Back to GetFilings.com



Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2005

 

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to            

 

Commission file number 001-09718

 


 

The PNC Financial Services Group, Inc.

(Exact name of registrant as specified in its charter)

 


 

Pennsylvania   25-1435979

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707

(Address of principal executive offices)

(Zip Code)

 

(412) 762-2000

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last report)

 


 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

 

As of April 29, 2005, there were 283,521,031 shares of the registrant’s common stock ($5 par value) outstanding.

 



Table of Contents

The PNC Financial Services Group, Inc.

Cross-Reference Index to 2005 First Quarter Form 10-Q

 

     Pages

PART I – FINANCIAL INFORMATION

    

Item 1. Financial Statements (Unaudited).

   39-60
    

Consolidated Income Statement

   39
    

Consolidated Balance Sheet

   40
    

Consolidated Statement of Cash Flows

   41
    

Notes To Consolidated Financial Statements

    
         

Note 1 Accounting Policies

   42
         

Note 2 Acquisitions

   46
         

Note 3 Trading Activities

   46
         

Note 4 Securities

   47
         

Note 5 Nonperforming Assets

   48
         

Note 6 Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

   48
         

Note 7 Goodwill And Other Intangible Assets

   49
         

Note 8 Cash Flows

   49
         

Note 9 Variable Interest Entities

   50
         

Note 10 Capital Securities Of Subsidiary Trusts

   50
         

Note 11 Certain Employee Benefit And Stock-Based Compensation Plans

   51
         

Note 12 Financial Derivatives

   52
         

Note 13 Earnings Per Share

   54
         

Note 14 Shareholders’ Equity And Comprehensive Income

   55
         

Note 15 Legal Proceedings

   56
         

Note 16 Segment Reporting

   57
         

Note 17 Commitments And Guarantees

   59
    

Statistical Information

    
         

Average Consolidated Balance Sheet And Net Interest Analysis

   61-62

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

   1-38, 61-62
    

Consolidated Financial Highlights

   1-2
    

Financial Review

    
         

Executive Summary

   3
         

Consolidated Income Statement Review

   6
         

Consolidated Balance Sheet Review

   9
         

Off-Balance Sheet Arrangements And Consolidated VIEs

   13
         

Review Of Businesses

   14
         

Risk Factors

   22
         

Critical Accounting Policies And Judgments

   22
         

2002 BlackRock Long-Term Retention And Incentive Plan

   25
         

Status Of Defined Benefit Pension Plan

   25
         

Risk Management

   26
         

Internal Controls and Disclosure Controls and Procedures

   35
         

Glossary of Terms

   35
         

Cautionary Statement Regarding Forward-Looking Information

   37

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

   26-34

Item 4. Controls and Procedures.

   35

PART II – OTHER INFORMATION

    

Item 1. Legal Proceedings.

   63

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

   64

Item 4. Submission of Matters to a Vote of Security Holders.

   64

Item 6. Exhibits.

   65

Signature

   65

Corporate Information

   66


Table of Contents

CONSOLIDATED FINANCIAL HIGHLIGHTS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Dollars in millions, except per share data

Unaudited


   Three months ended March 31

 
   2005

    2004

 

FINANCIAL PERFORMANCE

                

Revenue

                

Net interest income (taxable-equivalent basis) (a)

   $ 512     $ 497  

Noninterest income

     973       911  
    


 


Total revenue

   $ 1,485     $ 1,408  
    


 


Net income

   $ 354     $ 328  
    


 


Per common share

                

Diluted earnings

   $ 1.24     $ 1.15  
    


 


Cash dividends declared

   $ .50     $ .50  
    


 


SELECTED RATIOS

                

Return on

                

Average common shareholders’ equity

     19.17 %     18.84 %

Average assets

     1.72       1.81  

Net interest margin

     3.02       3.30  

Noninterest income to total revenue

     66       65  

Efficiency

     68       64  

 

See page 35 for a glossary of certain terms used in this report.

 

Certain prior period amounts included in these Consolidated Financial Highlights have been reclassified to conform with the current period presentation.


(a) The interest income earned on certain earning assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparisons of yields and margins for all earning assets, we have increased the interest income earned on tax-exempt assets to make them fully equivalent to other taxable interest income investments. The following is a reconciliation of net interest income as reported in the Consolidated Income Statement to net interest income on a taxable-equivalent basis (in millions):

 

     Three months ended March 31

     2005

   2004

Net interest income, GAAP basis

   $ 506    $ 494

Taxable-equivalent adjustment

     6      3
    

  

Net interest income, taxable-equivalent basis

   $ 512    $ 497
    

  

 

1


Table of Contents

Unaudited


   March 31
2005


    December 31
2004


    March 31
2004


 

BALANCE SHEET DATA (dollars in millions, except per share data)

                        

Assets

   $ 83,359     $ 79,723     $ 74,115  

Earning assets

     69,155       65,055       61,344  

Loans, net of unearned income

     44,674       43,495       39,451  

Allowance for loan and lease losses

     600       607       604  

Securities

     18,449       16,761       16,941  

Loans held for sale

     2,067       1,670       1,548  

Deposits

     55,169       53,269       48,125  

Borrowed funds

     14,514       11,964       13,722  

Allowance for unfunded loan commitments and letters of credit

     78       75       91  

Shareholders’ equity

     7,579       7,473       7,230  

Common shareholders’ equity

     7,571       7,465       7,221  

Book value per common share

     26.78       26.41       25.61  

Common shares outstanding (millions)

     283       283       282  

Loans to deposits

     81 %     82 %     82 %

ASSETS UNDER MANAGEMENT (billions)

   $ 432     $ 383     $ 361  

FUND ASSETS SERVICED (billions)

                        

Accounting/administration net assets

   $ 745     $ 721     $ 669  

Custody assets

     462       451       411  

CAPITAL RATIOS

                        

Tier 1 Risk-based

     8.7 %     9.0 %     9.1 %

Total Risk-based

     12.6       13.0       13.1  

Leverage

     7.3       7.6       7.7  

Tangible common

     5.3       5.7       5.8  

Shareholders’ equity to assets

     9.09       9.37       9.76  

Common shareholders’ equity to assets

     9.08       9.36       9.74  

ASSET QUALITY RATIOS

                        

Nonperforming assets to total loans, loans held for sale and foreclosed assets

     .35 %     .39 %     .56 %

Nonperforming loans to loans

     .29       .33       .46  

Net charge-offs to average loans (for the three months ended)

     .11       .13       .64  

Allowance for loan and lease losses to loans

     1.34       1.40       1.53  

Allowance for loan and lease losses to nonperforming loans

     458       424       330  

 

2


Table of Contents

FINANCIAL REVIEW

THE PNC FINANCIAL SERVICES GROUP, INC.

 

This Financial Review should be read together with our unaudited Consolidated Financial Statements and unaudited Statistical Information included elsewhere in this Report and Items 6, 7, 8 and 9A of our 2004 Annual Report on Form 10-K (“2004 Form 10-K”). We have reclassified certain prior period amounts to conform with the current year presentation. For information regarding certain business and regulatory risks, see the Risk Factors and Risk Management sections in this Financial Review and Items 1 and 7 of our 2004 Form 10-K. Also, see the Cautionary Statement Regarding Forward-Looking Information and Critical Accounting Policies And Judgments sections in this Financial Review for certain other factors that could cause actual results or future events to differ materially from those anticipated in the forward-looking statements included in this Report or from historical performance. See Note 16 Segment Reporting in the Notes to Consolidated Financial Statements included in Part I, Item 1 of this Report for a reconciliation of total business segment earnings to total PNC consolidated earnings as reported on a generally accepted accounting principles (“GAAP”) basis.

 

EXECUTIVE SUMMARY

 

THE PNC FINANCIAL SERVICES GROUP, INC.

 

PNC is one of the largest diversified financial services companies in the United States, operating businesses engaged in regional community banking, wholesale banking, wealth management, asset management and global fund processing services. We operate directly and through numerous subsidiaries, providing many of our products and services nationally and others in our primary geographic markets in Pennsylvania, New Jersey, Delaware, Ohio and Kentucky. We also provide certain asset management and global fund processing services internationally.

 

KEY STRATEGIC GOALS

 

Our strategy to enhance shareholder value centers on achieving growth in our lines of business underpinned by prudent management of risk, capital and expenses. In each of our business segments, the primary drivers of growth are the acquisition, expansion and retention of customer relationships. We strive to achieve such growth in our customer base by providing convenient banking options, leading technological systems and a broad range of asset management products and services. We also intend to grow through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.

 

In recent years, we have managed our interest rate risk to achieve a moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations. Our actions have created a balance sheet characterized by strong asset quality and significant flexibility to take advantage, where appropriate, of rising interest rates. We anticipate that interest rates will continue to rise in 2005 and that the overall impact of a rise in long-term interest rates will be beneficial to us.

 

During the first quarter of 2005, we initiated an intensive process known as “One PNC” to improve our operating efficiency. We intend for this enterprise-wide review to be completed and for implementation to begin during the third quarter of 2005. We expect to realize significant expense savings and revenue enhancements as a result of this initiative. We also expect these improvements in efficiency to bring us closer to our customers.

 

As previously reported, effective January 31, 2005 our majority-owned subsidiary BlackRock acquired SSRM Holdings, Inc. (“SSRM”), the holding company for State Street Research & Management Company and SSR Realty Advisors Inc., from MetLife, Inc. At closing, MetLife, Inc. received approximately $233 million in cash and approximately 550,000 shares of BlackRock restricted class A common stock. Additional cash consideration, which could increase the purchase price by up to 25%, may be paid over five years contingent on certain measures. The addition of SSRM enhanced BlackRock’s investment management platform and added $50 billion in U.S. equity, fixed income, alternative investment and real estate equity assets under management.

 

On February 10, 2005, we entered into an amended and restated agreement to acquire Riggs National Corporation (“Riggs”), a Washington, D.C. based banking company, replacing the original acquisition agreement entered into July 16, 2004. The transaction will give us a substantial presence on which to build a market leading franchise in the affluent Washington metropolitan area. The total consideration under the amended and restated agreement is comprised of a fixed number of approximately 6.4 million shares of PNC common stock and $286 million in cash, subject to adjustment. The merger has received regulatory and shareholder approval, but is subject to select remaining closing conditions including, among others, receipt of regulatory waivers.

 

We include additional information on Riggs and SSRM in Note 2 Acquisitions in the Notes To Consolidated Financial Statements in Item 1 of this Report and in the Risk Factors section of Item 2 of this Report.

 

KEY FACTORS AFFECTING FINANCIAL PERFORMANCE

 

Our financial performance is substantially affected by several external factors outside of our control, including:

 

    General economic conditions,

 

    Loan demand,

 

    Interest rates,

 

    The shape of the interest rate yield curve, and

 

    The performance of the capital markets.

 

In addition to changes in general economic conditions, including the direction, timing and magnitude of movement in

 

3


Table of Contents

interest rates and the performance of the capital markets, our success for the remainder of 2005 will depend, among other things, upon:

 

    Further success in the acquisition, growth and retention of customers,

 

    Growth in market share across businesses,

 

    Disciplined expense control and improved efficiency,

 

    Maintaining strong overall asset quality,

 

    Prudent risk and capital management, and

 

    Successful completion of the acquisition and integration of Riggs.

 

We seek a moderate risk profile to limit the risk of loss resulting from quickly changing market conditions. We focus on the development and management of our customer franchises to generate longer-term growth in revenue and earnings.

 

SUMMARY FINANCIAL RESULTS

 

Consolidated net income for the first three months of 2005 was $354 million, or $1.24 per diluted share, compared with net income of $328 million, or $1.15 per diluted share, for the first three months of 2004. Return on average shareholders’ equity was 19.17% for the first quarter of 2005 and 18.84% for the first quarter of 2004. Return on average assets was 1.72% for the first three months of 2005 compared with 1.81% for the first three months of 2004.

 

On January 18, 2005, our ownership in BlackRock was transferred from PNC Bank, National Association (“PNC Bank, N.A.”) to PNC Bancorp, Inc., our intermediate bank holding company. The transfer was effected primarily to give BlackRock more operating flexibility, particularly in connection with its acquisition of SSRM. As a result of the transfer, certain deferred tax liabilities recorded by PNC were reversed in the first quarter of 2005 in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 109, Accounting for Income Taxes. The reversal of deferred tax liabilities benefited our earnings by $45 million, or approximately $.16 per diluted share, in the first quarter of 2005.

 

Earnings for the first quarter of 2004 included an after-tax gain of $22 million, or $.08 per diluted share, related to the sale of our modified coinsurance contracts.

 

Our first quarter 2005 performance included the following accomplishments:

 

    Average loan balances increased $5.1 billion, or 13%, over the first quarter of 2004. The increase was driven by increased demand across commercial and consumer loan products.

 

    Average total deposits increased $6.0 billion, or 13%, compared with a year ago, as our relationship-based strategy resulted in higher certificates of deposit and money market account balances, as well as higher noninterest-bearing deposits. Time deposits increased as a result of higher Eurodollar borrowings.

 

    Noninterest income, which is primarily fee-based revenue, increased to $973 million for the quarter, an increase of 7% compared with the first quarter of 2004. The increase was driven primarily by strong performance at BlackRock, including its successful acquisition of SSRM.

 

    Taxable-equivalent net interest income of $512 million was $15 million higher than the prior year first quarter primarily due to higher income associated with increased average earning assets partially offset by higher interest rates paid on deposits.

 

    Asset quality continued to improve.

 

BALANCE SHEET HIGHLIGHTS

 

Total average assets were $83.4 billion for the first quarter of 2005 compared with $73.0 billion for the first quarter of 2004. In addition to the $7.9 billion increase in average interest-earning assets discussed below, the increase compared with the first quarter of 2004 reflected increases in average receivables related to securities sold but not settled that are included in other noninterest-earning assets.

 

Average interest-earning assets were $68.0 billion for the first three months of 2005 compared with $60.1 billion for the first three months of 2004. An increase of $5.1 billion in average loans was the primary factor for the increase in average interest-earning assets. In addition, average trading securities included in other interest-earning assets increased $1.5 billion in the first quarter of 2005 compared with the prior year first quarter and average trading assets included in federal funds sold and resale agreements increased $1.1 billion over the prior year period.

 

Average total loans were $44.0 billion for the first three months of 2005, an increase of $5.1 billion over the first three months of 2004. This increase was driven by continued improvements in market loan demand as well as targeted sales efforts across our banking businesses. The increase in average total loans reflected growth in home equity loans of approximately $2.6 billion and commercial loans of approximately $2.1 billion, partially offset by a $1.0 billion decline in lease financing loans. During the second quarter of 2004, we sold our vehicle leasing portfolio as more fully described in our 2004 Form 10-K.

 

Loans represented 65% of average interest-earning assets for both the first three months of 2005 and the first three months of 2004.

 

Average securities totaled $16.9 billion for the first three months of 2005 and $16.3 billion for the first three months of 2004. Securities comprised 25% of average interest-earning assets for the first quarter of 2005 compared with 27% of average interest-earning assets for the first quarter of 2004.

 

Funding cost is affected by the volume and type of funding sources that we have as well as the rates that we pay on those sources. Average total deposits were $53.4 billion for the first three months of 2005, an increase of $6.0 billion over the first three months of 2004. The increase in average total deposits was driven primarily by higher certificates of deposit, money market account and noninterest-bearing deposit balances, and by higher Eurodollar deposits. Average total deposits represented 64% of total sources of funds for the first three months of 2005 and 65% for the first quarter of 2004. Average transaction deposits were $37.0 billion for the first three months of 2005 compared with $34.8 billion for the first three months of 2004.

 

4


Table of Contents

Average borrowed funds were $15.0 billion for the first three months of 2005 and $13.1 billion for the first three months of 2004. The following contributed to this increase:

 

    Our issuance of $500 million senior bank notes in September 2004, $500 million of subordinated bank notes in December 2004 and $700 million of senior notes and $350 million of senior bank notes in March 2005,

 

    BlackRock’s issuance of $250 million of convertible debentures in February 2005, and

 

    An increase in short-term borrowings to fund asset growth.

 

These increases were partially offset by Federal Home Loan Bank maturities and senior and subordinated debt maturities during the last nine months of 2004.

 

Shareholders’ equity totaled $7.6 billion at March 31, 2005, compared with $7.5 billion at December 31, 2004. See the Consolidated Balance Sheet Review section of this Financial Review for additional information.

 

BUSINESS SEGMENT HIGHLIGHTS

 

Total business segment earnings for the first quarter of 2005 were $329 million compared with $326 million for the first quarter of 2004. Total business segment earnings were essentially flat in the comparison as the impact of revenue growth in several of the businesses and disciplined expense management in 2005 was mostly offset by the impact of an $18 million after-tax reduction in net gains on institutional loans held for sale. In addition, BlackRock LTIP expenses were included in the first quarter of 2005, but not in the prior year quarter.

 

Regional Community Banking

 

Earnings from Regional Community Banking totaled $121 million for the first quarter of 2005 compared with $102 million for the first quarter of 2004. The 19% increase in earnings was driven by continued customer and balance sheet growth, reduced noninterest expense and a lower provision for credit losses. Checking relationships as of March 31, 2005 grew 5% compared with March 31, 2004, while total average loans grew 16% and average demand deposits grew 4% for the first quarter of 2005 compared with the first quarter of 2004.

 

Wholesale Banking

 

Earnings from Wholesale Banking were $110 million for the first three months of 2005 and $122 million for the first three months of 2004. The lower earnings reflected a $26 million pretax decrease in net gains on institutional loans held for sale and a $9 million lower negative provision for credit losses. Excluding the impact of these factors, results for Wholesale Banking for the first quarter of 2005 reflected higher taxable-equivalent net interest income, disciplined expense management and growth in average loans and deposits compared with the prior year first quarter.

 

PNC Advisors

 

PNC Advisors earned $28 million in the first three months of 2005 and $31 million in the first three months of 2004. Earnings for the first quarter of 2004 included a $7 million after-tax gain recognized from the sale of certain investment consulting activities of the Hawthorn unit. Excluding the impact of this gain, the increase in earnings from the prior year resulted primarily from disciplined expense control and improved operating leverage.

 

BlackRock

 

BlackRock reported earnings of $47 million for the first three months of 2005 compared with $55 million for the first three months of 2004. The lower earnings in 2005 were due to nonrecurring pretax expenses of $9 million associated with the SSRM acquisition and $14 million of pretax LTIP expenses reported in the 2005 quarter, partially offset by higher advisory fees driven by a growing base of assets under management. In addition, results for the first quarter of 2004 included a $9 million net income benefit recognized during that quarter associated with the resolution of an audit performed by New York State on state income tax returns filed from 1998 through 2001. BlackRock’s assets under management grew to $391 billion at March 31, 2005 compared with $342 billion at December 31, 2004, due to the SSRM acquisition and new business.

 

PNC owns approximately 70% of BlackRock and we consolidate BlackRock into our financial statements. Accordingly, approximately 30% of BlackRock’s earnings are recognized as minority interest expense in the Consolidated Income Statement. BlackRock financial information included in the Financial Review section of this Report is presented on a stand-alone basis. The market value of our BlackRock shares was approximately $3.4 billion at March 31, 2005 while the book value at that date was $.6 billion.

 

PFPC

 

Earnings from PFPC totaled $23 million for the first quarter of 2005 and $16 million for the first quarter of 2004. Higher earnings in 2005 were attributable to disciplined expense control and improved operating leverage, as well as strong performance in key PFPC business units in part due to continued business expansion of our existing clients and new business wins. Earnings for the first quarter of 2005 also included a $6 million after-tax gain related to the resolution of a client contract dispute and a $5 million after-tax charge related to the prepayment of intercompany debt. PFPC’s accounting/administration net fund assets increased 11% and custody fund assets increased 12% as of March 31, 2005 compared with the balances at March 31, 2004. The increases were driven by new business, asset inflows from existing customers and equity market appreciation.

 

Other

 

Earnings attributable to “Other” for the first quarter of 2005 totaled $39 million compared with earnings of $18 million in the first quarter of 2004. The increase from the first quarter of 2004 reflected the benefit of the $45 million deferred tax liability reversal related to our investment in BlackRock, as described further under “Summary Financial Results,” and higher equity management gains in 2005, partially offset by $9 million of net securities losses in 2005 compared with $15 million of net securities gains in the prior year first quarter. In addition, “Other” for the first quarter of 2004 included the impact of the $22 million after-tax gain on the sale of our modified coinsurance contracts.

 

5


Table of Contents

CONSOLIDATED INCOME STATEMENT REVIEW

 

NET INTEREST INCOME AND NET INTEREST MARGIN

 

Changes in net interest income and margin result from the interaction of the volume and composition of earning assets and related yields, interest-bearing liabilities and related rates paid, and noninterest-bearing sources.

 

See Statistical Information-Average Consolidated Balance Sheet And Net Interest Analysis included on pages 61 and 62 of this Report for additional information.

 

Taxable-equivalent net interest income totaled $512 million for the first quarter of 2005 compared with $497 million for the first quarter of 2004. The increase in taxable-equivalent net interest income reflected the impact of higher average earning assets in 2005. Our Consolidated Financial Highlights section included in this Financial Review provides a reconciliation of net interest income as reported under GAAP to net interest income presented on a taxable-equivalent basis.

 

The net interest margin for the first quarter of 2005 was 3.02% compared with 3.30% for the first quarter of 2004. The following factors contributed to the decline in net interest margin:

 

    Higher balances in the trading account.

 

    An increase in the average rate paid on deposits of 64 basis points for the first quarter of 2005 compared with the first quarter of 2004. The average rate paid on money market accounts, the largest single component of interest-bearing deposits, increased 99 basis points, reflecting the increase in short-term interest rates that began in mid-2004.

 

    An increase in the average rate paid on borrowed funds of 102 basis points for the first quarter of 2005 compared with the year ago quarter.

 

These factors more than offset the effect of higher average yields on securities and loans in 2005.

 

PROVISION FOR CREDIT LOSSES

 

The provision for credit losses decreased $4 million, to $8 million, for the first quarter of 2005 compared with the first quarter of 2004. The decline in the provision for credit losses in 2005 primarily reflected the continued strong credit quality of the loan portfolio. The improved credit quality reflected both a decline in nonperforming loans and a reduction in problems related to performing credits. The favorable impact of these factors on the provision was partially offset by the impact of total average loan growth in 2005.

 

See Allowance for Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit in the Credit Risk Management portion of the Risk Management section of this Financial Review for additional information regarding factors impacting the provision for credit losses. We expect loan growth to continue to impact the provision during the remainder of 2005; however, the provision for credit losses will also be favorably impacted in the second quarter of 2005 by a significant recovery as a result of a litigation settlement.

 

NONINTEREST INCOME

 

Summary

 

Noninterest income totaled $973 million for the first quarter of 2005 compared with $911 million for the first quarter of 2004.

 

Higher noninterest income for the first quarter of 2005 reflected the following:

 

    A $61 million increase in asset management fees primarily due to BlackRock’s acquisition of SSRM,

 

    An increase of $27 million in trading income,

 

    A $25 million increase in equity management gains,

 

    A $16 million increase in fund servicing revenue, and

 

    A $10 million pretax settlement related to a PFPC client contractual matter.

 

These increases were partially offset by net securities losses in 2005 compared with gains in the prior year and a $26 million reduction in net gains on our remaining institutional loans held for sale as the liquidation of this portfolio nears completion.

 

Noninterest income for the first quarter of 2004 included a $34 million pretax gain related to the sale of our modified coinsurance contracts and a $10 million pretax gain related to the sale of certain investment consulting activities of the Hawthorn unit of PNC Advisors. Our 2004 Form 10-K more fully describes these two transactions.

 

Additional Analysis

 

Combined asset management and fund servicing fees amounted to $534 million for the first quarter of 2005, an increase of $77 million over the prior year first quarter. These increases reflected the impact of the SSRM acquisition and other growth in assets managed and serviced. Assets under management at March 31, 2005 totaled $432 billion, up $71 billion compared with the level at March 31, 2004. The acquisition of SSRM added $50 billion of assets under management during the first quarter of 2005. PFPC provided fund accounting/administration services for $745 billion of net fund investment assets and provided custody services for $462 billion of fund investment assets at March 31, 2005, compared with $669 billion and $411 billion, respectively, at March 31, 2004. The increases were driven by new business, asset inflows from existing customers and equity market appreciation.

 

Service charges on deposits totaled $59 million for both the first quarter of 2005 and first quarter of 2004. Although growth has been limited due to our offering of free checking in both the consumer and small business channels, free checking has positively impacted customer and demand deposit growth as well as other consumer-related fees.

 

First quarter 2005 brokerage fees totaled $55 million, a decline of $3 million from the first quarter of 2004 primarily due to weaker retail trading.

 

For the first quarter of 2005, consumer services fees increased $3 million, to $66 million, compared with the first quarter of 2004. Higher fees for 2005 reflected additional fees from debit card transactions primarily due to higher volumes, partially offset by the impact of the sale of certain out-of-footprint ATMs.

 

6


Table of Contents

Corporate services revenue totaled $107 million for the first three months of 2005 compared with $125 million for the first three months of 2004. Net gains in excess of valuation adjustments related to our liquidation of institutional loans held for sale totaled $2 million in the first quarter of 2005 compared with $28 million for the first quarter of 2004, reflecting the fact that our liquidation of institutional loans held for sale is essentially complete. This decrease was partially offset by the impact of higher fees in 2005 related to capital markets and commercial mortgage servicing activities.

 

Equity management (private equity) net gains on portfolio investments totaled $32 million for the first quarter of 2005 compared with net gains of $7 million for the first quarter of 2004.

 

Net securities losses were $9 million for the first quarter of 2005 compared with net securities gains of $15 million in the prior year first quarter.

 

Other noninterest income totaled $129 million for the first three months of 2005 compared with $127 million for the first three months of 2004. Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed.

 

Other noninterest income for the first quarter of 2005 included the following:

 

    Trading revenue included in other noninterest income increased $27 million, to $50 million, for the first three months of 2005 compared with the prior year. See Trading Risk within the Risk Management section of this Financial Review and Note 3 Trading Activities in the Notes to Consolidated Financial Statements included under Part I, Item 1 of this Report for additional information; and

 

    A $10 million settlement received in connection with a PFPC client contractual matter.

 

Other noninterest income for the first quarter of 2004 included the $34 million gain on the sale of our modified coinsurance contracts and the $10 million gain on sale of certain investment consulting activities of the Hawthorn unit referred to above.

 

PRODUCT REVENUE

 

Wholesale Banking offers treasury management, capital markets, commercial loan servicing and equipment leasing products that are marketed by several businesses across PNC.

 

Treasury management revenue, which includes fees as well as revenue from customer deposit balances, totaled $97 million for the first three months of 2005 and $88 million for the first three months of 2004. The increased revenue in 2005 reflected the longer term nature of treasury management deposits, strong deposit growth and a steady increase in business-to-business processing volumes.

 

Consolidated revenue from capital markets was $42 million for the first quarter of 2005, an increase of $10 million compared with the first quarter of 2004. Increases in loan syndication fees and client-related trading revenue drove the increase in capital markets revenue for the first quarter of 2005 compared with the prior year first quarter.

 

Midland Loan Services offers servicing and technology solutions for the commercial real estate finance industry. Midland’s revenue, which includes fees as well as revenue from servicing deposit balances, totaled $30 million for the first three months of 2005 and $25 million for the first three months of 2004. The revenue growth was driven primarily by growth in the commercial mortgage servicing portfolio and related services.

 

Consolidated revenue from equipment leasing products was $18 million for the first quarter of 2005 and $21 million for the first three months of 2004. The decline is due to the interest cost of funding the potential tax exposure on the cross-border leasing portfolio. See Cross-Border Leases and Related Tax and Accounting Matters in the Consolidated Balance Sheet Review section of this Financial Review for further information.

 

As a component of our advisory services to clients, we provide a select set of insurance products to fulfill specific customer financial needs. Primary insurance offerings include:

 

  Annuities,

 

  Credit life,

 

  Health,

 

  Disability, and

 

  Commercial lines coverage.

 

Client segments served by these insurance solutions include those in PNC Advisors, Regional Community Banking and Wholesale Banking. Insurance products are sold by PNC-licensed insurance agents and through licensed third-party arrangements. We recognized revenue of $14 million in the first quarter of 2005 and $15 million in the first quarter of 2004.

 

Additionally, through our subsidiary companies, PNC Insurance Corp. and Alpine Indemnity Limited, we act as a reinsurer for credit life and accident and health insurance provided to customers of our subsidiaries. We also write, assume and cede insurance for property, workers’ compensation, commercial general liability and automobile liability of PNC and its affiliates.

 

In the normal course of business PNC Insurance Corp. and Alpine Indemnity Limited maintain insurance reserves for reported claims and for claims incurred but not reported based on actuarial assessments.

 

7


Table of Contents

NONINTEREST EXPENSE

 

Total noninterest expense was $999 million for the first three months of 2005, an increase of $104 million compared with the first three months of 2004. The efficiency ratio was 68% for the first three months of 2005 compared with 64% for the first three months of 2004.

 

Noninterest expense for the first quarter of 2005 included an increase of $72 million in BlackRock operating expenses that reflected the impact of nonrecurring and ongoing costs associated with the SSRM acquisition, along with charges related to the BlackRock LTIP awards. See the discussion under the heading “2002 BlackRock Long-Term Retention and Incentive Plan” in this Financial Review for additional information on the latter expenses.

 

Noninterest expense for the first three months of 2004 included the following:

 

    Conversion-related and other nonrecurring costs totaling approximately $10 million related to our acquisition of United National; and

 

    A $6 million impairment charge on an intangible asset related to the orderly liquidation of a particular fund managed by BlackRock.

 

Apart from the impact of the items described above, noninterest expense increased $48 million, or 5%, in the first quarter of 2005 compared with the same period in 2004. The higher expenses were driven by increased sales incentives and the increased impact of expensing stock options. See Note 1 Accounting Policies in our Notes To Consolidated Financial Statements under Item 1 of this Report for additional information on our accounting for employee and director stock options.

 

We expect to record charges of approximately $.11 per diluted share for conversion-related and other nonrecurring costs over the course of the Riggs acquisition integration, the majority of which will be incurred in the second quarter of 2005.

 

Average full-time equivalent employees totaled approximately 23,800 in the first three months of 2005 and 2004. An increase for BlackRock was offset by a decrease for Regional Community Banking.

 

EFFECTIVE TAX RATE

 

Our effective tax rate for the first quarter of 2005 was 23.7% compared with 32.7% for the first quarter of 2004. The decrease in the effective rate for the first three months of 2005 was primarily attributable to the impact of the reversal of deferred tax liabilities in connection with the transfer of our ownership in BlackRock as discussed under “Summary Financial Results” in this Report and under Note 2 Acquisitions included in the Notes To Consolidated Financial Statements in Item 1 of this Report. This transaction reduced our first quarter 2005 tax provision by $45 million. The effective tax rate for the first quarter of 2004 was favorably impacted by the $9 million tax benefit recorded in that period as a result of resolving a BlackRock New York State audit.

