------------------------- Nine months ended September 30 - dollars in millions 2001 2000 2001 2000 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------------- PNC Bank Regional Community Banking $525 $430 $1,685 $1,497 26% 22% $40,188 $38,564 Corporate Banking 97 190 562 633 11 21 16,389 16,318 - -------------------------------------------------------------------------------------- --------------------- Total PNC Bank 622 620 2,247 2,130 21 22 56,577 54,882 - -------------------------------------------------------------------------------------- --------------------- Secured Finance PNC Real Estate Finance 53 50 161 155 18 17 5,253 5,583 PNC Business Credit 42 37 102 86 35 33 2,430 2,230 - -------------------------------------------------------------------------------------- --------------------- Total Secured Finance 95 87 263 241 23 22 7,683 7,813 - -------------------------------------------------------------------------------------- --------------------- Total Banking 717 707 2,510 2,371 21 22 64,260 62,695 - -------------------------------------------------------------------------------------- --------------------- Asset Management and Processing PNC Advisors 117 127 562 589 29 31 3,399 3,541 BlackRock 79 63 404 348 25 27 644 492 PFPC 49 31 556 505 31 20 1,759 1,578 - -------------------------------------------------------------------------------------- --------------------- Total Asset Management and Processing 245 221 1,522 1,442 28 28 5,802 5,611 - -------------------------------------------------------------------------------------- --------------------- Total business results 962 928 4,032 3,813 23 23 70,062 68,306 Other (104) (28) (130) (13) 427 221 - -------------------------------------------------------------------------------------- --------------------- Results from continuing operations 858 900 3,902 3,800 18 21 70,489 68,527 Discontinued operations 40 45 68 459 Cumulative effect of accounting change (5) - -------------------------------------------------------------------------------------- --------------------- Total Consolidated $893 $945 $3,902 $3,800 18 22 $70,557 $68,986 ==================================================================================================================================
5 REGIONAL COMMUNITY BANKING Nine months ended September 30 - dollars in millions 2001 2000 - ----------------------------------------------------------------- INCOME STATEMENT Net interest income $1,093 $1,058 Other noninterest income 507 443 Net securities gains (losses) 85 (4) - ----------------------------------------------------------------- Total revenue 1,685 1,497 Provision for credit losses 35 33 Noninterest expense 827 796 - ----------------------------------------------------------------- Pretax earnings 823 668 Income taxes 298 238 - ----------------------------------------------------------------- Earnings $525 $430 - ----------------------------------------------------------------- AVERAGE BALANCE SHEET Loans Consumer Home equity $6,219 $5,360 Indirect automobile 853 1,281 Other consumer 870 873 - ----------------------------------------------------------------- Total consumer 7,942 7,514 Commercial 3,588 3,676 Residential mortgage 8,691 11,538 Vehicle leasing 1,872 1,255 Other 135 142 - ----------------------------------------------------------------- Total loans 22,228 24,125 Securities available for sale 9,561 5,547 Loans held for sale 1,270 1,316 Assigned assets and other assets 7,129 7,576 - ----------------------------------------------------------------- Total assets $40,188 $38,564 - ----------------------------------------------------------------- Deposits Noninterest-bearing demand $4,515 $4,570 Interest-bearing demand 5,602 5,408 Money market 12,020 9,994 - ----------------------------------------------------------------- Total transaction deposits 22,137 19,972 Savings 1,870 2,030 Certificates 12,292 13,641 - ----------------------------------------------------------------- Total deposits 36,299 35,643 Other liabilities 1,177 319 Assigned capital 2,712 2,602 - ----------------------------------------------------------------- Total funds $40,188 $38,564 - ----------------------------------------------------------------- PERFORMANCE RATIOS Return on assigned capital 26% 22% Noninterest income to total revenue 35 29 Efficiency 47 51 ================================================================= Regional Community Banking provides deposit, branch-based brokerage, electronic banking and credit products and services to retail customers as well as deposit, credit, treasury management and capital markets products and services to small businesses primarily within PNC's geographic region. Regional Community Banking's strategic focus is on driving sustainable revenue growth, aggressively managing the revenue/expense relationship and improving the risk/return dynamic of this business. Regional Community Banking utilizes knowledge-based marketing capabilities to analyze customer demographic information, transaction patterns and delivery preferences to develop customized banking packages focused on improving customer satisfaction and profitability. Regional Community Banking has also invested heavily in building a sales culture and infrastructure while improving efficiency. Capital investments have been strategically directed towards the expansion of multi-channel distribution, consistent with customer preferences, as well as the delivery of relevant customer information to all distribution channels. Regional Community Banking contributed 55% of total business earnings for the first nine months of 2001 compared with 46% for the first nine months of 2000. Earnings increased $95 million or 22% to $525 million for the first nine months of 2001 primarily due to business growth and net securities gains. Excluding net securities gains from the first nine months of 2001 and net securities losses from the first nine months of 2000, earnings increased approximately 10% primarily driven by higher noninterest income, deposit growth and improved efficiency. Total revenue increased 13% to $1.685 billion for the first nine months of 2001. Excluding net securities gains and losses from both periods, revenue increased 7% in the period-to-period comparison primarily due to higher consumer transaction activity in 2001 and residential mortgage loan securitization gains. The provision for credit losses for the first nine months of 2001 was $35 million compared with $33 million for the same period in 2000. Total loans decreased in the comparison as growth in home equity loans and vehicle leases was more than offset by the reduction of residential mortgage loans due to securitizations and the continued downsizing of the indirect automobile lending portfolio. The decrease in residential mortgage loans was offset by an increase in securities available for sale. Total deposits grew 2% in the comparison driven by a $2.2 billion increase in transaction deposits. The increase in money market deposits resulted from targeted consumer marketing initiatives to add new accounts and retain existing customers as funds shifted from savings and certificates of deposit. 6 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. CORPORATE BANKING Nine months ended September 30 - dollars in millions 2001 2000 - ----------------------------------------------------------------- INCOME STATEMENT Credit-related revenue $289 $304 Noncredit revenue 273 329 - ----------------------------------------------------------------- Total revenue 562 633 Provision for credit losses 129 50 Noninterest expense 287 291 - ----------------------------------------------------------------- Pretax earnings 146 292 Income taxes 49 102 - ----------------------------------------------------------------- Earnings $97 $190 - ----------------------------------------------------------------- AVERAGE BALANCE SHEET Loans Middle market $5,834 $6,140 Large corporate 3,127 3,223 Energy, metals and mining 1,222 1,341 Communications 1,063 1,449 Leasing 2,264 1,768 Other 329 362 - ----------------------------------------------------------------- Total loans 13,839 14,283 Other assets 2,550 2,035 - ----------------------------------------------------------------- Total assets $16,389 $16,318 - ----------------------------------------------------------------- Deposits $4,764 $4,571 Assigned funds and other liabilities 10,396 10,523 Assigned capital 1,229 1,224 - ----------------------------------------------------------------- Total funds $16,389 $16,318 - ----------------------------------------------------------------- PERFORMANCE RATIOS Return on assigned capital 11% 21% Noncredit revenue to total revenue 49 52 Efficiency 51 46 ================================================================= Corporate Banking provides credit, equipment leasing, treasury management and capital markets products and services to large and mid-sized corporations, institutions and government entities primarily within PNC's geographic region. The strategic focus for Corporate Banking is on the middle market with an emphasis on higher-margin noncredit products and services, especially treasury management and capital markets, and on improving the risk/return characteristics of its lending business. Approximately 35% of Corporate Banking's loan portfolio represents syndicated loans. These credits are generally large commitments that are shared by a number of financial institutions to reduce exposure to any one customer. During the first quarter of 2001, the Corporation announced the decision to downsize the communications portfolio and certain portions of the energy, metals and mining and large corporate portfolios. The designated loans are included in Corporate Banking business results in both periods presented. Management continues to aggressively evaluate opportunities to reduce lending exposure and improve the risk/return characteristics of this business. This strategy could lead to significant changes and write-downs in connection with the execution of further downsizing actions. Corporate Banking contributed 10% of total business earnings for the first nine months of 2001 compared with 21% for the first nine months of 2000. Earnings declined to $97 million for the first nine months of 2001 compared with $190 million for the first nine months of 2000 primarily due to a higher provision for credit losses in 2001 related to portfolios that PNC is downsizing and lower noncredit revenue. Total revenue of $562 million for the first nine months of 2001 decreased $71 million compared with the same period in 2000. Credit-related revenue decreased 5% compared with the first nine months of 2000 as the impact of a wider net interest margin was more than offset by a decrease in average loans. The decrease in average loans in the period-to-period comparison was primarily due to reductions in the large corporate, energy, metals and mining, communications and middle market portfolios, partially offset by the expansion of equipment leasing. Middle market loans declined in the period-to-period comparison primarily due to strategies to improve the risk profile of this portfolio. Noncredit revenue includes noninterest income and the benefit of compensating balances received in lieu of fees. Noncredit revenue decreased $56 million compared with the first nine months of 2000 primarily due to the impact of weak equity market conditions that resulted in lower capital markets fees and valuation losses associated with equity investments. The provision for credit losses was $129 million for the first nine months of 2001 compared with $50 million for the first nine months of 2000. The higher provision was primarily related to portfolios that are being downsized. A sustained weakness or further weakening of the economy, or other factors that adversely affect asset quality, could result in an increase in the number of delinquencies, bankruptcies or defaults, and a higher level of nonperforming assets, net charge-offs and provision for credit losses in future periods. See Credit Risk in the Risk Management section of this Financial Review for additional information regarding credit risk. Treasury management and capital markets products offered through Corporate Banking are sold by several businesses across the Corporation and related profitability is included in the results of those businesses. Consolidated revenue from treasury management was $251 million for the first nine months of 2001 compared with $253 million for the first nine months of 2000. Increases in fee revenue were offset by lower income earned on customers' deposit balances resulting from the lower interest rate environment in 2001 and the impact of downsizing institutional lending. Consolidated revenue from capital markets was $89 million for the first nine months of 2001, a $10 million decrease compared with the first nine months of 2000 due to weak equity market conditions as well as the impact of downsizing certain lending portfolios. 7 PNC REAL ESTATE FINANCE Nine months ended September 30 - dollars in millions 2001 2000 - ---------------------------------------------------------------- INCOME STATEMENT Net interest income $88 $87 Noninterest income Commercial mortgage banking 45 45 Other 28 23 - ---------------------------------------------------------------- Total noninterest income 73 68 - ---------------------------------------------------------------- Total revenue 161 155 Provision for credit losses 3 Noninterest expense 117 102 - ---------------------------------------------------------------- Pretax earnings 41 53 Income tax (benefit) expense (12) 3 - ---------------------------------------------------------------- Earnings $53 $50 - ---------------------------------------------------------------- AVERAGE BALANCE SHEET Loans Commercial - real estate related $1,753 $2,021 Commercial real estate 2,321 2,427 - ---------------------------------------------------------------- Total loans 4,074 4,448 Commercial mortgages held for sale 220 180 Other assets 959 955 - ---------------------------------------------------------------- Total assets $5,253 $5,583 - ---------------------------------------------------------------- Deposits $466 $260 Assigned funds and other liabilities 4,392 4,940 Assigned capital 395 383 - ---------------------------------------------------------------- Total funds $5,253 $5,583 - ---------------------------------------------------------------- PERFORMANCE RATIOS Return on assigned capital 18% 17% Noninterest income to total revenue 45 44 Efficiency 58 53 ================================================================ PNC Real Estate Finance provides credit, capital markets, treasury management, commercial mortgage loan servicing and other products and services to developers, owners and investors in commercial real estate. PNC's commercial real estate financial services platform provides processing services through Midland Loan Services, Inc., a leading third-party provider of loan servicing and technology to the commercial real estate finance industry, and Columbia Housing Partners, LP, ("Columbia") a national syndicator of affordable housing equity. On October 17, 2001, PNC announced that it completed the acquisition of certain lending and servicing-related assets from TRI Acceptance Corporation. The acquisition will expand PNC Real Estate Finance's reach in multi-family finance, combining permanent loan capacity with PNC's traditional interim lending activities and Columbia's tax credit syndication capabilities. Over the past three years, PNC Real Estate Finance has been strategically shifting to a more balanced and valuable revenue stream by focusing on real estate processing businesses and increasing the value of its lending business by selling more fee-based products. During the first nine months of 2001, 45% of total revenue was generated by fee-based activities. Management continues to aggressively evaluate opportunities to reduce credit exposure and improve the risk/return characteristics of this business. PNC Real Estate Finance contributed 6% of total business earnings for the first nine months of 2001 compared with 5% for the first nine months of 2000. Earnings increased $3 million or 6% in the period-to-period comparison primarily due to growth in processing services. Average loans decreased 8% in the period-to-period comparison reflecting management's ongoing strategy to reduce balance sheet leverage. Total revenue was $161 million for the first nine months of 2001 compared with $155 million for the first nine months of 2000. The increase of $6 million or 4% was primarily due to higher commercial mortgage loan servicing fees, reflecting a larger servicing portfolio. The increase in servicing fees was offset by higher amortization of servicing intangibles that resulted from the larger servicing portfolio as well as lower commercial mortgage-backed securitization gains. The commercial mortgage servicing portfolio increased 32% in the comparison to $66 billion at September 30, 2001. COMMERCIAL MORTGAGE SERVICING PORTFOLIO In billions 2001 2000 - ---------------------------------------------------------------- January 1 $51 $45 Acquisitions/additions 23 10 Repayments/transfers (8) (5) - ---------------------------------------------------------------- September 30 $66 $50 ================================================================ The provision for credit losses was $3 million for the first nine months of 2001 and was primarily related to the sale of one nonperforming asset in the third quarter of 2001. Noninterest expense was $117 million for the first nine months of 2001 compared with $102 million in the same period last year. The increase was primarily due to non-cash (passive) losses on affordable housing investments that were more than offset by related income tax credits. 8 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. PNC BUSINESS CREDIT Nine months ended September 30 - dollars in millions 2001 2000 - ---------------------------------------------------------------- INCOME STATEMENT Net interest income $77 $74 Noninterest income 25 12 - ---------------------------------------------------------------- Total revenue 102 86 Provision for credit losses 13 7 Noninterest expense 23 22 - ---------------------------------------------------------------- Pretax earnings 66 57 Income taxes 24 20 - ---------------------------------------------------------------- Earnings $42 $37 - ---------------------------------------------------------------- AVERAGE BALANCE SHEET Loans $2,304 $2,158 Other assets 126 72 - ---------------------------------------------------------------- Total assets $2,430 $2,230 - ---------------------------------------------------------------- Deposits $81 $62 Assigned funds and other liabilities 2,188 2,020 Assigned capital 161 148 - ---------------------------------------------------------------- Total funds $2,430 $2,230 - ---------------------------------------------------------------- PERFORMANCE RATIOS Return on assigned capital 35% 33% Noninterest income to total revenue 25 14 Efficiency 22 24 ================================================================ PNC Business Credit provides asset-based lending, capital markets and treasury management products and services to middle market customers nationally. PNC Business Credit's lending services include loans secured by accounts receivable, inventory, machinery and equipment, and other collateral, and its customers include manufacturing, wholesale, distribution, retailing and service industry companies. PNC Business Credit's strategic focus is to build scale through portfolio acquisitions, expansion of existing offices as well as the addition of new marketing locations. The average loan portfolio grew 7% to $2.3 billion for the first nine months of 2001 primarily as a result of this expansion. PNC Business Credit currently operates 15 offices in 13 states with a centralized back office to provide consistency to the control environment as well as cost efficiencies. PNC Business Credit contributed 4% of total business earnings for the first nine months of 2001 and 2000. Earnings increased $5 million or 14% in the period-to-period comparison to $42 million for the first nine months of 2001 as higher revenue was partially offset by an increase in the provision for credit losses. Revenue was $102 million for the first nine months of 2001, a $16 million or 19% increase compared with the first nine months of 2000 primarily due to higher noninterest income. The increase in noninterest income primarily resulted from gains on equity interests received as compensation in conjunction with lending relationships. The provision for credit losses increased $6 million to $13 million for the first nine months of 2001 as a result of declining credit conditions in a weaker economy. PNC Business Credit loans are secured loans to borrowers with a weaker financial condition. As a result, in a weaker economy, the provision for credit losses may be adversely affected. See Credit Risk in the Risk Management section of this Financial Review for additional information regarding credit risk. Noninterest expense was $23 million and the efficiency ratio improved to 22% for the first nine months of 2001 compared with $22 million and 24%, respectively, for the first nine months of 2000. The efficiency ratio improved in the comparison primarily due to higher noninterest income and economies of scale resulting from a centralized back office. 