 

8


Table of Contents

CONSOLIDATED BALANCE SHEET REVIEW

 

BALANCE SHEET DATA

 

In millions


   March 31
2005


   December 31
2004


Assets

             

Loans, net of unearned income

   $ 44,674    $ 43,495

Securities available for sale and held to maturity

     18,449      16,761

Loans held for sale

     2,067      1,670

Other

     18,169      17,797
    

  

Total assets

   $ 83,359    $ 79,723

Liabilities

             

Funding sources

   $ 69,683    $ 65,233

Other

     5,565      6,513
    

  

Total liabilities

     75,248      71,746

Minority and noncontrolling interests in consolidated entities

     532      504

Total shareholders’ equity

     7,579      7,473
    

  

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

   $ 83,359    $ 79,723
    

  

 

Our Consolidated Balance Sheet is presented in Part I, Item 1 on page 40 of this Report.

 

Higher total assets at March 31, 2005 compared with the balance at December 31, 2004 were driven by loan growth resulting from continued improvements in market loan demand and higher securities balances that reflected short-term investing opportunities.

 

An analysis of changes in certain balance sheet categories follows.

 

LOANS, NET OF UNEARNED INCOME

 

Loans increased $1.2 billion, to $44.7 billion at March 31, 2005, compared with the balance at December 31, 2004. Improvements in market loan demand, in addition to targeted sales efforts across our banking businesses, drove the increase in total loans.

 

Details Of Loans

 

In millions


   March 31
2005


    December 31
2004


 

Commercial

                

Retail/wholesale

   $ 5,236     $ 4,961  

Manufacturing

     4,327       3,944  

Other service providers

     1,820       1,787  

Real estate related

     2,179       2,104  

Financial services

     1,308       1,145  

Health care

     560       560  

Other

     3,043       2,937  
    


 


Total commercial

     18,473       17,438  
    


 


Commercial real estate

                

Real estate projects

     1,404       1,460  

Mortgage

     521       520  
    


 


Total commercial real estate

     1,925       1,980  
    


 


Equipment lease financing

     3,719       3,907  
    


 


Total commercial lending

     24,117       23,325  
    


 


Consumer

                

Home equity

     12,968       12,734  

Automobile

     854       836  

Other

     1,953       2,036  
    


 


Total consumer

     15,775       15,606  
    


 


Residential mortgage

     5,007       4,772  

Vehicle lease financing

     158       189  

Other

     489       505  

Unearned income

     (872 )     (902 )
    


 


Total, net of unearned income

   $ 44,674     $ 43,495  
    


 


Supplement Loan Information

                

Loans excluding conduit

   $ 42,479     $ 41,243  

Market Street Funding Corporation conduit

     2,195       2,252  
    


 


Total loans

   $ 44,674     $ 43,495  
    


 


 

As the table above indicates, the loans that we hold continued to be diversified among numerous industries and types of businesses. The loans that we hold are also diversified across the geographic areas where we do business.

 

Commercial Lending Exposure (a)(b)

 

    

March 31

2005


   

December 31

2004


 

Investment grade or equivalent

            

$50 million or greater

   16 %   16 %

$25 million to < $50 million

   16 %   16 %

<$25 million

   15 %   15 %

Non-investment grade

            

$50 million or greater

   2 %   2 %

$25 million to < $50 million

   11 %   11 %

<$25 million

   40 %   40 %
    

 

Total

   100 %   100 %
    

 


(a) These statistics exclude the loans of Market Street Funding Corporation. The facilities extended by Market Street represent pools of granular obligations, structured to avoid excessive concentration of credit risk such that they attract an investment grade rating.
(b) Exposure represents the sum of all loans, leases, commitments and letters of credit.

 

9


Table of Contents

Net Unfunded Credit Commitments

 

In millions


  

March 31

2005


  

December 31

2004


Commercial

   $ 20,892    $ 20,969

Consumer

     8,020      7,655

Commercial real estate

     1,160      1,199

Education loans

     32      279

Lease financing

     178      162

Other

     44      42
    

  

Total

   $ 30,326    $ 30,306
    

  

 

Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. Commercial commitments are reported net of participations, assignments and syndications, primarily to financial institutions, totaling $6.1 billion at March 31, 2005 and $6.7 billion at December 31, 2004.

 

The increase in consumer net unfunded commitments at March 31, 2005 compared with the balance at December 31, 2004 was primarily due to net unfunded commitments related to growth in home equity loans.

 

Unfunded credit commitments related to Market Street totaled $950 million March 31, 2005 and $962 million at December 31, 2004 and are included in the preceding table primarily within the “Commercial” and “Consumer” categories. See the Off-Balance Sheet Arrangements And Consolidated VIEs section of this Financial Review and Note 9 Variable Interest Entities in the Notes to Consolidated Financial Statements in Part I, Item 1 of this Report for further information regarding Market Street.

 

In addition to credit commitments, our net outstanding standby letters of credit totaled $3.6 billion at March 31, 2005 and $3.7 billion at December 31, 2004. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur.

 

Cross-Border Leases and Related Tax and Accounting Matters

 

The equipment lease portfolio totaled $3.7 billion at March 31, 2005 and included approximately $1.7 billion of cross-border leases. Cross-border leases are primarily leveraged leases of equipment located in foreign countries, primarily in western Europe and Australia. We no longer enter into cross-border lease transactions.

 

Aggregate residual value at risk on the total commercial lease portfolio at March 31, 2005 was $1.1 billion. We have taken steps to mitigate $.6 billion of this residual risk, including residual value insurance coverage with third parties, third party guarantees, and other actions. Approximately $.5 billion of this risk was unmitigated at March 31, 2005.

 

The American Jobs Creation Act of 2004 (“AJCA”) limits the tax deductions that may be taken in a given year related to certain lease transactions, including the types of cross-border lease transactions that we have previously entered into. However, AJCA impacts only cross-border lease transactions entered into after March 12, 2004. All of our cross-border lease transactions were entered into prior to this date and are therefore not affected by AJCA. While only transactions entered into after March 12, 2004 are specifically impacted, AJCA is clear that no inference should be drawn as to the proper tax treatment of transactions entered into on or before this date. Thus, the tax treatment of existing transactions is still subject to challenge by the IRS.

 

As part of the audit of our 1998-2000 consolidated federal income tax returns, the IRS has proposed adjustments to several of our cross-border lease transactions.

 

The proposed adjustments would reverse the tax treatment of these transactions as we reported them on our filed tax returns. We believe the method used to report these transactions is supported by appropriate tax law and intend to pursue resolution of the matter through the appropriate IRS administrative appeal remedies. While we cannot predict with certainty the result of pursuing the administrative appeal remedies, any resolution would most likely involve a change in the timing of tax deductions which, in turn, depending on the exact resolution, could significantly impact the economics of these transactions. The IRS is also beginning an audit of our 2001-2003 consolidated federal income tax returns. We expect them to again propose adjustments to the cross-border lease transactions referred to above as well as to new cross-border lease transactions entered in those years.

 

Even though we intend to pursue resolution with the IRS through administrative appeal remedies, it is possible we will be unable to reach a settlement. If we are unable to reach settlement, we will evaluate other options, including litigation. There is, of course, no guarantee as to the outcome of litigation. We believe our reserves for these exposures were adequate at March 31, 2005.

 

Further, the Financial Accounting Standards Board (“FASB”) has begun to consider whether any change in the timing of tax benefits associated with these transactions should result in a recalculation under Statement of Financial Accounting Standards No. (“SFAS”) 13, “Accounting for Leases,” and whether a lessor should re-evaluate the classification of a leveraged lease when a recalculation of the lease is performed. In March 2005, the FASB directed its staff to issue a proposed Staff Position on this issue. If the FASB ultimately decides companies must recalculate and re-evaluate leveraged lease classification, a cumulative adjustment in the period of change which could be material and future adjustments to earnings could be required. However, under the leverage leasing accounting rules, any reductions in earnings would be recovered in future years over the remaining lives of the leases.

 

In addition to the transactions referred to above, two lease-to-service contract transactions that we were party to were structured as partnerships for tax purposes. We have been informed that the partnerships are under audit by the IRS. However, we do not believe that our exposure from these transactions is material to our consolidated results of operations or financial position.

 

10


Table of Contents

SECURITIES

 

Details Of Securities

 

In millions


  

Amortized

Cost


  

Fair

Value


March 31, 2005 (a)

             

SECURITIES AVAILABLE FOR SALE

             

Debt securities

             

U.S. Treasury and government agencies

   $ 4,893    $ 4,830

Mortgage-backed

     11,397      11,230

Commercial mortgage-backed

     1,026      1,000

Asset-backed

     1,036      1,026

State and municipal

     172      171

Other debt

     34      34

Corporate stocks and other

     158      158
    

  

Total securities available for sale

   $ 18,716    $ 18,449
    

  

December 31, 2004

             

SECURITIES AVAILABLE FOR SALE

             

Debt securities

             

U.S. Treasury and government agencies

   $ 4,735    $ 4,722

Mortgage-backed

     8,506      8,433

Commercial mortgage-backed

     1,380      1,370

Asset-backed

     1,910      1,901

State and municipal

     175      176

Other debt

     33      33

Corporate stocks and other

     123      125
    

  

Total securities available for sale

   $ 16,862    $ 16,760
    

  

SECURITIES HELD TO MATURITY

             

Debt securities

             

Asset-backed

   $ 1    $ 1
    

  

Total securities held to maturity

   $ 1    $ 1
    

  


(a) Securities held to maturity at March 31, 2005 were less than $1 million.

 

Securities represented 22% of total assets at March 31, 2005 and 21% of total assets at December 31, 2004. The increase in total securities compared with December 31, 2004 was primarily due to an increase in mortgage-backed securities, over half of which was in floating-rate securities, partially offset by decreases in commercial mortgage-backed and asset-backed securities.

 

At March 31, 2005, the securities available for sale balance included a net unrealized loss of $267 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2004 was a net unrealized loss of $102 million. The impact of increases in interest rates during the first quarter of 2005 was reflected in the higher net unrealized loss position at March 31, 2005.

 

The fair value of securities available for sale decreases when interest rates increase and vice versa. Further increases in interest rates after March 31, 2005, if sustained, will adversely impact the fair value of securities available for sale going forward compared with the balance at March 31, 2005. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax.

 

During April 2005, the front-end of the yield curve rallied to a lesser extent than did intermediate-term interest rates. We expected that this market movement was not reflective of a potential rise in short-term interest rates given recent inflation trends and the expected Federal Open Market Committee tightening action on May 3, 2005.

 

As a result, in late April 2005, we performed a balance sheet review and decided to adjust our securities and other earning assets positions to address the following objectives:

 

    Further reduce exposure to an anticipated rise in short-term interest rates, and

 

    Improve future net interest income levels without adding to duration risk.

 

To achieve these objectives, in late April and early May 2005, we sold $2.1 billion of securities available for sale and terminated $1.0 billion of resale agreements that were most sensitive to extension risk due to rising short-term interest rates. We also purchased $2.1 billion of securities with higher yields and lower extension risk. These transactions resulted in realized net securities and other losses of approximately $31 million, which will be included in our results of operations for the second quarter of 2005.

 

The expected weighted-average life of securities available for sale was 3 years and 3 months at March 31, 2005 and 2 years and 8 months at December 31, 2004.

 

We estimate the effective duration of securities available for sale is 2.3 years for an immediate 50 basis points parallel increase in interest rates and 1.9 years for an immediate 50 basis points parallel decrease in interest rates.

 

LOANS HELD FOR SALE

 

Education loans held for sale totaled $1.5 billion at March 31, 2005 and $1.1 billion at December 31, 2004 and represented the majority of our loans held for sale at each date. We classify substantially all of our education loans as loans held for sale. Generally, we sell education loans when the loans are placed into repayment status. Gains on sales of education loans are reflected in the Other noninterest income line item in our Consolidated Income Statement and in the results for the Regional Community Banking business segment.

 

Our liquidation of institutional loans held for sale resulted in net gains in excess of valuation adjustments of $2 million in the first quarter of 2005 and $28 million in the first quarter of 2004. These gains are reflected in the Corporate Services line item in our Consolidated Income Statement and in the results of the Wholesale Banking business segment. As the liquidation of institutional loans held for sale is essentially complete, any additional gains in the future will be minimal.

 

OTHER ASSETS

 

The increase of $.4 billion in “Assets-Other” in the preceding “Balance Sheet Data” table includes the impact of an increase in goodwill and other intangible assets. Goodwill and other intangible assets recorded in connection with the first quarter 2005 SSRM acquisition totaled $258 million. See Note 7 Goodwill And Other Intangible Assets for further information.

 

11


Table of Contents

CAPITAL AND FUNDING SOURCES

 

Details Of Funding Sources

 

In millions


  

March 31

2005


  

December 31

2004


Deposits

             

Money market

   $ 22,009    $ 21,250

Demand

     15,646      15,996

Retail certificates of deposit

     10,686      9,969

Savings

     2,821      2,851

Other time

     1,024      833

Time deposits in foreign offices

     2,983      2,370
    

  

Total deposits

     55,169      53,269
    

  

Borrowed funds

             

Federal funds purchased

     995      219

Repurchase agreements

     2,077      1,376

Bank notes and senior debt

     3,662      2,383

Subordinated debt

     3,988      4,050

Commercial paper

     2,381      2,251

Other borrowed funds

     1,411      1,685
    

  

Total borrowed funds

     14,514      11,964
    

  

Total

   $ 69,683    $ 65,233
    

  

 

The increase in deposits during the first quarter of 2005 reflected the impact of deposit retention and sales efforts that drove growth. Higher borrowed funds at March 31, 2005 were driven in part by PNC’s issuance of $700 million of senior debt and $350 million of senior bank notes in March 2005, BlackRock’s $250 million convertible debenture issuance in February 2005 in connection with the SSRM acquisition, and higher short-term borrowings to fund asset growth.

 

Capital

 

We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt and equity instruments, making treasury stock transactions, maintaining dividend policies and retaining earnings.

 

The increase of $.1 billion, to $7.6 billion, in total shareholders’ equity at March 31, 2005 compared with December 31, 2004 was primarily attributable to the retention of earnings in anticipation of the pending acquisition of Riggs. Partially offsetting this increase was a decline in the fair value of securities available for sale due to the impact of rising interest rates in 2005. These fair value changes are captured in the accumulated other comprehensive income (loss) component of shareholders’ equity. See Note 14 Shareholders’ Equity And Comprehensive Income in the Notes To Consolidated Financial Statements in Item 1 of this Report for additional information.

 

Common shares outstanding at March 31, 2005 were 282.8 million, an increase of .2 million over December 31, 2004.

 

As of February 16, 2005, our prior common stock repurchase program was terminated, and a new program to purchase up to 20 million shares was authorized. This program will remain in effect until fully utilized or until modified, superseded or terminated. We purchased .5 million common shares during the first quarter of 2005 at a total cost of $26 million. The extent and timing of additional share repurchases under the 2005 program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, and the potential impact on our credit rating. The pending acquisition of Riggs will continue to restrict share purchases over the remainder of 2005.

 

Risk-Based Capital

 

Dollars in millions


   March 31
2005


    December 31
2004


 

Capital components

                

Shareholders’ equity

                

Common

   $ 7,570     $ 7,465  

Preferred

     8       8  

Trust preferred capital securities (a)

     1,194       1,194  

Minority interest

     257       226  

Goodwill and other intangibles

     (3,331 )     (3,112 )

Net unrealized securities losses

     171       66  

Net unrealized losses (gains) on cash flow hedge derivatives

     8       (6 )

Equity investments in nonfinancial companies

     (48 )     (32 )

Other, net

     (12 )     (15 )
    


 


Tier 1 risk-based capital

     5,817       5,794  

Subordinated debt

     1,874       1,924  

Eligible allowance for credit losses

     679       683  

Other, net

                
    


 


Total risk-based capital

   $ 8,370     $ 8,401  
    


 


Assets

                

Risk-weighted assets, including off-balance sheet instruments and market risk equivalent assets

   $ 66,687     $ 64,539  

Adjusted average total assets

     80,165       75,757  

Capital ratios

                

Tier 1 risk-based

     8.7 %     9.0 %

Total risk-based

     12.6       13.0  

Leverage

     7.3       7.6  

Tangible common

     5.3       5.7  

(a) See Note 18 Capital Securities Of Subsidiary Trusts in the Notes to Consolidated Financial Statements in our 2004 Form 10-K regarding the deconsolidation of trust preferred securities at December 31, 2003 under GAAP. However, these securities remained a component of Tier 1 risk-based capital at March 31, 2005 and December 31, 2004 based upon guidance provided to bank holding companies from the Federal Reserve.

 

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, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institution’s capital strength. The declines in the capital ratios at March 31, 2005 compared with the ratios at December 31, 2004 were primarily caused by the addition of goodwill and other intangibles associated with the SSRM acquisition. We expect a further decline in these ratios as a result of the Riggs acquisition. At March 31, 2005, each of our banking subsidiaries was considered “well-capitalized” based on regulatory capital ratio requirements.

 

12


Table of Contents

OFF-BALANCE SHEET ARRANGEMENTS AND CONSOLIDATED VIES

 

We engage in a variety of activities that involve unconsolidated entities or that are otherwise not reflected in our Consolidated Balance Sheet that are generally referred to as “off-balance sheet arrangements.” Further information on these types of activities is included in Note 17 Commitments and Guarantees included in the Notes To Consolidated Financial Statements in Item 1 of this Report.

 

As discussed in our 2004 Form 10-K, we are involved with various entities in the normal course of business that may be deemed to be variable interest entities (VIEs). We consolidated certain VIEs effective in 2004 and 2003 for which we were determined to be the primary beneficiary. These consolidated VIEs and relationships with PNC are described in our 2004 Form 10-K under this same heading in Part I, Item 7 and in Note 2 Variable Interest Entities in the Notes To Consolidated Financial Statements included in Part II, Item 8 of that Report.

 

At March 31, 2005, the aggregate assets and debt of VIEs that we have consolidated in our financial statements are as follows:

 

Consolidated VIEs – PNC Is Primary Beneficiary

In millions


   Aggregate
Assets


   Aggregate
Debt


March 31, 2005

             

Market Street Funding Corporation

   $ 2,199    $ 2,199

Partnership interests in low income housing projects

     496      496

Other

     10      7
    

  

Total consolidated VIEs

   $ 2,705    $ 2,702
    

  

December 31, 2004

             

Market Street Funding Corporation

   $ 2,167    $ 2,167

Partnership interests in low income housing projects

     504      504

Other

     13      10
    

  

Total consolidated VIEs

   $ 2,684    $ 2,681
    

  

 

We also hold significant variable interests in other VIEs that have not been consolidated because we are not considered the primary beneficiary. Information on these VIEs follows:

 

Non-Consolidated VIEs - Significant Variable Interests

In millions


   Aggregate
Assets


   Aggregate
Debt


  

PNC Risk

of Loss (b)


March 31, 2005

                    

Collateralized debt obligations (a)

   $ 5,425    $ 4,988    $ 53

Private investment funds (a)

     3,111      486      13

Other partnership interests in low income housing projects

     37      28      4
    

  

  

Total significant variable interests

   $ 8,573    $ 5,502    $ 70
    

  

  

December 31, 2004

                    

Collateralized debt obligations (a)

   $ 3,152    $ 2,700    $ 33

Private investment funds (a)

     1,872      125      24

Other partnership interests in low income housing projects

     37      28      4
    

  

  

Total significant variable interests

   $ 5,061    $ 2,853    $ 61
    

  

  


(a) Held by BlackRock.
(b) Includes both PNC’s risk of loss and BlackRock’s risk of loss, limited to PNC’s ownership interest in BlackRock.

 

The increase in collateralized debt obligations at March 31, 2005 compared with December 31, 2004 reflected the impact of BlackRock’s acquisition of SSRM.

 

We also have subsidiaries that invest in and act as the investment manager for a private equity fund that is organized as a limited partnership as part of our equity management activities. The fund invests in private equity investments to generate capital appreciation and profits. As permitted by FIN 46, we have deferred applying the provisions of the interpretation for this entity pending further action by the FASB. Information on this entity follows:

 

Investment Company Accounting – Deferred Application

In millions


   Aggregate
Assets


   Aggregate
Equity


  

PNC Risk

of Loss


March 31, 2005

                    

Private Equity Fund

   $ 96    $ 96    $ 24

December 31, 2004

                    

Private Equity Fund

   $ 78    $ 76    $ 20

 

13


Table of Contents

REVIEW OF BUSINESSES

 

We operate five major businesses engaged in providing banking, asset management and global fund processing services. Banking businesses include regional community banking (consumer/small business), wholesale banking (corporate/institutional) and wealth management.

 

Our treasury management activities, which include cash and investment management, receivables management, disbursement services and global trade services; capital markets products, which include foreign exchange, derivatives and loan syndications; commercial loan servicing; and equipment leasing products are offered through Wholesale Banking and marketed by several businesses across PNC.

 

Results of individual businesses are presented based on our management accounting practices and our management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses change. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis.

 

Our capital measurement methodology is based on the concept of economic capital for Regional Community Banking, Wholesale Banking, PNC Advisors and PFPC. However, we have increased the capital assigned to Regional Community Banking to 6% of funds to reflect the capital required for well-capitalized banks and to approximate market comparables for this business. The capital for BlackRock reflects legal entity shareholders’ equity consistent with BlackRock’s separate public financial statement disclosures.

 

We have allocated the allowance for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the loan portfolios. Our allocation of the costs incurred by operations and other support areas not directly aligned with the businesses is primarily based on the use of services.

 

Total business segment financial results differ from total consolidated results. The impact of these differences is primarily reflected in minority interest in income of BlackRock and in the “Other” category in the Results of Businesses – Summary table that follows. “Other” includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as asset and liability management activities, related net securities gains or losses, equity management activities, differences between business segment performance reporting and financial statement reporting (GAAP), corporate overhead and intercompany eliminations. Business segment results, including inter-segment revenues, are included in Note 16 Segment Reporting included in the Notes To Consolidated Financial Statements under Part I, Item 1 of this Report.

 

“Other Information” included in the tables that follow is presented as of period end, except for the following, which represent amounts for the periods presented: net charge-offs and the related annualized net charge-off ratio; home equity portfolio credit statistics; gains on sales of education loans; average small business deposits; consolidated revenue from Treasury management, Capital markets, Midland Loan Services and equipment leasing; and average full-time equivalent employees (FTEs). FTE statistics as reported by business reflect staff directly employed by the respective businesses and exclude corporate and shared services employees. Prior period FTE amounts generally are not restated for organizational changes.

 

RESULTS OF BUSINESSES - SUMMARY

 

     Earnings

    Revenue

   Return on
Capital (b)


    Average Assets (c)

Three months ended March 31 - dollars in millions


   2005

    2004

    2005

   2004

   2005

    2004

    2005

   2004

                                                         

Banking businesses

                                                       

Regional Community Banking

   $ 121     $ 102     $ 506    $ 501    20 %   17 %   $ 22,970    $ 20,792

Wholesale Banking

     110       122       312      317    26     26       24,084      21,847

PNC Advisors

     28       31       156      170    38     38       2,879      2,660
    


 


 

  

              

  

Total banking businesses

     259       255       974      988                  49,933      45,299
    


 


 

  

              

  

Asset management and fund processing businesses

                                                       

BlackRock

     47       55       250      182    23     31       1,494      909

PFPC

     23       16       230      203    35     23       2,264      1,979
    


 


 

  

              

  

Total asset management and fund processing businesses

     70       71       480      385                  3,758      2,888
    


 


 

  

              

  

Total business segment earnings

     329       326       1,454      1,373                  53,691      48,187

Minority interest in income of BlackRock

     (14 )     (16 )                                       

Other

     39       18       31      35                  29,671      24,836
    


 


 

  

              

  

Total consolidated (a)

   $ 354     $ 328     $ 1,485    $ 1,408    19     19     $ 83,362    $ 73,023
    


 


 

  

              

  


(a) Business revenue is presented on a taxable-equivalent basis except for PFPC, which is presented on a book (GAAP) basis. A reconciliation of total consolidated revenue on a book basis to total consolidated revenue on a taxable equivalent basis follows:

 

Three months ended March 31 – in millions


   2005

   2004

Total consolidated revenue, book (GAAP) basis

   $ 1,479    $ 1,405

Taxable-equivalent adjustment

     6      3
    

  

Total consolidated revenue, taxable-equivalent basis

   $ 1,485    $ 1,408
    

  

 

(b) Percentages for BlackRock reflect return on equity.
(c) Period-end balances for BlackRock.

 

14


Table of Contents

REGIONAL COMMUNITY BANKING(Unaudited)

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions


   2005

    2004

 
INCOME STATEMENT                 

Net interest income

   $ 341     $ 333  

Noninterest income

                

Service charges on deposits

     57       57  

Investment products

     28       29  

Other

     80       82  
    


 


Total noninterest income

     165       168  
    


 


Total revenue

     506       501  

Provision for credit losses

     14       29  

Noninterest expense

                

Compensation and employee benefits

     128       136  

Net occupancy and equipment

     66       68  

Other

     105       108  
    


 


Total noninterest expense

     299       312  
    


 


Pretax earnings

     193       160  

Income taxes

     72       58  
    


 


Earnings

   $ 121     $ 102  
    


 


AVERAGE BALANCE SHEET

                

Loans

                

Consumer

                

Home equity

   $ 11,863     $ 9,478  

Indirect

     892       774  

Other consumer

     405       682  
    


 


Total consumer

     13,160       10,934  

Commercial

     4,372       3,901  

Floor plan

     1,013       947  

Residential mortgage

     677       813  

Other

     26       28  
    


 


Total loans

     19,248       16,623  

Goodwill

     991       994  

Loans held for sale

     1,345       1,115  

Other assets

     1,386       2,060  
    


 


Total assets

   $ 22,970     $ 20,792  
    


 


Deposits

                

Noninterest-bearing demand

   $ 6,715     $ 6,248  

Interest-bearing demand

     6,996       6,916  

Money market

     12,046       12,356  
    


 


Total transaction deposits

     25,757       25,520  

Savings

     2,724       2,508  

Certificates of deposit

     9,833       8,565  
    


 


Total deposits

     38,314       36,593  

Other liabilities

     132       432  

Capital

     2,447       2,362  
    


 


Total funds

   $ 40,893     $ 39,387  
    


 


PERFORMANCE RATIOS                 

Return on capital

     20 %     17 %

Noninterest income to total revenue

     33       34  

Efficiency

     59       62  

Three months ended March 31

Dollars in millions


   2005

    2004

 
OTHER INFORMATION                 

Total nonperforming assets (a)(b)

   $ 84     $ 75  

Net charge-offs (b)

   $ 14     $ 32  

Annualized net charge-off ratio (b)

     .29 %     .77 %

Home equity portfolio credit statistics:

                

% of first lien positions

     51 %     50 %

Weighted average loan-to-value ratios

     71 %     72 %

Weighted average FICO scores

     716       713  

Loans 90 days past due

     .20 %     .23 %

Gains on sales of education loans (c)

   $ 1          

Average FTE staff

     9,886       10,379  

ATMs

     3,610       3,486  

Branches

     770       769  

Consumer and small business checking relationships

     1,761,000       1,679,000  

Consumer DDA households using online banking

     743,000       637,000  

% of consumer DDA households using online banking

     47 %     42 %

Consumer DDA households using online bill payment

     131,000       102,000  

% of consumer DDA households using online bill payment

     8 %     7 %

Small business deposits:

                

Noninterest-bearing

   $ 4,086     $ 3,756  

Interest-bearing

   $ 1,556     $ 1,651  

Money market

   $ 2,630     $ 2,510  

Certificates of deposit

   $ 352     $ 324  

(a) Includes nonperforming loans of $74 million at March 31, 2005 and $64 million at March 31, 2004.
(b) During the first quarter of 2004, management changed its policy for recognizing charge-offs on smaller nonperforming commercial loans. This change resulted in the recognition of an additional $24 million of gross charge-offs for the first quarter of 2004.
(c) Included in “Other noninterest income” above.

 

Regional Community Banking earnings were $121 million for the first quarter of 2005 compared with $102 million for the same period in 2004. The 19% increase in earnings over last year was driven by continued growth in the business, a reduction in expenses and a lower provision for credit losses. Performance highlights for Regional Community Banking for the first quarter of 2005 include:

 

    Checking account relationships increased 5% over 2004. The increases in customer relationships and balances reflected account acquisition and improved customer retention in the consumer and small business banking customer segments.

 

    Expenses decreased and the efficiency ratio improved relative to 2004 levels. Rigorous expense management has provided opportunity for further investment in front line areas including additional distribution points and sales related positions.

 

    Average loans for the first quarter of 2005 increased $2.6 billion or 16% over 2004 levels due to consumer home equity loan demand and successful execution of our small business banking growth strategy.

 

    Total deposit balances continued to grow in the first quarter of 2005. Customer demand for certificates of deposit and money market products increased this quarter over fourth quarter 2004 due to the current rising interest rate environment.

 

15


Table of Contents
  We continued to take actions to optimize our branch network. During the first quarter, the bank opened one stand-alone and 4 in-store branches in attractive growth markets. In addition, nine branches were either relocated or consolidated to more efficiently serve existing markets.

 

  The percentage of our customers banking with us online continued to increase. As of March 31, 2005, 47% of our consumer checking relationships were utilizing web-based banking options compared with 42% a year earlier. Online bill payers increased 28% over the prior year.

 

Total revenue for the first quarter of 2005 was $506 million compared with $501 million for the same period last year. Taxable-equivalent net interest income of $341 million increased by $8 million or 2% due to the growth in loan and deposit balances. Factors limiting net interest income growth include a narrower spread between loan yields and deposit costs and an additional day of net interest reported in 2004, a leap year.

 

Noninterest income in the first quarter declined by $3 million from the same period in 2004. Fee income growth has been hindered by our offering of free checking in both the consumer and small business segments. Although it has reduced our service fees, free checking has positively impacted customer and demand deposit growth. Commensurate with the growth in checking account relationships, we experienced increases in other consumer checking related fee revenue, mainly debit card related income. The benefits of this growth were offset by lower gains on sales of assets (including one branch sale), a decline in investment revenues generated from annuity sales and a reduction in ATM surcharge revenue relating to the strategic decision to reduce the out-of-footprint ATM network. ATM surcharge revenue will continue to be under pressure as consumers increase the percentage of non-cash payment methods, such as debit card transactions.

 

The first quarter 2005 provision for credit losses decreased by $15 million from the first quarter of 2004. The smaller provision was driven by management’s decision to change the charge-off policy for commercial loans less than $250,000 in the first quarter of 2004. There was a one-time impact associated with this policy change. Overall credit quality indicators were stable. Provisions for loan charge-offs are expected to increase commensurate with loan growth in 2005.

 

Noninterest expenses in the first quarter of 2005 were $299 million, $13 million lower than the same period last year. Expenses were down $3 million after taking into account the $10 million of conversion related and other nonrecurring costs associated with the United acquisition last year. We are focused on increasing efficiency while continuing to invest in the business through the build-out of our branch network and expansion of the sales force. Overall, the investments in front line areas were offset by various expense initiatives and the continual reduction in the expense base associated with the United National acquisition.

 

We have adopted a relationship-based lending strategy to target homeowners, small businesses and auto dealerships while seeking to maintain a moderate risk profile in the loan portfolio.