9 PNC ADVISORS Nine months ended September 30 - dollars in millions 2001 2000 - ---------------------------------------------------------------- INCOME STATEMENT Net interest income $99 $102 Noninterest income Investment management and trust 302 307 Brokerage 100 132 Other 61 48 - ---------------------------------------------------------------- Total noninterest income 463 487 - ---------------------------------------------------------------- Total revenue 562 589 Provision for credit losses 1 3 Noninterest expense 376 385 - ---------------------------------------------------------------- Pretax earnings 185 201 Income taxes 68 74 - ---------------------------------------------------------------- Earnings $117 $127 - ---------------------------------------------------------------- AVERAGE BALANCE SHEET Loans Commercial $543 $623 Consumer 1,098 960 Residential mortgage 884 969 Other 395 547 - ---------------------------------------------------------------- Total loans 2,920 3,099 Other assets 479 442 - ---------------------------------------------------------------- Total assets $3,399 $3,541 - ---------------------------------------------------------------- Deposits $2,078 $2,048 Assigned funds and other liabilities 774 943 Assigned capital 547 550 - ---------------------------------------------------------------- Total funds $3,399 $3,541 - ---------------------------------------------------------------- PERFORMANCE RATIOS Return on assigned capital 29% 31% Noninterest income to total revenue 82 83 Efficiency 66 65 ================================================================ PNC Advisors provides a full range of tailored investment products and services to affluent individuals and families including full-service brokerage through J.J.B. Hilliard, W.L. Lyons, Inc. ("Hilliard Lyons") and investment advisory services to the ultra-affluent through Hawthorn. PNC Advisors also serves as investment manager and trustee for employee benefit plans and charitable and endowment assets. PNC Advisors is focused on selectively expanding Hilliard Lyons and Hawthorn, increasing market share in PNC's primary geographic region and leveraging its expansive distribution platform. PNC Advisors contributed 12% of total business earnings for the first nine months of 2001 compared with 14% for the first nine months of 2000. Earnings of $117 million for the first nine months of 2001 decreased 8% compared with the same period last year due to the impact of weak equity markets. Revenue decreased $27 million in the period-to-period comparison primarily due to lower levels of retail investor trading activity and weak equity markets. Management expects that revenues in this business will continue to be challenged at least until equity market conditions improve. Noninterest expense decreased $9 million in the period-to-period comparison primarily due to lower production-based compensation and expense management initiatives. ASSETS UNDER MANAGEMENT (a) September 30 - in billions 2001 2000 - ---------------------------------------------------------------- Personal investment management and trust $46 $51 Institutional trust 13 15 - ---------------------------------------------------------------- Total $59 $66 ================================================================ (a) Assets under management do not include brokerage assets administered. Assets under management decreased $7 billion as approximately $4 billion of net new asset inflows during the past twelve months were more than offset by a decline in the value of the equity component of customers' portfolios. See Asset Management Performance in the Risk Factors section of this Financial Review for additional information regarding the potential impact of market conditions and asset management performance on PNC's revenue. Brokerage assets administered by PNC Advisors were $26 billion at September 30, 2001, compared with $28 billion at September 30, 2000 and were also impacted by weak market conditions. PNC Advisors will continue to focus on acquiring new customers and growing and expanding existing customer relationships while aggressively managing the revenue/expense relationship. 10 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. BLACKROCK Nine months ended September 30 - dollars in millions 2001 2000 - ---------------------------------------------------------------- INCOME STATEMENT Investment advisory and administrative fees $376 $330 Other income 28 18 - ---------------------------------------------------------------- Total revenue 404 348 Operating expense 222 179 Fund administration and servicing costs - affiliates 47 58 Amortization 8 8 - ---------------------------------------------------------------- Total expense 277 245 - ---------------------------------------------------------------- Operating income 127 103 Nonoperating income 7 4 - ---------------------------------------------------------------- Pretax earnings 134 107 Income taxes 55 44 - ---------------------------------------------------------------- Earnings $79 $63 - ---------------------------------------------------------------- PERIOD-END BALANCE SHEET Intangible assets $184 $195 Other assets 460 297 - ---------------------------------------------------------------- Total assets $644 $492 - ---------------------------------------------------------------- Other liabilities $186 $148 Stockholders' equity 458 344 - ---------------------------------------------------------------- Total liabilities and stockholders' equity $644 $492 - ---------------------------------------------------------------- PERFORMANCE DATA Return on equity 25% 27% Operating margin (a) 36 36 Diluted earnings per share $1.22 $.97 ================================================================ (a) Excludes the impact of fund administration and servicing costs - affiliates. BlackRock is one of the largest publicly traded investment management firms in the United States with $226 billion of assets under management at September 30, 2001. BlackRock manages assets on behalf of institutions and individuals through a variety of fixed income, liquidity, equity and alternative investment separate accounts and mutual funds, including its flagship fund families, BlackRock Funds and BlackRock Provident Institutional Funds. In addition, BlackRock provides risk management and technology services to a growing number of institutional investors under the BlackRock Solutions brand name. BlackRock continues to focus on delivering superior investment performance to clients while pursuing strategies to build on core strengths and to selectively expand the firm's expertise and breadth of distribution. BlackRock contributed 8% of total business earnings for the first nine months of 2001 compared with 7% for the first nine months of 2000. Earnings increased 26% in the period-to-period comparison primarily due to an 18% increase in assets under management. New client mandates and additional funding from existing clients was $31 billion or 89% of the increase in assets under management. Total revenue for the first nine months of 2001 increased $56 million or 16% compared with the first nine months of 2000 primarily due to new institutional business and strong fixed-income performance. The increase in operating expense in the period-to-period comparison supported revenue growth and business expansion. ASSETS UNDER MANAGEMENT September 30 - in billions 2001 2000 - ---------------------------------------------------------------- Separate accounts Fixed income $119 $97 Liquidity 7 5 Liquidity - securities lending 8 11 Equity 8 7 Alternative investment products 5 3 - ---------------------------------------------------------------- Total separate accounts 147 123 - ---------------------------------------------------------------- Mutual funds (a) Fixed income 14 14 Liquidity 56 38 Equity 9 16 - ---------------------------------------------------------------- Total mutual funds 79 68 - ---------------------------------------------------------------- Total assets under management $226 $191 ================================================================ (a) Includes BlackRock Funds, BlackRock Provident Institutional Funds, BlackRock Closed End Funds, Short Term Investment Funds and BlackRock Global Series Funds. BlackRock, Inc. is approximately 70% owned by PNC and is listed on the New York Stock Exchange under the symbol BLK. Additional information about BlackRock is available in its filings with the Securities and Exchange Commission ("SEC") and may be obtained electronically at the SEC's home page at www.sec.gov. 11 PFPC Nine months ended September 30 - dollars in millions 2001 2000 - ---------------------------------------------------------------- INCOME STATEMENT Fund servicing revenue $556 $505 Operating expense 396 380 Amortization 19 24 - ---------------------------------------------------------------- Operating income 141 101 Nonoperating income (a) 11 21 Debt financing 71 71 - ---------------------------------------------------------------- Pretax earnings 81 51 Income taxes 32 20 - ---------------------------------------------------------------- Earnings $49 $31 - ---------------------------------------------------------------- AVERAGE BALANCE SHEET Intangible assets $1,072 $1,110 Other assets 687 468 - ---------------------------------------------------------------- Total assets $1,759 $1,578 - ---------------------------------------------------------------- Deposits $79 $139 Assigned funds and other liabilities 1,472 1,231 Assigned capital 208 208 - ---------------------------------------------------------------- Total funds $1,759 $1,578 - ---------------------------------------------------------------- PERFORMANCE RATIOS Operating margin 25% 20% Return on assigned capital 31 20 ================================================================ (a) Net of nonoperating expense PFPC is the largest full-service mutual fund transfer agent and second largest provider of mutual fund accounting and administration services in the United States, providing a wide range of fund services to the investment management industry. PFPC also provides customized processing solutions to the international marketplace through its Dublin, Ireland and Luxembourg operations. To meet the growing needs of the European marketplace, PFPC continues its pursuit of offshore expansion. PFPC is also focusing technological resources on targeted Web-based initiatives and exploring strategic alliances. PFPC contributed 5% of total business earnings for the first nine months of 2001 and 3% for the first nine months of 2000. Earnings increased $18 million or 58% in the period-to-period comparison and performance ratios improved significantly. The increase in earnings was primarily due to strong growth in transfer agency and sub-accounting revenue that resulted from an increase in shareholder accounts serviced. The first nine months of 2001 also benefited from focused expense control efforts and the comparative impact of Investor Services Group integration costs incurred in the prior-year period. Revenue of $556 million for the first nine months of 2001 increased $51 million or 10% compared with the first nine months of 2000. An increase in accounting/administration revenue, driven by new client growth, more than offset the impact of lower custody assets. Growth rates in this business are expected to slow as a result of lower market valuations and competitive pricing pressure. See Fund Servicing in the Risk Factors section of this Financial Review for additional information regarding matters that could impact fund servicing revenue. Operating expense increased 4% in the period-to-period comparison primarily due to business expansion partially offset by the comparative impact of one-time integration costs in the prior-year period. SERVICING STATISTICS September 30 2001 2000 - ---------------------------------------------------------------- Accounting/administration assets ($ in billions) (a) $500 $460 Custody assets ($ in billions) 359 434 Shareholder accounts (in millions) 47 43 ================================================================ (a) Includes net assets serviced offshore of approximately $16 billion and $8 billion at September 30, 2001 and 2000, respectively. 12 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. CONSOLIDATED INCOME STATEMENT REVIEW NET INTEREST INCOME ANALYSIS
Taxable-equivalent basis Average Balances Interest Income/Expense Average Yields/Rates Nine months ended September 30 - ---------------------------- -------------------------- ----------------------------- dollars in millions 2001 2000 Change 2001 2000 Change 2001 2000 Change - ----------------------------------------------------------------------------------------------------------------------------------- Interest-earning assets Loans held for sale $1,805 $2,681 $(876) $90 $163 $(73) 6.52% 8.10% (158)bp Securities available for sale 10,237 6,105 4,132 454 292 162 5.92 6.38 (46) Loans, net of unearned income Commercial 20,144 21,878 (1,734) 1,130 1,383 (253) 7.40 8.31 (91) Commercial real estate 2,567 2,689 (122) 146 179 (33) 7.50 8.73 (123) Consumer 9,095 9,210 (115) 563 589 (26) 8.28 8.55 (27) Residential mortgage 9,616 12,519 (2,903) 522 668 (146) 7.24 7.11 13 Lease financing 4,144 3,082 1,062 220 168 52 7.07 7.25 (18) Other 478 670 (192) 25 42 (17) 6.93 8.40 (147) - ------------------------------------------------------------------------ ------------------------- Total loans, net of unearned income 46,044 50,048 (4,004) 2,606 3,029 (423) 7.51 8.01 (50) Other 1,637 1,278 359 93 71 22 7.61 7.39 22 - ------------------------------------------------------------------------ ------------------------- Total interest-earning assets/ interest income 59,723 60,112 (389) 3,243 3,555 (312) 7.21 7.84 (63) Noninterest-earning assets 10,834 8,874 1,960 - ------------------------------------------------------------------------ Total assets $70,557 $68,986 $1,571 ======================================================================== Interest-bearing liabilities Deposits Demand and money market $20,994 $18,389 $2,605 419 472 (53) 2.66 3.43 (77) Savings 1,927 2,088 (161) 15 27 (12) 1.03 1.73 (70) Retail certificates of deposit 12,716 14,591 (1,875) 516 603 (87) 5.43 5.52 (9) Other time 534 633 (99) 26 31 (5) 6.48 6.45 3 Deposits in foreign offices 948 1,437 (489) 35 67 (32) 4.86 6.12 (126) - ------------------------------------------------------------------------ -------------------------- Total interest-bearing deposits 37,119 37,138 (19) 1,011 1,200 (189) 3.64 4.31 (67) Borrowed funds 13,637 14,422 (785) 540 711 (171) 5.23 6.49 (126) - ------------------------------------------------------------------------ -------------------------- Total interest-bearing liabilities/ interest expense 50,756 51,560 (804) 1,551 1,911 (360) 4.07 4.92 (85) -------------------------- ----------------------------- Noninterest-bearing liabilities, capital securities and shareholders' equity 19,801 17,426 2,375 - ------------------------------------------------------------------------ Total liabilities, capital securities and shareholders' equity $70,557 $68,986 $1,571 ======================================================================== Interest rate spread 3.14 2.92 22 Impact of noninterest-bearing sources .62 .71 (9) ----------------------------- Net interest income/margin $1,692 $1,644 $48 3.76% 3.63% 13bp ===================================================================================================================================
NET INTEREST INCOME Changes in net interest income and margin result from the interaction between the volume and composition of earning assets, related yields and associated funding costs. Accordingly, portfolio size, composition and yields earned and funding costs can have a significant impact on net interest income and margin. Taxable-equivalent net interest income of $1.692 billion for the first nine months of 2001 increased 3% compared with the first nine months of 2000. The increase was primarily due to the positive impact of transaction deposit growth and a lower rate environment that was partially offset by the impact of continued downsizing of the loan portfolio. The net interest margin widened 13 basis points to 3.76% for the first nine months of 2001 compared with 3.63% for the first nine months of 2000. The increase was primarily due to the impact of the lower rate environment and the benefit of growth in transaction deposits and downsizing of higher-cost, less valuable retail certificates and wholesale deposits. See Interest Rate Risk in the Risk Management section of this Financial Review for additional information regarding interest rate risk. Loans represented 77% of average interest-earning assets for the first nine months of 2001 compared with 83% for the first nine months of 2000. The decrease was primarily due to the continued downsizing of certain institutional lending portfolios and the securitization of residential mortgage loans during the first nine months of 2001. Securities available for sale represented 17% of average interest-earning assets for the first nine months of 2001 compared with 10% for the first nine months of 2000. The increase was primarily due to the securitization of residential mortgage loans as part of balance sheet and interest rate risk management activities. 13 Funding cost is affected by the volume and composition of funding sources as well as related rates paid thereon. Average deposits comprised 64% and 66% of total sources of funds for the first nine months of 2001 and 2000, respectively, with the remainder primarily comprised of wholesale funding obtained at prevailing market rates. Average demand and money market deposits increased $2.6 billion or 14% compared with the first nine months of 2000, primarily reflecting the impact of strategic marketing initiatives to grow more valuable transaction accounts, while all other interest-bearing deposit categories decreased in the period-to-period comparison. Average borrowed funds for the first nine months of 2001 decreased $785 million compared with the first nine months of 2000 as lower bank notes and senior debt were partially offset by increases in Federal Home Loan Bank borrowings and repurchase agreements. PROVISION FOR CREDIT LOSSES The provision for credit losses was $235 million for the first nine months of 2001 compared with $96 million for the first nine months of 2000. The increase was primarily related to institutional lending portfolios that PNC is downsizing and a $45 million addition to unallocated reserves, given the deterioration in economic conditions. See Credit Risk in the Risk Management section of this Financial Review for additional information regarding credit risk. NONINTEREST INCOME Noninterest income was $2.210 billion for the first nine months of 2001 and included $134 million of net securities gains and $82 million of equity management losses related to venture capital activities. Excluding equity management income and losses and net securities gains in both years, noninterest income increased 7% compared with the first nine months of 2000 primarily due to growth in asset management, fund servicing and consumer services revenue. Asset management fees of $645 million for the first nine months of 2001 increased $55 million or 9% primarily driven by new institutional business and strong fixed-income performance at BlackRock. Consolidated assets under management were $270 billion at September 30, 2001, a 13% increase compared with September 30, 2000. Fund servicing fees were $545 million for the first nine months of 2001, a $58 million or 12% increase compared with the first nine months of 2000 primarily driven by new client growth. Service charges on deposits increased 7% to $160 million for the first nine months of 2001 primarily due to an increase in transaction deposit accounts. Brokerage fees were $163 million for the first nine months of 2001 compared with $192 million for the first nine months of 2000. The decrease was primarily due to a decline in equity markets activity. Consumer services revenue of $171 million for the first nine months of 2001 increased $18 million or 12% compared with the first nine months of 2000 primarily due to the expansion of PNC's ATM network and the increase in transaction deposit accounts. Corporate services revenue was $230 million for the first nine months of 2001 compared with $248 million for the first nine months of 2000. Higher commercial mortgage servicing revenue was more than offset by valuation adjustments of other assets and lower capital markets revenue. Equity management, which is comprised of venture capital activities, reflected a net loss of $82 million for the first nine months of 2001 compared with $132 million of income for the first nine months of 2000. The decrease primarily resulted from a decline in the estimated fair value of partnership investments. At September 30, 2001, equity management investments totaling approximately $683 million, including net unrealized appreciation of $31 million, were comprised of approximately 60% direct investments and 40% partnership investments. These valuations are subject to market conditions and may be volatile. PNC is currently evaluating strategies to mitigate the impact of the revenue volatility of this business. Net securities gains were $134 million for the first nine months of 2001 and were partially offset by valuation adjustments and write-downs of other assets and e-commerce investments totaling $35 million that are reflected in corporate services and other noninterest income. Other noninterest income was $244 million for the first nine months of 2001 compared with $200 million for the first nine months of 2000. The increase was primarily due to higher revenue from trading activities and residential mortgage loan securitizations. NONINTEREST EXPENSE Noninterest expense was $2.350 billion for the first nine months of 2001 compared with $2.319 billion for the first nine months of 2000 and the efficiency ratio remained essentially flat at 57% during both periods. The increase in noninterest expense was primarily in businesses that have stronger revenue growth including the Regional Community Bank, BlackRock and PFPC. Average full-time equivalent employees totaled approximately 24,600 and 24,000 for the first nine months of 2001 and 2000, respectively. The increase was primarily in asset management and processing businesses. 14 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. CONSOLIDATED BALANCE SHEET REVIEW LOANS Loans were $42.1 billion at September 30, 2001, a decrease of $8.5 billion from year-end 2000 primarily due to residential mortgage loan securitizations and reductions in most commercial loan categories as a result of continuing efforts to reduce balance sheet leverage. DETAILS OF LOANS September 30 December 31 In millions 2001 2000 - ---------------------------------------------------------------- Commercial Manufacturing $4,567 $5,581 Retail/wholesale 4,293 4,413 Service providers 2,386 2,944 Real estate related 1,826 1,783 Financial services 1,608 1,726 Communications 934 1,296 Health care 658 722 Other 2,312 2,742 - ---------------------------------------------------------------- Total commercial 18,584 21,207 - ---------------------------------------------------------------- Commercial real estate Mortgage 591 673 Real estate project 2,024 1,910 - ---------------------------------------------------------------- Total commercial real estate 2,615 2,583 - ---------------------------------------------------------------- Consumer Home equity 6,883 6,228 Automobile 860 1,166 Other 1,378 1,739 - ---------------------------------------------------------------- Total consumer 9,121 9,133 - ---------------------------------------------------------------- Residential mortgage 6,815 13,264 Lease financing 5,663 4,845 Other 485 568 Unearned income (1,143) (999) - ---------------------------------------------------------------- Total, net of unearned income $42,140 $50,601 ================================================================ Loan portfolio composition continued to be geographically diversified among numerous industries and types of businesses. During 1999, total outstandings and exposure designated for downsizing totaled $3.7 billion and $10.5 billion, respectively. At September 30, 2001, remaining outstandings associated with this initiative were $321 million, of which $271 million were classified as loans with the remainder included in loans held for sale. Total remaining exposure related to this initiative was $1.3 billion at September 30, 2001. In addition, outstandings and exposure totaling approximately $2.5 billion and $7.0 billion, respectively, were designated for downsizing during the first quarter of 2001, primarily consisting of the communications portfolio and certain portions of the energy, metals and mining and large corporate portfolios in Corporate Banking. At September 30, 2001, remaining outstandings and exposure associated with this initiative were $1.6 billion and $4.5 billion, respectively. NET UNFUNDED COMMITMENTS (a) September 30 December 31 In millions 2001 2000 - ----------------------------------------------------------------- Commercial $21,009 $24,253 Commercial real estate 969 1,039 Consumer 4,750 4,414 Lease financing 123 123 Other 150 173 - ----------------------------------------------------------------- Total $27,001 $30,002 ================================================================= (a) Excludes unfunded commitments related to loans designated for downsizing in 1999 and 2001. Commitments to extend credit represent arrangements to lend funds subject to specified contractual conditions. Commercial commitments are reported net of participations, assignments and syndications, primarily to financial institutions, and total $7.4 billion at September 30, 2001 and $7.2 billion at December 31, 2000. Net outstanding letters of credit totaled $4.1 billion and $4.0 billion at September 30, 2001 and December 31, 2000, respectively, and consisted primarily of standby letters of credit that commit the Corporation to make payments on behalf of customers if specified future events occur. Unfunded commitments and letters of credit related to loans designated for downsizing in 2001 and 1999 totaled $3.9 billion at September 30, 2001 and $1.7 billion at December 31, 2000. SECURITIES AVAILABLE FOR SALE The fair value of securities available for sale at September 30, 2001 was $11.7 billion compared with $5.9 billion at December 31, 2000. Securities represented 16% of total assets at September 30, 2001 compared with 8% at December 31, 2000. The increase was primarily due to residential mortgage loan securitizations and purchases of asset-backed securities during the first nine months of 2001. The expected weighted-average life of securities available for sale was 5 years and 2 months at September 30, 2001 compared with 4 years and 5 months at December 31, 2000. At September 30, 2001, the securities available for sale balance included a net unrealized gain of $79 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2000 was a net unrealized loss of $54 million. Net unrealized gains and losses in the securities available for sale portfolio are included in accumulated other comprehensive income or loss, net of tax or, for the portion attributable to a hedged risk as part of a fair value hedge strategy, in net income. 15 DETAILS OF SECURITIES AVAILABLE FOR SALE Amortized Fair In millions Cost Value - ---------------------------------------------------------------- SEPTEMBER 30, 2001 Debt securities U.S. Treasury and government agencies $1,053 $1,059 Mortgage-backed 6,509 6,561 Asset-backed 2,472 2,501 State and municipal 65 68 Other debt 978 983 Corporate stocks and other 533 517 - ---------------------------------------------------------------- Total securities available for sale $11,610 $11,689 ================================================================ DECEMBER 31, 2000 Debt securities U.S. Treasury and government agencies $313 $313 Mortgage-backed 4,037 4,002 Asset-backed 902 893 State and municipal 94 96 Other debt 73 73 Corporate stocks and other 537 525 - ---------------------------------------------------------------- Total securities available for sale $5,956 $5,902 ================================================================ FUNDING SOURCES Total funding sources were $58.0 billion at September 30, 2001 and decreased $1.3 billion compared with December 31, 2000. Demand and money market deposits increased due to ongoing strategic marketing efforts to retain customers and increase money market balances as funds shifted from certificates of deposit. The change in the composition of borrowed funds reflected the impact of closing the sale of the residential mortgage banking business as well as a shift within categories to manage overall funding costs. DETAILS OF FUNDING SOURCES September 30 December 31 In millions 2001 2000 - ---------------------------------------------------------------- Deposits Demand and money market $30,773 $28,771 Savings 1,923 1,915 Retail certificates of deposit 11,577 14,175 Other time 495 567 Deposits in foreign offices 227 2,236 - ---------------------------------------------------------------- Total deposits 44,995 47,664 - ---------------------------------------------------------------- Borrowed funds Federal funds purchased 1,904 1,445 Repurchase agreements 672 607 Bank notes and senior debt 5,344 6,110 Federal Home Loan Bank borrowings 2,457 500 Subordinated debt 2,368 2,407 Other borrowed funds 301 649 - ---------------------------------------------------------------- Total borrowed funds 13,046 11,718 - ---------------------------------------------------------------- Total $58,041 $59,382 ================================================================ CAPITAL The access to and cost of funding new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, deposit insurance costs, and the level and nature of regulatory oversight depend, in large part, on a financial institution's capital strength. At September 30, 2001, the Corporation and each bank subsidiary were considered well capitalized based on regulatory capital ratio requirements. RISK-BASED CAPITAL September 30 December 31 Dollars in millions 2001 2000 - ----------------------------------------------------------------- Capital components Shareholders' equity Common $6,611 $6,344 Preferred 216 312 Trust preferred capital securities 848 848 Goodwill and other (2,192) (2,214) Net unrealized securities (gains) losses (55) 77 - ----------------------------------------------------------------- Tier I risk-based capital 5,428 5,367 Subordinated debt 1,616 1,811 Eligible allowance for credit losses 720 667 - ----------------------------------------------------------------- Total risk-based capital $7,764 $7,845 ================================================================= Assets Risk-weighted assets and off-balance-sheet instruments, and market risk equivalent assets $64,645 $62,430 Average tangible assets 66,681 66,809 ================================================================= Capital ratios Tier I risk-based 8.4% 8.6% Total risk-based 12.0 12.6 Leverage 8.1 8.0 ================================================================= The capital position is managed through balance sheet size and composition, issuance of debt and equity instruments, treasury stock activities, dividend policies and retention of earnings. On October 4, 2001, PNC redeemed all outstanding shares of Fixed/Adjustable Rate Noncumulative Preferred Stock Series F for approximately $205 million. On February 15, 2001, the Board of Directors authorized the Corporation to purchase up to 15 million shares of its common stock through February 28, 2002. During the first nine months of 2001, PNC repurchased 8.4 million shares of its common stock. 16 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. RISK FACTORS The Corporation is subject to a number of risks including, among others, those described below and in the Risk Management and Forward-Looking Statements sections of this Financial Review. These factors and others could impact the Corporation's business, financial condition and results of operations. BUSINESS AND ECONOMIC CONDITIONS The Corporation's business and results of operations are sensitive to general business and economic conditions in the United States. These conditions include the level and movement of interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the U.S. economy, in general, and the regional economies in which the Corporation conducts business. A sustained weakness or further weakening of the economy could decrease the demand for loans and other products and services offered by the Corporation, increase usage of unfunded commitments or increase the number of customers and counterparties who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to the Corporation. An increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of nonperforming assets, net charge-offs and provision for credit losses. Changes in interest rates could affect the value of certain on-balance-sheet and off-balance-sheet financial instruments of the Corporation. Higher interest rates would also increase the Corporation's cost to borrow funds and may increase the rate paid on deposits. Changes in interest rates could also affect the value of assets under management. In a period of rapidly rising interest rates, certain assets under management would likely be negatively impacted by reduced asset values and increased redemptions. Also, changes in equity markets could affect the value of equity investments and the net asset value of assets under management and administration. A decline or volatility in the equity markets could negatively affect noninterest revenues. TERRORIST ACTIVITIES The impact of the September 11th terrorist attacks or any future terrorist activities and responses to such activities cannot be predicted at this time with respect to severity or duration. The impact could adversely affect the Corporation in a number of ways including, among others, an increase in delinquencies, bankruptcies or defaults that could result in a higher level of nonperforming assets, net charge-offs and provision for credit losses. MONETARY AND OTHER POLICIES The financial services industry is subject to various monetary and other policies and regulations of the United States government and its agencies, which include the Federal Reserve Board, the Office of the Comptroller of Currency and the Federal Deposit Insurance Corporation as well as state regulators. The Corporation is particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. The Federal Reserve Board's policies influence the rates of interest that PNC charges on loans and pays on interest-bearing deposits and can also affect the value of on-balance-sheet and off-balance-sheet financial instruments. Those policies also influence, to a significant extent, the cost of funding for the Corporation. COMPETITION PNC operates in a highly competitive environment, both in terms of the products and services offered and the geographic markets in which PNC conducts business. This environment could become even more competitive in the future. The Corporation competes with local, regional and national banks, thrifts, credit unions and non-bank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, investment companies, venture capital firms, mutual fund complexes and insurance companies, as well as other entities that offer financial services, and through alternative delivery channels such as the World Wide Web. Technological advances and new legislation, among other changes, have lowered barriers to entry and have made it possible for non-bank institutions to offer products and services that traditionally have been provided by banks. Many of the Corporation's competitors benefit from fewer regulatory constraints and lower cost structures, allowing for more competitive pricing of products and services. The Gramm-Leach-Bliley Act ("the Act"), which was enacted on November 12, 1999, permits affiliations among banks, securities firms and insurance companies. The Act significantly changes the competitive environment in which the Corporation conducts business. This environment could result in expanded competition and a loss of customers and related revenue. DISINTERMEDIATION Disintermediation is the process of eliminating the role of the intermediary in completing a transaction. For the financial services industry, this means eliminating or significantly reducing the role of banks and other depository institutions in completing transactions that have traditionally involved banks. Disintermediation could result in, among other things, the loss of customer deposits and decreases in transactions that generate fee income. 17 ASSET MANAGEMENT PERFORMANCE Asset management revenue is primarily based on a percentage of the value of assets under management and performance fees expressed as a percentage of the returns realized on assets under management. A decline in the value of debt and equity instruments, among other things, could cause asset management revenue to decline. Investment performance is an important factor for the level of assets under management. Poor investment performance could impair revenue and growth as existing clients might withdraw funds in favor of better performing products. Also, performance fees could be lower or nonexistent. Additionally, the ability to attract funds from existing and new clients might diminish. FUND SERVICING Fund servicing fees are primarily based on the market value of the assets and the number of shareholder accounts administered by the Corporation for its clients. A rise in interest rates or a sustained weakness or further weakening or volatility in the debt and equity markets could influence an investor's decision to invest or maintain an investment in a mutual fund. As a result, fluctuations may occur in the level or value of assets that the Corporation has under administration. A significant investor migration from mutual fund investments could have a negative impact on the Corporation's revenues by reducing the assets and the number of shareholder accounts it administers. There has been and continues to be merger, acquisition and consolidation activity in the financial services industry. Mergers or consolidations of financial institutions in the future could reduce the number of existing or potential fund servicing clients. ACQUISITIONS The Corporation expands its business from time to time by acquiring other financial services companies. Factors pertaining to acquisitions that could adversely affect the Corporation's business and earnings include, among others: o anticipated cost savings or potential revenue enhancements that may not be fully realized or realized within the expected time frame; o key employee, customer or revenue loss following an acquisition that may be greater than expected; and o costs or difficulties related to the integration of businesses that may be greater than expected. RISK MANAGEMENT In the normal course of business, the Corporation assumes various types of risk, which include, among other things, credit risk, interest rate risk, liquidity risk, and risk associated with trading activities and financial derivatives. PNC has risk management processes designed to provide for risk identification, measurement and monitoring. CREDIT RISK Credit risk represents the possibility that a borrower, counterparty or insurer may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers, purchasing securities and entering into off-balance-sheet financial derivative transactions. The Corporation seeks to manage credit risk through, among other things, diversification, limiting exposure to any single industry or customer, requiring collateral, selling participations to third parties, and purchasing credit-related derivatives. NONPERFORMING ASSETS BY TYPE September 30 December 31 Dollars in millions 2001 2000 - ------------------------------------------------------------- Nonaccrual loans Commercial $324 $312 Commercial real estate 13 3 Consumer 4 2 Residential mortgage 6 4 Lease financing 14 2 - ------------------------------------------------------------- Total nonaccrual loans 361 323 Foreclosed and other assets Commercial real estate 2 3 Residential mortgage 2 8 Other 9 38 - ------------------------------------------------------------- Total foreclosed and other assets 13 49 - ------------------------------------------------------------- Total nonperforming assets $374 $372 ============================================================= Nonaccrual loans to total loans .86% .64% Nonperforming assets to total loans, loans held for sale and foreclosed assets .85 .71 Nonperforming assets to total assets .52 .53 ============================================================= The above table excludes $37 million and $18 million of equity management assets carried at estimated fair value at September 30, 2001 and December 31, 2000, respectively. The amount of nonperforming loans that were current as to principal and interest was $91 million at September 30, 2001 and $67 million at December 31, 2000. At September 30, 2001, approximately one-fifth of nonperforming assets were from portfolios that were designated for downsizing. A sustained weakness or further weakening of the economy, or other factors that adversely affect asset quality, could result in an increase in the number of delinquencies, bankruptcies or defaults, and a higher level of nonperforming assets, net charge-offs and provision for credit losses in future periods. See the Forward-Looking Statements section of this Financial Review for additional factors that could cause actual results to differ materially from forward-looking statements or historical performance. 