 

  Home equity loans grew by $2.4 billion or 25% on average for 2005 compared with the prior year. The increase is primarily attributable to the strength in loan demand throughout 2004 that has continued into the first quarter of 2005. We have noticed that consumer loan demand is starting to slow with the rise in interest rates that began last year; conversely, loan prepayments have also declined in recent months.

 

  Average commercial loans have grown 12% on the strength of increased loan demand from existing customers and an increase in the rate of small business customer acquisition.

 

  Floor plan and indirect loan portfolios grew 7% and 15% respectively over 2004 levels due to managed increases in our dealer portfolio through expanded relationships and higher dealer inventory levels.

 

  Residential mortgage loans decreased $136 million as the portfolio continues to decline each quarter. This decline will continue throughout 2005 as payoffs occur.

 

Growth in core deposits as a lower cost funding source is one of the primary objectives of our checking relationship growth strategy. Average total deposits increased $1.7 billion or 5% in the first quarter of 2005 compared with the prior year. The deposit growth was driven by increases in the number of consumer and small business checking relationships and the recapture of consumer savings and certificate of deposit balances in anticipation of rising interest rates. While average interest rates paid on deposits increased over the prior period, the earnings potential of deposits increased in the rising rate environment. We work closely with our asset and liability management group on deposits pricing and strategies to optimize customer and deposit balance growth while considering the expected rate environment.

 

  Average demand deposits grew 4% over last year driven by the growth in our consumer and small business customer bases. The growth rate in balances was equal to the growth rate in customers following a period where balance growth had exceeded customer growth. Customers are now actively seeking higher yielding savings and investment alternatives for their excess liquidity. As such, as rates rise, it is possible that the growth, on a percentage basis, in checking relationships will out-pace the growth in checking account balances.

 

  Checking relationship retention has improved and benefited from the increased penetration rates of debit card, online banking and online bill payment products and services.

 

  Customer balances in other deposit products, including savings, money market and certificates of deposits, increased $1.2 billion in the aggregate. This increase occurred during the past 9 months as the rise in interest rates began to attract funds back into certificates of deposits after an extended period of portfolio declines in a low interest rate environment.

 

Regional Community Banking provides deposit, lending, cash management and investment services to 2.2 million consumer and small business customers within our primary geographic area. Products and services offered to our customers include:

 

  Checking accounts,

 

  Savings, money market and certificates of deposit,

 

  Personal and business loans,

 

  Cash management, collection and payment services, and

 

  Investment and insurance services.

 

16


Table of Contents

WHOLESALE BANKING (Unaudited)

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions except as noted


   2005

    2004

 
INCOME STATEMENT                 

Net interest income

   $ 176     $ 164  

Noninterest income

                

Net commercial mortgage banking

                

Net gains on loan sales

     9       10  

Servicing and other fees, net of amortization

     14       11  

Net gains on institutional loans held for sale

     2       28  

Other

     111       104  
    


 


Noninterest income

     136       153  
    


 


Total revenue

     312       317  

Provision for credit losses

     (4 )     (13 )

Noninterest expense

     167       162  
    


 


Pretax earnings

     149       168  

Noncontrolling interests in income of consolidated entities

     (11 )     (10 )

Income taxes

     50       56  
    


 


Earnings

   $ 110     $ 122  
    


 


AVERAGE BALANCE SHEET

                

Loans

                

Corporate banking (a)

   $ 10,417     $ 9,875  

Commercial real estate

     1,807       1,665  

Commercial – real estate related

     1,782       1,585  

PNC Business Credit

     4,050       3,608  
    


 


Total loans (a)

     18,056       16,733  

Loans held for sale

     598       484  

Other assets

     5,430       4,630  
    


 


Total assets

   $ 24,084     $ 21,847  
    


 


Deposits

   $ 8,683     $ 6,694  

Commercial paper

     2,127       2,111  

Other liabilities

     3,777       3,725  

Capital

     1,692       1,854  
    


 


Total funds

   $ 16,279     $ 14,384  
    


 


PERFORMANCE RATIOS

                

Return on capital

     26 %     26 %

Noninterest income to total revenue

     44       48  

Efficiency

     54       51  
    


 


COMMERCIAL MORTGAGE SERVICING PORTFOLIO(in billions)

                

Beginning of period

   $ 98     $ 83  

Acquisitions/additions

     14       7  

Repayments/transfers

     (7 )     (4 )
    


 


End of period

   $ 105     $ 86  
    


 


OTHER INFORMATION

                

Consolidated revenue from:

                

Treasury management

   $ 97     $ 88  

Capital markets

   $ 42     $ 32  

Midland Loan Services

   $ 30     $ 25  

Equipment leasing

   $ 18     $ 21  

Total loans (a) (b)

   $ 18,595     $ 16,728  

Total nonperforming assets (b) (c)

   $ 65     $ 131  

Net charge-offs

   $ (2 )   $ 30  

Average FTE staff

     3,128       3,038  

Net carrying amount of commercial mortgage servicing rights (b)

   $ 258     $ 211  

(a) Reflects reclassification to loans related to Market Street conduit.
(b) Presented as of period-end.
(c) Includes nonperforming loans of $46 million at March 31, 2005 and $102 million at March 31, 2004.

 

Earnings from Wholesale Banking for the first quarter of 2005 declined 10% compared with the first quarter of 2004. The lower earnings compared with a year ago reflected a $26 million reduction in net gains on institutional loans held for sale and a lower negative provision for credit losses, which more than offset higher taxable-equivalent net interest income.

 

Highlights of the first three months of 2005 for Wholesale Banking include:

 

    Average loan balances increased $1.3 billion, or 8%, over the first quarter of 2004, driven by increased market demand.

 

    Average deposits increased $2.0 billion, or 30%, compared with the year-earlier period, as further described below.

 

    Asset quality continued to improve. Nonperforming assets at March 31, 2005 declined 50% compared with March 31, 2004.

 

    Several product areas produced strong revenue growth compared with a year ago: Capital markets revenue increased 31%, Midland Loan Services revenue increased 20%, and Treasury management revenue increased 10%.

 

Taxable-equivalent net interest income for the first three months of 2005 increased $12 million due to the impact of significant loan and deposit growth, net of $4 million of interest expense related to funding the potential tax exposure on the cross-border leasing portfolio.

 

As economic expansion continues, we expect our customers to require additional lending facilities and to increase utilization of existing facilities. Although competition for high-quality customers has increased, we believe we can compete effectively through competitive pricing within our risk/return parameters and the strength of our product offerings, such as treasury management and capital markets. We are winning new clients both within our primary geographic footprint and across the nation and this expansion is being accomplished within our risk/return parameters. Corporate banking, our primary geographic footprint business, as well as our national secured lending businesses, business credit and real estate finance, have benefited from improved economic conditions and sales efforts, resulting in significant loan growth.

 

The provision for credit losses was a negative $4 million for the first three months of 2005 and was a negative $13 million for the first three months of 2004. Asset quality remained strong, as demonstrated by the 50% decline in nonperforming assets. We anticipate that our provision for credit losses will continue to increase in 2005 compared with 2004, primarily driven by loan growth, excluding the favorable impact in the second quarter of 2005 of a significant recovery as a result of a litigation settlement.

 

17


Table of Contents

Noninterest income for the first three months of 2005 decreased $17 million compared with the first three months of 2004. The decrease was attributable primarily to a $26 million reduction in net gains on institutional loans held for sale. As the liquidation of institutional loans held for sale is essentially complete, any additional gains in 2005 will be minimal. Apart from the impact of this item, noninterest income increased $9 million due to higher fees from our capital markets and commercial mortgage servicing products.

 

Noninterest expense totaled $167 million for the first three months of 2005, an increase of $5 million or 3%, compared with the first three months of 2004. This increase was primarily due to higher staff expenses.

 

Average deposits in the first three months of 2005 increased 30% over the same period of 2004. This increase was primarily due to:

 

    Successful sales of treasury management products,

 

    A larger commercial mortgage servicing portfolio, which grew 22% from March 31, 2004 to March 31, 2005, and

 

    Strong liquidity positions within our customer base.

 

Through Wholesale Banking, we provide lending, treasury management, capital markets-related products and services, and commercial loan servicing to mid-sized corporations, government entities and selectively to large corporations. Wholesale Banking provides products and services generally within our primary geographic markets and provides certain products and services nationally.

 

Lending products include:

 

    Secured and unsecured loans

 

    Letters of credit

 

    Equipment leases

 

Treasury management services include:

 

    Cash and investment management

 

    Receivables management

 

    Disbursement services

 

    Funds transfer services

 

    Information reporting

 

    Global trade services

 

Capital markets products include:

 

    Foreign exchange

 

    Derivatives

 

    Loan syndications

 

    Securities underwriting and distribution

 

See the additional product revenue discussion regarding Treasury management, Capital markets, Midland Loan Services and equipment leasing on page 7.

 

18


Table of Contents

PNC ADVISORS (Unaudited)

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions except as noted


   2005

    2004

 

INCOME STATEMENT

                

Net interest income

   $ 28     $ 27  

Noninterest income

                

Investment management and trust

     81       81  

Brokerage

     28       30  

Other

     19       32  
    


 


Total noninterest income

     128       143  
    


 


Total revenue

     156       170  

Provision for credit losses

             1  

Noninterest expense

     112       120  
    


 


Pretax earnings

     44       49  

Income taxes

     16       18  
    


 


Earnings

   $ 28     $ 31  
    


 


AVERAGE BALANCE SHEET                 

Loans

                

Consumer

   $ 1,676     $ 1,386  

Residential mortgage

     100       154  

Commercial

     425       415  

Other

     277       292  
    


 


Total loans

     2,478       2,247  

Other assets

     401       413  
    


 


Total assets

   $ 2,879     $ 2,660  
    


 


Deposits

   $ 2,435     $ 2,189  

Other liabilities

     276       268  

Capital

     301       325  
    


 


Total funds

   $ 3,012     $ 2,782  
    


 


PERFORMANCE RATIOS                 

Return on capital

     38 %     38 %

Noninterest income to total revenue

     82       84  

Efficiency

     72       71  

ASSETS UNDER ADMINISTRATION (in billions) (a) (b)

                

Assets under management

                

Personal

   $ 40     $ 39  

Institutional

     9       9  
    


 


Total

   $ 49     $ 48  
    


 


Asset type

                

Equity

   $ 30     $ 28  

Fixed income

     13       14  

Liquidity/Other

     6       6  
    


 


Total

   $ 49     $ 48  
    


 


Nondiscretionary assets under administration

                

Personal

   $ 29     $ 29  

Institutional

     63       65  
    


 


Total

   $ 92     $ 94  
    


 


Asset type

                

Equity

   $ 32     $ 33  

Fixed income

     32       34  

Liquidity/Other

     28       27  
    


 


Total

   $ 92     $ 94  
    


 


OTHER INFORMATION (b)

                

Total nonperforming assets

   $ 9     $ 11  

Brokerage assets administered (in billions)

   $ 24     $ 24  

Full service brokerage offices

     73       76  

Financial consultants

     432       444  

Margin loans

   $ 249     $ 270  

Average FTE staff

     2,816       2,804  
    


 



(a) Excludes brokerage assets administered.
(b) Presented as of period-end, except for average FTEs.

 

Earnings from PNC Advisors totaled $28 million in the first three months of 2005 compared with $31 million in the prior year first quarter. PNC Advisors earnings increased $4 million in the first quarter of 2005 compared with the first quarter of 2004, excluding the effect in the first quarter of 2004 of a $7 million after-tax gain from the sale of certain investment consulting activities of the Hawthorn unit. Apart from this item, higher earnings in 2005 primarily reflected disciplined expense control and improved operating leverage that more than offset a decline in client-related trading revenue.

 

First quarter 2005 business highlights for PNC Advisors include:

 

    Average consumer loans increased 21% in the first quarter of 2005 compared with the prior year primarily due to home equity loan and line of credit volume.

 

    Average deposits increased 11% in the first quarter of 2005 compared with the first quarter of 2004.

 

    Average loan and deposit increases reflected the successful sales initiatives aimed at PNC Advisors’ advantage over its nonbank competitors.

 

    Hilliard Lyons retail trading volume declined in the first quarter of 2005 from December levels, in line with other brokerage firms.

 

Assets under management of $49 billion at March 31, 2005 increased $1 billion compared with the balance at March 31, 2004. The effect of comparatively higher equity markets more than offset net client asset outflows. Net client asset outflows are the result of ordinary course distributions from trust and investment management accounts and account closures exceeding investment additions from new and existing clients.

 

Taxable-equivalent net interest income increased $1 million in the first quarter of 2005 compared with the comparable prior year period primarily due to higher average consumer loan and deposit volume.

 

Investment management and trust revenue remained stable in the comparison as relatively higher equity markets in the first quarter of 2005 offset lost revenue from the investment consulting activities sold at the end of the first quarter of 2004 in the Hawthorn transaction. Brokerage revenue in the first quarter of 2005 decreased $2 million compared with the prior year period primarily due to weaker retail trading. Excluding the effect in 2004 of the $10 million pretax gain from the Hawthorn transaction, other income in the first quarter of 2005 declined $3 million from the first quarter of 2004 primarily due to lower client-related trading.

 

Noninterest expense declined $8 million in the first quarter of 2005 compared with the same period of the prior year. Lower expenses reflected efficiency initiatives as well as lower variable costs related to client-related trading and the effect of the Hawthorn transaction.

 

PNC Advisors provides a broad range of tailored investment, trust and private banking products and services to affluent individuals and families, including services to the ultra-affluent through its Hawthorn unit, and provides full-service brokerage through J.J.B. Hilliard, W.L. Lyons, Inc. (“Hilliard Lyons”). We also serve as investment manager and trustee for employee benefit plans and charitable and endowment assets and provide defined contribution plan services and investment options through our Vested Interest(trademark) product. We provide services to individuals and corporations primarily within PNC’s geographic markets.

 

19


Table of Contents

BLACKROCK (Unaudited)

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions except as noted


   2005

    2004

 
INCOME STATEMENT                 

Investment advisory and administrative fees

   $ 212     $ 160  

Other income

     38       22  
    


 


Total revenue

     250       182  

Operating expense

     161       104  

Operating expense – LTIP charge

     14          

Fund administration and servicing costs

     9       8  
    


 


Total expense

     184       112  
    


 


Operating income

     66       70  

Nonoperating income

     8       6  
    


 


Pretax earnings

     74       76  

Minority interest

                

Income taxes

     27       21  
    


 


Earnings

   $ 47     $ 55  
    


 


PERIOD-END BALANCE SHEET                 

Goodwill and other intangible assets

   $ 444     $ 186  

Other assets

     1,050       723  
    


 


Total assets

   $ 1,494     $ 909  
    


 


Liabilities and minority interest

   $ 648     $ 186  

Stockholders’ equity

     846       723  
    


 


Total liabilities and stockholders’ equity

   $ 1,494     $ 909  
    


 


PERFORMANCE DATA                 

Return on average equity

     23 %     31 %

Operating margin (a)

     38       41  

Diluted earnings per share

   $ .70     $ .84  
    


 


ASSETS UNDER MANAGEMENT (in billions) (b)

                

Separate accounts

                

Fixed income

   $ 240     $ 202  

Cash management

     7       6  

Cash management – securities lending

     7       9  

Equity

     19       9  

Alternative investment products

     19       6  
    


 


Total separate accounts

     292       232  
    


 


Mutual funds (c)

                

Fixed income

     25       25  

Cash management

     60       59  

Equity

     14       5  
    


 


Total mutual funds

     99       89  
    


 


Total assets under management

   $ 391     $ 321  
    


 


OTHER INFORMATION                 

Average FTE staff

     1,320       947  
    


 



(a) Calculated as operating income, adjusted for the LTIP charges, SSRM acquisition costs, and appreciation on Rabbi trust assets related to BlackRock’s deferred compensation plans, divided by total revenue less reimbursable property management compensation and fund administration and servicing costs. The following is a reconciliation of this presentation to operating margin calculated on a GAAP basis (operating income divided by total revenue) in millions.

 

Operating income, GAAP basis

   $ 66     $ 70  

Add back: LTIP charge

     14          

Less: portion of LTIP to be funded by BlackRock

     (2 )        

Add back: SSRM acquisition costs

     9          

Add back: appreciation on Rabbi trust assets

     2       1  
    


 


Operating income, as adjusted

   $ 89     $ 71  
    


 


Total revenue, GAAP basis

   $ 250     $ 182  
    


 


Less: reimbursable property management compensation

     4          

Less fund administration and servicing costs

     9       8  
    


 


Revenue used for operating margin calculation, as reported

   $ 237     $ 174  
    


 


Operating margin, GAAP basis

     26 %     38 %

Operating margin, as adjusted

     38 %     41 %
    


 


 

We believe that operating margin, as reported, is a more relevant indicator of management’s ability to effectively employ BlackRock’s resources. The portion of the LTIP charges associated with awards to be met with the contribution of shares of BlackRock stock by PNC has been excluded from operating income because, exclusive of impact related to LTIP participants’ option to put awarded shares to BlackRock, this non-cash charge will not impact BlackRock’s book value. Appreciation on Rabbi trust assets related to BlackRock’s deferred compensation plans has been excluded because investment performance of these assets has a nominal impact on net income. Reimbursable property management compensation represents compensation and benefits paid to certain BlackRock Realty Advisors, Inc. (“Realty”) personnel. These employees are retained on Realty’s payroll when properties are acquired by Realty’s clients. The related compensation and benefits are fully reimbursed by Realty’s clients and have been excluded from operating margin, as adjusted, because they bear no economic cost to BlackRock. We have excluded fund administration and servicing costs from the operating margin calculation because these costs are a fixed, asset-based expense which can fluctuate based on the discretion of a third party.

(b) At March 31.
(c) Includes BlackRock Funds, BlackRock Liquidity Funds, BlackRock Closed End Funds, Short Term Investment Fund and BlackRock Global Series Funds.

 

BlackRock earned $47 million for the quarter compared with $55 million a year ago. The lower earnings compared with the first quarter of 2004 were due to nonrecurring pretax expenses of $9 million associated with the SSRM acquisition and $14 million of pretax LTIP expenses in 2005, and a $9 million income tax benefit in the first quarter of 2004 resulting from the resolution of a New York State tax audit. Total revenue increased 37% compared with the first quarter of 2004 primarily due to a 32% increase in investment advisory fees driven by a growing base of assets under management.

 

During the first quarter of 2005, BlackRock continued to operate in a global marketplace characterized by substantial volatility. Increasing short-term interest rates, a flattening yield curve and volatility in global equity and commodities markets created challenging conditions across BlackRock’s asset classes. Highlights of BlackRock’s performance in the first quarter of 2005 include:

 

  Effective January 31, 2005, BlackRock completed its acquisition of SSRM, the holding company of State Street Research & Management Company and SSR Realty Advisors, for approximately $233 million in cash and approximately 550,000 shares of BlackRock restricted class A common stock. Substantially all of SSRM’s operations were integrated into BlackRock as of the closing date. BlackRock acquired assets under management totaling $50 billion in connection with this transaction.

 

  Assets under management at March 31, 2005 increased $70 billion, or 22%, compared with March 31, 2004. The increase was primarily attributable to the SSRM acquisition and growth in fixed income assets managed by BlackRock. Apart from the impact of SSRM, the increase in assets under management reflected net new subscriptions of $13 billion and net market appreciation of $7 billion.

 

  BlackRock continued to produce superior investment performance in fixed income and cash management products and continued to experience favorable operating leverage in these areas.

 

For information regarding the transfer of BlackRock from PNC Bank, N.A. to PNC Bancorp, Inc. and the related impact on PNC’s first quarter 2005 earnings, see Note 2 Acquisitions included in the Notes To Consolidated Financial Statements in Item 1 of this Report.

 

BlackRock is listed on the New York Stock Exchange under the symbol BLK. Additional information about BlackRock is available in its SEC filings at www.sec.gov and on BlackRock’s website, www.blackrock.com.

 

20


Table of Contents

PFPC (Unaudited)

 

Three months ended March 31

Dollars in millions except as noted


   2005

    2004

 
INCOME STATEMENT                 

Fund servicing revenue

   $ 220     $ 203  

Other revenue

     10          
    


 


Total revenue

     230       203  

Operating expense

     173       167  

Amortization (accretion) of other intangibles, net

     3       (3 )
    


 


Operating income

     54       39  

Nonoperating income (a)

             2  

Debt financing

     8       14  

Debt prepayment penalty

     8          
    


 


Pretax earnings

     38       27  

Income taxes

     15       11  
    


 


Earnings

   $ 23     $ 16  
    


 


AVERAGE BALANCE SHEET                 

Goodwill and other intangible assets

   $ 1,014     $ 1,027  

Other assets

     1,250       952  
    


 


Total assets

   $ 2,264     $ 1,979  
    


 


Debt financing

   $ 1,049     $ 1,163  

Other liabilities

     952       550  

Capital

     263       266  
    


 


Total funds

   $ 2,264     $ 1,979  
    


 


PERFORMANCE RATIOS                 

Return on capital

     35 %     23 %

Operating margin (b)

     23       19  
    


 


SERVICING STATISTICS (At March 31)

                

Accounting/administration net fund assets (in billions)

                

Domestic

   $ 680     $ 621  

Foreign (c)

     65       48  
    


 


Total

   $ 745     $ 669  
    


 


Asset type (in billions)

                

Money market

   $ 340     $ 337  

Equity

     245       198  

Fixed income

     107       95  

Other (d)

     53       39  
    


 


Total

   $ 745     $ 669  
    


 


Custody fund assets (in billions)

   $ 462     $ 411  
    


 


Shareholder accounts (in millions)

                

Transfer agency

     20       22  

Subaccounting

     39       33  
    


 


Total

     59       55  
    


 


OTHER INFORMATION                 

Average FTE staff

     4,833       4,910  
    


 



(a) Net of nonoperating expense.
(b) Operating income divided by total revenue.
(c) Represents net assets serviced offshore.
(d) Includes alternative investment net assets serviced.

 

PFPC earnings for the first quarter of 2005 increased 44% compared with the first quarter of 2004 due to disciplined expense control and improved operating leverage, as well as strong performance in key PFPC business units. Earnings for the first quarter of 2005 include a $6 million after-tax gain related to the resolution of a client contract dispute and a $5 million after-tax charge related to the prepayment of intercompany debt.

 

Highlights of PFPC’s first quarter 2005 performance include:

 

    Managed account services continued to grow its client base, as assets on the ADVISORport separate accounts platform reached $29 billion, an increase of 44% compared with March 31, 2004.

 

    Alternative investment net assets serviced increased 39%, to $48 billion, compared with March 31, 2004, reflecting continued success in pursuing hedge fund and other alternative investment business.

 

    Offshore revenues grew 20% and assets serviced offshore grew 33% compared with the first quarter of 2004, in part due to exchange rate movements since March 31, 2004.

 

Fund servicing revenue increased $17 million, or 8%, over the first quarter of 2004 reflecting strong overall performance in part due to continued business expansion of our existing clients, new business wins, as well as comparatively favorable equity market conditions and increases in out-of-pocket and pass-through items of $3 million, which had no impact on earnings.

 

Operating expense increased 4% in the first quarter of 2005 compared with the year-earlier period and reflected disciplined expense control. Of this increase, $3 million represented out-of-pocket and pass-through items referred to above.

 

Prior year first quarter operating income benefited from accretion of $7 million related to a single discounted client contract liability, which ended during the second quarter of 2004.

 

PFPC’s first quarter 2005 earnings also benefited from a reduction in pretax financing costs of $6 million, attributable to the debt refinancing discussed below and the retirement of debt during 2004 totaling $115 million. PFPC repaid another $33 million in intercompany debt during the first quarter of 2005 and anticipates continued debt reductions over the remainder of the year.

 

Effective January 2005, PFPC restructured its remaining intercompany term debt obligations given the comparatively favorable interest rate environment at that time. PFPC recorded debt prepayment penalties totaling $8 million on a pretax basis in the first quarter of 2005 to effect the restructuring, which is expected to be more than offset by resulting interest expense savings of approximately $10 million over the course of 2005.

 

As previously reported, in January 2005 PFPC accepted approximately $10 million to resolve a client contract dispute, which is reflected as other revenue in the table above.

 

Increases in both accounting/administration and custody fund assets at March 31, 2005 compared with March 31, 2004 resulted primarily from new business, asset inflows from existing customers and equity market appreciation. Subaccounting shareholder accounts serviced by PFPC increased over the year-earlier period due to net new business and growth in existing client accounts. Total assets serviced by PFPC amounted to $1.8 trillion at March 31, 2005 compared with $1.7 trillion at March 31, 2004.

 

PFPC’s performance is partially dependent on the underlying performance of its fund clients and, in particular, their ability to attract and retain customers. As a result, to the extent that PFPC clients’ businesses are adversely affected by ongoing governmental investigations into the practices of the mutual and hedge fund industries, PFPC’s results could be impacted.

 

21


Table of Contents

RISK FACTORS

 

We are subject to a number of risks potentially affecting our business, financial condition, results of operations and cash flows. These include, among others, those described in the Consolidated Balance Sheet Review, Risk Management and Cautionary Statement Regarding Forward-Looking Information sections of this Financial Review and elsewhere in this Report. In addition to risks described in other parts of this Report, the Supervision and Regulation Section of Item 1 and the Risk Factors section of Item 7 of our 2004 Form 10-K describe the following key risk factors that affect us:

 

    Supervision and regulation,

 

    Business and economic conditions,

 

    Impact of monetary and other policies,

 

    Acquisitions,

 

    Competition,

 

    Asset management performance,

 

    Fund servicing, and

 

    Terrorist activities and international hostilities.

 

Our 2004 Form 10-K includes a detailed description of the other key factors.

 

PENDING ACQUISITION OF RIGGS NATIONAL CORPORATION; OTHER ACQUISITIONS

 

Our pending acquisition of Riggs National Corporation presents us with a number of risks and uncertainties related both to the transaction itself and to the integration of the remaining Riggs businesses into PNC. These risks and uncertainties include the following:

 

    Completion of the transaction is dependent on, among other things, receipt of regulatory waivers, the timing of which cannot be predicted with precision at this point and which may not be received at all.

 

    Successful completion of the transaction and our ability to realize the benefits that we anticipate from the acquisition also depend on the nature of any future developments with respect to Riggs’ regulatory and legal issues, the ability to comply with the terms of all current or future requirements (including any related action plan) resulting from these issues, and the extent of future costs and expenses arising as a result of these issues, including the impact of increased litigation risk and any claims for indemnification or advancement of costs.

 

    Riggs’ regulatory and legal issues may cause reputational harm to PNC following the acquisition and integration of its business into ours.

 

    The transaction may be materially more expensive to complete than anticipated as a result of unexpected factors or events.

 

    The integration into PNC of the Riggs business and operations that we acquire, which will include conversion of Riggs’ different systems and procedures, may take longer or be more costly than anticipated and may have unanticipated adverse results relating to Riggs’ or PNC’s existing businesses.

 

    It may take longer than expected to realize the anticipated cost savings of the acquisition, and the anticipated cost savings may not be achieved in their entirety.

 

    The anticipated strategic and other benefits of the acquisition to PNC are dependent in part on the future performance of Riggs’ business. We can provide no assurance as to actual future results, which could be affected by various factors, including the risks and uncertainties generally related to the performance of PNC’s and Riggs’ businesses (with respect to Riggs, you may review Riggs’ SEC reports, which are accessible on the SEC’s website at www.sec.gov) or due to factors related to the acquisition of Riggs and the process of integrating Riggs’ business at closing into PNC.

 

In addition to the pending Riggs acquisition, we grow our business from time to time by acquiring other financial services companies. Other acquisitions generally present similar risks to those described above relating to the Riggs transaction. As a regulated financial institution, we could also be prevented from pursuing attractive acquisition opportunities due to regulatory restraints.

 

CRITICAL ACCOUNTING POLICIES AND JUDGMENTS

 

Our consolidated financial statements are prepared by applying certain accounting policies. Note 1 Accounting Policies in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report and in Part II, Item 8 of our 2004 Form 10-K describe the most significant accounting policies that we use. Certain of these policies require us to make estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations that may significantly affect our reported results and financial position for the period or in future periods.

 

We must use estimates, assumptions, and judgments when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such third-party information is not available, we estimate fair value primarily by using cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact our future financial condition and results of operations.

 

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

 

We maintain allowances for loan and lease losses and unfunded loan commitments and letters of credit at levels that we believe are sufficient to absorb estimated probable credit losses inherent in the portfolio. We determine the adequacy of

 

22


Table of Contents

the allowances based on periodic evaluations of the credit portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others:

 

    Expected default probabilities,

 

    Loss given default,

 

    Exposure at default,

 

    Amounts and timing of expected future cash flows on impaired loans,

 

    Value of collateral,

 

    Estimated losses on consumer loans and residential mortgages, and

 

    General amounts for historical loss experience.

 

Our process also considers economic conditions, uncertainties in estimating losses and inherent risks in the various credit portfolios. All of these factors may be susceptible to significant change. Also, we base the allocation of the allowance for loan and lease losses to specific loan pools on historical loss trends and our judgment concerning those trends.

 

Commercial loans are the largest category of credits and are the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses. We have allocated approximately $505 million, or 84%, of the total allowance for loan and lease losses at March 31, 2005 to the commercial loan category. This allocation also considers other relevant factors such as:

 

    Actual versus estimated losses,

 

    Regional and national economic conditions,

 

    Business segment and portfolio concentrations,

 

    Industry competition and consolidation,

 

    The impact of government regulations, and

 

    Risk of potential estimation or judgmental errors, including the accuracy of risk ratings.

 

To the extent actual outcomes differ from our estimates, additional provision for credit losses may be required that would reduce future earnings. See the following for additional information: the Credit Risk Management section of this Financial Review; and Note 1 Accounting Policies and Note 6 Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report.

 

Private Equity Asset Valuation

 

At March 31, 2005, private equity investments carried at estimated fair value totaled $497 million compared with $470 million at December 31, 2004. As of March 31, 2005, approximately 40% of the amount is invested directly in a variety of companies and approximately 60% is invested in various limited partnerships. Private equity unfunded commitments totaled $108 million at March 31, 2005 compared with $119 million at December 31, 2004.

 

We value private equity assets at each balance sheet date based primarily on either, in the case of limited partnership investments, the financial statements received from the general partner or, for direct investments, the estimated fair value of the investments. There is a time lag in our receipt of the financial information that is the primary basis for the valuation of our limited partnership interests. We recognized in the first quarter of 2005 valuation changes related to limited partnership investments that reflected the impact of fourth quarter 2004 market conditions and performance of the underlying companies. Due to the nature of the direct investments, we must make assumptions as to future performance, financial condition, liquidity, availability of capital, and market conditions, among others, to determine the estimated fair value of the investments. The valuation procedures that we apply to direct investments include techniques such as cash flow multiples for the entity, independent appraisals of the value of the entity or the pricing used to value the entity in a recent financing transaction. We value general partnership interests based on the underlying investments of the partnership utilizing procedures consistent with those applied to direct investments.

 

We reflect changes in the value of equity management investments in our results of operations. Market conditions and actual performance of the companies that we invest in could differ from these assumptions, resulting in lower valuations that could reduce earnings in future periods. Accordingly, the valuations may not represent amounts that will ultimately be realized from these investments.

 

Commercial Mortgage Servicing Rights

 

Commercial mortgage servicing rights (“MSR”) are intangible assets that represent the value of rights that arise from the servicing of commercial loan contracts. While servicing is inherent in most financial assets, it becomes a distinct asset (a) when contractually separated from the underlying financial asset by sale or securitization of the asset with servicing retained or (b) through the separate purchase and assumption of the servicing. The value of our MSR asset (both originated and purchased) arises from estimates of future revenues from contractually specified servicing fees, interest income and other ancillary revenues, net of estimated operating expenses which are expected to provide an acceptable level of risk adjusted return for us as the servicer.

 

We estimate the fair value of our MSR asset using a discounted cash flow methodology that calculates the net present value of future cash flows of the servicing portfolio over the estimated life of the asset based on various assumptions and market factors. The most significant assumptions and market factors include:

 

    Interest rates for escrow and deposit balance earnings,

 

    Discount rates,

 

    Estimated prepayment speeds, and

 

    Estimated servicing costs.

 

23


Table of Contents

We review the reasonableness of these factors based on expectations of the portfolio, market conditions, and loan characteristics.

 

Our commercial loan servicing portfolio is subject to various risks, the most significant being interest rate risk, which subject our MSR asset to impairment risk. While our MSR asset is amortized over its estimated life in proportion to estimated net servicing income, it is also tested for impairment at a strata level on a quarterly basis. The impairment testing includes a positive and negative scenario for sensitivity characteristics. If the estimated fair value of the MSR is less than its carrying value, an impairment loss would be recognized in the current period; however, any fair value in excess of the cost basis would not be recognized as income.

 

Lease Residuals

 

We provide financing for various types of equipment, aircraft, energy and power systems, and rolling stock through a variety of lease arrangements. Leases are carried at the sum of lease payments and the estimated residual value of the leased property, less unearned income. Residual value insurance or guarantees by governmental entities cover a significant portion of the residual value. Residual values are subject to judgments as to the value of the underlying equipment that can be affected by changes in economic and market conditions and the financial viability of the residual guarantors and insurers. To the extent not guaranteed or assumed by a third party, or otherwise insured against, we bear the risk of ownership of the leased assets. This includes the risk that the actual value of the leased assets at the end of the lease term will be less than the residual value, which could result in an impairment charge and reduce earnings in the future. These residual values are reviewed for impairment no less than on an annual basis.

 

Goodwill

 

Goodwill arising from business acquisitions represents the value attributable to unidentifiable intangible elements in the business acquired. Most of our goodwill relates to value inherent in the fund servicing and banking businesses. The value of this goodwill is dependent upon our ability to provide quality, cost effective services in the face of competition from other market participants on a national and global basis. This ability in turn relies upon continuing investments in processing systems, the development of value-added service features, and the ease of access to our services.

 

As such, goodwill value is supported ultimately by earnings, which is driven by the volume of business transacted and, for certain businesses, the market value of assets under administration or for which processing services are provided. Lower earnings resulting from a lack of growth or our inability to deliver cost effective services over sustained periods can lead to impairment of goodwill, which could result in a charge and reduced earnings in the future. At least annually, management evaluates events or changes in circumstances that may indicate impairment in the carrying amount of goodwill. See Note 7 Goodwill And Other Intangible Assets in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report for additional information.

 

Revenue Recognition

 

We derive net interest and noninterest income from various sources, including:

 

    Lending,

 

    Securities portfolio,

 

    Investment management and fund servicing,

 

    Customer deposits,

 

    Loan servicing,

 

    Brokerage services,

 

    Sale of loans and securities,

 

    Certain private equity activities, and

 

    Securities and derivatives trading activities including foreign exchange.

 

We also earn fees and commissions from issuing loan commitments, standby letters of credit and financial guarantees, selling various insurance products, providing treasury management services and participating in certain capital market transactions.

 

The timing and amount of revenue that we recognize in any period is dependent on estimates, judgments, assumptions, and interpretation of contractual terms. Changes in these factors can have a significant impact on revenue recognized in any period due to changes in products, market conditions or industry norms. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report for additional information.

 

Income Taxes

 

Because our ownership interest in BlackRock, as measured by value, is less than 80%, federal tax law requires us to file two consolidated federal income tax returns: one for PNC and subsidiaries excluding the consolidated results of BlackRock and its subsidiaries, and a second return solely for BlackRock and its subsidiaries. We and our subsidiaries also file state and local income tax returns in many jurisdictions.

 

In the normal course of business, we and our subsidiaries enter into transactions for which the tax treatment is unclear or subject to varying interpretations. In addition, filing requirements, methods of filing and the calculation of taxable income in various state and local jurisdictions are subject to differing interpretations.

 

We evaluate and assess the relative risks and merits of the appropriate tax treatment of transactions, filing positions, filing methods and taxable income calculation after considering statutes, regulations, judicial precedent, and other information, and maintain tax accruals consistent with our evaluation of these relative risks and merits. The result of our evaluation and assessment is by its nature an estimate. We and our subsidiaries are routinely subject to audit and challenges from taxing authorities. In the event we resolve a challenge for an amount different than amounts previously accrued, we will account for the difference in the period in which we resolve the matter.

 

24


Table of Contents

Our tax treatment of certain leasing transactions is currently being challenged by the IRS, as described under Cross-Border Leases and Related Tax and Accounting Matters in the Consolidated Balance Sheet Review section of this Financial Review.

 

Legal Contingencies

 

We are subject to a variety of legal and regulatory proceedings and claims, including those described in Note 15 Legal Proceedings in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report and others arising in the normal course of our business. We review these matters with internal and external legal counsel and accrue reserves when we determine that it is probable that a liability has been incurred and that the amount of loss can be reasonably estimated. We regularly review these accruals and adjust the reserves as appropriate to reflect changes in the status of the proceedings and claims.

 

The reserves that we establish for these types of contingencies are based upon our opinion of the likely future outcome of legal and regulatory proceedings and claims. The final resolution of legal and regulatory proceedings is frequently different, possibly significantly, from the resolution we anticipated. Also, we may not be able to reasonably estimate the loss from a proceeding even if some liability is probable or the actual loss may be different from an estimated loss. As a result, our ultimate financial exposure to legal and regulatory proceedings and claims may be substantially different from what is reflected in the related reserves.

 

2002 BLACKROCK LONG-TERM RETENTION AND INCENTIVE PLAN

 

See Note 11 Certain Employee Benefit And Stock-Based Compensation Plans in the Notes To Consolidated Financial Statements of this Report for a description of BlackRock’s 2002 Long-Term Retention and Incentive Plan (“ LTIP”).

 

Under the BlackRock LTIP, awards fully vest at the end of any three-month period beginning on or after January 1, 2005 and ending on or prior to March 30, 2007 during which the average closing price of BlackRock’s common stock is at least $62 per share. During the first quarter of 2005, BlackRock’s average closing stock price exceeded the $62 threshold. In addition, the vesting of awards is contingent on the participants’ continued employment with BlackRock for periods ranging from two to five years.

 

We reported pretax charges in the second half of 2004 totaling $110 million in connection with the LTIP, based upon management’s determination that full vesting of the LTIP Awards was probable as of September 30, 2004. Note 22 Stock-Based Compensation Plans included in Part II, Item 8 of our 2004 Form 10-K provides additional information on these charges.

 

We reported pretax charges of $15 million in the first quarter of 2005 related to the LTIP Awards. We expect to report additional pretax charges of approximately $16 million per quarter through December 2006 related to the remaining service period of the LTIP Awards granted to date.

 

STATUS OF DEFINED BENEFIT PENSION PLAN

 

We have a noncontributory, qualified defined benefit pension plan (“plan” or “pension plan”) covering eligible employees. Retirement benefits are derived from a cash balance formula based on compensation levels, age and length of service. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants. Plan assets are currently approximately 60% invested in equity investments with most of the remainder invested in fixed income instruments. Plan fiduciaries determine and review the plan’s investment policy.

 

We calculate the expense associated with the pension plan in accordance with SFAS 87, “Employers’ Accounting for Pensions,” and we use assumptions and methods that are compatible with the requirements of SFAS 87, including a policy of reflecting trust assets at their fair market value. On an annual basis, we review the actuarial assumptions related to the pension plan, including the discount rate, rate of compensation increase and the expected return on plan assets. Neither the discount rate nor the compensation increase assumptions significantly affect pension expense. However, the expected long-term return on assets assumption does significantly affect pension expense. Actual investment returns also significantly affect expense, as each one percentage point difference in actual return compared with our expected return causes the following year’s expense to change by up to $3 million. Below are the effects of certain changes in assumptions, using 2005 estimated expense as a baseline.

 

    

Estimated

Increase to

Pension
Expense

(In millions)


.5% decrease in discount rate

   $ 1

.5% decrease in expected long-term return on assets

     7

.5% increase in compensation rate

     1

 

We currently estimate a pretax $6 million benefit to pension expense in 2005 compared with pretax expense of $10 million in 2004.

 

25


Table of Contents

The primary reasons for the expected decrease in pension expense in 2005 are favorable returns on investment assets in 2004, which reduce amortization of actuarial losses and increase the value of assets used to calculate expected returns for 2005, and plan modifications relating to PFPC, as future retirement benefits will accrue only under a defined contribution plan.

 

In accordance with SFAS 87 and SFAS 132 (Revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” we may have to eliminate any prepaid pension asset and recognize a minimum pension liability if the accumulated benefit obligation exceeds the fair value of plan assets at year-end. We would recognize the corresponding charge as a component of other comprehensive income and it would reduce total shareholders’ equity, but it would not affect net income. At December 31, 2004, the fair value of plan assets was $1.492 billion, which exceeded the accumulated benefit obligation of $1.111 billion. The status at year-end 2005 will depend primarily upon 2005 investment returns and the level of contributions, if any, made to the plan by us during 2005.

 

Plan asset investment performance has the most impact on contribution requirements. However, contribution requirements are not particularly sensitive to actuarial assumptions. Investment performance will drive the amount of permitted contributions in future years. Also, current law sets limits as to both minimum and maximum contributions to the plan. In any event, any large near-term contributions to the plan will be at our discretion, as we expect that the minimum required contributions under the law will be minimal or zero for several years.

 

We maintain other defined benefit plans that have a less significant effect on financial results, including various nonqualified supplemental retirement plans for certain employees. We merged a qualified pension plan for former United National employees into our plan during the fourth quarter of 2004.

 

RISK MANAGEMENT

 

We encounter risk as part of the normal course of our business and we design risk management processes to help manage these risks. The Risk Management section included in Part II, Item 7 of our 2004 Form 10-K provides a general overview of the risk measurement, control strategies and monitoring aspects of our corporate-level risk management processes. Additionally, our 2004 Form 10-K provides an analysis of the risk management processes for what we view as our primary areas of risk: credit, operational, liquidity, and market, as well as a discussion of our use of financial derivatives as part of our overall asset and liability risk management process. The following information in this Risk Management section updates our 2004 Form 10-K disclosures in these areas.

 

CREDIT RISK MANAGEMENT

 

Credit risk represents the possibility that a customer, counterparty or issuer 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 financial derivative transactions. Credit risk is one of the most common risks in banking and is one of our most significant risks.

 

Nonperforming, Past Due And Potential Problem Assets

 

Nonperforming assets include nonaccrual loans, troubled debt restructurings, nonaccrual loans held for sale or foreclosed, and other assets. In addition, certain performing assets have interest payments that are past due or have the potential for future repayment problems.

 

Nonperforming Assets By Type

 

Dollars in millions


  

March 31

2005


   

December 31

2004


 

Nonaccrual loans

                

Commercial

   $ 83     $ 89  

Lease financing

     5       5  

Commercial real estate

     11       14  

Consumer

     13       11  

Residential mortgage

     19       21  
    


 


Total nonaccrual loans

     131       140  

Troubled debt restructured loan

             3  
    


 


Total nonperforming loans

     131       143  

Nonperforming loans held for sale (a)

     2       3  

Foreclosed and other assets

                

Lease

     13       14  

Residential mortgage

     11       10  

Other

     5       5  
    


 


Total foreclosed and other assets

     29       29  

Total nonperforming assets (b)

   $ 162     $ 175  
    


 


Nonperforming loans to total loans

     .29 %     .33 %

Nonperforming assets to total loans, loans held for sale and foreclosed assets

     .35       .39  

Nonperforming assets to total assets

     .19       .22  

(a) Includes troubled debt restructured loans held for sale of $2 million as of March 31, 2005 and December 31, 2004.
(b) Excludes equity management assets carried at estimated fair value of $33 million at March 31, 2005 and $32 million at December 31, 2004 and included in Other assets on the Consolidated Balance Sheet. These amounts include troubled debt restructured assets of $10 million at March 31, 2005 and $11 million at December 31, 2004.

 

26


Table of Contents

The foreclosed lease assets at March 31, 2005 and December 31, 2004 primarily represent our repossession of collateral related to a single airline industry credit during the second quarter of 2003 that was previously classified as a nonaccrual loan. This asset is currently leased to a third party.

 

The amount of nonperforming loans that was current as to principal and interest was $22 million at March 31, 2005 and $44 million at December 31, 2004.

 

Nonperforming Assets By Business

 

In millions


  

March 31

2005


  

December 31

2004


Regional Community Banking

   $ 84    $ 91

Wholesale Banking

     65      71

PNC Advisors

     9      9

Other

     4      4
    

  

Total nonperforming assets

   $ 162    $ 175
    

  

 

Change In Nonperforming Assets

 

In millions


   2005

    2004

 

January 1

   $ 175     $ 328  

Purchases

             12  

Transferred from accrual

     32       47  

Returned to performing

     (5 )     (1 )

Principal reductions and payoffs

     (25 )     (74 )

Asset sales

     (4 )     (42 )

Charge-offs and valuation adjustments

     (11 )     (41 )
    


 


March 31

   $ 162     $ 229  
    


 


 

The amount of nonperforming loans held for sale that was current as to principal and interest was zero at both March 31, 2005 and December 31, 2004.

 

Accruing Loans And Loans Held For Sale Past Due 90 Days Or More

 

     Amount

   Percent of Total
Outstandings


 

Dollars in millions


  

March 31

2005


  

Dec. 31

2004


  

March 31

2005


   

Dec. 31

2004


 

Commercial

   $ 17    $ 15    .09 %   .09 %

Commercial real estate

     18      2    .94     .10  

Consumer

     17      18    .11     .12  

Residential mortgage

     13      14    .26     .29  

Lease financing

                          
    

  

  

 

Total loans

     65      49    .15     .11  

Loans held for sale

     6      9    .29     .54  
    

  

  

 

Total loans and loans held for sale

   $ 71    $ 58    .15 %   .13 %
    

  

  

 

 

Loans and loans held for sale that are not included in nonperforming or past due categories but cause us to be uncertain about the borrower’s ability to comply with existing repayment terms over the next six months, totaled $39 million and zero respectively, at March 31, 2005 compared with $65 million and zero, respectively at December 31, 2004. Approximately 60% of these loans are in the Wholesale Banking portfolio.

 

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

 

We maintain an allowance for loan and lease losses to absorb losses from the loan portfolio. We determine the allowance based on quarterly assessments of the probable estimated losses inherent in the loan portfolio. While we make allocations to specific loans and pools of loans, the total reserve is available for all loan and lease losses.

 

Allocation Of Allowance For Loan And Lease Losses

 

     March 31, 2005

    December 31, 2004

 

Dollars in millions


   Allowance

  

Loans to

Total

Loans


    Allowance

  

Loans to

Total

Loans


 

Commercial

   $ 505    41.4 %   $ 503    40.1 %

Commercial real estate

     22    4.3       26    4.5  

Consumer

     32    35.3       35    35.9  

Residential mortgage

     6    11.2       6    11.0  

Lease financing

     31    6.7       33    7.3  

Other

     4    1.1       4    1.2  
    

  

 

  

Total

   $ 600    100 %   $ 607    100.0 %
    

  

 

  

 

In addition to the allowance for loan and lease losses, we maintain an allowance for unfunded loan commitments and letters of credit. We report this allowance as a liability on our Consolidated Balance Sheet. We determine this amount using estimates of the probability of the ultimate funding and losses related to those credit exposures. This methodology is similar to the methodology we use for determining the adequacy of our allowance for loan and lease losses.

 

Rollforward Of Allowance For Unfunded Loan Commitments And Letters Of Credit

 

In millions


   2005

   2004

January 1

   $ 75    $ 91

Net change in allowance for unfunded loan commitments and letters of credit

     3       
    

  

March 31

   $ 78    $ 91
    

  

 

The provision for credit losses for 2005 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of March 31, 2005 reflected changes in loan portfolio composition, the impact of refinements to our reserve methodology, and changes in asset quality. The provision includes amounts for probable losses on loans and credit exposure related to unfunded loan commitments and letters of credit.

 

Rollforward Of Allowance For Loan And Lease Losses

 

In millions


   2005

    2004

 

January 1

   $ 607     $ 632  

Charge-offs

     (22 )     (75 )

Recoveries

     10       13  
    


 


Net charge-offs

     (12 )     (62 )

Provision for credit losses

     8       12  

Acquired allowance (United National)

             22  

Net change in allowance for unfunded loan commitments and letters of credit

     (3 )        
    


 


March 31

   $ 600     $ 604  
    


 


 

27


Table of Contents

The allowance as a percent of nonperforming loans was 458% and as a percent of total loans was 1.34% at March 31, 2005. The comparable percentages at December 31, 2004 were 424% and 1.40%.

 

During the first quarter of 2004, we changed our policy for recognizing charge-offs on smaller nonperforming commercial loans. As a result, we recognized an additional $24 million of gross charge-offs for the first quarter of 2004.

 

Charge-Offs And Recoveries

 

Three months ended March 31

Dollars in millions


   Charge-offs

   Recoveries

  

Net

Charge-offs


  

Percent of

Average

Loans


 
2005                            

Commercial

   $ 12    $ 6    $ 6    .14 %

Consumer

     10      4      6    .16  
    

  

  

  

Total

   $ 22    $ 10    $ 12    .11  
    

  

  

  

2004

                           

Commercial

   $ 59    $ 8    $ 51    1.30 %

Commercial real estate

     2             2    .36  

Consumer

     11      3      8    .25  

Residential mortgage

     1      1              

Lease financing

     2      1      1    .10  
    

  

  

  

Total

   $ 75    $ 13    $ 62    .64 %
    

  

  

  

 

We establish reserves to provide coverage for probable losses not considered in the specific, pool and consumer reserve methodologies, such as, but not limited to, potential judgment and data errors. Furthermore, events may have occurred as of the reserve evaluation date that are not yet reflected in risk measures or characteristics of the portfolio due to inherent lags in information. Our evaluation of these factors and other relevant factors, such as the imprecision in estimating probable losses, determines the level of reserves established at the evaluation date. The total amount of reserves for these factors was $100 million at March 31, 2005 and $101 million at December 31, 2004 and were assigned in the tables above to loan categories and to business segments based on the relative specific and pool allocation amounts. This portion of the allowance for loan and lease losses represented 17% of the total allowance and .22% of total loans at March 31, 2005 and 17% of the total allowance and .23% of total loans at December 31, 2004.

 

CREDIT-RELATED INSTRUMENTS

 

Credit Default Swaps

 

Credit default swaps provide, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying financial instruments. We use the contracts primarily to mitigate credit risk associated with commercial lending activities as well as proprietary derivative and convertible bond trading. At March 31, 2005, we used credit default swaps with $304 million in notional amount to reduce credit risk associated with commercial lending activities, $75 million in notional amount to reduce risk associated with convertible arbitrage trading and $160 million in notional amount related to proprietary trading activities. The comparable amounts were $336 million, $23 million and zero at December 31, 2004. Credit default swaps are included in the Free-Standing Derivatives table in the Financial Derivatives section of this Risk Management discussion. We realized minimal net gains in connection with credit default swaps during the first quarter of 2005 and $1.0 million in the first quarter of 2004.

 

Interest Rate Derivative Risk Participation Agreements

 

We enter into risk participation agreements to share credit exposure with other financial counterparties related to interest rate derivative contracts or take on credit exposure to generate revenue. Risk participation agreements entered into subsequent to June 30, 2003 used by us to mitigate credit risk had a notional amount of $189 million at March 31, 2005 compared with $200 million at December 31, 2004. Risk participation agreements in which we assumed credit exposure had a notional amount of $29 million at March 31, 2005 and $30 million at December 31, 2004.

 

Agreements entered into prior to July 1, 2003 are considered to be financial guarantees and, therefore, are not included in the Financial Derivatives section of this Risk Management discussion. Risk participation agreements entered into prior to July 1, 2003 used by us to mitigate credit risk had a notional amount of $11 million at March 31, 2005 compared with $36 million at December 31, 2004. Risk participation agreements entered into in which we assumed credit risk exposure had a total notional amount of $19 million at March 31, 2005 compared with $24 million at December 31, 2004.

 

OPERATIONAL RISK MANAGEMENT

 

Operational risk is defined as the risk of financial loss or other damage to us resulting from inadequate or failed internal processes or systems, human factors, or from external events. Operational risk may occur in any of our business activities and manifests itself in various ways, including but not limited to the following:

 

    Errors related to transaction processing and systems,

 

    Breaches of the system of internal controls and compliance requirements,

 

    Business interruptions and execution of unauthorized transactions and fraud by employees or third parties.

 

Operational losses may arise from legal actions due to operating deficiencies or noncompliance with contracts, laws or regulations.

 

To monitor and control operational risk, we maintain a comprehensive framework including policies and a system of internal controls that is designed to manage risk and to provide management with timely and accurate information about the operations of PNC.

 

LIQUIDITY RISK MANAGEMENT

 

Liquidity risk is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We manage liquidity risk to help ensure that we can obtain cost-effective funding to meet current and future obligations under both normal “business as usual” and stressful circumstances.

 

28


Table of Contents

Our largest source of funding on a consolidated basis is the deposit base that comes from our retail and wholesale banking activities. Other borrowed funds come from a diverse mix of long and short-term funding sources. Liquid assets and unused borrowing capacity from a number of sources are also available to maintain our liquidity position.

 

Liquid assets consist of short-term investments (federal funds sold and other short-term investments) and securities available for sale. At March 31, 2005, our liquid assets totaled $20.8 billion, with $9.3 billion pledged as collateral for borrowings, trust, and other commitments.

 

PNC Bank, N.A. is a member of the Federal Home Loan Bank and as such has access to advances from the Federal Home Loan Bank secured generally by residential mortgages, other real estate related loans, and mortgage-backed securities. At March 31, 2005, our total unused borrowing capacity from the Federal Home Loan Bank under current collateral requirements was $20.4 billion.

 

We can also obtain funding through alternative forms of borrowing, including federal funds purchased, repurchase agreements, and short-term and long-term debt issuances. In July 2004, PNC Bank, N.A. established a program to offer up to $20 billion in senior and subordinated unsecured debt obligations with maturities of more than nine months. As of March 31, 2005, PNC Bank, N.A. had issued $1.4 billion of debt under this program, including $350 million of 13-month floating rate notes, due April 28, 2006, issued during the first quarter of 2005 with interest payable monthly at the rate of 1-month LIBOR minus 3.5 basis points. These notes are not redeemable or subject to repayment at the option of the holder prior to maturity. In December 2004, PNC Bank, N.A. established a program to offer up to $3.0 billion of its commercial paper. As of March 31, 2005, $100 million of commercial paper was outstanding under this program.

 

Our parent company’s routine funding needs consist primarily of dividends to PNC shareholders, share repurchases, debt service, the funding of non-bank affiliates, and acquisitions. The principal source of parent company cash flow is the dividends it receives from PNC Bank, N.A. There are statutory and regulatory limitations on the ability of national banks to pay dividends or make other capital distributions or to extend credit to the parent company or its non-bank subsidiaries. Dividends may also be impacted by the bank’s capital needs and by contractual restrictions. The amount available for dividend payments to the parent company by PNC Bank, N.A. without prior regulatory approval was approximately $402 million at March 31, 2005.

 

In addition to dividends from PNC Bank, N.A., other sources of parent company liquidity include cash and short-term investments, as well as dividends and loan repayments from other subsidiaries. As of March 31, 2005, the parent company had approximately $1.0 billion in funds available from its cash and short-term investments.

 

We can also generate liquidity for the parent company and PNC’s non-bank subsidiaries through the issuance of securities in public or private markets. On March 10, 2005, PNC issued two series of senior debt under PNC’s effective shelf registration statements. The first series consisted of $350 million of 4.2% Senior Notes due 2008 and the second series consisted of $350 million of 4.5% Senior Notes due 2010. Neither series of Senior Notes is redeemable by PNC or subject to repayment at the option of the holder primarily due to the increase in parent company liquidity resulting from the senior debt issuances.

 

At March 31, 2005, we had unused capacity under effective shelf registration statements of approximately $2.0 billion of debt or equity securities and $100 million of trust preferred capital securities. During the first quarter of 2005, no parent company senior debt matured. As of March 31, 2005, there were no parent company contractual obligations with maturities less than one year. We terminated our $200 million non-reciprocal parent company credit facility effective March 31, 2005.

 

MARKET RISK MANAGEMENT OVERVIEW

 

Market risk is the risk of a loss in earnings or economic value due to adverse movements in market factors such as interest rates, credit spreads, foreign exchange rates, and equity prices.

 

MARKET RISK MANAGEMENT – INTEREST RATE RISK

 

Interest rate risk results primarily from our traditional banking activities of gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates, and consumer preferences, affect the difference between the interest that we earn on assets and the interest that we pay on liabilities.

 

PNC’s Asset and Liability Management group centrally manages interest rate risk subject to interest rate risk limits and certain policies approved by the Asset and Liability Committee and the Board Finance Committee. In February 2005, the Board Finance Committee approved a policy change which entailed limiting the sensitivity of PNC’s duration of equity. This limit replaced the previous economic value of equity (“EVE”) sensitivity limits.

 

Sensitivity results and market interest rate benchmarks for the first quarter of 2005 and 2004 follow:

 

Interest Sensitivity Analysis

 

    

First

Quarter
2005


    First
Quarter
2004


 
Net Interest Income Sensitivity Simulation             

Effect on net interest income in first year from gradual interest rate change over following 12 months of:

            

100 basis point increase

   1.3 %   (.5 )%

100 basis point decrease

   (.8 )%   (.6 )%

Effect on net interest income in second year from gradual interest rate change over the preceding 12 months of:

            

100 basis point increase

   2.6 %   2.4 %

100 basis point decrease

   (6.0 )%   (8.3 )%
Duration of Equity Model             

Base case duration of equity (in years):

   (1.0 )   (1.3 )
Key Period-End Interest Rates             

One month LIBOR

   2.87 %   1.09 %

Three-year swap

   4.39 %   2.39 %

 

29


Table of Contents

In addition to measuring the effect on net interest income assuming parallel changes in current interest rates, we routinely simulate the effects of a number of nonparallel interest rate environments. The following Net Interest Income Sensitivity To Alternative Rate Scenarios table reflects the percentage change in net interest income over the next two 12 month periods assuming PNC Economist’s most likely rate forecast, implied market forward rates and a lower/flatter rate scenario. We are inherently sensitive to a flatter yield curve.

 

Net Interest Income Sensitivity To Alternative Rate Scenarios (for first quarter 2005)

 

     PNC
Economist


    Market
Forward


    Low/Flat

 

Change in forecasted net interest income:

                  

First year sensitivity

   1.6 %   .6 %   (1.4 )%

Second year sensitivity

   .7 %   (1.0 )%   (3.9 )%

 

When forecasting net interest income, we make assumptions about interest rates and the shape of the yield curve, the volume and characteristics of new business, and the behavior of existing positions. These assumptions determine the future level of simulated net interest income in the base interest rate scenario and the other interest rate scenarios presented in the following table. These simulations assume that as assets and liabilities mature, they are replaced or repriced at market rates.

 

All changes in forecasted net interest income are relative to results in a base rate scenario where current market rates are assumed to remain unchanged over the forecast horizon.

 

The graph below presents the yield curves for the base rate scenario and each of the alternative scenarios one year forward.

 

LOGO

 

Over the last several years, we have taken steps to position our balance sheet to benefit from rising long-term interest rates. Going forward, we believe that we have the deposit funding base and flexibility to change our investment profile to take advantage, where appropriate, of opportunities presented by a higher rate environment.

 

MARKET RISK MANAGEMENT – TRADING RISK

 

Our trading activities include the underwriting of fixed income and equity securities, as well as customer-driven and proprietary trading in fixed income securities, equities, derivatives, and foreign exchange.

 

We use value-at-risk (“VaR”) as the primary means to measure and monitor market risk in trading activities. Our Board Finance Committee establishes an enterprise-wide VaR limit on our trading activities.

 

The following table shows VaR usage for the first quarter of 2005 by product type:

 

VaR Usage by Product Type

 

In millions


   Min

   Max

   Avg

Fixed Income

   $ 5.3    $ 9.4    $ 7.3

Equity

     .7      1.2      .9

Foreign Exchange

     .1      .5      .2
                  

Total

     6.4      10.6    $ 8.4

 

To help ensure the integrity of the models used to calculate VaR for each portfolio and enterprise-wide, we use a process known as backtesting. The backtesting process consists of comparing actual observations of trading-related gains or losses against the VaR levels that were calculated at the close of the prior day. We would expect a maximum of two to three instances a year in which actual losses exceeded the prior day VaR measure. During the first three months of 2005, there were no such instances at the enterprise-wide level. The following graph shows a comparison of enterprise-wide trading-related gains and losses against prior day VaR for the period.

 

LOGO

 

Total trading-related revenue was $52 million in the first quarter of 2005 and $25 million for the first quarter of 2004. Trading-related revenue includes both net interest income and noninterest income from trading activities. Enterprise-wide trading-related losses occurred on 15 of the 62 business days in the first quarter of 2005. See Note 3 Trading Activities in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report for additional information.

 

30


Table of Contents

MARKET RISK MANAGEMENT – EQUITY AND OTHER INVESTMENT RISK

 

Equity investment risk is the risk of potential losses associated with investing in both private and public equity markets.

 

The primary risk measurement for equity and other investments is economic capital. In addition to extending credit, taking deposits, and underwriting and trading financial instruments, we make and manage direct investments in a variety of transactions, including management buyouts, recapitalizations, and later-stage growth financings in a variety of industries. We have investments in non-affiliated and affiliated funds that make similar private equity investments, although new investments in non-affiliated funds will be minimal. The economic and/or book value of these investments and other assets such as loan servicing rights are directly affected by changes in market factors.

 

Private Equity

 

The private equity portfolio is comprised of investments that vary by industry, stage and type of investment. We continue to make private equity investments at a moderate pace, consistent with current market conditions. See Private Equity Asset Valuation in the Critical Accounting Policies And Judgments section of this Financial Review for additional information.

 

Other Investments

 

We also make investments in affiliated and non-affiliated funds with both traditional and alternative investment strategies. Such investments include investments in BlackRock’s mutual funds, hedge funds, and CDOs. The economic values could be driven by either the fixed-income market or the equity markets, or both. As of March 31, 2005, major investments of this type included low income housing tax credits and capitalized servicing rights for commercial mortgage loans.