18 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. CHANGE IN NONPERFORMING ASSETS In millions 2001 2000 - ---------------------------------------------------------------- January 1 $372 $325 Transferred from accrual 513 291 Returned to performing (14) (3) Principal reductions (143) (125) Sales (162) (31) Charge-offs and other (192) (103) - ---------------------------------------------------------------- September 30 $374 $354 ================================================================ ACCRUING LOANS PAST DUE 90 DAYS OR MORE Amount Percent of Loans -------------------------------------------------------- September 30 December 31 September 30 December 31 Dollars in millions 2001 2000 2001 2000 - ----------------------------------------------------------------------------- Commercial $37 $46 .20% .22% Commercial real estate 11 6 .42 .23 Consumer 23 24 .25 .26 Residential mortgage 42 36 .62 .27 Lease financing 2 1 .04 .03 - -------------------------------------------------- Total $115 $113 .27 .22 ============================================================================= Loans not included in nonaccrual or past due categories, but where information about possible credit problems causes management to be uncertain about the borrower's ability to comply with existing repayment terms over the next nine months totaled $146 million at September 30, 2001. ALLOWANCE FOR CREDIT LOSSES In determining the adequacy of the allowance for credit losses, the Corporation makes specific allocations to impaired loans and to pools of watchlist and nonwatchlist loans for various credit risk factors. Allocations to loan pools are developed by business segment and risk rating and are based on historical loss trends and management's judgment concerning those trends and other relevant factors. Those factors may include, among other things, actual versus estimated losses, regional and national economic conditions, business segment and portfolio concentrations, industry competition and consolidation, and the impact of government regulations. Consumer and residential mortgage loan allocations are made at a total portfolio level based on historical loss experience adjusted for portfolio activity and economic conditions. While PNC's pool reserve methodologies strive to reflect all risk factors, there continues to be a certain element of risk associated with, but not limited to, potential estimation or judgmental errors. Unallocated reserves are designed to provide coverage for such risks. While allocations are made to specific loans and pools of loans, the total reserve is available for all credit losses. Senior management's Reserve Adequacy Committee provides oversight for the allowance evaluation process, including quarterly evaluations and methodology and estimation changes. The results of the evaluations are reported to the Credit Committee of the Board of Directors. The provision for credit losses for the first nine months of 2001 and the evaluation of the allowance for credit losses as of September 30, 2001 reflected changes in loan portfolio composition, the net impact of downsizing credit exposure and changes in asset quality. The unallocated portion of the allowance for credit losses represented 20% of the total allowance and .35% of total loans at September 30, 2001 compared with 20% and .26%, respectively, at December 31, 2000. During the third quarter of 2001, PNC added $45 million to unallocated reserves given the deterioration in economic conditions. ROLLFORWARD OF ALLOWANCE FOR CREDIT LOSSES In millions 2001 2000 - ---------------------------------------------------------------- January 1 $675 $674 Charge-offs (219) (131) Recoveries 29 36 - ---------------------------------------------------------------- Net charge-offs (190) (95) Provision for credit losses 235 96 - ---------------------------------------------------------------- September 30 $720 $675 ================================================================ The allowance as a percent of nonaccrual loans and total loans was 199% and 1.71%, respectively, at September 30, 2001. The comparable year-end 2000 percentages were 209% and 1.33%, respectively. CHARGE-OFFS AND RECOVERIES Percent of Nine months ended September 30 Net Average Dollars in millions Charge-offs Recoveries Charge-offs Loans - ---------------------------------------------------------------------- 2001 Commercial $165 $13 $152 1.01% Commercial real estate 6 1 5 .26 Consumer 31 13 18 .26 Residential mortgage 1 1 .01 Lease financing 16 2 14 .45 - ------------------------------------------------------------ Total $219 $29 $190 .55 ====================================================================== 2000 Commercial $86 $14 $72 .44% Commercial real estate 2 4 (2) (.10) Consumer 34 16 18 .26 Residential mortgage 4 1 3 .03 Lease financing 5 1 4 .17 - ------------------------------------------------------------ Total $131 $36 $95 .25 ====================================================================== Net charge-offs were $190 million or .55% of average loans for the first nine months of 2001 compared with $95 million or .25% for the same period in 2000. The increase was primarily related to loans in institutional lending portfolios that PNC is downsizing. CREDIT-RELATED INSTRUMENTS Credit default swaps provide, for a fee, an assumption of a portion of the credit risk associated with the underlying financial instruments. The Corporation primarily uses such contracts to mitigate credit risk associated with commercial lending activities. At September 30, 2001, credit default swaps of $140 million in notional value were used by the Corporation to hedge credit risk associated with commercial lending activities. 19 INTEREST RATE RISK Interest rate risk arises primarily through the Corporation's traditional business activities of extending loans and accepting deposits. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the spread between interest earned on assets and interest paid on liabilities. In managing interest rate risk, the Corporation seeks to minimize its reliance on a particular interest rate scenario as a source of earnings while maximizing net interest income and net interest margin. To further these objectives, the Corporation uses securities purchases and sales, short-term and long-term funding, financial derivatives and other capital markets instruments. Interest rate risk is centrally managed by Asset and Liability Management. The Corporation actively measures and monitors components of interest rate risk including term structure or repricing risk, yield curve or nonparallel rate shift risk, basis risk and options risk. The Corporation measures and manages both the short-term and long-term effects of changing interest rates. An income simulation model is designed to measure the sensitivity of net interest income to changing interest rates over the next twenty-four month period. An economic value of equity model is designed to measure the sensitivity of the value of existing on-balance-sheet and off-balance-sheet positions to changing interest rates. The income simulation model is the primary tool used to measure the direction and magnitude of changes in net interest income resulting from changes in interest rates. Forecasting net interest income and its sensitivity to changes in interest rates requires that the Corporation make assumptions about the volume and characteristics of new business and the behavior of existing positions. These business assumptions are based on the Corporation's experience, business plans and published industry experience. Key assumptions employed in the model include prepayment speeds on mortgage-related assets and consumer loans, loan volumes and pricing, deposit volumes and pricing, the expected life and repricing characteristics of nonmaturity loans and deposits, and management's financial and capital plans. Because these assumptions are inherently uncertain, the model cannot precisely estimate net interest income or precisely predict the effect of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to the timing, magnitude and frequency of interest rate changes, the difference between actual experience and the assumed volume and characteristics of new business and behavior of existing positions, and changes in market conditions and management strategies, among other factors. The Corporation's interest rate risk management policies provide that net interest income should not decrease by more than 3% if interest rates gradually increase or decrease from current rates by 100 basis points over a twelve-month period. At September 30, 2001, if interest rates were to gradually increase by 100 basis points over the next twelve months, the model indicated that net interest income would decrease by .3%. If interest rates were to gradually decrease by 100 basis points over the next twelve months, the model indicated that net interest income would decrease by 1.8%. The Corporation models additional interest rate scenarios covering a wider range of rate movements to identify yield curve, term structure and basis risk exposures. These scenarios are developed based on historical rate relationships or management's expectations regarding the future direction and level of interest rates. Depending on market conditions and other factors, these scenarios may be modeled more or less frequently. Such analyses are used to identify risk and develop strategies. An economic value of equity model is used by the Corporation to value all current on-balance-sheet and off-balance-sheet positions under a range of instantaneous interest rate changes. The resulting change in the value of equity is a measure of overall long-term interest rate risk inherent in the Corporation's existing on-balance-sheet and off-balance-sheet positions. The Corporation uses the economic value of equity model to complement the net interest income simulation modeling process. The Corporation's interest rate risk management policies provide that the economic value of equity should not decline by more than 1.5% of the book value of assets for a 200 basis point instantaneous increase or decrease in interest rates. Based on the results of the economic value of equity model at September 30, 2001, if interest rates were to instantaneously increase by 200 basis points, the model indicated that the economic value of existing on-balance-sheet and off-balance-sheet positions would decline by 1.3% of assets. If interest rates were to instantaneously decrease by 200 basis points, the model indicated that the economic value of existing on-balance-sheet and off-balance-sheet positions would increase by .2% of assets. 20 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. LIQUIDITY RISK Liquidity represents the Corporation's ability to obtain cost-effective funding to meet the needs of customers as well as the Corporation's financial obligations. Liquidity is centrally managed by Asset and Liability Management, with oversight provided by the Corporate Asset and Liability Committee and the Finance Committee of the Board of Directors. Access to capital markets funding sources is a key factor affecting liquidity management. Access to such markets is in part based on the Corporation's credit ratings, which are influenced by a number of factors including capital ratios, asset quality and earnings. Additional factors that impact liquidity include the maturity structure of existing assets, liabilities, and off-balance-sheet positions, the level of liquid securities and loans available for sale, and the Corporation's ability to securitize and sell various types of loans. Liquidity can also be provided through the sale of liquid assets, which consist of short-term investments, loans held for sale and securities available for sale. At September 30, 2001, such assets totaled $15.0 billion, with $6.4 billion pledged as collateral for borrowings, trust and other commitments. Liquidity can also be obtained through secured advances from the Federal Home Loan Bank, of which PNC Bank, N.A., PNC's largest bank subsidiary, is a member. These borrowings are generally secured by residential mortgages, other real-estate related loans and mortgage-backed securities. At September 30, 2001, approximately $10.8 billion of residential mortgages and other real-estate related loans were available as collateral for borrowings from the Federal Home Loan Bank. Funding can also be obtained through alternative forms of borrowing, including federal funds purchased, repurchase agreements and short-term and long-term debt issuances. Liquidity for the parent company and subsidiaries is also generated through the issuance of securities in public or private markets and lines of credit. At September 30, 2001, the Corporation had unused capacity under effective shelf registration statements of approximately $4.3 billion of debt and equity securities and $400 million of trust preferred capital securities. On October 29, 2001, PNC issued $600 million of Floating Rate Senior Notes due 2004 and $400 million of 5.75% Senior Notes due 2006, reducing unused shelf capacity to $3.3 billion. In addition, the Corporation had an unused line of credit of $500 million at September 30, 2001. The principal source of parent company revenue and cash flow is dividends from subsidiary banks. PNC Bancorp, Inc. is a wholly-owned subsidiary of the parent company and is the holding company for all bank subsidiaries. There are legal limitations on the ability of bank subsidiaries to pay dividends and make other distributions to PNC Bancorp, Inc. and in turn to the parent company. Without regulatory approval, the amount available for dividend payments to PNC Bancorp, Inc. by all bank subsidiaries was $312 million at September 30, 2001. Dividends may also be impacted by capital needs, regulatory requirements, corporate policies, contractual restrictions and other factors. Management believes the Corporation has sufficient liquidity to meet current obligations to borrowers, depositors, debt holders and others. The impact of replacing maturing liabilities is reflected in the income simulation model in the overall asset and liability management process. TRADING ACTIVITIES Most of PNC's trading activities are designed to provide capital markets services to customers and not to position the Corporation's portfolio for gains from market movements. PNC participates in derivatives and foreign exchange trading as well as underwriting and "market making" in equity securities as an accommodation to customers. PNC also engages in trading activities as part of risk management strategies. Risk associated with trading, capital markets and foreign exchange activities is managed using a value-at-risk approach that combines interest rate risk, foreign exchange rate risk, spread risk and volatility risk. Using this approach, exposure is measured as the potential loss due to a two standard deviation, one-day move in interest rates. The combined period-end value-at-risk of all trading operations using this measurement was estimated as less than $1.2 million at September 30, 2001. 21 FINANCIAL DERIVATIVES The Corporation uses a variety of financial derivatives as part of the overall asset and liability risk management process to manage interest rate, market and credit risk inherent in the Corporation's business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total rate of return swaps, purchased interest rate caps and floors and futures contracts are the primary instruments used by the Corporation for interest rate risk management. Interest rate swaps are agreements with a counterparty to exchange periodic fixed and floating interest payments calculated on a notional amount. The floating rate is based on a money market index, primarily short-term LIBOR. Total rate of return swaps are agreements with a counterparty to exchange an interest rate payment for the total rate of return on a specified reference index calculated on a notional amount. Purchased interest rate caps and floors are agreements where, for a fee, the counterparty agrees to pay the Corporation the amount, if any, by which a specified market interest rate exceeds or is less than a defined rate applied to a notional amount, respectively. Interest rate futures contracts are exchange-traded agreements to make or take delivery of a financial instrument at an agreed upon price and are settled in cash daily. Financial derivatives involve, to varying degrees, interest rate, market and credit risk. For interest rate and total rate of return swaps, caps and floors and futures contracts, only periodic cash payments and, with respect to caps and floors, premiums, are exchanged. Therefore, cash requirements and exposure to credit risk are significantly less than the notional value. Not all elements of interest rate, market and credit risk are addressed through the use of financial or other derivatives, and such instruments may be ineffective for their intended purposes due to unanticipated market characteristics among other reasons. The following table sets forth changes, during the first nine months of 2001, in the notional value of financial derivatives used for risk management and designated as accounting hedges under Statement of Financial Accounting Standards ("SFAS") No. 133. FINANCIAL DERIVATIVES ACTIVITY
Weighted- December 31 January 1 September 30 Average Dollars in millions 2000 Adjustments (a) 2001 Additions Maturities Terminations 2001 Maturity - ------------------------------------------------------------------------------------------------------------------------------------ Interest rate risk management Interest rate swaps Receive fixed $4,756 $180 $4,936 $5,900 $(1,618) $(120) $9,098 2 yrs. 10 mos. Pay fixed 1 248 249 247 (345) 151 3 yrs. 5 mos. Basis swaps 2,230 (1,773) 457 190 (480) 167 3 yrs. 6 mos. Interest rate caps 308 (243) 65 44 (84) 25 4 yrs. 7 mos. Interest rate floors 3,238 (238) 3,000 60 (3,048) 12 2 yrs. 3 mos. Futures contracts 416 (116) 300 9 mos. - --------------------------------------------------------------------------------------------------------------------- Total interest rate risk management 10,533 (1,826) 8,707 6,857 (1,618) (4,193) 9,753 - --------------------------------------------------------------------------------------------------------------------- Commercial mortgage banking risk management Interest rate swaps 311 311 846 (949) 208 9 yrs. 3 mos. Total rate of return swaps 75 75 225 (125) 175 4 mos. - --------------------------------------------------------------------------------------------------------------------- Total commercial mortgage banking risk management 386 386 1,071 (125) (949) 383 Student lending activities Forward contracts 347 (347) Credit-related activities Credit default swaps 4,391 (4,391) - --------------------------------------------------------------------------------------------------------------------- Total $15,657 $(6,564) $9,093 $7,928 $(1,743) $(5,142) $10,136 ====================================================================================================================================
(a) Primarily consists of derivatives that are not designated as accounting hedges under SFAS No. 133 and instruments no longer considered financial derivatives under SFAS No. 133. 22 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. The following table sets forth the notional value and the fair value of financial derivatives used for risk management and designated as accounting hedges under SFAS No. 133. Weighted-average interest rates presented are based on the implied forward yield curve at September 30, 2001. FINANCIAL DERIVATIVES
Weighted-Average Interest Rates Notional ------------------------------- September 30, 2001 - dollars in millions Value Fair Value Paid Received -------------------------------------------------------------------------------------------------------------------------------- Interest rate risk management Asset rate conversion Interest rate swaps (a) Receive fixed designated to loans $7,085 $209 3.30% 5.25% Pay fixed designated to loans 151 (9) 5.92 3.87 Basis swaps designated to loans 167 3.88 3.88 Interest rate caps designated to loans (b) 25 NM NM Interest rate floors designated to loans (c) 12 NM NM Future contracts designated to loans 300 NM NM -------------------------------------------------------------------------------------------------------- Total asset rate conversion 7,740 200 -------------------------------------------------------------------------------------------------------- Liability rate conversion Interest rate swaps (a) Receive fixed designated to borrowed funds 2,013 186 4.74 6.23 -------------------------------------------------------------------------------------------------------- Total liability rate conversion 2,013 186 -------------------------------------------------------------------------------------------------------- Total interest rate risk management 9,753 386 -------------------------------------------------------------------------------------------------------- Commercial mortgage banking risk management Pay fixed interest rate swaps designated to loans (a) 208 (9) 5.71 5.22 Pay total rate of return swaps designated to loans (a) 175 (4) 6.10 2.03 -------------------------------------------------------------------------------------------------------- Total commercial mortgage banking risk management 383 (13) -------------------------------------------------------------------------------------------------------- Total financial derivatives $10,136 $373 ==============================================================================================================================