 

ECONOMIC CAPITAL

 

Our Economic Capital Committee governs the measurement of economic capital. This Committee meets at least quarterly to review economic capital measurements and approve methodology changes. The economic capital framework is a measure of the potential losses above and beyond expected losses. Potential one year losses are capitalized to a level consistent with a financial institution with an A rating by the credit rating agencies. Economic capital incorporates risk associated with potential credit losses (Credit Risk), fluctuations of the estimated market value of financial instruments (Market Risk), failure of people, processes or systems (Operational Risk), and income losses associated with declining volumes, margins and/or fees, and the fixed cost structure of the business (Business Risk). We estimate credit and market risks at an exposure level while we estimate the remaining risk types at an institution or business segment level. We routinely compare the output of our economic capital model with industry benchmarks.

 

FINANCIAL DERIVATIVES

 

We use a variety of financial derivatives as part of the overall asset and liability risk management process to help manage interest rate, market and credit risk inherent in our business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total return swaps, interest rate caps and floors and futures contracts are the primary instruments used by us for interest rate risk management.

 

Financial derivatives involve, to varying degrees, interest rate, market and credit risk. For interest rate swaps and total 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 amount.

 

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.

 

Accounting Hedges-Fair Value Hedging Strategies

 

We enter into interest rate and total return swaps, caps, floors and interest rate futures derivative contracts to hedge designated commercial mortgage loans held 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 interest income, interest expense or noninterest income depending on the hedged item.

 

Accounting Hedges-Cash Flow Hedging Strategy

 

We enter 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 these derivatives is reported in other assets or other liabilities and offset in accumulated other comprehensive income for the effective portion of the derivatives. When the hedged transaction culminates, any unrealized gains or losses related to these swap contracts are removed from accumulated other comprehensive income and are included in interest income. Any ineffectiveness of the strategy, as defined by our documented policies and procedures, is reported in interest income.

 

31


Table of Contents

Free-Standing Derivatives

 

To accommodate customer needs, we also enter into financial derivative transactions primarily consisting of interest rate swaps, caps, floors and foreign exchange and equity contracts. We manage our market risk exposure from customer positions through transactions with third-party dealers. The credit risk associated with derivatives executed with customers is essentially the same as that involved in extending loans and is subject to normal credit policies. We may obtain collateral based on our assessment of the customer.

 

Also included in free-standing derivatives are transactions that we enter into for risk management and proprietary purposes that are not designated as accounting hedges, primarily interest rate basis swaps, total return swaps, credit default swaps and certain interest rate-lock loan origination commitments as well as commitments to buy or sell mortgage loans.

 

Basis swaps are agreements involving the exchange of payments, based on notional amounts, of two floating rate financial instruments denominated in the same currency, one pegged to one reference rate and the other tied to a second reference rate (e.g., swapping payments tied to one-month LIBOR for payments tied to three-month LIBOR). We use these contracts to mitigate the impact on earnings of exposure to a certain referenced interest rate.

 

Interest rate-lock commitments for, as well as commitments to buy or sell, real estate mortgage loans that we intend to sell are considered free-standing derivatives. Our interest rate exposure on the rate lock commitments is economically hedged with pay-fixed interest rate swaps and forward sale commitments. These contracts mitigate the impact on earnings of exposure to a certain referenced rate.

 

We purchase credit default swaps to mitigate the economic impact of credit losses on specifically identified existing lending relationships. These derivatives typically are based upon the change in value, due to changing credit spreads, of publicly-issued bonds issued by our customer.

 

We enter into risk participation agreements to share some of the credit exposure with other financial counterparties related to interest rate derivative contracts or to take on credit exposure to generate revenue. We will be required to make/receive payments under these guaranties if a customer defaults on its obligation to perform under certain credit agreements. Agreements entered into prior to July 1, 2003 are considered financial guarantees. Agreements entered into after June 30, 2003 are considered free-standing derivatives.

 

We occasionally purchase or originate financial instruments that contain an embedded derivative. At the inception of the financial instrument, we assess whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the financial instrument (host contract), whether the financial instrument that embodies both the embedded derivative and the host contract is measured at fair value with changes in fair value reported in earnings, and whether a separate instrument with the same terms as the embedded instrument would not meet the definition of a derivative. If the embedded derivative does not meet these three conditions, the embedded derivative would qualify as a derivative instrument and be recorded apart from the host contract and carried at fair value with changes recorded in current earnings.

 

Free-standing derivatives also include positions we take based on market expectations or to benefit from price differentials between financial instruments and the market based upon stated risk management objectives.

 

32


Table of Contents

The following tables provide the notional amount and fair value of financial derivatives used for risk management and designated as accounting hedges as well as free-standing derivatives at March 31, 2005 and December 31, 2004. Weighted-average interest rates presented are based on contractual terms, if fixed, or the implied forward yield curve at each respective date, if floating. The credit risk amounts of these derivatives as of March 31, 2005 and December 31, 2004 are presented in Note 12 Financial Derivatives in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

 

Financial Derivatives - 2005                                 
    

Notional

Amount


   Fair Value

   

Weighted-

Average
Maturity


  

Weighted-Average

Interest Rates


 

March 31, 2005 - dollars in millions


           Paid

    Received

 
Accounting Hedges                                 

Interest rate risk management

                                

Asset rate conversion

                                

Interest rate swaps (a)

                                

Receive fixed

   $ 1,460    $ (16 )   3 yrs. 4 mos.    4.32 %   3.82 %

Pay fixed

     12            2 yrs. 10 mos.    3.68     4.36  

Interest rate caps (b)

     4            5 yrs.    NM     NM  

Futures contracts

     91            1 yr. 4 mos.    NM     NM  
    

  


                

Total asset rate conversion

     1,567      (16 )                 
    

  


                

Liability rate conversion

                                

Interest rate swaps (a)

                                

Receive fixed

     4,445      133     6 yrs. 8 mos.    4.55     5.44  
    

  


                

Total interest rate risk management

     6,012      117                   
    

  


                

Commercial mortgage banking risk management

                                

Pay fixed interest rate swaps (a)

     293            10 yrs. 4 mos.    4.82     4.93  

Pay total return swaps designated to loans held for sale (a)

     150      2     1 mo.    NM     2.51  
    

  


                

Total commercial mortgage banking risk management

     443      2                   
    

  


                

Total accounting hedges (c)

   $ 6,455    $ 119                   
    

  


                
Free-Standing Derivatives                                 

Customer-related

                                

Interest rate

                                

Swaps

   $ 34,680    $ 22     3 yrs. 10 mos.    4.28 %   4.26 %

Caps/floors

                                

Sold

     696      (6 )   4 yrs. 8 mos.    NM     NM  

Purchased

     293      4     2 yrs. 11 mos.    NM     NM  

Futures

     1,946      2     1 yr.    NM     NM  

Foreign exchange

     11,421      2     5 mos.    NM     NM  

Equity

     2,161      (41 )   2 yrs. 4 mos.    NM     NM  

Swaptions

     864      (2 )   16 yrs. 4 mos.    NM     NM  

Other

     310      1     10 yrs 9 mos.    NM     NM  
    

  


                

Total customer-related

     52,371      (18 )                 
    

  


                

Other risk management and proprietary

                                

Interest rate

                                

Swaps

     4,528      3     8 yrs. 3 mos.    4.69     4.66  

Basis swaps

     1,219      2     2 yrs. 1 mo.    3.46     3.75  

Pay fixed swaps

     1,509      10     9 yrs. 11mos.    4.44     4.55  

Caps/floors

                                

Sold

     2,000      (3 )   1 yr. 4 mos.    NM     NM  

Purchased

     2,800      12     1 yr. 11 mos.    NM     NM  

Futures

     14,333      (1 )   1 yr. 6 mos.    NM     NM  

Credit derivatives

     539      (2 )   4 yrs. 6 mos.    NM     NM  

Risk participation agreements

     218            5 yrs. 6 mos.    NM     NM  

Commitments related to mortgage-related assets

     1,541      (10 )   3 mos.    NM     NM  

Options

                                

Eurodollar

     34,000      2     5 mos.    NM     NM  

Treasury notes/bonds

     110            2 mos.    NM     NM  

Swaptions

     12,247      21     5 yrs. 10 mos.    NM     NM  

Other

     75      (1 )   2 mos.    NM     NM  
    

  


                

Total other risk management and proprietary

     75,119      33                   
    

  


                

Total free-standing derivatives

   $ 127,490    $ 15                   
    

  


                

(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of a notional amount, 54% were based on 1-month LIBOR, 46% on 3-month LIBOR.

(b) Interest rate caps with a notional amount of $4 million require the counterparty to pay the Corporation the excess, if any, of the Prime Rate over a weighted-average strike of 5.03%. At March 31, 2005 the Prime Rate was 5.75%.

(c) Fair value amounts include accrued interest of $47 million.

NM-Not meaningful

 

33


Table of Contents
Financial Derivatives - 2004                                 
    

Notional

Amount


  

Fair Value


   

Weighted-

Average

Maturity


  

Weighted-Average

Interest Rates


 

December 31, 2004 - dollars in millions


           Paid

    Received

 
Accounting Hedges                                 

Interest rate risk management

                                

Asset rate conversion

                                

Interest rate swaps (a)

                                

Receive fixed

   $ 360    $ (1 )   5 yrs. 1 mo.    3.97 %   3.72 %

Pay fixed

     12            3 yrs. 1 mo.    3.68     3.69  

Interest rate caps (b)

     4            5 yrs. 3 mos.    NM     NM  

Futures contracts

     124            2 yrs.    NM     NM  
    

  


                

Total asset rate conversion

     500      (1 )                 
    

  


                

Liability rate conversion

                                

Interest rate swaps (a)

                                

Receive fixed

     3,745      215     7 yrs. 5 mos.    4.12     5.64  
    

  


                

Total interest rate risk management

     4,245      214                   
    

  


                

Commercial mortgage banking risk management

                                

Pay fixed interest rate swaps (a)

     195      (4 )   10 yrs. 4 mos.    4.79     4.66  

Pay total return swaps designated to loans held for sale (a)

     75      (1 )        NM     1.98  
    

  


                

Total commercial mortgage banking risk management

     270      (5 )                 
    

  


                

Total accounting hedges (c)

   $ 4,515    $ 209                   
    

  


                
Free-Standing Derivatives                                 

Customer-related

                                

Interest rate

                                

Swaps

   $ 32,339    $ 18     3 yrs. 9 mos.    3.91 %   3.90 %

Caps/floors

                                

Sold

     698      (8 )   3 yrs. 8 mos.    NM     NM  

Purchased

     452      7     2 yrs. 5 mos.    NM     NM  

Futures

     3,014      1     1 yr.    NM     NM  

Foreign exchange

     7,245      10     6 mos.    NM     NM  

Equity

     2,186      (29 )   2 yrs. 4 mos.    NM     NM  

Swaptions

     644            17 yrs. 11mos.    NM     NM  

Other

     330      1     10 yrs. 9 mos.    NM     NM  
    

                         

Total customer-related

     46,908                          
    

                         

Other risk management and proprietary

                                

Interest rate

                                

Swaps

     4,347      (2 )   7 yrs. 10 mos.    4.29     4.30  

Basis swaps

     1,064      2     1 yr. 1 mo.    3.04     3.15  

Pay fixed swaps

     1,204      (10 )   10 yrs. 7 mos.    4.37     4.41  

Futures

     9,329            2 yrs. 4 mos.    NM     NM  

Credit derivatives

     359      (4 )   4 yrs. 5 mos.    NM     NM  

Risk participation agreements

     230            6 yrs. 8 mos.    NM     NM  

Commitments related to mortgage-related assets

     782      1     2 mos.    NM     NM  

Options

                                

Eurodollar

     27,750      2     4 mos.    NM     NM  

Treasury notes/bonds

     890      (2 )   2 mos.    NM     NM  

Swaptions

     9,589      (1 )   5 yrs. 10 mos.    NM     NM  

Other

     45            4 mos.    NM     NM  
    

  


                

Total other risk management and proprietary

     55,589      (14 )                 
    

  


                

Total free-standing derivatives

   $ 102,497    $ (14 )                 
    

  


                

(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of a notional amount, 38% were based on 1-month LIBOR, 62% on 3-month LIBOR.
(b) Interest rate caps with a notional amount of $4 million require the counterparty to pay the Corporation the excess, if any, of the Prime Rate over a weighted-average strike of 5.03%. At December 31, 2004, the Prime Rate was 5.25%.
(c) Fair value amounts include accrued interest of $45 million.

NM - Not meaningful

 

34


Table of Contents

INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES

 

As of March 31, 2005, we performed an evaluation under the supervision and with the participation of our management, including the Chairman and Chief Executive Officer and the Vice Chairman and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures and of changes in our internal control over financial reporting.

 

Based on that evaluation, our management, including the Chairman and Chief Executive Officer and the Vice Chairman and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of March 31, 2005, and that there has been no change in internal control over financial reporting that occurred during the first quarter of 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

GLOSSARY OF TERMS

 

Accounting/administration net fund assets - Net domestic and foreign fund investment assets for which we provide accounting and administration services. We do not include these assets on our Consolidated Balance Sheet.

 

Adjusted average total assets - Primarily comprised of total average quarterly assets plus (less) unrealized losses (gains) on available-for-sale debt securities, less goodwill and certain other intangible assets.

 

Annualized - Adjusted to reflect a full year of activity.

 

Assets under management - Assets over which we have sole or shared investment authority for our customers/clients. We do not include these assets on our Consolidated Balance Sheet.

 

Capital - Represents the amount of resources that a business segment should hold to guard against potentially large losses that could cause insolvency. It is based on a measurement of economic risk, as opposed to risk as defined by regulatory bodies or generally accepted accounting principles. The economic capital measurement process involves converting a risk distribution to the capital that is required to support the risk, consistent with an institution’s target credit rating. As such, economic risk serves as a “common currency” of risk that allows an institution to compare different risks on a similar basis.

 

Charge-off - Process of removing a loan or portion of a loan from a bank’s balance sheet because the loan is considered uncollectible. A charge-off is also recorded when a loan is transferred to held for sale and the loan’s market value is less than its carrying amount.

 

Common shareholders’ equity to total assets - Common shareholders’ equity divided by total assets. Common shareholders’ equity equals total shareholders’ equity less preferred stock and the portion of capital surplus and retained interest related to the preferred stock.

 

Credit derivatives - Contractual agreements that provide protection against a credit event of one or more referenced credits. The nature of a credit event is established by the protection buyer and protection seller at the inception of a transaction, and such events include bankruptcy, insolvency and failure to meet payment obligations when due. The buyer of the credit derivative pays a periodic fee in return for a payment by the protection seller upon the occurrence, if any, of a credit event.

 

Custody assets - All investment assets held on behalf of clients under safekeeping arrangements. We do not include these assets on our Consolidated Balance Sheet. Investment assets held in custody at other institutions on our behalf are included in the appropriate asset categories on the Consolidated Balance Sheet as if physically held by us.

 

Derivatives - Financial contracts whose value is derived from publicly traded securities, interest rates, currency exchange rates or market indices. Derivatives cover a wide assortment of financial contracts, including forward contracts, futures, options and swaps.

 

Earning assets - Assets that generate income, which include: federal funds sold; resale agreements; other short-term investments, including trading securities; loans held for sale; loans, net of unearned income; securities; and certain other assets.

 

Economic value of equity (“EVE”) - The present value of the expected cash flows of our existing assets less the present value of the expected cash flows of our existing liabilities, plus the present value of the net cash flows of our existing off-balance sheet positions.

 

Effective duration - A measurement, expressed in years, that, when multiplied by a change in interest rates, would approximate the percentage change in value of on- and off-balance sheet positions.

 

Efficiency - Noninterest expense divided by the sum of net interest income and noninterest income.

 

Foreign exchange contracts - Contracts that provide for the future receipt and delivery of foreign currency at previously agreed-upon terms.

 

Funds transfer pricing - A management accounting methodology designed to recognize the net interest income effects of sources and uses of funds provided by the assets and liabilities of business segments. These balances are assigned funding rates that represent the interest cost for us to raise/invest funds with similar maturity and repricing structures, using the least-cost funding sources available.

 

Futures and forward contracts - Contracts in which the buyer agrees to purchase and the seller agrees to deliver a specific financial instrument at a predetermined price or yield. May be settled either in cash or by delivery of the underlying financial instrument.

 

35


Table of Contents

Institutional lending repositioning - A 2001 PNC strategic action taken to build a more diverse and valuable business mix designed to create shareholder value over time by reducing lending leverage and improving the risk/return characteristics of the banking business.

 

Interest rate floors and caps - Interest rate protection instruments that involve payment from the seller to the buyer of an interest differential, which represents the difference between a short-term rate (e.g., three-month LIBOR) and an agreed-upon rate (the strike rate) applied to a notional principal amount.

 

Interest rate swap contracts - Contracts that are entered into primarily as an asset/liability management strategy to reduce interest rate risk. Interest rate swap contracts are exchanges of interest rate payments, such as fixed-rate payments for floating-rate payments, based on notional principal amounts.

 

Leverage ratio - Tier 1 risk-based capital divided by adjusted average total assets.

 

Net interest margin - Annualized taxable-equivalent net interest income divided by average earning assets.

 

Nondiscretionary assets under administration - Assets we hold for our customers/clients in a non-discretionary, custodial capacity. We do not include these assets on our Consolidated Balance Sheet.

 

Noninterest income to total revenue - Total noninterest income divided by total revenue. Total revenue includes total noninterest income plus net interest income.

 

Nonperforming assets - Nonperforming assets include nonaccrual loans, troubled debt restructured loans, nonaccrual loans held for sale, foreclosed assets and other assets. Interest income does not accrue on assets classified as nonperforming.

 

Nonperforming loans - Nonperforming loans include loans to commercial, lease financing, consumer, commercial real estate and residential mortgage customers as well as troubled debt restructured loans. Nonperforming loans do not include nonaccrual loans held for sale or foreclosed and other assets. Interest income does not accrue on loans classified as nonperforming.

 

Notional amount - A number of currency units, shares, or other units specified in a derivatives contract.

 

Recovery - Cash proceeds received on a loan that had previously been charged off. The amount received is credited to the allowance for loan and lease losses.

 

Return on capital - Annualized net income divided by average capital.

 

Return on average assets - Annualized net income divided by average assets.

 

Return on average common equity - Annualized net income divided by average common shareholders’ equity.

 

Risk-weighted assets - Primarily computed by the assignment of specific risk-weights (as defined by The Board of Governors of the Federal Reserve System) to assets and off-balance sheet instruments.

 

Securitization - The process of legally transforming financial assets into securities.

 

Shareholders’ equity to total assets - Period-end total shareholders’ equity divided by period-end total assets.

 

Tangible common capital ratio - Common shareholders’ equity less goodwill and other intangible assets (excluding mortgage servicing rights) divided by total assets less goodwill and other intangible assets (excluding mortgage servicing rights).

 

Taxable-equivalent interest - The interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. In order to provide more meaningful comparisons of yields and margins for all earning assets, the interest income earned on tax-exempt assets is increased to make them fully equivalent to other taxable interest income investments.

 

Tier 1 risk-based capital - Tier 1 capital equals: total shareholders’ equity, plus trust preferred capital securities, plus certain minority interests that are held by others; less goodwill and certain intangible assets, less equity investments in nonfinancial companies and less net unrealized holding losses on available-for-sale equity securities. Net unrealized holding gains on available-for-sale equity securities, net unrealized holding gains (losses) on available-for-sale debt securities and net unrealized holding gains (losses) on cash flow hedge derivatives are excluded from total shareholders’ equity for tier 1 capital purposes.

 

Tier 1 risk-based capital ratio - Tier 1 risk-based capital divided by period-end risk-weighted assets.

 

Total fund assets serviced - Total domestic and foreign fund investment assets for which we provide related processing services. We do not include these assets on our Consolidated Balance Sheet.

 

Total deposits - The sum of total transaction deposits, savings accounts, certificates of deposit, other time deposits and deposits in foreign offices.

 

Total return swap - A non-traditional swap where one party agrees to pay the other the “total return” of a defined underlying asset (e.g., loan), usually in return for receiving a stream of LIBOR based cash flows. The total returns of the asset, including interest and any default shortfall, are passed through to the counterparty. The counterparty is therefore assuming the credit and economic risk of the underlying asset.

 

36


Table of Contents

Total risk-based capital - Tier 1 risk-based capital plus qualifying senior and subordinated debt, other minority interest not qualified as tier 1, and the allowance for loan and lease losses, subject to certain limitations.

 

Total risk-based capital ratio - Total risk-based capital divided by period-end risk-weighted assets.

 

Transaction deposits - The sum of money market and interest-bearing demand deposits and demand and other noninterest-bearing deposits.

 

Yield curve (shape of the yield curve, flat yield curve) - A graph showing the relationship between the yields on financial instruments or market indices of the same credit quality with different maturities. For example, a “normal” or “positive” yield curve exists when long-term bonds have higher yields than short-term bonds. A “flat” yield curve exists when yields are the same for short-term and long-term bonds. A “steep” yield curve exists when yields on long-term bonds are significantly higher than on short-term bonds.

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

 

We make statements in this Report, and we may from time to time make other statements, regarding our outlook or expectations for earnings, revenues, expenses and/or other matters regarding or affecting PNC that are forward-looking statements. Forward-looking statements are typically identified by words such as “believe,” “expect,” “anticipate,” “intend,” “outlook,” “estimate,” “forecast,” “project” and other similar words and expressions.

 

Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date they are made. We do not assume any duty and do not undertake to update our forward-looking statements. Actual results or future events could differ, possibly materially, from those that we anticipated in our forward-looking statements, and future results could differ materially from our historical performance.

 

In addition to factors that we have disclosed in our 2004 Annual Report on Form 10-K and in other SEC reports and those that we discuss elsewhere in this Report, our forward-looking statements are subject to, among others, the following risks and uncertainties, which could cause actual results or future events to differ materially from those that we anticipated in our forward-looking statements or from our historical performance:

 

    Changes in political, economic or industry conditions, the interest rate environment, or the financial and capital markets (including as a result of actions of the Federal Reserve Board affecting interest rates, the money supply, or otherwise reflecting changes in monetary policy), which could affect: (a) credit quality and the extent of our credit losses; (b) the extent of funding of our unfunded loan commitments and letters of credit; (c) our allowances for loan and lease losses and unfunded loan commitments and letters of credit; (d) demand for our credit or fee-based products and services; (e) our net interest income; (f) the value of assets under management and assets serviced, of private equity investments, of other debt and equity investments, of loans held for sale, or of other on-balance sheet or off-balance sheet assets; or (g) the availability and terms of funding necessary to meet our liquidity needs;

 

    The impact on us of legal and regulatory developments, including the following: (a) the resolution of legal proceedings or regulatory and other governmental inquiries; (b) increased litigation risk from recent regulatory and other governmental developments; (c) the results of the regulatory examination process, our failure to satisfy the requirements of agreements with governmental agencies, and regulators’ future use of supervisory and enforcement tools; (d) legislative and regulatory reforms, including changes to tax laws; and (e) changes in accounting policies and principles, with the impact of any such developments possibly affecting our ability to operate our businesses or our financial condition or results of operations or our reputation, which in turn could have an impact on such matters as business generation and retention, our ability to attract and retain management, liquidity and funding;

 

    The impact on us of changes in the nature or extent of our competition;

 

    The introduction, withdrawal, success and timing of our business initiatives and strategies;

 

    Customer acceptance of our products and services, and our customers’ borrowing, repayment, investment and deposit practices;

 

    The impact on us of changes in the extent of customer or counterparty delinquencies, bankruptcies or defaults, which could affect, among other things, credit and asset quality risk and our provision for credit losses;

 

    The ability to identify and effectively manage risks inherent in our businesses;

 

    How we choose to redeploy available capital, including the extent and timing of any share repurchases and acquisitions or other investments in our businesses;

 

    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;

 

37


Table of Contents
    The timing and pricing of any sales of loans or other financial assets held for sale;

 

    Our ability to obtain desirable levels of insurance and to successfully submit claims under applicable insurance policies;

 

    The relative and absolute investment performance of assets under management; and

 

    The extent of terrorist activities and international hostilities, increases or continuations of which may adversely affect the economy and financial and capital markets generally or us specifically.

 

We describe the risks and uncertainties presented by our pending acquisition of Riggs National Corporation and other acquisitions and similar transactions in the Risk Factors section of this Financial Review.

 

You can find additional information on the foregoing risks and uncertainties and additional factors that could affect results anticipated in our forward-looking statements or from our historical performance in our 2004 Annual Report on Form 10-K that we filed with the SEC. You can access our SEC reports on the SEC’s website at www.sec.gov or on or through the PNC corporate website at www.pnc.com.

 

Also, BlackRock’s SEC reports (accessible on the SEC’s website or on or through BlackRock’s website at www.blackrock.com) discuss in more detail those risks and uncertainties that involve BlackRock that could affect the results anticipated in forward-looking statements or from historical performance. You may review the BlackRock SEC reports for a more detailed discussion of those risks and uncertainties and additional factors as they may affect BlackRock.

 

38


Table of Contents

CONSOLIDATED INCOME STATEMENT

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Three months ended March 31 - in millions, except per share data

Unaudited


   2005

    2004

INTEREST INCOME               

Loans and fees on loans

   $ 578     $ 490

Securities available for sale and held to maturity

     173       145

Other

     53       31
    


 

Total interest income

     804       666
    


 

INTEREST EXPENSE               

Deposits

     182       104

Borrowed funds

     116       68
    


 

Total interest expense

     298       172
    


 

Net interest income

     506       494

Provision for credit losses

     8       12
    


 

Net interest income less provision for credit losses

     498       482
    


 

NONINTEREST INCOME               

Asset management

     314       253

Fund servicing

     220       204

Service charges on deposits

     59       59

Brokerage

     55       58

Consumer services

     66       63

Corporate services

     107       125

Equity management gains

     32       7

Net securities gains (losses)

     (9 )     15

Other

     129       127
    


 

Total noninterest income

     973       911
    


 

NONINTEREST EXPENSE               

Compensation

     479       389

Employee benefits

     83       74

Net occupancy

     73       68

Equipment

     74       74

Marketing

     20       20

Other

     270       270
    


 

Total noninterest expense

     999       895
    


 

Income before minority and noncontrolling interests and income taxes

     472       498

Minority and noncontrolling interests in income of consolidated entities

     6       7

Income taxes

     112       163
    


 

Net income

   $ 354     $ 328
    


 

EARNINGS PER COMMON SHARE               

Basic

   $ 1.26     $ 1.16

Diluted

   $ 1.24     $ 1.15
AVERAGE COMMON SHARES OUTSTANDING               

Basic

     281       282

Diluted

     284       284
    


 

See accompanying Notes to Consolidated Financial Statements.

 

39


Table of Contents

CONSOLIDATED BALANCE SHEET

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except par value
Unaudited


   March 31
2005


    December 31
2004


 
ASSETS                 

Cash and due from banks

   $ 2,908     $ 3,230  

Federal funds sold and resale agreements

     1,252       1,635  

Other short-term investments, including trading securities

     2,354       1,848  

Loans held for sale

     2,067       1,670  

Securities available for sale and held to maturity

     18,449       16,761  

Loans, net of unearned income of $872 and $902

     44,674       43,495  

Allowance for loan and lease losses

     (600 )     (607 )
    


 


Net loans

     44,074       42,888  

Goodwill

     2,976       3,001  

Other intangible assets

     613       354  

Other

     8,666       8,336  
    


 


Total assets

   $ 83,359     $ 79,723  
    


 


LIABILITIES                 

Deposits

                

Noninterest-bearing

   $ 12,808     $ 12,915  

Interest-bearing

     42,361       40,354  
    


 


Total deposits

     55,169       53,269  

Borrowed funds

                

Federal funds purchased

     995       219  

Repurchase agreements

     2,077       1,376  

Bank notes and senior debt

     3,662       2,383  

Subordinated debt

     3,988       4,050  

Commercial paper

     2,381       2,251  

Other borrowed funds

     1,411       1,685  
    


 


Total borrowed funds

     14,514       11,964  

Allowance for unfunded loan commitments and letters of credit

     78       75  

Accrued expenses

     2,288       2,406  

Other

     3,199       4,032  
    


 


Total liabilities

     75,248       71,746  
    


 


Minority and noncontrolling interests in consolidated entities

     532       504  
SHAREHOLDERS’ EQUITY                 

Preferred stock (a)

                

Common stock - $5 par value
Authorized 800 shares, issued 353 shares

     1,764       1,764  

Capital surplus

     1,275       1,265  

Retained earnings

     8,485       8,273  

Deferred compensation expense

     (42 )     (51 )

Accumulated other comprehensive loss

     (175 )     (54 )

Common stock held in treasury at cost: 70 and 70 shares

     (3,728 )     (3,724 )
    


 


Total shareholders’ equity

     7,579       7,473  
    


 


Total liabilities, minority and noncontrolling interests, and shareholders’ equity

   $ 83,359     $ 79,723  
    


 



(a) Less than $.5 million at each date.

 

See accompanying Notes to Consolidated Financial Statements.

 

40


Table of Contents

CONSOLIDATED STATEMENT OF CASH FLOWS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Three months ended March 31 - in millions

Unaudited


   2005

    2004

 
OPERATING ACTIVITIES                 

Net income

   $ 354     $ 328  

Adjustments to reconcile net income to net cash provided by operating activities

                

Provision for credit losses

     8       12  

Depreciation, amortization and accretion

     80       73  

Deferred income taxes

     (9 )     82  

Securities transactions

     9       (15 )

Valuation adjustments

     (2 )     (14 )

Net change in

                

Loans held for sale

     (398 )     (162 )

Other short-term investments

     (376 )     (527 )

Other

     (1,117 )     (1 )
    


 


Net cash used by operating activities

     (1,451 )     (224 )
    


 


INVESTING ACTIVITIES                 

Net change in

                

Loans

     (650 )     (334 )

Federal funds sold and resale agreements

     383       (103 )

Repayment of securities

     686       896  

Sales

                

Securities

     5,458       1,807  

Loans

     7          

Foreclosed and other nonperforming assets

     5       3  

Purchases

                

Securities

     (8,548 )     (3,183 )

Loans

     (551 )     (879 )

Net cash (paid) received for acquisitions/divestitures

     (243 )     (253 )

Other

     (9 )     (67 )
    


 


Net cash used by investing activities

     (3,462 )     (2,113 )
    


 


FINANCING ACTIVITIES                 

Net change in

                

Noninterest-bearing deposits

     (107 )     (13 )

Interest-bearing deposits

     2,007       616  

Federal funds purchased

     776       2,429  

Repurchase agreements

     701       168  

Commercial paper

     130       (292 )

Sales/issuances

                

Bank notes and senior debt

     1,299          

Subordinated debt

             6  

Other borrowed funds

     26,270       7,267  

Common stock

     45       60  

Repayments/maturities of other borrowed funds

     (26,349 )     (7,780 )

Acquisition of treasury stock

     (39 )     (164 )

Cash dividends paid

     (142 )     (141 )
    


 


Net cash provided by financing activities

     4,591       2,156  
    


 


NET (DECREASE) INCREASE IN CASH AND DUE FROM BANKS      (322 )     (181 )

Cash and due from banks at beginning of period

     3,230       2,968  
    


 


Cash and due from banks at end of period

   $ 2,908     $ 2,787  
    


 


CASH PAID FOR                 

Interest

   $ 263     $ 154  

Income taxes

     65       57  
NON-CASH ITEMS                 

Transfer from loans held for sale to loans, net

     3       28  

Transfer from loans to other assets

     4       11  
    


 


 

See accompanying Notes to Consolidated Financial Statements.