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional value, 76% were based on 1-month LIBOR, 23% on 3-month LIBOR and the remainder on other short-term indices. (b) Interest rate caps with notional values of $15 million require the counterparty to pay the Corporation the excess, if any, of 3-month LIBOR over a weighted-average strike of 6.40%. In addition, interest rate caps with notional values of $6 million require the counterparty to pay the excess, if any, of 1-month LIBOR over a weighted-average strike of 6.00%. At September 30, 2001, 3-month LIBOR was 2.59%. (c) Interest rate floors with notional values of $5 million require the counterparty to pay the excess, if any, weighted-average strike of 5.50% over 1-month LIBOR. In addition, interest rate floors with notional values of $5 million require the counterparty to pay the excess, if any, weighted-average strike of 4.50% over 3-month LIBOR. At September 30, 2001, 1-month LIBOR was 2.63% and 3-month LIBOR was 2.59%. NM- Not meaningful 23 The following table sets forth the notional value and the estimated fair value of financial derivatives used for risk management. Weighted-average interest rates presented are based on the implied forward yield curve at December 31, 2000. FINANCIAL DERIVATIVES
Weighted-Average Interest Rates Notional Estimated ------------------------------- December 31, 2000 - dollars in millions Value Fair Value Paid Received --------------------------------------------------------------------------------------------------------------------------------- Interest rate risk management Asset rate conversion Interest rate swaps (a) Receive fixed designated to loans $3,250 $27 5.96% 5.56% Basis swaps designated to other earning assets 226 3 5.63 5.85 Interest rate caps designated to loans (b) 308 4 NM NM Interest rate floors designated to loans (c) 3,238 (1) NM NM -------------------------------------------------------------------------------------------------------- Total asset rate conversion 7,022 33 -------------------------------------------------------------------------------------------------------- Liability rate conversion Interest rate swaps (a) Receive fixed designated to: Interest-bearing deposits 125 4 5.85 6.73 Borrowed funds 1,381 57 5.96 6.60 Pay fixed designated to borrowed funds 1 5.88 5.78 Basis swaps designated to borrowed funds 2,004 10 5.76 5.79 -------------------------------------------------------------------------------------------------------- Total liability rate conversion 3,511 71 -------------------------------------------------------------------------------------------------------- Total interest rate risk management 10,533 104 -------------------------------------------------------------------------------------------------------- Commercial mortgage banking risk management Pay fixed interest rate swaps designated to securities (a) 135 (8) 6.94 6.04 Pay fixed interest rate swaps designated to loans (a) 176 3 5.76 5.99 Pay total rate of return swaps designated to loans (a) 75 (5) 5.76 6.15 -------------------------------------------------------------------------------------------------------- Total commercial mortgage banking risk management 386 (10) -------------------------------------------------------------------------------------------------------- Student lending activities - Forward contracts (d) 347 NM NM Credit-related activities - Credit default swaps (d) 4,391 (2) NM NM -------------------------------------------------------------------------------------------------------- Total financial derivatives $15,657 $92 =================================================================================================================================
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional value, 62% were based on 1-month LIBOR, 36% on 3-month LIBOR and the remainder on other short-term indices. (b) Interest rate caps with notional values of $61 million, $95 million and $150 million require the counterparty to pay the Corporation the excess, if any, of 3-month LIBOR over a weighted-average strike of 6.00%, 1-month LIBOR over a weighted-average strike of 5.68% and Prime over a weighted-average strike of 8.76%, respectively. At December 31, 2000, 3-month LIBOR was 6.40%, 1-month LIBOR was 6.56% and Prime was 9.50%. (c) Interest rate floors with notional values of $3.0 billion, require the counterparty to pay the excess, if any, of the weighted-average strike of 4.63% over 3-month LIBOR. At December 31, 2000, 3-month LIBOR was 6.40%. (d) Due to the structure of these contracts, they are no longer considered financial derivatives under SFAS No. 133. NM- Not meaningful OTHER DERIVATIVES To accommodate customer needs, PNC enters into customer-related financial derivative transactions primarily consisting of interest rate swaps, caps, floors and foreign exchange contracts. Risk exposure from customer positions is managed through transactions with other dealers. Additionally, the Corporation enters into other derivative transactions for risk management purposes that are not designated as accounting hedges. OTHER DERIVATIVES
At September 30, 2001 -------------------------------------------------------------------- 2001 Positive Negative Average Notional Fair Fair Net Asset Fair In millions Value Value Value (Liability) Value (a) - --------------------------------------------------------------------------------------------------------------------------------- Customer-related Interest rate Swaps $18,338 $379 $(379) $(8) Caps/floors Sold 3,849 (35) $(35) (22) Purchased 3,118 28 28 19 Foreign exchange 4,925 64 (54) 10 12 Other 2,402 38 (32) 6 3 - --------------------------------------------------------------------------------------------------------------------------------- Total customer-related 32,632 509 (500) 9 4 Other 6,595 21 (4) 17 19 - --------------------------------------------------------------------------------------------------------------------------------- Total other derivatives $39,227 $530 $(504) $26 $23 =================================================================================================================================
(a) Represents average for nine months ended September 30, 2001. 24 FINANCIAL REVIEW THE PNC FINANCIAL SERVICES GROUP, INC. THIRD QUARTER 2001 VS. 2000 Earnings for the third quarter of 2001 were $298 million or $1.02 per diluted share compared with earnings of $299 million or $1.01 per diluted share for the third quarter of 2000. Excluding net losses from venture capital activities, third quarter 2001 earnings were $1.05 per diluted share. Return on average common shareholders' equity was 17.92% and return on average assets was 1.71% for the third quarter of 2001 compared with 19.99% and 1.72%, respectively, for the third quarter of 2000. Taxable-equivalent net interest income of $564 million for the third quarter of 2001 increased $30 million or 6% compared with the third quarter of 2000. The increase was primarily due to the positive impact of transaction deposit growth and a lower rate environment that was partially offset by the impact of continued downsizing of the loan portfolio. The net interest margin widened 32 basis points to 3.86% primarily due to the impact of the lower rate environment and the benefit of growth in transaction deposits and downsizing of higher-cost, less valuable retail certificates and wholesale deposits. The provision for credit losses was $110 million for the third quarter of 2001 compared with $30 million for the third quarter of 2000. The increase in the provision was primarily due to a $45 million addition to unallocated reserves given the deterioration in overall economic conditions. The remainder of the increase in the provision for credit losses primarily related to commercial loans in portfolios that are being downsized. Noninterest income increased 13% to $789 million for the third quarter of 2001 and included $88 million of net securities gains and $13 million of equity management losses related to venture capital activities. Excluding net securities gains and equity management losses in both years, noninterest income increased 3% compared with the third quarter of 2000. Asset management fees of $208 million for the third quarter of 2001 remained flat compared with the prior-year quarter as growth in new institutional business at BlackRock was offset by the impact of weak equity markets on investment management and trust revenue in PNC Advisors. Fund servicing fees of $182 million for the third quarter of 2001 increased $14 million or 8% compared with the third quarter of 2000 primarily due to new client growth. Service charges on deposits were $56 million for the third quarter of 2001, up 12% compared with the same period last year primarily due to an increase in transaction deposit accounts. Brokerage fees decreased $7 million or 11% compared with the third quarter of 2000 as the impact of a decline in equity markets activity was partially offset by an increase in annuity commissions at the Regional Community Bank. Consumer services revenue of $58 million for the third quarter of 2001 increased $3 million or 5% compared with the prior-year quarter primarily due to the expansion of PNC's ATM network and the increase in transaction deposit accounts. Corporate services revenue was $78 million for the third quarter of 2001 compared with $86 million for the third quarter of 2000. The decrease was primarily due to the impact of weaker capital market conditions. Equity management reflected net losses of $13 million for the third quarter of 2001 compared with $3 million of net losses for the third quarter of 2000. The increase in net losses primarily resulted from a decline in the estimated fair value of partnership investments. Net securities gains were $88 million for the third quarter of 2001 compared with $7 million for the third quarter of 2000. Other noninterest income was $78 million for the third quarter of 2001 compared with $68 million for the third quarter of 2000. Noninterest expense was $786 million and the efficiency ratio was 55% in the third quarter of 2001 compared with $747 million and 57%, respectively, during the third quarter of 2000. The increase in noninterest expense was primarily in businesses that had stronger revenue growth including the Regional Community Bank, BlackRock and PFPC. Total assets were $71.9 billion at September 30, 2001 compared with $69.9 billion at September 30, 2000. Average interest-earning assets were $57.9 billion for the third quarter of 2001 compared with $59.7 billion for the third quarter of 2000. The decrease was primarily due to an $2.5 billion decrease in commercial loans related to initiatives to downsize certain higher-risk, non-strategic portfolios. Average securities available for sale increased by nearly $5 billion and residential mortgage loans decreased by a corresponding amount due to the securitization of residential mortgage loans following the sale of PNC Mortgage. Average deposits were $44.6 billion and represented 65% of total sources of funds for the third quarter of 2001 compared with $45.9 billion and 66%, respectively, in the third quarter of 2000. While total deposits decreased $1.3 billion, an increase in transaction deposits of $2.9 billion or 11% was more than offset by a $4.1 billion decrease in higher-cost retail certificates and wholesale deposits. Average borrowed funds declined 7% to $12.5 billion for the third quarter of 2001 compared with $13.5 billion for the third quarter of 2000 as PNC continues to reduce its reliance on wholesale funding. Nonperforming assets were $374 million at September 30, 2001 compared with and $354 million at September 30, 2000. The ratio of nonperforming assets to total loans, 25 loans held for sale and foreclosed assets was .85% at September 30, 2001 compared with .68% at September 30, 2000. The increase primarily resulted from the downsizing of the loan portfolio. The allowance for credit losses was $720 million and represented 1.71% of period-end loans and 199% of nonperforming loans at September 30, 2001. The comparable ratios were 1.36% and 219%, respectively, at September 30, 2000. Net charge-offs were $65 million or .59% of average loans in the third quarter of 2001. The comparable amounts were $30 million or .24%, respectively, in the third quarter of 2000. The increase in net charge-offs was primarily related to commercial loans in portfolios that PNC is downsizing. FORWARD-LOOKING STATEMENTS This report and other statements made by the Corporation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act with respect to the outlook or expectations for earnings, revenues, asset quality, share repurchases, and other future financial or business performance, strategies and expectations. Forward-looking statements are typically identified by words or phrases such as "believe," "feel," "expect," "anticipate," "intend," "outlook," "estimate," "forecast," "position," "target," "mission," "assume," "achievable," "potential," "strategy," "goal," "objective," "plan," "aspiration," "outcome," "continue," "remain," "maintain," "seek," "strive," "trend" and variations of such words and similar expressions, or future or conditional verbs such as "will," "would," "should," "could," "might," "can," "may" or similar expressions. The Corporation cautions that forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements and future results could differ materially from historical performance. Forward-looking statements speak only as of the date they are made, and the Corporation assumes no duty to update forward-looking statements. In addition to factors mentioned elsewhere in this report or previously disclosed in the Corporation's SEC reports (accessible on the SEC's website at www.sec.gov), the following factors, among others, could cause actual results to differ materially from forward-looking statements or historical performance: (1) adjustments to recorded results of the sale of the residential mortgage banking business after final settlement is completed; (2) changes in political, economic or industry conditions, the interest rate environment or financial and capital markets, which could result in: a deterioration in credit quality and increased credit losses; an adverse effect on the allowance for loan losses; a reduction in demand for credit or fee-based products and services, net interest income, value of assets under management and assets serviced, value of debt and equity investments, or value of on-balance-sheet and off-balance-sheet assets; or changes in the availability and terms of funding necessary to meet PNC's liquidity needs; (3) relative investment performance of assets under management; (4) the introduction, withdrawal, success and timing of business initiatives and strategies, decisions regarding further reductions in balance sheet leverage, and PNC's inability to realize cost savings or revenue enhancements, implement integration plans and other consequences of mergers, acquisitions, restructurings and divestitures; (5) customer borrowing, repayment, investment and deposit practices and their acceptance of PNC's products and services; (6) the impact of increased competition; (7) the means PNC chooses to redeploy available capital, including the extent and timing of any share repurchases and investments in PNC businesses; (8) the inability to manage risks inherent in PNC's business; (9) the unfavorable resolution of legal proceedings; (10) the denial of insurance coverage for claims made by PNC; (11) an increase in the number of customer or counterparty delinquencies, bankruptcies or defaults that could result in, among other things, increased credit and asset quality risk, a higher loan loss provision and reduced profitability; (12) the impact, extent and timing of technological changes, the adequacy of intellectual property protection and costs associated with obtaining rights in intellectual property claimed by others; (13) actions of the Federal Reserve Board and legislative and regulatory actions and reforms; and (14) terrorist activities, including the September 11 terrorist attacks, which may adversely affect the general economy, financial and capital markets, specific industries, and PNC. The Corporation cannot predict the severity or duration of effects stemming from such activities or any actions taken in connection with them. Some of the above factors are described in more detail in the Risk Factors section of this Financial Review and factors relating to credit risk, interest rate risk, liquidity risk, trading activities, and financial and other derivatives are discussed in the Risk Management section of this Financial Review. Other factors are described elsewhere in this report. 26 CONSOLIDATED STATEMENT OF INCOME THE PNC FINANCIAL SERVICES GROUP, INC.
Three months ended September 30 Nine months ended September 30 ------------------------------- ------------------------------- In millions, except per share data 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------------- INTEREST INCOME Loans and fees on loans $776 $1,025 $2,596 $3,018 Securities available for sale 153 99 452 290 Loans held for sale 22 47 90 163 Other 29 30 93 71 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest income 980 1,201 3,231 3,542 - ---------------------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE Deposits 280 434 1,011 1,200 Borrowed funds 139 236 540 711 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest expense 419 670 1,551 1,911 - ---------------------------------------------------------------------------------------------------------------------------------- Net interest income 561 531 1,680 1,631 Provision for credit losses 110 30 235 96 - ---------------------------------------------------------------------------------------------------------------------------------- Net interest income less provision for credit losses 451 501 1,445 1,535 - ---------------------------------------------------------------------------------------------------------------------------------- NONINTEREST INCOME Asset management 208 208 645 590 Fund servicing 182 168 545 487 Service charges on deposits 56 50 160 150 Brokerage 54 61 163 192 Consumer services 58 55 171 153 Corporate services 78 86 230 248 Equity management (13) (3) (82) 132 Net securities gains 88 7 134 4 Other 78 68 244 200 - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 789 700 2,210 2,156 - ---------------------------------------------------------------------------------------------------------------------------------- NONINTEREST EXPENSE Staff expense 419 399 1,258 1,206 Net occupancy 55 50 162 151 Equipment 64 54 181 165 Amortization 26 27 79 83 Marketing 13 16 38 48 Distributions on capital securities 15 17 48 50 Other 194 184 584 616 - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 786 747 2,350 2,319 - ---------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations before income taxes 454 454 1,305 1,372 Income taxes 156 155 447 472 - ---------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 298 299 858 900 - ---------------------------------------------------------------------------------------------------------------------------------- Income from discontinued operations (less applicable income taxes of $15, $0 and $30) 23 40 45 - ---------------------------------------------------------------------------------------------------------------------------------- Net income before cumulative effect of accounting change 298 322 898 945 Cumulative effect of accounting change (less applicable income tax benefit of $2) (5) - ---------------------------------------------------------------------------------------------------------------------------------- Net income $298 $322 $893 $945 - ---------------------------------------------------------------------------------------------------------------------------------- EARNINGS PER COMMON SHARE Continuing operations Basic $1.03 $1.02 $2.94 $3.05 Diluted 1.02 1.01 2.91 3.03 Net income Basic $1.03 $1.10 $3.06 $3.21 Diluted 1.02 1.09 3.03 3.18 CASH DIVIDENDS DECLARED PER COMMON SHARE .48 .45 1.44 1.35 AVERAGE COMMON SHARES OUTSTANDING Basic 286 289 288 290 Diluted 289 292 291 293 ==================================================================================================================================
See accompanying Notes to Consolidated Financial Statements. 27 CONSOLIDATED BALANCE SHEET THE PNC FINANCIAL SERVICES GROUP, INC.