 

41


Table of Contents

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

THE PNC FINANCIAL SERVICES GROUP, INC.

 

BUSINESS

 

We are one of the largest diversified financial services companies in the United States, operating businesses engaged in:

 

    Regional community banking,

 

    Wholesale banking,

 

    Wealth management,

 

    Asset management, and

 

    Global fund processing services.

 

We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania, New Jersey, Delaware, Ohio and Kentucky. We also provide certain asset management and global fund processing services internationally. We are subject to intense competition from other financial services companies and are subject to regulation by various domestic and international authorities.

 

NOTE 1 ACCOUNTING POLICIES

 

BASIS OF FINANCIAL STATEMENT PRESENTATION

 

Our unaudited interim consolidated financial statements include the accounts of the parent company and its subsidiaries, most of which are wholly owned, and certain partnership interests and variable interest entities. We prepared these interim consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have eliminated all significant intercompany accounts and transactions. We have also reclassified certain prior period amounts to conform to the 2005 presentation. These reclassifications did not have a material impact on our consolidated financial condition or results of operations.

 

In our opinion, the consolidated financial statements reflect all normal, recurring adjustments needed to present fairly our results for the interim periods.

 

When preparing these consolidated financial statements, we have assumed that you have read the audited consolidated financial statements included in our 2004 Annual Report on Form 10-K.

 

Special Purpose Entities

 

Special purpose entities are broadly defined as legal entities structured for a particular purpose. We use special purpose entities in various legal forms to conduct normal business activities. Special purpose entities that meet the criteria for a Qualifying Special Purpose Entity (“QSPE”) as defined in Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” are not required to be consolidated. We review special purpose entities that are not QSPEs for consolidation in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (Revised 2003), “Consolidation of Variable Interest Entities” (“FIN 46R”).

 

In general, a variable interest entity (“VIE”) is a special purpose entity formed as a corporation, partnership, limited liability corporation, or any other legal structure used to conduct activities or hold assets that either:

 

    Does not have equity investors with voting rights that can directly or indirectly make decisions about the entity’s activities through those voting rights or similar rights, or

 

    Has equity investors that do not provide enough cash or other financial resources for the entity to support its activities.

 

A VIE often holds financial assets, including loans or receivables, real estate or other property.

 

We consolidate a VIE if we are considered to be the primary beneficiary. The primary beneficiary is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the entity’s residual returns, or both. Upon consolidation of a VIE, we generally record all of the VIE’s assets, liabilities and noncontrolling interests at fair value, with future changes based upon consolidation accounting principles. See Note 9 Variable Interest Entities for more information about VIEs in which we hold a significant interest but are not required to consolidate.

 

BUSINESS COMBINATIONS

 

We record the net assets of companies that we acquire at their estimated fair value at the date of acquisition and we include the results of operations of the acquired business in our consolidated income statement from the date of acquisition. We recognize as goodwill the excess of the purchase price over the estimated fair value of the net assets acquired.

 

USE OF ESTIMATES

 

We prepare the consolidated financial statements using financial information available at the time, which requires us to make estimates and assumptions that affect the amounts reported. Actual results will differ from these estimates and the differences may be material to the consolidated financial statements.

 

REVENUE RECOGNITION

 

We earn net interest and noninterest income from various sources, including:

 

    Lending,

 

    Securities portfolio,

 

    Investment management and fund servicing,

 

    Customer deposits,

 

    Loan servicing,

 

    Brokerage services, and

 

    Securities and derivatives trading activities including foreign exchange.

 

We also earn revenue from selling loans and securities, and we recognize income or loss from certain private equity activities. We also earn fees and commissions from:

 

    Issuing loan commitments, standby letters of credit and financial guarantees,

 

    Selling various insurance products,

 

    Providing treasury management services, and

 

    Participating in certain capital markets transactions.

 

42


Table of Contents

We recognize revenue from loan servicing, securities and derivatives and foreign exchange trading, and securities underwriting activities as they are earned based on contractual terms, as transactions occur or as services are provided. Revenue earned on interest-earning assets is recognized based on the effective yield of the financial instrument. Service charges on deposit accounts are recognized as charged. Brokerage fees and gains on the sale of securities and certain derivatives are recognized on a trade-date basis.

 

We recognize asset management and fund servicing fees primarily as the services are performed. Asset management fees are primarily based on a percentage of the fair value of the assets under management and performance fees are primarily based on a percentage of the returns on such assets. Fund servicing fees are primarily based on a percentage of the fair value of the fund assets and the number of shareholder accounts we service.

 

We recognize revenue from the sale of loans upon closing of the transaction. We record private equity income or loss based on changes in the valuation of the underlying investments or when we dispose of our interest.

 

In certain circumstances, revenue is reported net of associated expenses in accordance with applicable accounting guidance and industry practice.

 

LOANS AND LEASES

 

Loans are stated at the principal amounts outstanding, net of unearned income and premium or discount on loans purchased. Interest income related to loans other than nonaccrual loans is accrued based on the principal amount outstanding and credited to interest income as earned using the interest method. Significant loan fees are deferred and accreted to interest income over the respective lives of the loans. Loan origination costs are not deferred and are included in noninterest expense. The net impact of this practice compared with full accrual of fees and amortization of costs is not material to our consolidated results of operations.

 

We also provide financing for various types of equipment, aircraft, energy and power systems, and rolling stock through a variety of lease arrangements. Direct financing leases are carried at the aggregate of lease payments plus estimated residual value of the leased property, less unearned income. Leveraged leases, a form of financing lease, are carried net of nonrecourse debt. We recognize income over the term of the lease using methods that approximate the level yield method. Lease residual values are reviewed for other-than-temporary impairment on at least an annual basis. Gains or losses on the sale of leased assets are included in other noninterest income while valuation adjustments on lease residuals are included in other noninterest expense.

 

NONPERFORMING ASSETS

 

Nonperforming assets include:

 

    Nonaccrual loans,

 

    Troubled debt restructurings,

 

    Nonaccrual loans held for sale, and

 

    Foreclosed assets.

 

Other than consumer loans, we generally classify loans and loans held for sale as nonaccrual when we determine that the collection of interest or principal is doubtful or when a default of interest or principal has existed for 90 days or more, unless the loans are well secured and in the process of collection. When interest accrual is discontinued, accrued but uncollected interest credited to income in the current year is reversed and unpaid interest accrued in the prior year, if any, is charged against the allowance for loan and lease losses. We classify home equity loans as nonaccrual at 120 days past due and home equity lines of credit as nonaccrual at 180 days past due and record them at the lower of cost or market value, less liquidation costs, unless the loans are well-secured and in the process of collection. Loans well-secured by residential real estate, including home equity and home equity lines of credit, are classified as nonaccrual at 12 months past due. We charge-off loans other than consumer loans based on the facts and circumstances of the individual loan. Consumer loans that are not well-secured or in the process of collection are generally charged-off in the month they become 120 days past due.

 

A loan is categorized as a troubled debt restructuring in the period of restructuring if a significant concession is granted due to deterioration in the financial condition of the borrower.

 

Nonperforming loans are generally not returned to performing status until the obligation is brought current and the borrower has performed in accordance with the contractual terms for a reasonable period of time and collection of the contractual principal and interest is no longer doubtful.

 

Nonaccrual commercial and commercial real estate loans and troubled debt restructurings are designated as impaired loans. We recognize interest collected on these loans on the cash basis or cost recovery method.

 

Foreclosed assets are comprised of any asset seized or property acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure. These assets are recorded on the date acquired at the lower of the related loan balance or market value of the collateral less estimated disposition costs. We estimate market values primarily based on appraisals when available or quoted market prices on liquid assets. Subsequently, foreclosed assets are valued at the lower of the amount recorded at acquisition date or the current market value less estimated disposition costs. Valuation adjustments on these assets and gains or losses realized from disposition of such property are reflected in noninterest expense.

 

ALLOWANCE FOR LOAN AND LEASE LOSSES

 

We maintain the allowance for loan and lease losses at a level that we believe to be adequate to absorb estimated probable credit losses inherent in the loan portfolio. The allowance is increased by the provision for credit losses, which is charged against operating results, and decreased by the amount of charge-offs, net of recoveries. Our determination of the adequacy of the allowance is based on periodic evaluations of the credit portfolio and other relevant factors. This evaluation is inherently subjective as it requires material estimates, including, among others:

 

    Expected default probabilities,

 

    Loss given default,

 

    Exposure at default,

 

    Amounts and timing of expected future cash flows on impaired loans,

 

    Value of collateral,

 

    Estimated losses on consumer loans and residential mortgages, and

 

43


Table of Contents
    General amounts for historical loss experience, economic conditions, potential estimation or judgmental errors, losses and inherent risks in the various credit portfolios, all of which may be susceptible to significant change.

 

In determining the adequacy of the allowance for loan and lease losses, we make specific allocations to impaired loans, to pools of watchlist and nonwatchlist loans and to consumer and residential mortgage loans. We also allocate reserves to provide coverage for probable losses not covered in specific, pool and consumer reserve methodologies related to qualitative and measurement factors. While allocations are made to specific loans and pools of loans, the total reserve is available for all credit losses.

 

Specific allocations are made to significant impaired loans and are determined in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” with impairment measured generally based on the present value of the loan’s expected cash flows, the loan’s observable market price or the fair value of the loan’s collateral. We establish a minimum specific allowance on all impaired loans at the applicable pool reserve allocation rate for similar loans.

 

Allocations to loan pools are developed by business segment and risk rating and are based on historical loss trends and our judgment concerning those trends and other relevant factors. These factors may include, among others:

 

    Actual versus estimated losses,

 

    Regional and national economic conditions,

 

    Business segment and portfolio concentrations,

 

    Industry competition and consolidation, and

 

    The impact of government regulations.

 

Loss factors are based on industry and/or internal experience and may be adjusted for significant factors that, based on our judgment, impact the collectibility of the portfolio as of the balance sheet date. 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 our pool reserve methodologies strive to reflect all risk factors, there continues to be a certain element of uncertainty associated with, but not limited to, potential estimation or judgmental errors. We provide additional reserves that are designed to provide coverage for expected losses attributable to such risks. In addition, these incremental reserves also include factors which may not be directly measured in the determination of specific or pooled reserves. These factors include:

 

    General economic and business conditions affecting our key lending areas,

 

    Credit quality trends,

 

    Recent loss experience in particular segments of the portfolio,

 

    Duration of the current economic cycle, and

 

    Bank regulatory examination results.

 

ALLOWANCE FOR UNFUNDED LOAN COMMITMENTS AND LETTERS OF CREDIT

 

We maintain the allowance for unfunded loan commitments and letters of credit at a level we believe is adequate to absorb estimated probable losses related to these unfunded credit facilities. We determine the adequacy of the allowance based on periodic evaluations of the unfunded credit facilities including an assessment of the probability of commitment usage, credit risk factors for loans outstanding to these same customers, and the terms and expiration dates of the unfunded credit facilities. Net adjustments to the allowance for unfunded loan commitments and letters of credit are included in the provision for credit losses.

 

STOCK-BASED COMPENSATION

 

Prior to January 2003, we accounted for employee stock-based compensation plans under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related guidance. We did not recognize stock-based employee compensation expense related to stock options prior to 2003 as all options to purchase our stock or our subsidiaries’ stock granted under these plans had an exercise price equal to the market value of the underlying stock on the date of grant. Effective January 1, 2003, we adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” prospectively to all employee awards granted, modified or settled after January 1, 2003. We did not restate results for prior years. Since we adopted SFAS 123 prospectively, the cost related to stock-based employee compensation included in net income for the three months ended March 31, 2005 and 2004 is less than what we would have recognized if we had applied the fair value based method to all awards since the original effective date of the standard.

 

The following table shows the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123, as amended, to all outstanding and unvested awards in each period.

 

Pro Forma Net Income And Earnings Per Share

 

     Three months ended

 

In millions, except for
per share data


   March 31, 2005

    March 31, 2004

 

Net income as reported

   $ 354     $ 328  

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

     11       8  

Deduct: Total stock-based employee compensation expense determined under the fair value method for all awards, net of related tax effects

     (13 )     (13 )
    


 


Pro forma net income

   $ 352     $ 323  
    


 


Earnings per share

                

Basic-as reported

   $ 1.26     $ 1.16  

Basic-pro forma

   $ 1.25     $ 1.15  

Diluted-as reported

   $ 1.24     $ 1.15  

Diluted-pro forma

   $ 1.24     $ 1.13  
    


 


 

For purposes of computing stock option expense and pro forma results, we estimated the fair value of stock options and employee stock purchase plan shares using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are very subjective. Therefore, the pro forma results are estimates of results of operations as if compensation expense had been recognized for all stock-based compensation awards and are not indicative of the impact on future periods.

 

44


Table of Contents

We used the following assumptions in the option pricing model to determine 2005 and 2004 stock option expense.

 

Option Pricing Assumptions

 

Weighted-average for the three months
ended March 31


   2005

    2004

 

Risk-free interest rate

   3.7 %   3.4 %

Dividend yield

   3.8 %   3.6 %

Volatility

   26.4 %   28.9 %

Expected life

   5 yrs.     5 yrs.  
    

 

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In December 2004, the FASB issued SFAS 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R replaces SFAS 123 and supersedes APB 25. SFAS 123R requires compensation cost related to share-based payments to employees to be recognized in the financial statements based on their fair value. In April 2005, the Securities and Exchange Commission issued a rule which delays the required effective date to the beginning of an entity’s fiscal year which begins after June 15, 2005. Accordingly, we will adopt SFAS 123R effective January 1, 2006, using the modified prospective method of transition. This method requires the provisions of SFAS 123R be applied to new awards and awards modified, repurchased or cancelled after the effective date. Based on our review of the provisions of SFAS 123R and given the fact that we previously adopted the fair value recognition provisions of SFAS 123 on January 1, 2003, we do not expect the adoption of the revised standard to have a significant impact on our consolidated financial statements.

 

In December 2004, the FASB issued FASB Staff Position (“FSP”) 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisions within the American Jobs Creation Act of 2004.” The American Jobs Creation Act of 2004 (“AJCA”) was signed into law in October 2004 and creates a one-time opportunity for US companies to repatriate undistributed earnings from foreign subsidiaries at a substantially reduced federal tax rate. The reduced rate is achieved via an 85% dividends received deduction. FSP 109-2 provides entities additional time beyond the reporting period that includes the enactment date to assess the effect of AJCA on its plans for repatriation of foreign earnings.

 

In our case, foreign earnings must be repatriated by December 31, 2005 in order to qualify for this benefit. Two of our subsidiaries, BlackRock and PFPC, have foreign subsidiaries with undistributed earnings that may be available for repatriation. We are considering the repatriation of up to $17 million of foreign earnings, of which $15 million relates to BlackRock and $2 million relates to PFPC. The tax effect of repatriation could range from zero to a $1 million expense. We expect to complete our evaluation by the end of the second quarter of 2005.

 

In December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” SFAS 153 amends the APB 29 exception to fair value measurement for nonmonetary exchanges to apply only to those exchanges which lack commercial substance, as defined in the standard. SFAS 153 is effective for nonmonetary asset exchanges that we enter into in fiscal periods beginning after June 15, 2005. The adoption of this standard is not expected to have a material impact on our consolidated financial statements.

 

In March 2004, the Emerging Issues Task Force (“EITF”) supplemented EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance for evaluating whether an investment is other-than-temporarily impaired and requires disclosures about unrealized losses on available for sale debt and equity securities. In September 2004, the FASB issued FSP EITF Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue 03-1,” which deferred the effective date of the recognition and measurement provisions of the consensus until further guidance is issued. The impact on future earnings, if any, of the recognition and measurement provisions of EITF 03-1 will not be known until the FASB issues its guidance. At March 31, 2005, the total unrealized losses in the securities available for sale portfolio was $270 million compared with total unrealized losses of $125 million at December 31, 2004.

 

In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3, “Accounting for Loans and Debt Securities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an initial investment in loans or debt securities acquired in a transfer if those differences relate, at least in part, to a deterioration of credit quality. SOP 03-3 prohibits companies from carrying over valuation allowances in the initial accounting for such loans and limits the yield that may be accreted to the excess of undiscounted expected cash flows over the initial investment in the loan. Decreases in expected cash flows are recognized as impairment and increases are recognized prospectively through an adjustment of the loan yield. SOP 03-3 is effective for loans and debt securities acquired by PNC on or after January 1, 2005. Our adoption of this guidance did not have a significant effect on our financial condition or results of operations.

 

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” In November 2003, the FASB issued FSP 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” FSP 150-3 deferred indefinitely the classification and measurement provisions of SFAS 150 for certain mandatorily redeemable noncontrolling interests, including interests that are redeemed only upon the liquidation of a limited-life subsidiary. The mandatorily redeemable noncontrolling interests in these

 

45


Table of Contents

entities, which for PNC represent noncontrolling interests in affordable housing partnerships, are included in the consolidated balance sheet under the caption, “Minority and noncontrolling interests in consolidated entities.” Generally, on the date these VIEs are terminated, the liquidation value of the noncontrolling interests would equal the residual value of the net assets of the respective entity at that date. The distribution of that liquidation value to the noncontrolling interest holders would generally be in proportion to their respective interests. Liquidation and settlement of these noncontrolling interests at March 31, 2005 would have resulted in payments of approximately $233 million based on the terms of the respective entities’ governing documents and the measurement principles included in SFAS 150.

 

NOTE 2 ACQUISITIONS

 

RIGGS NATIONAL CORPORATION

 

On February 10, 2005, we entered into an amended and restated agreement to acquire Riggs National Corporation (“Riggs”), a Washington, D.C. based banking company, replacing the original acquisition agreement entered into July 16, 2004. Riggs has assets of approximately $6.0 billion and provides commercial and retail banking services through 51 branches in the metropolitan Washington, D.C. area. The transaction will give us a substantial presence on which to build a market leading franchise in the affluent Washington metropolitan area. The total consideration under the amended and restated agreement is comprised of a fixed number of approximately 6.4 million shares of PNC common stock and $286 million in cash, subject to adjustment. The merger has received regulatory and shareholder approval, but is subject to select remaining closing conditions including, among others, receipt of regulatory waivers. Our Current Reports on Form 8-K dated July 16, 2004, July 22, 2004 and February 10, 2005 provide additional information on this pending acquisition.

 

SSRM HOLDINGS INC.

 

Effective January 31, 2005, BlackRock acquired SSRM Holdings, Inc. (“SSRM”), the holding company of State Street Research & Management Company and SSR Realty Advisors Inc., from MetLife, Inc. SSRM, through its subsidiaries, actively manages stock, bond, balanced and real estate portfolios for both institutional and individual investors. Substantially all of SSRM’s operations were integrated into BlackRock as of the closing date. BlackRock acquired assets under management totaling $50 billion in connection with this transaction. At closing, MetLife, Inc. received approximately $233 million in cash and approximately 550,000 shares of BlackRock restricted class A common stock. Additional cash consideration, which could increase the purchase price by up to 25%, may be paid over five years contingent on certain measures.

 

On January 18, 2005, our ownership in BlackRock was transferred from PNC Bank, National Association to PNC Bancorp, Inc., our intermediate bank holding company. The transfer was effected primarily to give BlackRock more operating flexibility, particularly in connection with its acquisition of SSRM. As a result of the transfer, certain deferred tax liabilities recorded by PNC were reversed in the first quarter of 2005 in accordance with SFAS 109. The reversal of deferred tax liabilities increased our earnings by $45 million, or approximately $.16 per diluted share, in the first quarter of 2005.

 

In January 2005, BlackRock issued a bridge promissory note for $150 million, using the proceeds to facilitate the SSRM acquisition. In February 2005, BlackRock issued $250 million aggregate principal amount of convertible debentures. BlackRock used a portion of the net proceeds from this issuance to retire the bridge promissory note. These convertible debentures are included with bank notes and senior debt on our Consolidated Balance Sheet at March 31, 2005. Note 31 Subsequent Events in our 2004 Form 10-K includes further information on these convertible debentures.

 

NOTE 3 TRADING ACTIVITIES

 

Our trading activities include the underwriting of fixed income securities and equity securities, as well as customer-driven and proprietary trading in fixed income securities, equities, derivatives, and foreign exchange.

 

Total trading revenue includes both net interest income from trading securities and net funding of financial derivatives, and other noninterest income from securities underwriting, foreign exchange and gains or losses from changes in the fair value of financial derivatives positions that are not used for hedging purposes. Specific components of total trading revenue are as follows:

 

Three months ended March 31 – in millions


   2005

   2004

Net interest income

   $ 2    $ 2

Other noninterest income

     50      23
    

  

Total trading revenue

   $ 52    $ 25
    

  

Securities underwriting and trading

   $ 5    $ 10

Foreign exchange

     8      7

Financial derivatives

     39      8
    

  

Total trading revenue

   $ 52    $ 25
    

  

 

Trading assets and liabilities consisted of the following:

 

In millions


   March 31, 2005

   December 31, 2004

Assets

             

Securities (a)

   $ 1,804    $ 1,184

Resale agreements (b)

     252      624

Financial derivatives (c)

     722      661
    

  

Total assets

   $ 2,778    $ 2,469
    

  

Liabilities

             

Securities sold short (d)

   $ 597    $ 1,008

Repurchase agreements and

other borrowings (e)

     686      599

Financial derivatives (f)

     688      659
    

  

Total liabilities

   $ 1,971    $ 2,266
    

  


(a) Included in Other short-term investments, including trading securities, on the Consolidated Balance Sheet.
(b) Included in Federal funds sold and resale agreements.
(c) Included in Other assets.
(d) Included in Other borrowed funds.
(e) Included in Repurchase agreements and Other borrowed funds.
(f) Included in Other liabilities.

 

46


Table of Contents

NOTE 4 SECURITIES

 

In millions


  

Amortized

Cost


   Unrealized

   

Fair

Value


      Gains

   Losses

   

March 31, 2005 (a)

                            
SECURITIES AVAILABLE FOR SALE                             

Debt securities

                            

U.S. Treasury and government agencies

   $ 4,893           $ (63 )   $ 4,830

Mortgage-backed

     11,397    $ 2      (169 )     11,230

Commercial mortgage-backed

     1,026             (26 )     1,000

Asset-backed

     1,036             (10 )     1,026

State and municipal

     172      1      (2 )     171

Other debt

     34                     34
    

  

  


 

Total debt securities

     18,558      3      (270 )     18,291

Corporate stocks and other

     158                     158
    

  

  


 

Total securities available for sale

   $ 18,716    $ 3    $ (270 )   $ 18,449
    

  

  


 

December 31, 2004

                            
SECURITIES AVAILABLE FOR SALE                             

Debt securities

                            

U.S. Treasury and government agencies

   $ 4,735           $ (13 )   $ 4,722

Mortgage-backed

     8,506    $ 9      (82 )     8,433

Commercial mortgage-backed

     1,380      5      (15 )     1,370

Asset-backed

     1,910      5      (14 )     1,901

State and municipal

     175      2      (1 )     176

Other debt

     33                     33
    

  

  


 

Total debt securities

     16,739      21      (125 )     16,635

Corporate stocks and other

     123      2              125
    

  

  


 

Total securities available for sale

   $ 16,862    $ 23    $ (125 )   $ 16,760
    

  

  


 

SECURITIES HELD TO MATURITY                             

Debt securities: Asset-backed

   $ 1                   $ 1
    

                 

Total securities held to maturity

   $ 1                   $ 1
    

                 


(a) Securities held to maturity at March 31, 2005 totaled less than $1.0 million.

 

Securities represented 22% of total assets at March 31, 2005 and 21% at December 31, 2004. The increase in available for sale securities was primarily due to an increase in mortgage-backed securities, over half of which was in floating-rate securities, partially offset by decreases in commercial mortgage-backed and asset-backed securities.

 

At March 31, 2005, the securities available for sale balance included a net unrealized loss of $267 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2004 was a net unrealized loss of $102 million. The impact of increases in interest rates during the first quarter of 2005 was reflected in the higher net unrealized loss position at March 31, 2005.

 

We do not believe that any individual unrealized losses as of March 31, 2005 represent an other-than-temporary impairment. The $63 million unrealized losses reported for U.S Treasury and government agencies were primarily related to obligations of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). The $169 million unrealized losses reported for mortgage-backed securities relate primarily to securities issued by Fannie Mae, Freddie Mac and certain private issuers. The $26 million unrealized losses reported for commercial mortgage-backed securities relate primarily to fixed-rate securities of certain private issuers. The $10 million unrealized losses reported for asset-backed securities relate primarily to fixed-rate securities collateralized by home equity and automobile loans. The majority of the unrealized losses reported are attributable to changes in interest rates and not from the deterioration of the credit quality of the issuer.

 

The fair value of securities available for sale decreases when interest rates increase and vice versa. Further increases in interest rates after March 31, 2005, if sustained, will adversely impact the fair value of securities available for sale going forward compared with the balance March 31, 2005. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax.

 

During April 2005, the front-end of the yield curve rallied to a lesser extent than did intermediate-term interest rates. We expected that this market movement was not reflective of a potential rise in short-term interest rates given recent inflation trends and the expected Federal Open Market Committee tightening action on May 3, 2005.

 

47


Table of Contents

As a result, in late April 2005, we performed a balance sheet review and decided to adjust our securities and other earning assets positions to address the following objectives:

 

    Further reduce exposure to an anticipated rise in short-term interest rates, and

 

    Improve future net interest income levels without adding to duration risk.

 

To achieve these objectives, in late April and early May 2005, we sold $2.1 billion of securities available for sale and terminated $1.0 billion of resale agreements that were most sensitive to extension risk due to rising short-term interest rates. We also purchased $2.1 billion of securities with higher yields and lower extension risk. These transactions resulted in realized net securities and other losses of approximately $31 million, which will be included in our results of operations for the second quarter of 2005.

 

The expected weighted-average life of securities available for sale was 3 years and 3 months as of March 31, 2005 and 2 years and 8 months at December 31, 2004.

 

Information relating to securities sold is set forth in the following table:

 

Securities Sold

 

Three months ended

March 31

In millions


  Proceeds

 

Gross

Gains


 

Gross

Losses


   

Net

Gains

(Losses)


   

Income Tax

Expense/

(Benefit)


 
2005   $ 5,458   $ 11   $ (20 )   $ (9 )   $ (3 )
2004     1,807     19     (4 )     15       5  
   

 

 


 


 


 

 

NOTE 5 NONPERFORMING ASSETS

 

Nonperforming assets were as follows:

 

In millions


   March 31
2005


   December 31
2004


Nonperforming loans (a)

   $ 131    $ 143

Nonperforming loans held for sale (b)

     2      3

Foreclosed and other assets

     29      29
    

  

Total nonperforming assets (c)

   $ 162    $ 175
    

  


(a) Includes a troubled debt restructured loan of $3 million as of December 31, 2004.
(b) Includes troubled debt restructured loans held for sale of $2 million as of March 31, 2005 and December 31, 2004.
(c) Excludes equity management assets carried at estimated fair value of $33 million as of March 31, 2005 and $32 million as of December 31, 2004. These assets included troubled debt restructured assets of $10 million at March 31, 2005 and $11 million as of December 31, 2004.

 

NOTE 6 ALLOWANCES FOR LOAN AND LEASE LOSSES AND UNFUNDED LOAN COMMITMENTS AND LETTERS OF CREDIT

 

Changes in the allowance for loan and lease losses were as follows:

 

In millions


   2005

    2004

 

Allowance at January 1

   $ 607     $ 632  

Charge-offs

                

Commercial (a)

     (12 )     (59 )

Commercial real estate

             (2 )

Consumer

     (10 )     (11 )

Residential mortgage

             (1 )

Lease financing

             (2 )
    


 


Total charge-offs

     (22 )     (75 )
    


 


Recoveries

                

Commercial

     6       8  

Commercial real estate

                

Consumer

     4       3  

Residential mortgage

             1  

Lease financing

             1  
    


 


Total recoveries

     10       13  
    


 


Net charge-offs

                

Commercial

     (6 )     (51 )

Commercial real estate

             (2 )

Consumer

     (6 )     (8 )

Residential mortgage

                

Lease financing

             (1 )
    


 


Total net charge-offs

     (12 )     (62 )
    


 


Provision for credit losses

     8       12  

Acquired allowance (United National)

             22  

Net change in allowance for unfunded loan commitments and letters of credit

     (3 )        
    


 


Allowance at March 31

   $ 600     $ 604  
    


 



(a) During the first quarter of 2004, we changed our policy for recognizing charge-offs on smaller nonperforming commercial loans. This change resulted in the recognition of an additional $24 million of gross charge-offs for the first quarter of 2004.

 

Changes in the allowance for unfunded loan commitments and letters of credit were as follows:

 

In millions


   2005

   2004

Allowance at January 1

   $ 75    $ 91

Net change in allowance for unfunded loan commitments and letters of credit

     3       
    

  

Allowance at March 31

   $ 78    $ 91
    

  

 

48


Table of Contents

NOTE 7 GOODWILL AND OTHER INTANGIBLE ASSETS

 

A summary of the changes in goodwill by business for the three months ended March 31, 2005 follows:

 

Goodwill

 

In millions


  

December 31

2004


  

Additions/

Adjustments


   

March 31

2005


Regional Community Banking

   $ 991            $ 991

Wholesale Banking

     679              679

PNC Advisors

     153              153

BlackRock

     177    $ 10       187

PFPC

     945              945

Other

     56      (35 )     21
    

  


 

Total

   $ 3,001    $ (25 )   $ 2,976
    

  


 

 

BlackRock recorded $10 million of goodwill and $248 million of customer-related intangible assets described below in connection with its acquisition of SSRM in January 2005. See Note 2 Acquisitions for further information on the SSRM acquisition.

 

Our ownership of BlackRock continues to change primarily when BlackRock repurchases its shares in the open market and issues shares pursuant to its employee compensation plans. We recognize goodwill because BlackRock repurchases its shares at an amount greater than book value and this results in an increase in our percentage ownership interest. We reduced goodwill by $35 million in the first quarter of 2005 as a result of BlackRock’s stock activity, including the issuance of shares in the SSRM transaction.

 

The gross carrying amount, accumulated amortization and net carrying amount of other intangible assets by major category consisted of the following:

 

Other Intangible Assets

 

In millions


  

March 31

2005


   

December 31

2004


 

Customer-related and other intangibles

                

Gross carrying amount

   $ 463     $ 214  

Accumulated amortization

     (109 )     (102 )
    


 


Net carrying amount

   $ 354     $ 112  
    


 


Mortgage and other loan servicing rights

                

Gross carrying amount

   $ 424     $ 408  

Accumulated amortization

     (165 )     (166 )
    


 


Net carrying amount

   $ 259     $ 242  
    


 


Total

   $ 613     $ 354  
    


 


 

Most of our other intangible assets have finite lives and are amortized primarily on a straight-line basis or, in the case of mortgage and other loan servicing rights, on an accelerated basis. At December 31, 2004, we had two indefinite-lived other intangible assets included in “Customer-related and other intangibles” in the table above with a total carrying value of $4 million. In connection with the SSRM acquisition, BlackRock recorded $248 million of management contracts during the first quarter of 2005, of which approximately $196 million are considered to have indefinite lives.