September 30 December 31 In millions, except par value 2001 2000 - --------------------------------------------------------------------------------------------------------------------------- ASSETS Cash and due from banks $3,513 $3,662 Short-term investments 1,605 1,151 Loans held for sale 1,753 1,655 Securities available for sale 11,689 5,902 Loans, net of unearned income of $1,143 and $999 42,140 50,601 Allowance for credit losses (720) (675) - --------------------------------------------------------------------------------------------------------------------------- Net loans 41,420 49,926 Goodwill and other amortizable assets 2,393 2,468 Investment in discontinued operations 356 Other 9,571 4,724 - --------------------------------------------------------------------------------------------------------------------------- Total assets $71,944 $69,844 =========================================================================================================================== LIABILITIES Deposits Noninterest-bearing $8,905 $8,490 Interest-bearing 36,090 39,174 - --------------------------------------------------------------------------------------------------------------------------- Total deposits 44,995 47,664 Borrowed funds Federal funds purchased 1,904 1,445 Repurchase agreements 672 607 Bank notes and senior debt 5,344 6,110 Federal Home Loan Bank borrowings 2,457 500 Subordinated debt 2,368 2,407 Other borrowed funds 301 649 - --------------------------------------------------------------------------------------------------------------------------- Total borrowed funds 13,046 11,718 Other 6,228 2,958 - --------------------------------------------------------------------------------------------------------------------------- Total liabilities 64,269 62,340 - --------------------------------------------------------------------------------------------------------------------------- Mandatorily redeemable capital securities of subsidiary trusts 848 848 SHAREHOLDERS' EQUITY Preferred stock 5 7 Common stock - $5 par value Authorized 800 and 450 shares Issued 353 shares 1,764 1,764 Capital surplus 1,267 1,303 Retained earnings 7,166 6,736 Deferred benefit expense (26) (25) Accumulated other comprehensive income (loss) from continuing operations 155 (43) Accumulated other comprehensive loss from discontinued operations (45) Common stock held in treasury at cost: 69 and 63 shares (3,504) (3,041) - --------------------------------------------------------------------------------------------------------------------------- Total shareholders' equity 6,827 6,656 - --------------------------------------------------------------------------------------------------------------------------- Total liabilities, capital securities and shareholders' equity $71,944 $69,844 ===========================================================================================================================
See accompanying Notes to Consolidated Financial Statements. 28 CONSOLIDATED STATEMENT OF CASH FLOWS THE PNC FINANCIAL SERVICES GROUP, INC.
Nine months ended September 30 - in millions 2001 2000 - --------------------------------------------------------------------------------------------------------------------------------- OPERATING ACTIVITIES Net income $893 $945 Discontinued operations (40) (45) Cumulative effect of accounting change 5 - --------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 858 900 Adjustments to reconcile income from continuing operations to net cash provided by operating activities Provision for credit losses 235 96 Depreciation, amortization and accretion 221 252 Deferred income taxes 245 286 Net securities gains (131) (6) Valuation adjustments 12 24 Change in Loans held for sale (116) 1,326 Other (982) (1,129) - --------------------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 342 1,749 - --------------------------------------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES Net change in loans 774 (425) Repayment of securities available for sale 1,733 679 Sales Securities available for sale 18,901 4,648 Loans 3,845 187 Foreclosed assets 13 18 Purchases Securities available for sale (23,485) (5,810) Loans (246) Net cash received (paid) for acquisitions/divestitures 503 (4) Other (57) (191) - --------------------------------------------------------------------------------------------------------------------------------- Net cash provided (used) by investing activities 1,981 (898) - --------------------------------------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES Net change in Noninterest-bearing deposits 415 348 Interest-bearing deposits (3,084) 1,344 Federal funds purchased 459 60 Repurchase agreements 65 200 Sales/issuances Bank notes and senior debt 1,147 2,848 Federal Home Loan Bank borrowings 3,123 1,781 Subordinated debt 1 593 Other borrowed funds 27,438 28,985 Common stock 154 118 Repayments/maturities Bank notes and senior debt (1,915) (3,715) Federal Home Loan Bank borrowings (1,155) (3,456) Subordinated debt (200) (514) Other borrowed funds (27,787) (28,683) Acquisition of treasury stock (608) (327) Series F preferred stock tender offer (96) Cash dividends paid (429) (407) - --------------------------------------------------------------------------------------------------------------------------------- Net cash used by financing activities (2,472) (825) - --------------------------------------------------------------------------------------------------------------------------------- (DECREASE) INCREASE IN CASH AND DUE FROM BANKS (149) 26 Cash and due from banks at beginning of year 3,662 3,080 - --------------------------------------------------------------------------------------------------------------------------------- Cash and due from banks at end of period $3,513 $3,106 ================================================================================================================================= CASH PAID FOR Interest $1,525 $1,946 Income taxes 105 235 NON-CASH ITEMS Transfer of residential loans to securities available for sale 3,775 Transfer from loans held for sale to loans 6 Transfer from loans to other assets 5 18 =================================================================================================================================
See accompanying Notes to Consolidated Financial Statements. 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE PNC FINANCIAL SERVICES GROUP, INC. BUSINESS The PNC Financial Services Group, Inc. ("Corporation" or "PNC") is one of the largest diversified financial services companies in the United States, operating businesses engaged in regional community banking, corporate banking, real estate finance, asset-based lending, wealth management, asset management and global fund services. The Corporation provides certain products and services nationally and others in PNC's primary geographic markets in Pennsylvania, New Jersey, Delaware, Ohio and Kentucky. The Corporation also provides certain asset management and global fund services internationally. PNC is subject to intense competition from other financial services companies and is subject to regulation by various domestic and international authorities. ACCOUNTING POLICIES BASIS OF FINANCIAL STATEMENT PRESENTATION The unaudited consolidated interim financial statements include the accounts of PNC and its subsidiaries, most of which are wholly owned. Such statements have been prepared in accordance with accounting principles generally accepted in the United States. All significant intercompany accounts and transactions have been eliminated. In the opinion of management, the financial statements reflect all adjustments of a normal recurring nature necessary for a fair statement of results for the interim periods presented. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the amounts reported. Actual results will differ from such estimates and the differences may be material to the consolidated financial statements. The consolidated financial statements and notes to consolidated financial statements reflect the residential mortgage banking business, which was sold on January 31, 2001, in discontinued operations, unless otherwise noted. The notes included herein should be read in conjunction with the audited consolidated financial statements included in The PNC Financial Services Group, Inc.'s 2000 Annual Report. FINANCIAL DERIVATIVES The Corporation uses a variety of financial derivatives as part of the overall asset and liability risk management process to manage interest rate, market and credit risk inherent in the Corporation's business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total rate of return swaps, purchased interest rate caps and floors and futures contracts are the primary instruments used by the Corporation for interest rate risk management. Interest rate swaps are agreements with a counterparty to exchange periodic fixed and floating interest payments calculated on a notional amount. The floating rate is based on a money market index, primarily short-term LIBOR. Total rate of return swaps are agreements with a counterparty to exchange an interest rate payment for the total rate of return on a specified reference index calculated on a notional amount. Purchased interest rate caps and floors are agreements where, for a fee, the counterparty agrees to pay the Corporation the amount, if any, by which a specified market interest rate exceeds or is less than a defined rate applied to a notional amount, respectively. Interest rate futures contracts are exchange-traded agreements to make or take delivery of a financial instrument at an agreed upon price and are settled in cash daily. Financial derivatives involve, to varying degrees, interest rate, market and credit risk. The Corporation manages these risks as part of its asset and liability management process and through credit policies and procedures. The Corporation seeks to minimize the credit risk by entering into transactions with only a select number of high-quality institutions, establishing credit limits, requiring bilateral-netting agreements, and, in certain instances, segregated collateral. CASH FLOW HEDGING STRATEGY The Corporation enters into interest rate swap contracts to modify the interest rate characteristics of designated commercial loans from variable to fixed in order to reduce the impact of interest rate changes on future interest income. The fair value of the derivative is reported in other assets or other liabilities and offset in accumulated other comprehensive income for the effective portion of the derivative. Ineffectiveness of the strategy, as defined under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 137 and No. 138, if any, is reported in net interest income. Amounts reclassed into earnings, when the hedged transaction affects earnings, are included in net interest income. FAIR VALUE HEDGING STRATEGIES The Corporation enters into interest rate and total rate of return swaps, caps, floors and interest rate futures derivative contracts to hedge designated commercial mortgage loans held for sale, securities available for sale, commercial loans, bank notes, senior debt and subordinated debt for changes in fair value primarily due to changes in interest rates. Adjustments related to the ineffective portion of fair value hedging instruments are recorded in either net interest income or noninterest income depending on the hedged item. 30 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE PNC FINANCIAL SERVICES GROUP, INC. CUSTOMER AND OTHER DERIVATIVES To accommodate customer needs, PNC also enters into financial derivative transactions primarily consisting of interest rate swaps, caps, floors and foreign exchange contracts. Risk exposures from customer positions are managed through transactions with other dealers. Additionally, the Corporation enters into other derivative transactions for risk management purposes that are not designated as accounting hedges. The positions of customer and other derivatives are recorded at fair value and changes in value are included in noninterest income. Effective January 1, 2001, the Corporation implemented SFAS No. 133. The statement requires the Corporation to recognize all derivative instruments as either assets or liabilities on the balance sheet at fair value. Financial derivatives are reported at fair value in other assets or other liabilities. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, the Corporation must designate the hedging instrument, based on the exposure being hedged, as either a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. For derivatives that are designated as fair value hedges (i.e., hedging the exposure to changes in the fair value of an asset or a liability attributable to a particular risk), the gain or loss on derivatives as well as the loss or gain on the hedged items are recognized in current earnings. For derivatives designated as cash flow hedges (i.e., hedging the exposure to variability in expected future cash flows), the effective portions of the gain or loss on derivatives are reported as a component of accumulated other comprehensive income in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivatives in excess of the hedged future cash flows, if any, is recognized in current earnings. For derivatives not designated as hedges, the gain or loss is recognized in current earnings. FINANCIAL DERIVATIVES - PRE-SFAS NO. 133 Prior to January 1, 2001, interest rate swaps, caps and floors that modified the interest rate characteristics (such as from fixed to variable, variable to fixed, or one variable index to another) of designated interest-bearing assets or liabilities were accounted for under the accrual method. The net amount payable or receivable from the derivative contract was accrued as an adjustment to interest income or interest expense of the designated instrument. Premiums on contracts were deferred and amortized over the life of the agreement as an adjustment to interest income or interest expense of the designated instruments. Unamortized premiums were included in other assets. Changes in the fair value of financial derivatives accounted for under the accrual method were not reflected in results of operations. Realized gains and losses, except losses on terminated interest rate caps and floors, were deferred as an adjustment to the carrying amount of the designated instruments and amortized over the shorter of the remaining original life of the agreements or the designated instruments. Losses on terminated interest rate caps and floors were recognized immediately in results of operations. If the designated instruments were disposed, the fair value of the associated derivative contracts and any unamortized deferred gains or losses were included in the determination of gain or loss on the disposition of such instruments. Contracts not qualifying for accrual accounting were marked to market with gains or losses included in noninterest income. Credit default swaps were entered into to mitigate credit risk and lower the required regulatory capital associated with commercial lending activities. If the credit default swaps qualified for hedge accounting treatment, the premium paid to enter into the credit default swaps were recorded in other assets and deferred and amortized to noninterest expense over the life of the agreement. Changes in the fair value of credit default swaps qualifying for hedge accounting treatment were not reflected in the Corporation's financial position and had no impact on results of operations. If the credit default swap did not qualify for hedge accounting treatment or if the Corporation was the seller of credit protection, the credit default swap was marked to market with gains or losses included in noninterest income. Due to the particular structure of the Corporation's credit default swaps discussed in the preceding paragraphs, these instruments are not considered financial derivatives under the provisions of SFAS No. 133. Commencing January 1, 2001, the premiums paid to enter credit default swaps not considered to be derivatives are recorded in other assets and amortized to noninterest expense over the life of the agreement. 31 RECENT ACCOUNTING PRONOUNCEMENTS SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (a replacement of Financial Accounting Standards Board ("FASB") Statement No. 125) was issued in September 2000. Although SFAS No. 140 has changed many of the rules regarding securitizations, it continues to require an entity to recognize the financial and servicing assets it controls and the liabilities it has incurred and to derecognize financial assets when control has been surrendered in accordance with the criteria provided in the standard. As required, the Corporation began application of the new rules prospectively to transactions beginning in the second quarter of 2001. SFAS No. 140 also requires certain disclosures pertaining to securitization transactions effective for fiscal years ended after December 15, 2000. PNC included these required disclosures in its December 31, 2000 consolidated financial statements. In July 2001, the FASB issued SFAS No. 141, "Business Combinations." SFAS No. 141 requires the purchase method of accounting be used for all business combinations initiated or completed after June 30, 2001 and eliminates the pooling-of-interests method of accounting. The statement also addresses disclosure requirements for business combinations and initial recognition and measurement criteria for goodwill and other intangible assets as a result of purchase business combinations. Also in July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets," which changes the accounting from amortizing goodwill to an impairment-only approach. The amortization of goodwill, including goodwill recognized relating to past business combinations, will cease upon adoption of the new standard. Impairment testing for goodwill at a reporting unit level will be required on at least an annual basis. The new standard also addresses other accounting matters, disclosure requirements and financial statement presentation issues relating to goodwill and other intangible assets. The Corporation will adopt SFAS No. 142 effective January 1, 2002. Assuming no impairment adjustments are necessary, no future business combinations and no other changes to goodwill, the Corporation expects net income to increase by approximately $94 million in 2002 resulting from the cessation of goodwill amortization. In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which requires that the fair value of a liability be recognized when incurred for the retirement of a long-lived asset and the value of the related asset be increased by that amount. The statement also requires that the liability be maintained at its present value in subsequent periods and outlines certain disclosures for such obligations. The adoption of this statement, which is effective January 1, 2003, is not expected to have a material impact on the Corporation's financial statements. In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which replaces SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Assets to be Disposed Of." This statement primarily defines one accounting model for long-lived assets to be disposed of by sale, including discontinued operations, and addresses implementation issues regarding the impairment of long-lived assets. The adoption of this statement, which is effective January 1, 2002, is not expected to have a material impact on the Corporation's financial statements. DISCONTINUED OPERATIONS On January 31, 2001, PNC closed the sale of its residential mortgage banking business to Washington Mutual, F.A. The income and net assets of the residential mortgage banking business, which are presented on one line in the income statement and balance sheet, respectively, are as follows: INCOME FROM DISCONTINUED OPERATIONS Nine months ended September 30 - in millions 2001 2000 - --------------------------------------------------------------- Total income from operations after tax $15 $45 Total gain on disposal after tax 25 - --------------------------------------------------------------- Total income from discontinued operations $40 $45 =============================================================== Certain closing date adjustments are currently in dispute between PNC and the buyer. The disputed matters will be resolved in accordance with procedures provided for in the purchase agreement. The ultimate financial impact of the sale will not be determined until final settlement is completed. INVESTMENT IN DISCONTINUED OPERATIONS December 31 - in millions 2000 - ---------------------------------------------------------------- Loans held for sale $3,003 Securities available for sale 3,016 Loans, net of unearned income 739 Goodwill and other amortizable assets 1,925 All other assets 1,168 - ---------------------------------------------------------------- Total assets 9,851 - ---------------------------------------------------------------- Deposits 1,150 Borrowed funds 7,601 Other liabilities 744 - ---------------------------------------------------------------- Total liabilities 9,495 - ---------------------------------------------------------------- Net assets $356 ================================================================ CASH FLOWS During the first nine months of 2001, divestiture activity that affected cash flows consisted of $383 million of divested net assets and cash receipts of $503 million. During the first nine months of 2000, acquisition activity that affected cash flows consisted of $22 million of acquired assets, $2 million of acquired liabilities and cash payments of $3 million. 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE PNC FINANCIAL SERVICES GROUP, INC. TRADING ACTIVITIES Most of PNC's trading activities are designed to provide capital markets services to customers and not to position the Corporation's portfolio for gains from market movements. PNC participates in derivatives and foreign exchange trading as well as underwriting and "market making" in equity securities as an accommodation to customers. PNC also engages in trading activities as part of risk management strategies. Net trading income for the first nine months of 2001 totaled $118 million compared with $68 million for the prior-year period and was included in noninterest income as follows: Nine months ended September 30 - in millions 2001 2000 - ---------------------------------------------------------------- Corporate services $5 $7 Equity management 2 Other noninterest income Securities trading (a) 40 32 Derivatives trading 54 11 Foreign exchange 19 16 - ---------------------------------------------------------------- Net trading income $118 $68 ================================================================ (a) Securities trading primarily includes income from principal transactions, underwriting services and "market making." SECURITIES AVAILABLE FOR SALE
Unrealized Amortized ------------------------------------- Fair In millions Cost Gains Losses Value - ----------------------------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 2001 Debt securities U.S. Treasury and government agencies $1,053 $6 $1,059 Mortgage-backed 6,509 53 $(1) 6,561 Asset-backed 2,472 30 (1) 2,501 State and municipal 65 3 68 Other debt 978 6 (1) 983 - ----------------------------------------------------------------------------------------------------------------------------------- Total debt securities 11,077 98 (3) 11,172 Corporate stocks and other 533 52 (68) 517 - ----------------------------------------------------------------------------------------------------------------------------------- Total securities available for sale $11,610 $150 $(71) $11,689 =================================================================================================================================== DECEMBER 31, 2000 Debt securities U.S. Treasury and government agencies $313 $1 $(1) $313 Mortgage-backed 4,037 13 (48) 4,002 Asset-backed 902 1 (10) 893 State and municipal 94 2 96 Other debt 73 1 (1) 73 - ----------------------------------------------------------------------------------------------------------------------------------- Total debt securities 5,419 18 (60) 5,377 Corporate stocks and other 537 2 (14) 525 - ----------------------------------------------------------------------------------------------------------------------------------- Total securities available for sale $5,956 $20 $(74) $5,902 ===================================================================================================================================
The fair value of securities available for sale at September 30, 2001 was $11.7 billion compared with $5.9 billion at December 31, 2000. Securities represented 16% of total assets at September 30, 2001 compared with 8% at December 31, 2000. The expected weighted-average life of securities available for sale was 5 years and 2 months at September 30, 2001 compared with 4 years and 5 months at December 31, 2000. At September 30, 2001, the securities available for sale balance included a net unrealized gain of $79 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2000 was a net unrealized loss of $54 million. Net unrealized gains and losses in the securities available for sale portfolio are included in accumulated other comprehensive income or loss, net of tax or, for the portion attributable to a hedged risk as part of a fair value hedge strategy, in net income. Net securities gains associated with the disposition of securities available for sale were $134 million for the first nine months of 2001 compared with $4 million for the first nine months of 2000. Net securities losses of $3 million for the first nine months of 2001, and net securities gains of $2 million for the first nine months of 2000, related to commercial mortgage banking activities, were included in corporate services revenue. 33 NONPERFORMING ASSETS Nonperforming assets were as follows: September 30 December 31 In millions 2001 2000 - --------------------------------------------------------------------- Nonaccrual loans $361 $323 Foreclosed and other assets 13 49 - --------------------------------------------------------------------- Total nonperforming assets $374 $372 ===================================================================== The above table excludes $37 million and $18 million of equity management assets carried at estimated fair value at September 30, 2001 and December 31, 2000, respectively. ALLOWANCE FOR CREDIT LOSSES Changes in the allowance for credit losses were as follows: In millions 2001 2000 - --------------------------------------------------------------------- Allowance at January 1 $675 $674 Charge-offs Commercial (165) (86) Commercial real estate (6) (2) Consumer (31) (34) Residential mortgage (1) (4) Lease financing (16) (5) - --------------------------------------------------------------------- Total charge-offs (219) (131) Recoveries Commercial 13 14 Commercial real estate 1 4 Consumer 13 16 Residential mortgage 1 Lease financing 2 1 - --------------------------------------------------------------------- Total recoveries 29 36 - --------------------------------------------------------------------- Net charge-offs Commercial (152) (72) Commercial real estate (5) 2 Consumer (18) (18) Residential mortgage (1) (3) Lease financing (14) (4) - --------------------------------------------------------------------- Total net charge-offs (190) (95) Provision for credit losses 235 96 - --------------------------------------------------------------------- Allowance at September 30 $720 $675 ===================================================================== FINANCIAL DERIVATIVES Effective January 1, 2001, the Corporation implemented SFAS No. 133. As a result of the adoption of this statement, the Corporation recognized, in the first quarter of 2001, an after-tax loss from the cumulative effect of a change in accounting principle of $5 million reported in the consolidated income statement and an after-tax accumulated other comprehensive loss of $4 million. The impact of the adoption of this standard related to the residential mortgage banking business that was sold is reflected in the results of discontinued operations. Earnings adjustments resulting from cash flow and fair value hedge ineffectiveness were not significant to the results of operations of the Corporation during the first nine months of 2001. During the next twelve months, the Corporation expects to reclassify to earnings $110 million of pretax net gains on cash flow hedge derivatives currently reported in accumulated other comprehensive income. These net gains may result from anticipated net cash flows on receive fixed interest rate swaps and would offset reductions in net interest income recognized on the related floating rate commercial loans. At September 30, 2001 and December 31, 2000, the Corporation's exposure to credit losses with respect to financial derivatives was not material. LEGAL PROCEEDINGS The Corporation and persons to whom the Corporation may have indemnification obligations, in the normal course of business, are subject to various pending and threatened legal proceedings in which claims for monetary damages and other relief are asserted. Management, after consultation with legal counsel, does not at the present time anticipate the ultimate aggregate liability, if any, arising out of such legal proceedings will have a material adverse effect on the Corporation's financial condition. At the present time, management is not in a position to determine whether any such pending or threatened legal proceedings will have a material adverse effect on the Corporation's results of operations in any future reporting period. 34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE PNC FINANCIAL SERVICES GROUP, INC. COMPREHENSIVE INCOME Comprehensive income from continuing operations was $513 million for the third quarter of 2001 and $1.056 billion for the first nine months of 2001, compared with $345 million and $940 million, respectively, in 2000. The Corporation's other comprehensive income consists of unrealized gains or losses on securities available for sale and cash flow hedge derivatives, foreign currency translation and minimum pension liability adjustments. The income effects allocated to each component of other comprehensive income are as follows: Nine months ended September 30, 2001 Pretax Tax Benefit After-tax In millions Amount (Expense) Amount - ---------------------------------------------------------------------------- Unrealized securities gains $127 $(45) $82 Less: Reclassification adjustment for losses realized in net income (8) 3 (5) - ---------------------------------------------------------------------------- Net unrealized securities gains 135 (48) 87 - ---------------------------------------------------------------------------- SFAS No. 133 transition adjustment (6) 2 (4) Unrealized gains on cash flow hedge derivatives 149 (52) 97 Less: Reclassification adjustment for losses realized in net income (27) 9 (18) - ---------------------------------------------------------------------------- Net unrealized gains on cash flow hedge derivatives 170 (59) 111 - ---------------------------------------------------------------------------- Other comprehensive income from continuing operations $305 $(107) $198 ============================================================================ Year ended December 31, 2000 Pretax Tax Benefit After-tax In millions Amount (Expense) Amount - ---------------------------------------------------------------------------- Unrealized securities gains $127 $(41) $86 Less: Reclassification adjustment for losses realized in net income (3) 1 (2) - ---------------------------------------------------------------------------- Net unrealized securities gains 130 (42) 88 Minimum pension liability adjustment 2 (1) 1 - ---------------------------------------------------------------------------- Other comprehensive income from continuing operations $132 $(43) $89 ============================================================================ The accumulated balances related to each component of other comprehensive income (loss) are as follows: September 30 December 31 In millions 2001 2000 - ------------------------------------------------------------------ Net unrealized securities gains (losses) $55 $(32) Net unrealized gains on cash flow hedge derivatives 111 Minimum pension liability adjustment (11) (11) Accumulated other comprehensive income (loss) from continuing operations $155 $(43) ================================================================== 35 EARNINGS PER SHARE The following table sets forth basic and diluted earnings per share calculations.
Three months ended Nine months ended September 30 September 30 -------------------- ----------------------- In millions, except share and per share data 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------------------------------ CALCULATION OF BASIC EARNINGS PER COMMON SHARE Income from continuing operations $298 $299 $858 $900 Less: Preferred dividends declared 3 5 13 14 - ------------------------------------------------------------------------------------------------------------------------------------ Income from continuing operations applicable to basic earnings per common share 295 294 845 886 Income from discontinued operations applicable to basic earnings per common share 23 40 45 Cumulative effect of accounting change applicable to basic earnings per common share (5) - ------------------------------------------------------------------------------------------------------------------------------------ Net income applicable to basic earnings per common share $295 $317 $880 $931 Basic weighted-average common shares outstanding (in thousands) 286,282 288,958 287,908 290,213 Basic earnings per common share from continuing operations $1.03 $1.02 $2.94 $3.05 Basic earnings per common share from discontinued operations .08 .14 .16 Basic earnings per common share from cumulative effect of accounting change (.02) - ------------------------------------------------------------------------------------------------------------------------------------ Basic earnings per common share $1.03 $1.10 $3.06 $3.21 ==================================================================================================================================== CALCULATION OF DILUTED EARNINGS PER COMMON SHARE Income from continuing operations $298 $299 $858 $900 Less: Dividends declared on nonconvertible preferred stock Series F 3 5 12 14 - ------------------------------------------------------------------------------------------------------------------------------------ Income from continuing operations applicable to diluted earnings per common share 295 294 846 886 Income from discontinued operations applicable to diluted earnings per common share 23 40 45 Cumulative effect of accounting change applicable to diluted earnings per common share (5) - ------------------------------------------------------------------------------------------------------------------------------------ Net income applicable to diluted earnings per common share $295 $317 $881 $931 Basic weighted-average common shares outstanding (in thousands) 286,282 288,958 287,908 290,213 Weighted-average common shares to be issued using average market price and assuming: Conversion of preferred stock Series A and B 103 118 107 120 Conversion of preferred stock Series C and D 861 974 882 1,005 Conversion of debentures 17 19 17 20 Exercise of stock options 1,530 1,906 1,873 1,215 Incentive share awards 421 55 347 163 - ------------------------------------------------------------------------------------------------------------------------------------ Diluted weighted-average common shares outstanding (in thousands) 289,214 292,030 291,134 292,736 Diluted earnings per common share from continuing operations $1.02 $1.01 $2.91 $3.03 Diluted earnings per common share from discontinued operations .08 .14 .15 Diluted earnings per common share from cumulative effect of accounting change (.02) - ------------------------------------------------------------------------------------------------------------------------------------ Diluted earnings per common share $1.02 $1.09 $3.03 $3.18 ====================================================================================================================================
36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE PNC FINANCIAL SERVICES GROUP, INC. SEGMENT REPORTING PNC operates seven major businesses engaged in regional community banking, corporate banking, real estate finance, asset-based lending, wealth management, asset management and global fund services. Business results are presented based on PNC's management accounting practices and the Corporation's management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to generally accepted accounting principles; therefore, PNC's business results are not necessarily comparable with similar information for any other financial services institution. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. The management accounting process uses various balance sheet and income statement assignments and transfers to measure performance of the businesses. Methodologies change from time to time as management accounting practices are enhanced and businesses change. Securities available for sale or borrowings and related net interest income are assigned based on the net asset or liability position of each business. Capital is assigned based on management's assessment of inherent risks and equity levels at independent companies providing similar products and services. The allowance for credit losses is allocated based on management's assessment of risk inherent in the loan portfolios. Support areas not directly aligned with the businesses are allocated primarily based on the utilization of services. Total business financial results differ from consolidated results from continuing operations primarily due to differences between management accounting practices and generally accepted accounting principles, loan portfolios and businesses that were designated for downsizing during 1999, equity management activities, minority interests, residual asset and liability management activities, eliminations, unallocated reserves and unassigned items, the impact of which is reflected in the "Other" category. BUSINESS SEGMENT PRODUCTS AND SERVICES Regional Community Banking provides deposit, branch-based brokerage, electronic banking and credit products and services to retail customers as well as deposit, credit, treasury management and capital markets products and services to small businesses primarily within PNC's geographic region. Corporate Banking provides credit, equipment leasing, treasury management and capital markets products and services to large and mid-sized corporations, institutions and government entities primarily within PNC's geographic region. PNC Real Estate Finance provides credit, capital markets, treasury management, commercial mortgage loan servicing and other products and services to developers, owners and investors in commercial real estate. PNC's commercial real estate financial services platform provides processing services through Midland Loan Services, Inc., a leading third-party provider of loan servicing and technology to the commercial real estate finance industry, and Columbia Housing Partners, LP, a national syndicator of affordable housing equity. PNC Business Credit provides asset-based lending, capital markets and treasury management products and services to middle market customers nationally. PNC Business Credit's lending services include loans secured by accounts receivable, inventory, machinery and equipment, and other collateral, and its customers include manufacturing, wholesale, distribution, retailing and service industry companies. PNC Advisors provides a full range of tailored investment products and services to affluent individuals and families including full-service brokerage through J.J.B. Hilliard, W.L. Lyons, Inc. and investment advisory services to the ultra-affluent through Hawthorn. PNC Advisors also serves as investment manager and trustee for employee benefit plans and charitable and endowment assets. BlackRock is one of the largest publicly traded investment management firms in the United States with $226 billion of assets under management at September 30, 2001. BlackRock manages assets on behalf of institutions and individuals through a variety of fixed income, liquidity, equity and alternative investment separate accounts and mutual funds, including its flagship fund families, BlackRock Funds and BlackRock Provident Institutional Funds. In addition, BlackRock provides risk management and technology services to a growing number of institutional investors under the BlackRock Solutions brand name. PFPC is the largest full-service mutual fund transfer agent and second largest provider of mutual fund accounting and administration services in the United States, providing a wide range of fund services to the investment management industry. PFPC also provides customized processing solutions to the international marketplace through its Dublin, Ireland and Luxembourg operations. 37 RESULTS OF BUSINESSES