 

For customer-related intangibles, the estimated remaining useful lives range from approximately one year to 20 years, with a weighted-average remaining useful life of approximately six years. Our mortgage and other loan servicing rights are amortized primarily over a period of seven to ten years in proportion to the estimated net servicing income from the related loans.

 

The changes in the carrying amount of goodwill and net other intangible assets for the three months ended March 31, 2005, are as follows:

 

Changes in Goodwill and Other Intangibles

 

In millions


   Goodwill

    Customer-
Related


   

Servicing

Rights


 

Balance at December 31, 2004

   $ 3,001     $ 112     $ 242  

Additions/adjustments:

                        

BlackRock acquisition of SSRM

     10       248          

BlackRock acquisition of Cigna management contracts

             1          

Other - BlackRock share repurchases

     (35 )                

Wholesale Banking

                     24  

Amortization

             (7 )     (7 )
    


 


 


Balance at March 31, 2005

   $ 2,976     $ 354     $ 259  
    


 


 


 

Amortization expense on intangible assets for the first quarter of 2005 was $14 million. Amortization expense on existing intangible assets for the remainder of 2005 and for 2006 through 2010 is estimated to be as follows:

 

    Remainder of 2005: $44 million

 

    2006: $56 million,

 

    2007: $54 million,

 

    2008: $52 million,

 

    2009: $45 million, and

 

    2010: $27 million.

 

NOTE 8 CASH FLOWS

 

Acquisition and divestiture activity during the first quarter of 2005 and 2004 that affected our cash flows included the following:

 

    BlackRock’s acquisition of SSRM in January 2005 resulted in $241 million of net cash paid.

 

    BlackRock’s acquisition of management contracts from Cigna resulted in $2 million of cash paid during the first quarter of 2005.

 

    Our acquisition of United National in January 2004 resulted in $336 million of cash paid and $72 million of cash and due from banks received.

 

    During the first quarter of 2004, we sold certain investment consulting activities of PNC Advisors’ Hawthorn unit, resulting in net cash proceeds of $11 million.

 

49


Table of Contents

NOTE 9 VARIABLE INTEREST ENTITIES

 

As discussed in our 2004 Form 10-K, we are involved with various entities in the normal course of business that may be deemed to be VIEs. We consolidated certain VIEs effective in 2004 and 2003 for which we were determined to be the primary beneficiary. These consolidated VIEs and relationships with PNC are described in our 2004 Form 10-K.

 

At March 31, 2005, the aggregate assets and debt of VIEs that we have consolidated in our financial statements are as follows:

 

Consolidated VIEs – PNC Is Primary Beneficiary

 

In millions


  

Aggregate

Assets


  

Aggregate

Debt


March 31, 2005

             

Market Street Funding Corporation

   $ 2,199    $ 2,199

Partnership interests in low income housing projects

     496      496

Other

     10      7
    

  

Total consolidated VIEs

   $ 2,705    $ 2,702
    

  

December 31, 2004

             

Market Street Funding Corporation

   $ 2,167    $ 2,167

Partnership interests in low income housing projects

     504      504

Other

     13      10
    

  

Total consolidated VIEs

   $ 2,684    $ 2,681
    

  

 

We also hold significant variable interests in other VIEs that have not been consolidated because we are not considered the primary beneficiary. Information on these VIEs follows:

 

Non-Consolidated VIEs – Significant Variable Interests

 

In millions


   Aggregate
Assets


   Aggregate
Debt


  

PNC Risk

of Loss(b)


March 31, 2005

                    

Collateralized debt obligations (a)

   $ 5,425    $ 4,988    $ 53

Private investment funds (a)

     3,111      486      13

Other partnership interests in low income housing projects

     37      28      4
    

  

  

Total significant variable interests

   $ 8,573    $ 5,502    $ 70
    

  

  

December 31, 2004

                    

Collateralized debt obligations (a)

   $ 3,152    $ 2,700    $ 33

Private investment funds (a)

     1,872      125      24

Other partnership interests in low income housing projects

     37      28      4
    

  

  

Total significant variable interests

   $ 5,061    $ 2,853    $ 61
    

  

  


(a) Held by BlackRock.
(b) Includes both PNC’s risk of loss and BlackRock’s risk of loss, limited to PNC’s ownership interest in BlackRock.

 

We also have subsidiaries that invest in and act as the investment manager for a private equity fund that is organized as a limited partnership as part of our equity management activities. The fund invests in private equity investments to generate capital appreciation and profits. As permitted by FIN 46, we have deferred applying the provisions of the interpretation for this entity pending further action by the FASB. Information on this entity follows:

 

Investment Company Accounting – Deferred Application

 

In millions


   Aggregate
Assets


   Aggregate
Equity


  

PNC Risk

of Loss


March 31, 2005

                    

Private Equity Fund

   $ 96    $ 96    $ 24
    

  

  

December 31, 2004

                    

Private Equity Fund

   $ 78    $ 76    $ 20
    

  

  

 

NOTE 10 CAPITAL SECURITIES OF SUBSIDIARY TRUSTS

 

Capital securities represent non-voting preferred beneficial interests in the assets of PNC Institutional Capital Trusts A and B, PNC Capital Trusts C and D, and United National Bank Capital Trust I and Capital Statutory Trust II (the “Trusts”). We have more information on the Trusts in Note 18 Capital Securities Of Subsidiary Trusts in our 2004 Form 10-K.

 

The United National Bank Trusts were acquired effective January 1, 2004 as part of the United National acquisition. In the event of certain changes or amendments to regulatory requirements or federal tax rules, the capital securities are redeemable in whole.

 

Trust A is a wholly owned finance subsidiary of PNC Bank, N.A., PNC’s principal bank subsidiary. All other Trusts are wholly owned finance subsidiaries of PNC. The obligations of the respective parent of each Trust, when taken collectively, are the equivalent of a full and unconditional guarantee of the obligations of such Trust under the terms of the Capital Securities. Such guarantee is subordinate in right of payment in the same manner as other junior subordinated debt. There are certain restrictions on PNC’s overall ability to obtain funds from its subsidiaries. For additional disclosure on these funding restrictions, including an explanation of dividend and intercompany loan limitations, see Note 4 Regulatory Matters in our 2004 Form 10-K.

 

50


Table of Contents

NOTE 11 CERTAIN EMPLOYEE BENEFIT AND STOCK-BASED COMPENSATION PLANS

 

Pension and Post-Retirement Plans

 

As more fully described in our 2004 Form 10-K, we have a noncontributory, qualified defined benefit pension plan covering eligible employees. Retirement benefits are derived from a cash balance formula based on compensation levels, age and length of service. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants.

 

We also maintain nonqualified supplemental retirement plans for certain employees. All retirement benefits provided under these plans are unfunded and we make any payments to plan participants. We also provide certain health care and life insurance benefits for qualifying retired employees (“post-retirement benefits”) through various plans.

 

The components of our net periodic pension and post-retirement benefit cost for the first quarter of 2005 and 2004 were as follows:

 

     Qualified
Pension Plan


    Nonqualified
Pension Plan


   Post-retirement
Benefits


 

Three months ended
March 31
In millions


   2005

    2004

    2005

   2004

   2005

    2004

 

Service cost

   $ 9     $ 10                   $ 1     $ 1  

Interest cost

     16       17     $ 1    $ 1      4       4  

Expected return on plan assets

     (31 )     (30 )                              

Amortization of prior service cost

                                   (2 )     (2 )

Recognized net actuarial loss

     6       6       1      1      1       2  
    


 


 

  

  


 


Net periodic cost

   $ —       $ 3     $ 2    $ 2    $ 4     $ 5  
    


 


 

  

  


 


 

2002 BlackRock Long-Term Retention and Incentive Plan

 

BlackRock’s long-term retention and incentive plan (“LTIP”) permits the grant of up to $240 million in deferred compensation awards (the “LTIP Awards”), subject to the achievement of certain performance hurdles by BlackRock no later than March 2007. If the performance hurdles are achieved, up to $200 million of the LTIP Awards will be funded with up to 4 million shares of BlackRock common stock to be surrendered by PNC and distributed to LTIP participants, less income tax withholding. Shares attributable to value in excess of our $200 million LTIP funding requirement will be available to support BlackRock’s future long-term retention and incentive programs but are not subject to surrender until the programs are approved by BlackRock’s Compensation Committee of its Board of Directors. In addition, shares distributed to LTIP participants will include an option to put such distributed shares back to BlackRock at fair market value. BlackRock will fund the remainder of the LTIP Awards with up to $40 million in cash. In general, LTIP participants must also be employed by BlackRock on the payment date in early 2007 to receive payment for an award. As of March 31, 2005 BlackRock had awarded approximately $234 million in LTIP Awards.

 

The LTIP Awards fully vest at the end of any three-month period beginning on or after January 1, 2005 and ending on or prior to March 30, 2007 during which the average closing price of BlackRock’s common stock is at least $62 per share. During the first quarter of 2005, BlackRock’s average closing stock price exceeded the $62 threshold. In addition, the vesting of awards is contingent on the participants’ continued employment with BlackRock for periods ranging from two to five years.

 

We reported pretax charges in the second half of 2004 totaling $110 million in connection with the LTIP, based upon management’s determination that full vesting of the LTIP Awards was probable as of September 30, 2004. Note 22 Stock-Based Compensation Plans included in our 2004 Form 10-K provides additional information on these charges.

 

We reported pretax charges of $15 million in the first quarter of 2005 related to the LTIP Awards. We expect to report additional pretax charges of approximately $16 million per quarter through December 2006 related to the remaining service period of the LTIP Awards granted to date.

 

51


Table of Contents

NOTE 12 FINANCIAL DERIVATIVES

 

We use a variety of derivative financial instruments to help manage interest rate risk and reduce the effects that changes in interest rates may have on net income, fair value of assets and liabilities, and cash flows caused by interest rate volatility. These instruments include interest rate swaps, interest rate caps and floors, future contracts, and total return swaps.

 

Fair Value Hedging Strategies

 

We enter into interest rate and total return swaps, caps, floors and interest rate futures derivative contracts to hedge designated commercial mortgage loans held 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 interest income, interest expense or noninterest income depending on the hedged item.

 

Cash Flow Hedging Strategy

 

We enter 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. We are hedging our exposure to the variability of future cash flows for all forecasted transactions for a maximum of 10 years for hedges converting floating-rate commercial loans to fixed. The fair value of these derivatives is reported in other assets or other liabilities and offset in accumulated other comprehensive income for the effective portion of the derivatives. When the hedged transaction culminates, any unrealized gains or losses related to these swap contracts are reclassified from accumulated other comprehensive income and into earnings in the same period or periods during which the hedged forecasted transaction affects earnings are included in interest income. Ineffectiveness of the strategy, as defined by risk management policies and procedures, if any, is reported in interest income.

 

During the next twelve months, we expect to reclassify to earnings $3.3 million of pretax net gains, or $2.2 million after-tax, on cash flow hedge derivatives currently reported in accumulated other comprehensive income. This amount could differ from amounts actually recognized due to changes in interest rates and the addition of other hedges subsequent to March 31, 2005. These net gains are anticipated to result from net cash flows on receive fixed interest rate swaps and would mitigate reductions in interest income recognized on the related floating rate commercial loans.

 

As of March 31, 2005 we have determined that there were no hedging positions where it was probable that certain forecasted transactions may not occur within the originally designated time period.

 

If a derivative is not effective in accomplishing the hedge objective of offsetting either changes in the fair value or cash flows of the hedged item for the risk being hedged, then any ineffectiveness present in the hedge relationship is recognized in current earnings. The ineffective portion of the change in value of these derivatives resulted in a minimal net loss for the three months ended March 31, 2005 compared with net loss of $2 million in the same period of 2004.

 

Free-Standing Derivatives

 

To accommodate customer needs, we also enter into financial derivative transactions primarily consisting of interest rate swaps, caps, floors and foreign exchange and equity contracts. We manage our market risk exposure from customer positions through transactions with third-party dealers. The credit risk associated with derivatives executed with customers is essentially the same as that involved in extending loans and is subject to normal credit policies. We may obtain collateral based on our assessment of the customer.

 

Basis swaps are agreements involving the exchange of payments, based on notional amounts, of two floating rate financial instruments denominated in the same currency, one pegged to one reference rate and the other tied to a second reference rate (e.g., swapping payments tied to one-month LIBOR for payments tied to three-month LIBOR). We use these contracts to mitigate the impact on earnings of exposure to a certain referenced interest rate.

 

We purchase credit default swaps to mitigate the economic impact of credit losses on specifically identified existing lending relationships. These derivatives typically are based upon the change in value, due to changing credit spreads, of publicly-issued bonds issued by our customer.

 

Interest rate lock commitments for, as well as commitments to buy or sell, mortgage loans that we intend to sell are considered free-standing derivatives. Our interest rate exposure on certain commercial mortgage interest rate lock commitments is economically hedged with pay-fixed interest rate swaps and forward sales agreements. These contracts mitigate the impact on earnings of exposure to a certain referenced rate.

 

Free-standing derivatives also include positions we take based on market expectations or to benefit from price differentials between financial instruments and the market based upon stated risk management objectives.

 

Derivative Counterparty Credit Risk

 

By purchasing and writing derivative contracts we are exposed to credit risk if the counterparties fail to perform. Our credit risk is equal to the fair value gain in the derivative contract. We minimize credit risk through credit approvals, limits, monitoring procedures and collateral requirements. We generally enter into transactions with counterparties that carry high quality credit ratings.

 

We enter into risk participation agreements to share some of the credit exposure with other counterparties related to interest rate derivative contracts or to take on credit exposure to generate revenue. Risk participation agreements entered into prior to July 1, 2003 were

 

52


Table of Contents

considered financial guarantees and therefore not included in derivatives. Agreements entered into subsequent to June 30, 2003 are included in the derivative table that follows. We determine that we meet our objective of reducing credit risk associated with certain counterparties to derivative contracts when the participation agreements share in their proportional credit losses of those counterparties.

 

We generally have established agreements with our major derivative dealer counterparties that provide for exchanges of marketable securities or cash to collateralize either party’s positions. At March 31, 2005 we held cash and U.S. government and mortgage-backed securities with a fair value of $127 million and pledged U.S. agency and mortgage-backed securities with a fair value of $138 million under these agreements.

 

The total notional or contractual amounts, estimated net fair value and credit risk for derivatives at March 31, 2005 and December 31, 2004 were as follows:

 

     March 31, 2005

   December 31, 2004

In millions


  

Notional

amount


  

Estimated

net fair

value


    Credit risk

   Notional
amount


   Estimated
net fair
value


    Credit risk

ACCOUNTING HEDGES                                            

Fair value hedges

   $ 4,995    $ 135     $ 147    $ 4,155    $ 210     $ 217

Cash flow hedges

     1,460      (16 )            360      (1 )      
    

  


 

  

  


 

Total

   $ 6,455    $ 119     $ 147    $ 4,515    $ 209     $ 217
    

  


 

  

  


 

FREE-STANDING DERIVATIVES                                            

Interest rate contracts

   $ 64,004    $ 45     $ 380    $ 52,447    $ 8     $ 385

Equity contracts

     2,161      (41 )     138      2,186      (29 )     123

Foreign exchange contracts

     11,421      2       74      7,245      10       79

Credit contracts

     539      (2 )     1      359      (4 )      

Options

     47,221      21       118      38,873      (1 )     103

Risk participation agreements

     218                     230               

Commitments related to mortgage-related assets

     1,541      (10 )     2      782      1       3

Other

     385              9      375      1       6
    

  


 

  

  


 

Total

   $ 127,490    $ 15     $ 722    $ 102,497    $ (14 )   $ 699
    

  


 

  

  


 

 

 

53


Table of Contents

NOTE 13 EARNINGS PER SHARE

 

Basic and diluted earnings per common share calculations follow:

 

Three months ended March 31
In millions, except share and per share data


   2005

   2004

CALCULATION OF BASIC EARNINGS PER COMMON SHARE              

Net income applicable to basic earnings per common share (a)

   $ 354    $ 328

Basic weighted-average common shares outstanding (in thousands)

     281,291      282,237
    

  

Basic earnings per common share

   $ 1.26    $ 1.16
    

  

CALCULATION OF DILUTED EARNINGS PER COMMON SHARE (b)              

Net income

   $ 354    $ 328

Less: BlackRock adjustment for common stock equivalents

     1      1
    

  

Net income applicable to diluted earnings per common share

   $ 353    $ 327

Basic weighted-average common shares outstanding (in thousands)

     281,291      282,237

Conversion of preferred stock Series A and B

     82      87

Conversion of preferred stock Series C and D

     632      695

Conversion of debentures

     2      13

Exercise of stock options

     873      1,054

Incentive share awards

     1,087      372
    

  

Diluted weighted-average common shares outstanding (in thousands)

     283,967      284,458
    

  

Diluted earnings per common share

   $ 1.24    $ 1.15
    

  


             

(a)    Preferred dividends declared were less than $.5 million for each period.

             

(b)    Excludes stock options considered to be anti-dilutive (in thousands)

     13,103      7,915

 

54


Table of Contents

NOTE 14 SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

 

Activity in shareholders’ equity for the first three months of 2005 follows. Our preferred stock outstanding as of March 31, 2005 and December 31, 2004 totaled less than $.5 million at each date and, therefore, is excluded from the table.

 

In millions, except per
share data


  

Shares
Outstanding

Common
Stock


   Common
Stock


   Capital
Surplus


    Retained
Earnings


    Deferred
Compen-
sation
Expense


    Accumulated Other
Comprehensive Loss


   

Treasury

Stock


    Total

 

Balance at December 31, 2004

   283    $ 1,764    $ 1,265     $ 8,273     $ (51 )   $ (54 )   $ (3,724 )   $ 7,473  

Net income

                         354                               354  

Other comprehensive income (loss), net of tax

                                                            

Net unrealized securities losses

                                         (105 )             (105 )

Net unrealized losses on cash flow hedge derivatives

                                         (14 )             (14 )

Other (a)

                                         (2 )             (2 )
                                                        


Comprehensive income

                                                         233  
                                                        


Cash dividends declared

                                                            

Common ($.50 per share)

                         (142 )                             (142 )

Preferred

                                                            

Treasury stock activity

                 9                               (4 )     5  

Tax benefit of stock option plans

                 2                                       2  

Stock options granted

                 7                                       7  

Subsidiary stock transactions

                 (8 )                                     (8 )

Deferred compensation expense

                                 9                       9  
    
  

  


 


 


 


 


 


Balance at March 31, 2005

   283    $ 1,764    $ 1,275     $ 8,485     $ (42 )   $ (175 )   $ (3,728 )   $ 7,579  
    
  

  


 


 


 


 


 


 

A summary of the components of the change in accumulated other comprehensive income (loss) follows:

 

Three months ended March 31, 2005

In millions


   Pretax Amount

    Tax Benefit (Expense)

   After-tax Amount

 

Change in net unrealized securities losses

                       

Increase in net unrealized losses on securities held at period end

   $ (165 )   $ 58    $ (107 )

Less: Net losses realized in net income (b)

     (3 )     1      (2 )
    


 

  


Change in net unrealized securities losses

     (162 )     57      (105 )
    


 

  


Change in net unrealized losses on cash flow hedge derivatives

                       

Increase in net unrealized losses on cash flow hedge derivatives

     (20 )     7      (13 )

Less: Net gains realized in net income

     1              1  
    


 

  


Change in net unrealized losses on cash flow hedge derivatives

     (21 )     7      (14 )
    


 

  


Other (a)

     (3 )     1      (2 )
    


 

  


Other comprehensive loss

   $ (186 )   $ 65    $ (121 )
    


 

  


 

The accumulated balances related to each component of other comprehensive income (loss) are as follows:

 

     March 31, 2005

    December 31, 2004

 

In millions


   Pretax

    After-tax

    Pretax

    After-tax

 

Net unrealized securities losses

   $ (264 )   $ (171 )   $ (102 )   $ (66 )

Net unrealized gains (losses) on cash flow hedge derivatives

     (12 )     (8 )     9       6  

Other (a)

     6       4       9       6  
    


 


 


 


Accumulated other comprehensive loss

   $ (270 )   $ (175 )   $ (84 )   $ (54 )
    


 


 


 



(a) Consists of interest-only strip valuation adjustments, foreign currency translation adjustments and minimum pension liability adjustments.
(b) The pretax amount represents net unrealized losses at December 31, 2004 that were realized in 2005 when the related securities were sold. This amount differs from net securities losses included in the Consolidated Income Statement primarily because it does not include gains or losses realized on securities that were purchased and then sold during 2005.

 

55


Table of Contents

NOTE 15 LEGAL PROCEEDINGS

 

There are several pending judicial or administrative proceedings or other matters arising out of the three 2001 transactions (the “PAGIC transactions”) that gave rise to a financial statement restatement that we announced in January 2002. In December 2004, we entered into settlement agreements relating to certain of the lawsuits and other claims arising out of the PAGIC transactions. These pending proceedings and settlement agreements are described in our 2004 Annual Report on Form 10-K under Item 3. We are making progress towards completing those aspects of the settlement agreements that remain subject to conditions. In particular, the United States District Court for the Western District of Pennsylvania has scheduled a hearing on August 4, 2005 in the consolidated class action lawsuit brought on behalf of certain purchasers of our common stock to determine whether to approve the proposed settlement agreement.

 

In January 2005, we settled with one of our insurers under our Executive Blended Risk insurance coverage, and in March 2005, we settled with another of these insurers with respect to our claim related to our contribution of $90 million to the Restitution Fund established under our June 2003 Deferred Prosecution Agreement with the United States Department of Justice pertaining to the PAGIC transactions. (These settlements were in addition to the settlement with an insurer in December 2004 as described in our Form 10-K). Under the January settlement, the insurer made a payment to us of $4.5 million. Under the March settlement, the insurer has paid us $11.25 million, but we are obligated to return this amount if the settlement of the consolidated class action referred to above does not receive court approval, does not become effective or becomes unenforceable. Each of the amounts in these settlements represents a portion of the insurer’s share of our overall claim against our insurers with respect to any amounts disbursed out of the Restitution Fund. We are preserving our claim against our insurers with whom we have not settled. The amount of the January settlement was recognized in our income statement for the first quarter of 2005. The amount of the March settlement will not be recognized until the potential obligation to return the funds described above has been eliminated.

 

Some of our subsidiaries are defendants (or have potential contractual contribution obligations to other defendants) in several pending lawsuits brought during late 2002 and 2003 arising out of the bankruptcy of Adelphia Communications Corporation. There also are threatened additional proceedings arising out of the same matters. One of the lawsuits is pending in the United States Bankruptcy Court for the Southern District of New York and has been brought on Adelphia’s behalf as an adversary proceeding by the unsecured creditors’ committee in Adelphia’s bankruptcy proceeding. A motion to intervene on behalf of the equity committee is also pending in this case. The other lawsuits (one of which is a putative consolidated class action) have been brought by holders of debt and equity securities of Adelphia and have been consolidated for pretrial purposes in the United States District Court for the Southern District of New York. These lawsuits arise out of lending and securities underwriting activities engaged in by these PNC subsidiaries together with other financial services companies. In the aggregate, more than 400 other financial services companies and numerous other companies and individuals have been named as defendants in one or more of the lawsuits. Collectively, with respect to some or all of the defendants, the lawsuits allege violations of federal securities laws, violations of common law duties, aiding and abetting such violations, voidable preference payments, and fraudulent transfers, among other matters. The lawsuits seek unquantified monetary damages, interest, attorneys’ fees and other expenses, and a return of the alleged voidable preference and fraudulent transfer payments, among other remedies. We believe that we have substantial defenses to the claims against us in these lawsuits and intend to defend them vigorously. These lawsuits are currently in initial stages and present complex issues of law and fact. As a result, we are not currently capable of evaluating our exposure, if any, resulting from these lawsuits.

 

On April 29, 2005, an amended complaint was filed in the putative class action against PNC; PNC Bank; our Pension Plan and its Pension Committee in the United States District Court for the Eastern District of Pennsylvania (originally filed in December 2004). The complaint claims violations of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), arising out of the January 1, 1999 conversion of our Pension Plan from a traditional defined benefit formula into a “cash balance” formula, the design and continued operation of the Plan, and other related matters. Plaintiffs seek to represent a class of all current and former employee-participants in and beneficiaries of the Plan as of December 31, 1998 and thereafter. Plaintiffs also seek to represent a subclass of all current and former employee-participants in and beneficiaries of the Plan as of December 31, 1998 and thereafter who were or would have become eligible for an early retirement subsidy under the former Plan at some time prior to the date of the amended complaint. The plaintiffs are seeking damages and equitable relief available under ERISA, including interest, costs, and attorneys’ fees. We believe that we have substantial defenses to the claims against us in this lawsuit and intend to defend it vigorously.

 

In addition to the proceedings or other matters referred to above, PNC and persons to whom we may have indemnification obligations, in the normal course of business, are subject to various other pending and threatened legal proceedings in which claims for monetary damages and other relief are asserted. Management does not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of such other legal proceedings will have a material adverse effect on our financial position. However, we cannot now determine whether or not any claims asserted against us, whether in the proceedings or other matters specifically described above or otherwise, will have a material adverse effect on our results of operations in any future reporting period.

 

56


Table of Contents

NOTE 16 SEGMENT REPORTING

 

We operate five major businesses engaged in providing banking, asset management and global fund processing products and services. Banking businesses include regional community banking (consumer/small business), wholesale banking (corporate/institutional) and wealth management.

 

Assets, revenue and earnings attributable to foreign activities were not material in the periods presented.

 

Results of individual businesses are presented based on our management accounting practices and our operating structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses change. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis.

 

Assets receive a funding charge and liabilities and capital receive a funding credit based on a transfer pricing methodology that incorporates product maturities, duration and other factors. Capital is intended to cover unexpected losses and is assigned to the banking and processing businesses using our risk-based economic capital model. We increased the capital assigned to Regional Community Banking to 6% of funds to reflect the capital required for well-capitalized banks and to approximate market comparables for this business. The capital for BlackRock reflects legal entity shareholders’ equity consistent with BlackRock’s separate public financial statement disclosures. We have allocated the allowances for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the loan portfolios. The costs incurred by operations and other support areas not directly aligned with the businesses are allocated primarily based on the use of services.

 

Total business segment financial results differ from total consolidated results. The impact of these differences is reflected in the “Intercompany Eliminations” and “Other” categories. “Intercompany Eliminations” reflects activities conducted among our businesses that are eliminated in the consolidated results. “Other” includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as asset and liability management activities, related net securities gains, equity management activities and minority interest in income of BlackRock, differences between business segment performance reporting and financial statement reporting (GAAP), and corporate overhead.

 

BUSINESS SEGMENT PRODUCTS AND SERVICES

 

Regional Community Banking provides deposit, lending, and cash management services, and investment services through PNC Investments, LLC, to approximately 2.2 million consumer and small business customers within our primary geographic footprint.

 

Wholesale Banking provides lending, treasury management, capital markets-related products and services, and commercial loan servicing to mid-sized corporations, government entities and selectively to large corporations. Lending products include secured and unsecured loans, letters of credit and equipment leases. Treasury management services include cash and investment management, receivables management, disbursement services, funds transfer services, information reporting and global trade services. Capital markets products include foreign exchange, derivatives, loan syndications and securities underwriting and distribution. Wholesale Banking provides products and services generally within our primary geographic markets and provides certain products and services nationally.

 

PNC Advisors provides a broad range of tailored investment, trust and private banking products and services to affluent individuals and families, including services to the ultra-affluent through its Hawthorn unit and full-service brokerage through J.J.B. Hilliard, W.L. Lyons, Inc. PNC Advisors also serves as investment manager and trustee for employee benefit plans and charitable and endowment assets and provides nondiscretionary defined contribution plan services and investment options through its Vested Interest® product. PNC Advisors provides services to individuals and corporations primarily within our primary geographic markets.

 

BlackRock is one of the largest publicly traded investment management firms in the United States with approximately $391 billion of assets under management at March 31, 2005. BlackRock manages assets on behalf of institutional and individual investors worldwide through a variety of equity, fixed income, cash management and alternative investment products. Mutual funds include the flagship fund families, BlackRock Funds and BlackRock Liquidity Funds (formerly BlackRock Provident Institutional Funds). In addition, BlackRock provides risk management, investment system outsourcing and financial advisory services to a growing number of institutional investors. See Note 2 Acquisitions for further information regarding the 2005 SSRM acquisition.

 

PFPC is among the largest providers of mutual fund transfer agency and accounting and administration services in the United States, offering a wide range of fund processing services to the investment management industry, and providing processing solutions to the international marketplace through its Ireland and Luxembourg operations.

 

57


Table of Contents

Results Of Businesses

 

Three months ended March 31
In millions


   Regional
Community
Banking


   Wholesale
Banking


   

PNC

Advisors


   BlackRock

   PFPC

    Other

   

Intercompany

Eliminations


    Consolidated

2005                                                            
INCOME STATEMENT                                                            

Net interest income (expense)

   $ 340    $ 175     $ 28    $ 8    $ (14 )   $ (30 )   $ (1 )   $ 506

Noninterest income

     165      136       128      250      228       84       (18 )     973
    

  


 

  

  


 


 


 

Total revenue

     505      311       156      258      214       54       (19 )     1,479

Provision for credit losses

     14      (4 )                           (2 )             8

Depreciation and amortization

     12      5       2      7      14       19               59

Other noninterest expense

     287      162       110      177      162       58       (16 )     940
    

  


 

  

  


 


 


 

Earnings before minority and other interests and income taxes

     192      148       44      74      38       (21 )     (3 )     472

Minority and other interests in income of consolidated entities

            (11 )                           17               6

Income taxes

     71      49       16      27      15       (66 )             112
    

  


 

  

  


 


 


 

Earnings

   $ 121    $ 110     $ 28    $ 47    $ 23     $ 28     $ (3 )   $ 354
    

  


 

  

  


 


 


 

Inter-segment revenue

   $ 1    $ 1     $ 3    $ 8    $ 1     $ 5     $ (19 )      
    

  


 

  

  


 


 


 

AVERAGE ASSETS (a)

   $ 22,970    $ 24,084     $ 2,879    $ 1,494    $ 2,264     $ 31,298     $ (1,627 )   $ 83,362
    

  


 

  

  


 


 


 

2004                                                            
INCOME STATEMENT                                                            

Net interest income (expense)

   $ 332    $ 163     $ 27    $ 6    $ (11 )   $ (13 )   $ (10 )   $ 494

Noninterest income

     168      153       143      182      202       80       (17 )     911
    

  


 

  

  


 


 


 

Total revenue

     500      316       170      188      191       67       (27 )     1,405

Provision for credit losses

     29      (13 )     1                     (5 )             12

Depreciation and amortization

     12      5       3      5      7       17               49

Other noninterest expense

     300      157       117      107      157       28       (20 )     846
    

  


 

  

  


 


 


 

Earnings before minority and other interests and income taxes

     159      167       49      76      27       27       (7 )     498

Minority and other interests in income of consolidated entities

            (10 )                           17               7

Income taxes

     57      55       18      21      11       3       (2 )     163
    

  


 

  

  


 


 


 

Earnings

   $ 102    $ 122     $ 31    $ 55    $ 16     $ 7     $ (5 )   $ 328
    

  


 

  

  


 


 


 

Inter-segment revenue

   $ 2    $ 1     $ 4    $ 9    $ 3     $ 8     $ (27 )      
    

  


 

  

  


 


 


 

AVERAGE ASSETS (a)

   $ 20,792    $ 21,847     $ 2,660    $ 909    $ 1,979     $ 27,029     $ (2,193 )   $ 73,023
    

  


 

  

  


 


 


 


(a) Period-end balances for BlackRock.
(b) Certain revenue and expense amounts shown in the preceding table differ from amounts included in the “Review of Businesses” section of Part I, Item 2 of this Form 10-Q due to the presentation in Item 2 of business revenues on a taxable-equivalent basis (except for PFPC) and classification differences related to BlackRock and PFPC. BlackRock income classified as net interest income in the preceding table represents the net of investment income and interest expense as presented in the “Review of Businesses” section. PFPC income classified as net interest income (expense) in the preceding table represents the interest components of nonoperating income (net of nonoperating expense), debt financing, debt prepayment penalty and fund servicing revenue as disclosed in the “Review of Businesses” section.