PNC Regional Real PNC Three months ended September 30 Community Corporate Estate Business PNC In millions Banking Banking Finance Credit Advisors BlackRock PFPC Other Total - ------------------------------------------------------------------------------------------------------------------------------------ 2001 INCOME STATEMENT Net interest income (a) $375 $113 $31 $26 $31 $2 $(19) $5 $564 Noninterest income 210 65 24 5 142 135 183 25 789 - ------------------------------------------------------------------------------------------------------------------------------------ Total revenue 585 178 55 31 173 137 164 30 1,353 Provision for credit losses 15 41 5 5 44 110 Depreciation and amortization 20 3 5 1 5 7 12 14 67 Other noninterest expense 256 88 36 6 115 85 124 9 719 - ------------------------------------------------------------------------------------------------------------------------------------ Pretax earnings 294 46 9 19 53 45 28 (37) 457 Income taxes 108 15 (6) 7 19 18 11 (13) 159 - ------------------------------------------------------------------------------------------------------------------------------------ Earnings $186 $31 $15 $12 $34 $27 $17 $(24) $298 ==================================================================================================================================== Inter-segment revenue $1 $1 $14 $5 $1 $(22) ==================================================================================================================================== AVERAGE ASSETS $39,926 $15,950 $5,178 $2,432 $3,358 $644 $1,792 $(284) $68,996 ==================================================================================================================================== 2000 INCOME STATEMENT Net interest income (a) $355 $145 $28 $25 $34 $2 $(12) $(43) $534 Noninterest income 151 68 24 4 157 127 169 700 - ------------------------------------------------------------------------------------------------------------------------------------ Total revenue 506 213 52 29 191 129 157 (43) 1,234 Provision for credit losses 11 12 5 2 30 Depreciation and amortization 21 3 4 1 4 5 12 16 66 Other noninterest expense 241 92 31 7 123 86 120 (19) 681 - ------------------------------------------------------------------------------------------------------------------------------------ Pretax earnings 233 106 17 16 64 38 25 (42) 457 Income taxes 84 36 5 23 15 10 (15) 158 - ------------------------------------------------------------------------------------------------------------------------------------ Earnings $149 $70 $17 $11 $41 $23 $15 $(27) $299 ==================================================================================================================================== Inter-segment revenue $1 $1 $21 $3 $(26) ==================================================================================================================================== AVERAGE ASSETS $39,320 $16,729 $5,541 $2,343 $3,470 $492 $1,560 $(872) $68,583 ==================================================================================================================================== Nine months ended September 30 In millions - ------------------------------------------------------------------------------------------------------------------------------------ 2001 INCOME STATEMENT Net interest income (a) $1,093 $381 $88 $77 $99 $7 $(50) $(3) $1,692 Noninterest income 592 181 73 25 463 404 546 (74) 2,210 - ------------------------------------------------------------------------------------------------------------------------------------ Total revenue 1,685 562 161 102 562 411 496 (77) 3,902 Provision for credit losses 35 129 3 13 1 54 235 Depreciation and amortization 62 10 16 2 13 19 33 43 198 Other noninterest expense 765 277 101 21 363 258 382 (15) 2,152 - ------------------------------------------------------------------------------------------------------------------------------------ Pretax earnings 823 146 41 66 185 134 81 (159) 1,317 Income taxes 298 49 (12) 24 68 55 32 (55) 459 - ------------------------------------------------------------------------------------------------------------------------------------ Earnings $525 $97 $53 $42 $117 $79 $49 $(104) $858 ==================================================================================================================================== Inter-segment revenue $3 $3 $49 $13 $4 $(72) ==================================================================================================================================== AVERAGE ASSETS $40,188 $16,389 $5,253 $2,430 $3,399 $644 $1,759 $427 $70,489 ==================================================================================================================================== 2000 INCOME STATEMENT Net interest income (a) $1,058 $417 $87 $74 $102 $4 $(34) $(64) $1,644 Noninterest income 439 216 68 12 487 348 489 97 2,156 - ------------------------------------------------------------------------------------------------------------------------------------ Total revenue 1,497 633 155 86 589 352 455 33 3,800 Provision for credit losses 33 50 7 3 3 96 Depreciation and amortization 63 10 14 2 11 15 38 42 195 Other noninterest expense 733 281 88 20 374 230 366 32 2,124 - ------------------------------------------------------------------------------------------------------------------------------------ Pretax earnings 668 292 53 57 201 107 51 (44) 1,385 Income taxes 238 102 3 20 74 44 20 (16) 485 - ------------------------------------------------------------------------------------------------------------------------------------ Earnings $430 $190 $50 $37 $127 $63 $31 $(28) $900 ==================================================================================================================================== Inter-segment revenue $3 $3 $64 $9 $(79) ==================================================================================================================================== AVERAGE ASSETS $38,564 $16,318 $5,583 $2,230 $3,541 $492 $1,578 $221 $68,527 ====================================================================================================================================
(a) Taxable-equivalent basis 38 Statistical Information THE PNC FINANCIAL SERVICES GROUP, INC. CONSOLIDATED AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS
Nine months ended September 30 --------------------------------------------------------------------- 2001 2000 --------------------------------------------------------------------- Average Taxable-equivalent basis Average Average Average Yields/ Dollars in millions Balances Interest Yields/Rates Balances Interest Rates - ------------------------------------------------------------------------------------------------------------------------------------ ASSETS Interest-earning assets Loans held for sale $1,805 $90 6.52% $2,681 $163 8.10% Securities available for sale U.S. Treasury and government agencies and corporations 3,846 167 5.77 1,748 77 5.89 Other debt 6,285 282 5.99 3,752 185 6.56 State, municipal and other 106 5 6.79 605 30 6.68 - ----------------------------------------------------------------------------------- ------------------------- Total securities available for sale 10,237 454 5.92 6,105 292 6.38 Loans, net of unearned income Commercial 20,144 1,130 7.40 21,878 1,383 8.31 Commercial real estate 2,567 146 7.50 2,689 179 8.73 Consumer 9,095 563 8.28 9,210 589 8.55 Residential mortgage 9,616 522 7.24 12,519 668 7.11 Lease financing 4,144 220 7.07 3,082 168 7.25 Other 478 25 6.93 670 42 8.40 - ----------------------------------------------------------------------------------- ------------------------- Total loans, net of unearned income 46,044 2,606 7.51 50,048 3,029 8.01 Other 1,637 93 7.61 1,278 71 7.39 - ----------------------------------------------------------------------------------- ------------------------- Total interest-earning assets/interest income 59,723 3,243 7.21 60,112 3,555 7.84 Noninterest-earning assets Investment in discontinued operations 68 459 Allowance for credit losses (681) (684) Cash and due from banks 2,935 2,665 Other assets 8,512 6,434 - ------------------------------------------------------------------------ ------------ Total assets $70,557 $68,986 - ------------------------------------------------------------------------ ------------ LIABILITIES, CAPITAL SECURITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities Interest-bearing deposits Demand and money market $20,994 419 2.66 $18,389 472 3.43 Savings 1,927 15 1.03 2,088 27 1.73 Retail certificates of deposit 12,716 516 5.43 14,591 603 5.52 Other time 534 26 6.48 633 31 6.45 Deposits in foreign offices 948 35 4.86 1,437 67 6.12 - ----------------------------------------------------------------------------------- ------------------------- Total interest-bearing deposits 37,119 1,011 3.64 37,138 1,200 4.31 Borrowed funds Federal funds purchased 2,344 86 4.81 2,115 99 6.13 Repurchase agreements 1,041 30 3.71 737 32 5.68 Bank notes and senior debt 5,349 215 5.31 6,675 325 6.41 Federal Home Loan Bank borrowings 2,155 74 4.54 1,648 78 6.18 Subordinated debt 2,368 127 7.14 2,405 134 7.44 Other borrowed funds 380 8 2.90 842 43 6.71 - ----------------------------------------------------------------------------------- ------------------------- Total borrowed funds 13,637 540 5.23 14,422 711 6.49 - ----------------------------------------------------------------------------------- ------------------------- Total interest-bearing liabilities/interest expense 50,756 1,551 4.07 51,560 1,911 4.92 Noninterest-bearing liabilities and shareholders' equity Demand and other noninterest-bearing deposits 8,299 8,098 Accrued expenses and other liabilities 3,962 2,440 Mandatorily redeemable capital securities of subsidiary trusts 848 848 Shareholders' equity 6,692 6,040 - ------------------------------------------------------------------------ ------------ Total liabilities, capital securities and shareholders' $70,557 $68,986 equity - ------------------------------------------------------------------------------------------------------------------------------------ Interest rate spread 3.14 2.92 Impact of noninterest-bearing sources .62 .71 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income/margin $1,692 3.76% $1,644 3.63% - ------------------------------------------------------------------------------------------------------------------------------------
Nonaccrual loans are included in loans, net of unearned income. The impact of financial derivatives used in interest rate risk management is included in the interest income/expense and average yields/rates of the related assets and liabilities. Average balances of securities available for sale are based on amortized historical cost (excluding SFAS No. 115 adjustments to fair value). Loan fees for the nine months ended September 30, 2001 and September 30, 2000 were both $89 million. For each of the three months ended September 30, 2001, June 30, 2001 and September 30, 2000 loan fees were $29 million, $30 million and $29 million, respectively. 39
- ------------------------------------------------------------------------------------------------------------------------------------ Third Quarter 2001 Second Quarter 2001 Third Quarter 2000 - ------------------------------------------------------------------------------------------------------------------------------------ Average Average Average Average Yields/ Average Yields/ Average Yields/ Balances Interest Rates Balances Interest Rates Balances Interest Rates - ------------------------------------------------------------------------------------------------------------------------------------ $1,695 $22 5.06% $1,720 $31 7.06% $2,151 $47 8.77% 3,908 56 5.69 3,696 54 5.79 1,662 25 5.97 6,910 97 5.61 7,913 122 6.18 3,934 65 6.65 91 1 7.75 101 2 7.33 583 9 6.08 - ------------------------------ ---------------------------- ----------------------------- 10,909 154 5.66 11,710 178 6.07 6,179 99 6.41 19,296 333 6.76 20,271 375 7.31 21,800 472 8.47 2,548 43 6.67 2,572 48 7.40 2,688 61 8.85 9,102 181 7.86 9,096 188 8.29 9,174 201 8.72 7,771 138 7.11 8,459 152 7.18 12,405 222 7.16 4,381 75 6.76 4,149 74 7.08 3,238 58 7.24 456 7 6.04 459 7 6.66 646 14 8.64 - ------------------------------ ---------------------------- ----------------------------- 43,554 777 7.04 45,006 844 7.46 49,951 1,028 8.13 1,724 30 6.86 1,562 30 7.94 1,445 30 8.05 - ------------------------------ ---------------------------- ----------------------------- 57,882 983 6.72 59,998 1,083 7.19 59,726 1,204 7.98 515 (678) (683) (680) 2,921 2,907 2,848 8,871 8,494 6,689 - --------------- ------------- -------------- $68,996 $70,716 $69,098 - --------------- ------------- -------------- $21,559 123 2.25 $20,944 134 2.57 $18,914 175 3.68 1,925 4 .84 1,936 5 .94 2,020 9 1.81 11,785 142 4.79 12,662 175 5.54 14,776 217 5.85 501 8 6.26 537 8 6.48 619 10 6.55 357 3 3.54 1,096 12 4.17 1,342 23 6.50 - ------------------------------ ---------------------------- ----------------------------- 36,127 280 3.07 37,175 334 3.60 37,671 434 4.58 1,497 14 3.60 2,604 28 4.31 1,904 32 6.51 893 7 2.90 958 9 3.64 846 14 5.84 4,973 57 4.51 5,189 67 5.09 6,290 108 6.75 2,459 22 3.48 2,550 31 4.78 1,105 20 7.16 2,332 41 6.98 2,364 42 7.15 2,419 45 7.44 373 (2) (1.93) 365 3 3.32 954 17 7.18 - ------------------------------ ---------------------------- ----------------------------- 12,527 139 4.35 14,030 180 5.09 13,518 236 6.85 - ------------------------------ ---------------------------- ----------------------------- 48,654 419 3.40 51,205 514 4.01 51,189 670 5.18 8,476 8,229 8,239 4,273 3,777 2,637 848 848 848 6,745 6,657 6,185 - --------------- ------------- -------------- $68,996 $70,716 $69,098 - ------------------------------------------------------------------------------------------------------------------------------------ 3.32 3.18 2.80 .54 .58 .74 - ------------------------------------------------------------------------------------------------------------------------------------ $564 3.86% $569 3.76% $534 3.54% - ------------------------------------------------------------------------------------------------------------------------------------
40 QUARTERLY REPORT ON FORM 10-Q THE PNC FINANCIAL SERVICES GROUP, INC. Securities and Exchange Commission Washington, D.C. 20549 Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2001. Commission File Number 1-9718 THE PNC FINANCIAL SERVICES GROUP, INC. Incorporated in the Commonwealth of Pennsylvania IRS Employer Identification No. 25-1435979 Address: One PNC Plaza 249 Fifth Avenue Pittsburgh, Pennsylvania 15222-2707 Telephone: (412) 762-2000 As of October 31, 2001 The PNC Financial Services Group, Inc. had 284,067,222 shares of common stock ($5 par value) outstanding. The PNC Financial Services Group, Inc. (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 and (2) has been subject to such filing requirements for the past 90 days. The following sections of the Financial Review set forth in the cross-reference index are incorporated in the Quarterly Report on Form 10-Q. Cross-reference Page(s) - --------------------------------------------------------------- PART I FINANCIAL INFORMATION Item 1 Financial Statements Consolidated Statement of Income for the three months and nine months ended September 30, 2001 and 2000 27 Consolidated Balance Sheet as of September 30, 2001 and December 31, 2000 28 Consolidated Statement of Cash Flows for the nine months ended September 30, 2001 and 2000 29 Notes to Consolidated Financial 30 - 38 Statements Consolidated Average Balance Sheet and Net Interest Analysis 39 - 40 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 3 - 26 Item 3 Quantitative and Qualitative Disclosures About Market Risk 17 - 24 - --------------------------------------------------------------- PART II OTHER FINANCIAL INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K The following exhibit index lists Exhibits filed with this Quarterly Report on Form 10-Q: 10.15 Forms of Second Amendment to Change in Control Severance Agreements 12.1 Computation of Ratio of Earnings to Fixed Charges 12.2 Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividends 99 The Corporation's Employee Stock Purchase Plan, as amended ================================================================================ Copies of these Exhibits may be obtained electronically at the Securities and Exchange Commission's home page at www.sec.gov. Copies may also be obtained without charge by writing to Lynn Fox Evans, Director of Financial Reporting, at corporate headquarters, by calling (412) 762-1553 or via e-mail at financial.reporting@pnc.com. The Corporation filed the following Report on Form 8-K since June 30, 2001: Form 8-K dated as of July 25, 2001, reporting on entering into underwriting agreements with respect to the public offering of $450,000,000 of Floating Rate Senior Notes due 2003, and $700,000,000 of 5.75% Senior Notes due 2006, and on the form of notes and related guarantees, filed pursuant to Item 5. Form 8-K dated as of October 29, 2001, reporting on entering into underwriting agreements with respect to the public offering of $600,000,000 of Floating Rate Senior Notes due 2004, and $400,000,000 of 5.75% Senior Notes due 2006, and on the form of notes and related guarantees, filed pursuant to Item 5. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on November 14, 2001, on its behalf by the undersigned thereunto duly authorized. THE PNC FINANCIAL SERVICES GROUP, INC. By: /s/ Robert L. Haunschild --------------------------- Robert L. Haunschild Senior Vice President and Chief Financial Officer 41 CORPORATE INFORMATION THE PNC FINANCIAL SERVICES GROUP, INC. CORPORATE HEADQUARTERS The PNC Financial Services Group, Inc. One PNC Plaza 249 Fifth Avenue Pittsburgh, Pennsylvania 15222-2707 (412) 762-2000 STOCK LISTING The PNC Financial Services Group, Inc. common stock is listed on the New York Stock Exchange under the symbol PNC. INTERNET INFORMATION The PNC Financial Services Group, Inc.'s financial reports and information about its products and services are available on the Internet at www.pnc.com. FINANCIAL INFORMATION The Corporation's Annual Report on Form 10-K is filed with the Securities and Exchange Commission ("SEC"). Copies of this document and other filings, including Exhibits thereto, may be obtained electronically at the SEC's home page at www.sec.gov. Copies may also be obtained without charge by writing to Lynn Fox Evans, Director of Financial Reporting, at corporate headquarters, by calling (412) 762-1553 or via e-mail at financial.reporting@pnc.com. INQUIRIES For financial services call 1-888-PNC-2265. Individual shareholders should contact Shareholder Relations at (800) 982-7652. Analysts and institutional investors should contact William H. Callihan, Vice President, Investor Relations, at (412) 762-8257 or via e-mail at investor.relations@pnc.com. News media representatives and others seeking general information should contact R. Jeep Bryant, Director of Corporate Communications, at (412) 762-8221 or via e-mail at corporate.communications@pnc.com. COMMON STOCK PRICES/DIVIDENDS DECLARED The table below sets forth by quarter the range of high and low sale and quarter-end closing prices for The PNC Financial Services Group, Inc. common stock and the cash dividends declared per common share. Cash Dividends High Low Close Declared ===================================================================== 2001 QUARTER - --------------------------------------------------------------------- First $75.813 $56.000 $67.750 $.48 Second 71.110 62.400 65.790 .48 Third 70.390 51.140 57.250 .48 - --------------------------------------------------------------------- Total $1.44 ===================================================================== 2000 QUARTER - --------------------------------------------------------------------- First $48.500 $36.000 $45.063 $.45 Second 57.500 41.000 46.875 .45 Third 66.375 47.625 65.000 .45 Fourth 75.000 56.375 73.063 .48 - --------------------------------------------------------------------- Total $1.83 ===================================================================== DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN The PNC Financial Services Group, Inc. Dividend Reinvestment and Stock Purchase Plan enables holders of common and preferred stock to purchase additional shares of common stock conveniently and without paying brokerage commissions or service charges. A prospectus and enrollment card may be obtained by writing to Shareholder Relations at corporate headquarters. REGISTRAR AND TRANSFER AGENT The Chase Manhattan Bank 85 Challenger Road Ridgefield Park, New Jersey 07660 (800) 982-7652 42