 

58


Table of Contents

NOTE 17 COMMITMENTS AND GUARANTEES

 

EQUITY FUNDING COMMITMENTS

 

We had commitments to make additional equity investments in certain equity management entities of $108 million and in affordable housing limited partnerships of $43 million at March 31, 2005.

 

STANDBY LETTERS OF CREDIT

 

We issue standby letters of credit and have risk participations in standby letters of credit and bankers’ acceptances issued by other financial institutions, in each case to support obligations of our customers to third parties. If the customer fails to meet its financial or performance obligation to the third party under the terms of the contract, then upon the request of the guaranteed party, we would be obligated to make payment to them. The standby letters of credit and risk participations in standby letters of credit and bankers’ acceptances outstanding on March 31, 2005 had terms ranging from less than one year to 10 years. The aggregate maximum amount of future payments we could be required to make under outstanding standby letters of credit and risk participations in standby letters of credit and bankers’ acceptances was $5.4 billion at March 31, 2005.

 

Assets valued as of March 31, 2005 of approximately $880 million secured certain specifically identified standby letters of credit. Approximately $1.8 billion in recourse provisions from third parties was also available for this purpose as of March 31, 2005. In addition, a portion of the remaining standby letters of credit and letter of credit risk participations issued on behalf of specific customers is also secured by collateral or guarantees that secure the customers’ other obligations to us. The carrying amount of the liability for our obligations related to standby letters of credit and risk participations in standby letters of credit and bankers’ acceptances was $50 million at March 31, 2005.

 

STANDBY BOND PURCHASE AGREEMENTS AND OTHER LIQUIDITY FACILITIES

 

We enter into standby bond purchase agreements to support municipal bond obligations and enter into certain other liquidity facilities to support individual pools of receivables acquired by unrelated commercial paper conduits. At March 31, 2005, our total commitments under these facilities were $296 million and $239 million, respectively.

 

INDEMNIFICATIONS

 

We are a party to numerous acquisition or divestiture agreements under which we have purchased or sold, or agreed to purchase or sell, various types of assets. These agreements can cover the purchase or sale of:

 

    Entire businesses,

 

    Loan portfolios,

 

    Branch banks,

 

    Partial interests in companies, or

 

    Other types of assets.

 

These agreements generally include indemnification provisions under which we indemnify the third parties to these agreements against a variety of risks to the indemnified parties as a result of the transaction in question. When PNC is the seller, the indemnification provisions will generally also provide the buyer with protection relating to the quality of the assets we are selling and the extent of any liabilities being assumed by the buyer. Due to the nature of these indemnification provisions, we cannot quantify the total potential exposure to us resulting from them.

 

We provide indemnification in connection with securities offering transactions in which we are involved. When we are the issuer of the securities, we provide indemnification to the underwriters or placement agents analogous to the indemnification provided to the purchasers of businesses from us, as described above. When we are an underwriter or placement agent, we provide a limited indemnification to the issuer related to our actions in connection with the offering and, if there are other underwriters, indemnification to the other underwriters intended to result in an appropriate sharing of the risk of participating in the offering. Due to the nature of these indemnification provisions, we cannot quantify the total potential exposure to us resulting from them.

 

We enter into certain types of agreements that include provisions for indemnifying third parties, such as:

 

    Agreements relating to providing various servicing and processing functions to third parties,

 

    Agreements relating to the creation of trusts or other legal entities to facilitate leasing transactions, commercial mortgage-backed securities transactions (loan securitizations) and certain other off-balance sheet transactions,

 

    Syndicated credit agreements, as a syndicate member,

 

    Sales of individual loans, and

 

    Litigation settlement agreements.

 

Due to the nature of these indemnification provisions, we cannot calculate our aggregate potential exposure under them.

 

We enter into certain types of agreements, including leases, assignments of leases, and subleases, in which we agree to indemnify third parties for acts by our agents, assignees and/or sublessees, and employees. While we do not believe these indemnification liabilities are material, either individually or in total, we cannot calculate our potential exposure.

 

We enter into contracts for the delivery of technology service in which we indemnify the other party against claims of patent and copyright infringement by third parties. Due to the nature of these indemnification provisions, we cannot calculate our aggregate potential exposure under this type of indemnification.

 

We engage in certain insurance activities which require our employees to be bonded. We satisfy this bonding requirement by issuing letters of credit in a total amount of approximately $5 million.

 

In the ordinary course of business, we enter into contracts with third parties under which the third parties provide services on behalf of PNC. In many of these contracts, we agree to indemnify the third party service provider under certain circumstances. The terms of the indemnity vary from contract to contract and the amount of the indemnification liability, if any, cannot be determined.

 

59


Table of Contents

We are a general or limited partner in certain asset management and investment limited partnerships, many of which contain indemnification provisions that would require us to make payments in excess of our remaining funding commitments. While in certain of these partnerships the maximum liability to us is limited to the sum of our unfunded commitments and partnership distributions received by us, in the others the indemnification liability is unlimited. As a result, we cannot determine our aggregate potential exposure for these indemnifications.

 

Pursuant to their bylaws, PNC and its subsidiaries provide indemnification to directors, officers and, in some cases, employees and agents against certain liabilities incurred as a result of their service on behalf of or at the request of PNC and its subsidiaries. PNC and its subsidiaries also advance on behalf of covered individuals costs incurred in connection with certain claims or proceedings, subject to written undertakings by each such individual to repay all amounts so advanced if it is ultimately determined that the individual is not entitled to indemnification. We advanced such costs on behalf of several such individuals with respect to pending litigation or investigations during the first three months of 2005. It is not possible for us to determine the aggregate potential exposure resulting from the obligation to provide this indemnity or to advance such costs.

 

In connection with the lending of securities held by PFPC as an intermediary on behalf of certain of its clients, we provide indemnification to those clients against the failure of the borrowers to return the securities. The market value of the securities lent is fully secured on a daily basis; therefore, the exposure to us is limited to temporary shortfalls in the collateral as a result of short-term fluctuations in trading prices of the loaned securities. At March 31, 2005, the total maximum potential exposure as a result of these indemnity obligations was approximately $6.5 billion, although we held collateral at the time in excess of that amount.

 

CONTINGENT PAYMENTS IN CONNECTION WITH CERTAIN ACQUISITIONS

 

A number of the acquisition agreements to which we are a party and under which we have purchased various types of assets, including the purchase of entire businesses, partial interests in companies, or other types of assets, require us to make additional payments in future years if certain predetermined goals occur within a specific time period. As some of these provisions do not specify dollar limitations, we cannot quantify our total exposure resulting from these agreements.

 

60


Table of Contents

STATISTICAL INFORMATION

THE PNC FINANCIAL SERVICES GROUP, INC.

 

AVERAGE CONSOLIDATED BALANCE SHEET AND NET INTEREST ANALYSIS

 

     First Quarter 2005

    Fourth Quarter 2004

 

Taxable-equivalent basis

Dollars in millions


  

Average

Balances


   

Interest

Income/
Expense


  

Average

Yields/
Rates


   

Average

Balances


   

Interest

Income/
Expense


  

Average

Yields/
Rates


 
ASSETS                                           

Interest-earning assets

                                          

Securities available for sale and held to maturity

                                          

Securities available for sale

                                          

U.S. Treasury and government agencies/corporations

   $ 6,897     $ 66    3.85 %   $ 6,895     $ 61    3.52 %

Other debt

     9,631       101    4.19       8,846       88    4.00  

State and municipal

     172       4    8.50       175       4    9.43  

Corporate stocks and other

     172       3    7.55       188       2    3.80  
    


 

        


 

      

Total securities available for sale

     16,872       174    4.13       16,104       155    3.85  

Securities held to maturity

                          1            4.92  
    


 

        


 

      

Total securities available for sale and held to maturity

     16,872       174    4.13       16,105       155    3.85  

Loans, net of unearned income

                                          

Commercial

     17,935       245    5.47       17,312       221    5.02  

Commercial real estate

     2,015       27    5.44       2,080       27    5.02  

Consumer

     15,641       206    5.33       15,280       199    5.19  

Residential mortgage

     4,855       63    5.18       4,683       61    5.16  

Lease financing

     3,041       34    4.51       3,216       36    4.46  

Other

     495       5    4.11       502       5    3.64  
    


 

        


 

      

Total loans, net of unearned income

     43,982       580    5.30       43,073       549    5.04  

Loans held for sale

     1,941       15    3.16       1,771       16    3.46  

Federal funds sold and resale agreements

     2,249       13    2.25       1,274       7    2.17  

Other

     2,937       28    3.82       2,302       22    3.67  
    


 

        


 

      

Total interest-earning assets/interest income

     67,981       810    4.79       64,525       749    4.59  

Noninterest-earning assets

                                          

Allowance for loan and lease losses

     (611 )                  (582 )             

Cash and due from banks

     2,987                    3,038               

Other assets

     13,005                    11,791               
    


              


            

Total assets

   $ 83,362                  $ 78,772               
    


              


            
LIABILITIES, MINORITY AND NONCONTROLLING INTERESTS, AND SHAREHOLDERS’ EQUITY                                           

Interest-bearing liabilities

                                          

Interest-bearing deposits

                                          

Money market

   $ 16,562       70    1.71     $ 16,328       56    1.34  

Demand

     7,965       11    .57       7,999       10    .50  

Savings

     2,831       5    .67       2,819       4    .59  

Retail certificates of deposit

     10,296       72    2.86       9,761       66    2.69  

Other time

     902       9    3.87       892       8    3.42  

Time deposits in foreign offices

     2,373       15    2.47       1,628       8    1.92  
    


 

        


 

      

Total interest-bearing deposits

     40,929       182    1.80       39,427       152    1.52  

Borrowed funds

                                          

Federal funds purchased

     1,659       10    2.49       1,676       9    1.94  

Repurchase agreements

     2,306       13    2.25       1,906       8    1.75  

Bank notes and senior debt

     2,663       19    2.84       2,535       15    2.29  

Subordinated debt

     3,911       42    4.27       3,476       37    4.27  

Commercial paper

     2,344       15    2.52       1,947       10    2.06  

Other borrowed funds

     2,159       17    3.20       1,070       9    3.30  
    


 

        


 

      

Total borrowed funds

     15,042       116    3.09       12,610       88    2.76  
    


 

        


 

      

Total interest-bearing liabilities/interest expense

     55,971       298    2.15       52,037       240    1.82  

Noninterest-bearing liabilities, minority and noncontrolling interests, and shareholders’ equity

                                          

Demand and other noninterest-bearing deposits

     12,432                    12,539               

Allowance for unfunded loan commitments and letters of credit

     76                    96               

Accrued expenses and other liabilities

     6,856                    6,283               

Minority and noncontrolling interests in consolidated entities

     527                    501               

Shareholders’ equity

     7,500                    7,316               
    


              


            

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

   $ 83,362                  $ 78,772               
    


              


            

Interest rate spread

                  2.64                    2.77  

Impact of noninterest-bearing sources

                  .38                    .35  
            

  

         

  

Net interest income/margin

           $ 512    3.02 %           $ 509    3.12 %
            

  

         

  

 

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. Basis adjustments related to hedged items are included in noninterest-earning assets and noninterest-bearing liabilities. Average balances of securities are based on amortized historical cost (excluding SFAS 115 adjustments to fair value which are included in other assets).

 

61


Table of Contents
    Third Quarter 2004

    Second Quarter 2004

    First Quarter 2004

 

Taxable-equivalent basis

Dollars in millions


 

Average

Balances


   

Interest

Income/
Expense


 

Average

Yields/
Rates


   

Average

Balances


   

Interest

Income/
Expense


 

Average

Yields/
Rates


   

Average

Balances


   

Interest

Income/
Expense


 

Average

Yields/
Rates


 
ASSETS                                                            

Interest-earning assets

                                                           

Securities available for sale and held to maturity

                                                           

Securities available for sale

                                                           

U.S. Treasury and government agencies/corporations

  $ 6,288     $ 49   3.10 %   $ 6,654     $ 48   2.91 %   $ 6,432     $ 49   3.03 %

Other debt

    8,667       85   3.90       8,624       78   3.63       9,293       89   3.83  

State and municipal

    216       5   10.35       225       3   5.65       264       4   5.15  

Corporate stocks and other

    201       2   4.37       259       2   2.40       282       4   5.91  
   


 

       


 

       


 

     

Total securities available for sale

    15,372       141   3.67       15,762       131   3.33       16,271       146   3.57  

Securities held to maturity

    2           (.70 )     2           5.78       2           11.69  
   


 

       


 

       


 

     

Total securities available for sale and held to maturity

    15,374       141   3.67       15,764       131   3.33       16,273       146   3.57  

Loans, net of unearned income

                                                           

Commercial

    16,915       211   4.87       16,445       203   4.89       15,827       203   5.07  

Commercial real estate

    2,120       25   4.58       2,100       23   4.41       2,249       27   4.72  

Consumer

    14,673       187   5.06       13,968       177   5.08       12,719       165   5.23  

Residential mortgage

    4,354       56   5.16       3,622       47   5.18       3,492       46   5.29  

Lease financing

    3,182       35   4.38       3,437       38   4.46       4,050       47   4.66  

Other

    507       4   3.02       497       3   2.91       517       4   2.74  
   


 

       


 

       


 

     

Total loans, net of unearned income

    41,751       518   4.89       40,069       491   4.89       38,854       492   5.05  

Loans held for sale

    1,578       10   2.42       1,636       13   3.19       1,560       8   1.98  

Federal funds sold and resale agreements

    1,283       6   2.07       1,896       9   1.68       2,235       8   1.50  

Other

    1,746       17   3.92       1,551       18   4.64       1,162       15   5.30  
   


 

       


 

       


 

     

Total interest-earning assets/interest income

    61,732       692   4.44       60,916       662   4.34       60,084       669   4.44  

Noninterest-earning assets

                                                           

Allowance for loan and lease losses

    (593 )                 (603 )                 (653 )            

Cash and due from banks

    2,851                   2,793                   2,895              

Other assets

    11,372                   10,762                   10,697              
   


             


             


           

Total assets

  $ 75,362                 $ 73,868                 $ 73,023              
   


             


             


           
LIABILITIES, MINORITY AND NONCONTROLLING INTERESTS, AND SHAREHOLDERS’ EQUITY                                                            

Interest-bearing liabilities

                                                           

Interest-bearing deposits

                                                           

Money market

  $ 15,916       37   .93     $ 16,027       30   .75     $ 15,581       28   .72  

Demand

    7,857       8   .39       7,878       7   .35       7,873       7   .37  

Savings

    2,730       3   .44       2,595       2   .34       2,590       2   .32  

Retail certificates of deposit

    9,100       60   2.64       8,650       58   2.69       8,780       60   2.71  

Other time

    825       7   3.23       680       6   3.46       343       5   5.86  

Time deposits in foreign offices

    1,561       6   1.46       1,485       4   .99       806       2   .98  
   


 

       


 

       


 

     

Total interest-bearing deposits

    37,989       121   1.27       37,315       107   1.15       35,973       104   1.16  

Borrowed funds

                                                           

Federal funds purchased

    1,940       7   1.44       2,303       6   1.00       1,912       4   .92  

Repurchase agreements

    1,158       4   1.23       1,508       4   .86       1,157       2   .94  

Bank notes and senior debt

    2,709       16   2.28       2,752       15   2.18       2,752       15   2.15  

Subordinated debt

    3,411       34   3.89       3,545       33   3.79       3,593       35   3.88  

Commercial paper

    1,679       6   1.48       1,815       5   1.08       2,111       6   1.09  

Other borrowed funds

    858       6   3.10       633       7   4.36       1,622       6   1.40  
   


 

       


 

       


 

     

Total borrowed funds

    11,755       73   2.45       12,556       70   2.21       13,147       68   2.07  
   


 

       


 

       


 

     

Total interest-bearing liabilities/interest expense

    49,744       194   1.55       49,871       177   1.42       49,120       172   1.40  

Noninterest-bearing liabilities, minority and noncontrolling interests, and shareholders’ equity

                                                           

Demand and other noninterest-bearing deposits

    12,477                   11,681                   11,350              

Allowance for unfunded loan commitments and letters of credit

    84                   90                   90              

Accrued expenses and other liabilities

    5,470                   4,773                   5,020              

Minority and noncontrolling interests in consolidated entities

    466                   419                   434              

Shareholders’ equity

    7,121                   7,034                   7,009              
   


             


             


           

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

  $ 75,362                 $ 73,868                 $ 73,023              
   


             


             


           

Interest rate spread

                2.89                   2.92                   3.04  

Impact of noninterest-bearing sources

                .30                   .26                   .26  
           

 

         

 

         

 

Net interest income/margin

          $ 498   3.19 %           $ 485   3.18 %           $ 497   3.30 %
           

 

         

 

         

 

 

Loan fees for the three months ended March 31, 2005, December 31, 2004, September 30, 2004, June 30, 2004 and March 31, 2004 were $24 million, $28 million, $26 million, $29 million and $26 million, respectively. Interest income includes the effects of taxable-equivalent adjustments using a marginal federal income tax rate of 35% to increase tax-exempt interest income to a taxable-equivalent basis. The taxable-equivalent adjustments for the three months ended March 31, 2005, December 31, 2004, September 30, 2004, June 30, 2004 and March 31, 2004 were $6 million, $6 million, $7 million, $4 million and $3 million, respectively.

 

62


Table of Contents

PART II OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

There are several pending judicial or administrative proceedings or other matters arising out of the three 2001 transactions (the “PAGIC transactions”) that gave rise to a financial statement restatement that we announced in January 2002. In December 2004, we entered into settlement agreements relating to certain of the lawsuits and other claims arising out of the PAGIC transactions. These pending proceedings and settlement agreements are described in our 2004 Annual Report on Form 10-K under Item 3. We are making progress towards completing those aspects of the settlement agreements that remain subject to conditions. In particular, the United States District Court for the Western District of Pennsylvania has scheduled a hearing on August 4, 2005 in the consolidated class action lawsuit brought on behalf of certain purchasers of our common stock to determine whether to approve the proposed settlement agreement.

 

In January 2005, we settled with one of our insurers under our Executive Blended Risk insurance coverage, and in March 2005, we settled with another of these insurers with respect to our claim related to our contribution of $90 million to the Restitution Fund established under our June 2003 Deferred Prosecution Agreement with the United States Department of Justice pertaining to the PAGIC transactions. (These settlements were in addition to the settlement with an insurer in December 2004 as described in our Form 10-K). Under the January settlement, the insurer made a payment to us of $4.5 million. Under the March settlement, the insurer has paid us $11.25 million, but we are obligated to return this amount if the settlement of the consolidated class action referred to above does not receive court approval, does not become effective or becomes unenforceable. Each of the amounts in these settlements represents a portion of the insurer’s share of our overall claim against our insurers with respect to any amounts disbursed out of the Restitution Fund. We are preserving our claim against our insurers with whom we have not settled. The amount of the January settlement was recognized in our income statement for the first quarter of 2005. The amount of the March settlement will not be recognized until the potential obligation to return the funds described above has been eliminated.

 

Some of our subsidiaries are defendants (or have potential contractual contribution obligations to other defendants) in several pending lawsuits brought during late 2002 and 2003 arising out of the bankruptcy of Adelphia Communications Corporation. There also are threatened additional proceedings arising out of the same matters. One of the lawsuits is pending in the United States Bankruptcy Court for the Southern District of New York and has been brought on Adelphia’s behalf as an adversary proceeding by the unsecured creditors’ committee in Adelphia’s bankruptcy proceeding. A motion to intervene on behalf of the equity committee is also pending in this case. The other lawsuits (one of which is a putative consolidated class action) have been brought by holders of debt and equity securities of Adelphia and have been consolidated for pretrial purposes in the United States District Court for the Southern District of New York. These lawsuits arise out of lending and securities underwriting activities engaged in by these PNC subsidiaries together with other financial services companies. In the aggregate, more than 400 other financial services companies and numerous other companies and individuals have been named as defendants in one or more of the lawsuits. Collectively, with respect to some or all of the defendants, the lawsuits allege violations of federal securities laws, violations of common law duties, aiding and abetting such violations, voidable preference payments, and fraudulent transfers, among other matters. The lawsuits seek unquantified monetary damages, interest, attorneys’ fees and other expenses, and a return of the alleged voidable preference and fraudulent transfer payments, among other remedies. We believe that we have substantial defenses to the claims against us in these lawsuits and intend to defend them vigorously. These lawsuits are currently in initial stages and present complex issues of law and fact. As a result, we are not currently capable of evaluating our exposure, if any, resulting from these lawsuits.

 

On April 29, 2005, an amended complaint was filed in the putative class action against PNC; PNC Bank; our Pension Plan and its Pension Committee in the United States District Court for the Eastern District of Pennsylvania (originally filed in December 2004). The complaint claims violations of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), arising out of the January 1, 1999 conversion of our Pension Plan from a traditional defined benefit formula into a “cash balance” formula, the design and continued operation of the Plan, and other related matters. Plaintiffs seek to represent a class of all current and former employee-participants in and beneficiaries of the Plan as of December 31, 1998 and thereafter. Plaintiffs also seek to represent a subclass of all current and former employee-participants in and beneficiaries of the Plan as of December 31, 1998 and thereafter who were or would have become eligible for an early retirement subsidy under the former Plan at some time prior to the date of the amended complaint. The plaintiffs are seeking damages and equitable relief available under ERISA, including interest, costs, and attorneys’ fees. We believe that we have substantial defenses to the claims against us in this lawsuit and intend to defend it vigorously.

 

In addition to the proceedings or other matters referred to above, PNC and persons to whom we may have indemnification obligations, in the normal course of business, are subject to various other pending and threatened legal proceedings in which claims for monetary damages and other relief are asserted. Management does not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of such other legal proceedings will have a material adverse effect on our financial position. However, we cannot now determine whether or not any claims asserted against us, whether in the proceedings or other matters specifically described above or otherwise, will have a material adverse effect on our results of operations in any future reporting period.

 

63


Table of Contents

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

Details of our repurchases of PNC common stock during the first quarter of 2005 are included in the following table:

 

In thousands, except per share data

 

2005 period


   Total shares
purchased (a)


   Average
price
paid per
share


   Total shares
purchased as
part of
publicly
announced
programs (b)


   Maximum
number of
shares that
may yet be
purchased
under the
programs (b)


January 1 – January 31

   76    $ 54.60         16,994

February 1 – February 28

   245    $ 52.64    151    14,866

March 1 – March 31

   422    $ 52.73    344    14,522
    
  

  
    

Total

   743    $ 52.89    495     
    
  

  
    

(a) Includes PNC common stock purchased under the program referred to in note (b) to this table and PNC common stock purchased in connection with our various employee benefit plans.
(b) Our prior stock repurchase program allowed us to purchase up to 20 million shares on the open market or in privately negotiated transactions and terminated on February 16, 2005. As of that date, a new program to purchase 15 million shares was authorized. This program will remain in effect until fully utilized or until modified, superseded or terminated.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

An annual meeting of shareholders of The PNC Financial Services Group, Inc. was held on April 26, 2005 for the purpose of considering and acting upon the following matters: (1) the election of 16 directors to serve until the next annual meeting and until their successors are elected and qualified and (2) the ratification of the Audit Committee’s selection of Deloitte & Touche LLP as PNC’s independent auditors for 2005.

 

Sixteen directors were elected and the aggregate votes cast for or against/withheld were as follows:

 

     Aggregate Votes

Nominee


   For

   Against/Withheld

Paul W. Chellgren

   234,819,845    8,963,343

Robert N. Clay

   238,553,271    5,229,917

J. Gary Cooper

   238,823,440    4,959,748

George A. Davidson, Jr.

   238,397,932    5,385,256

Richard B. Kelson

   236,000,151    7,783,037

Bruce C. Lindsay

   239,645,935    4,137,253

Anthony A. Massaro

   234,739,854    9,043,334

Thomas H. O’Brien

   237,783,739    5,999,449

Jane G. Pepper

   239,495,803    4,287,385

James E. Rohr

   236,462,268    7,320,920

Lorene K. Steffes

   239,611,300    4,171,888

Dennis F. Strigl

   234,900,360    8,882,828

Stephen G. Thieke

   239,637,693    4,145,495

Thomas J. Usher

   233,355,337    10,427,851

Milton A. Washington

   233,609,274    10,173,914

Helge H. Wehmeier

   238,400,669    5,382,519

 

The Audit Committee’s selection of Deloitte & Touche LLP as PNC’s independent auditors for 2005 was ratified and the aggregate votes cast for or against and the abstentions were as follows:

 

Aggregate Votes

For

  Against

  Abstain

239,850,414   2,160,330   1,772,444

 

With respect to both of the preceding matters, holders of our common and voting preferred stock voted together as a single class. The following table sets forth, as of the February 28, 2005 record date, the number of shares of each class or series of stock that were issued and outstanding and entitled to vote, the voting power per share, and the aggregate voting power of each class or series:

 

Title of Class or Series


   Voting Rights
Per Share


   Number of
Shares Entitled
to Vote


   Aggregate
Voting Power


 

Common Stock

   1    282,985,715    282,985,715  

$1.80 Cumulative Convertible Preferred Stock - Series A

   8    8,040    64,320  

$1.80 Cumulative Convertible Preferred Stock - Series B

   8    2,128    17,024  

$1.60 Cumulative Convertible Preferred Stock - Series C

   4/2.4    160,841    268,068  

$1.80 Cumulative Convertible Preferred Stock - Series D

   4/2.4    217,227    362,045  
              

Total possible votes

             283,697,172 *

* Represents greatest number of votes possible. Actual aggregate voting power was less since each holder of such preferred stock was entitled to a number of votes equal to the number of full shares of common stock into which such holder’s preferred stock was convertible.

 

64


Table of Contents

ITEM 6. EXHIBITS

 

The following exhibit index lists Exhibits filed, or in the case of Exhibits 32.1 and 32.2 furnished, with this Quarterly Report on Form 10-Q:

 

EXHIBIT INDEX

 

10.33    2005 Form of director stock option agreement
12.1    Computation of Ratio of Earnings to Fixed Charges
12.2    Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividends
31.1    Certification of Chairman and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2    Certification of Vice Chairman and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1    Certification of Chairman and Chief Executive Officer pursuant to 18 U.S.C. Section 1350
32.2    Certification of Vice Chairman and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

 

You can receive copies of these Exhibits electronically at the SEC’s home page at www.sec.gov or from the public reference section of the SEC, at prescribed rates, at 450 Fifth Street NW, Washington, D.C. 20549. The Exhibits are also available as part of the Form 10-Q on or through PNC’s corporate website at www.pnc.com in the “For Investors” section. Shareholders may also receive copies, without charge, by contacting Shareholder Relations at (800) 843-2206 or via e-mail at [email protected].

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on May 9, 2005 on its behalf by the undersigned thereunto duly authorized.

 

The PNC Financial Services Group, Inc.

/s/ William S. Demchak


William S. Demchak

Vice Chairman and Chief Financial Officer

(Principal Financial Officer)

 

65


Table of Contents

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.’s 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

 

We are subject to the informational requirements of the Securities Exchange Act of 1934. Therefore, we file annual, quarterly and current reports as well as proxy materials with the Securities and Exchange Commission (“SEC”). You may obtain copies of these and other filings, including exhibits, electronically at the SEC’s internet website at www.sec.gov or on or through PNC’s corporate internet website at www.pnc.com in the “For Investors” section. Copies may also be obtained without charge by contacting Shareholder Services at (800) 982-7652 or via e-mail at [email protected].

 

CORPORATE GOVERNANCE AT PNC

 

Information about our Board and its committees and corporate governance at PNC is available in the corporate governance section of the “For Investors” page of PNC’s corporate website at www.pnc.com. Shareholders who would like to request printed copies of the PNC Code of Business Conduct and Ethics, our Corporate Governance Guidelines or the charters of our Board’s Audit, Nominating and Governance and Personnel and Compensation Committees (all of which are posted on the PNC website) may do so by sending their requests to Thomas R. Moore, Corporate Secretary, at corporate headquarters at the above address. Copies will be provided without charge to shareholders.

 

INQUIRIES

 

For financial services call 1-888-PNC-2265. Individual shareholders should contact Shareholder Services at (800) 982-7652.

 

Analysts and institutional investors should contact William H. Callihan, Senior Vice President, Director of Investor Relations, at (412) 762-8257 or via e-mail at [email protected].

 

News media representatives and others seeking general information should contact:

Brian Goerke, Director of External Communications, at (412) 762-4550 or via e-mail at [email protected].

 

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.

 

     High

   Low

   Close

  

Cash

Dividends
Declared


2005 Quarter                            

First

   $ 57.57    $ 50.30    $ 51.48    $ .50
2004 Quarter                            

First

   $ 59.79    $ 52.68    $ 55.42    $ .50

Second

     56.00      50.70      53.08      .50

Third

     54.22      48.90      54.10      .50

Fourth

     57.64      50.70      57.44      .50
                         

Total

                        $ 2.00
                         

 

DIVIDEND POLICY

 

Holders of The PNC Financial Services Group, Inc. common stock are entitled to receive dividends when declared by the Board of Directors out of funds legally available. The Board presently intends to continue the policy of paying quarterly cash dividends. However, future dividends will depend on earnings, the financial condition of The PNC Financial Services Group, Inc. and other factors, including applicable government regulations and policies and contractual restrictions.

 

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 for service charges. A prospectus and enrollment form may be obtained by contacting Shareholder Services at (800) 982-7652.

 

REGISTRAR AND TRANSFER AGENT

 

Computershare Investor Services, LLC

2 North LaSalle Street

Chicago, Illinois 60602

(800) 982-7652

 

66