ITEM 1A. RISK FACTORS
An investment in the Company involves risk, some of which, including market, liquidity, credit, operational, legal, compliance, reputational and strategic risks, could be substantial and is inherent in the Company’s business. This risk also includes the possibility that the value of the investment could decrease considerably, and dividends or other distributions concerning the investment could be reduced or eliminated. Discussed below are risk factors that could adversely affect financial results and condition, as well as the value of, and return on investments made in the Company. Although the Company believes that these risks are the most important for you to consider, you should read this section in conjunction with the Consolidated Financial Statements, the notes to those Financial Statements and management’s discussion and analysis of financial condition and results of operations.
Risks Related to the Company’s Lending Activities
Deterioration in local economies or real estate market may adversely affect financial performance.
The Company serves individuals and businesses located in Maine, New Hampshire, and Vermont. A substantial portion of the loan portfolio is secured by real estate in these areas and the value of the associated collateral is subject to local real estate market conditions. Furthermore, many customers in the hospitality industry rely upon a high number of tourists to vacation destinations and attractions within the Company’s markets. The Company’s success is largely dependent on the economic conditions, including employment levels, population growth, income levels, savings trends and government policies in those market areas. A downturn in the local economies may adversely affect collateral values, sources of funds, and demand for products, all of which could have a negative impact on results of operations, financial condition and business expansion.
High concentrations of commercial loans may increase exposure to credit loss upon borrower default.
As of December 31, 2020, approximately 60% of the Banks’s loan portfolio consisted of commercial real estate, commercial and industrial and construction loans. Commercial loan portfolio concentration generally exposes lenders to greater risk of delinquency and loss than residential real estate loans because repayment of the loans often depends on the successful operation and income streams from the property. Commercial loans typically involve larger balances to single borrowers or groups of related borrowers as compared to residential real estate loans. As the Bank’s loan portfolio contains a significant number of large commercial loans, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans, provision for loan losses, and/or an increase in loan charge-offs, all of which could adversely affect the Company’s financial condition and results of operations.
Prepayments of loans may negatively impact the Company’s business. Generally, customers may prepay the principal amount of their outstanding loans at any time.
The speeds at which such prepayments occur, as well as the size of such prepayments, are within the customers’ discretion. Fluctuations in interest rates, in certain circumstances, may also lead to high levels of loan prepayments, which may also have an adverse impact on net interest income. If customers prepay the principal amount of their loans, and the Company is unable to lend those funds to other borrowers or invest the funds at the same or higher interest rates, interest income will be reduced. A significant reduction in interest income could have a negative impact on results of operations and financial condition.
Secondary mortgage market conditions may adversely affect financial condition and earnings.
The secondary mortgage markets are impacted by interest rates and investor demand for residential mortgage loans and increased investor yield requirements for these loans. These conditions may fluctuate in the future. As a result, a prolonged period of secondary market illiquidity may reduce the Company’s loan production volumes, change loan portfolio composition, and reduce operating results. Secondary markets are affected by Fannie Mae, Freddie Mac, and Ginny Mae (collectively, the "Agencies") for loan purchases that meet their conforming loan requirements. These agencies could limit purchases of conforming loans due to capital constraints, changes in conforming loan criteria or other factors. Proposals to reform mortgage finance could affect the role of the Agencies and the market for conforming loans.
The Bank is exposed to risk of environmental liabilities with respect to properties to which it takes title.
In the course of business, the Bank may own or foreclose and take title to real estate that may be subject to environmental liabilities with respect to subject property. As a result, the Company may be held liable for property damage, personal
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injury, investigation and restoration costs. The cost associated with investigation or restoration activities could be substantial. In addition, as the owner or former owner of a contaminated site, the Company may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property.
Greater than anticipated credit losses in the loan portfolios may adversely affect earnings.
Credit losses are inherent in the business of making loans and could have a material adverse effect on operating results. The Company makes various assumptions and judgments about the collectability of the loan portfolio and provides an allowance for loan losses based on a number of factors. The allowance for loan losses is evaluated on a periodic basis using current information, including the quality of the loan portfolio, economic conditions, values of the underlying collateral and the level of non-accrual loans. Although the Company believes the allowance for loan losses is appropriate to absorb probable losses in the loan portfolio, this allowance may not be adequate. Increases in the allowance will result in an expense for the period, thereby reducing reported net income.
The Financial Accounting Standards Board has issued Accounting Standards Update 2016-13, Measurement of Credit Losses on Financial Instruments. This standard, often referred to as CECL requires companies to recognize an allowance for credit losses using a new current expected credit loss model. Any increase in the allowance for credit losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on the Company’s financial condition and results of operations. This is discussed further in Note 1- Summary of Significant Accounting Policies of the Consolidated Financial Statements in this Annual Report on Form 10-K. The Company has adopted CECL as of January 1, 2021.
Risks Related to the Company’s Business
The COVID-19 pandemic may adversely impact our business and financial results, as it is highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
The COVID-19 pandemic is creating extensive disruptions to the economy and to the lives of individuals. Governments, businesses, and the public are taking unprecedented actions to contain the spread of COVID-19 and to mitigate its effects, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal stimulus, and legislation designed to deliver monetary aid and other relief. While the scope, duration, and full effects of COVID-19 are rapidly evolving, the pandemic and related efforts to contain it have disrupted economic activity, adversely affected the functioning of financial markets, impacted interest rates, increased economic and market uncertainty, and disrupted trade and supply chains. If these effects continue for a prolonged period or result in sustained economic stress or recession, many of the risk factors identified in our Form 10-K could be exacerbated and such effects could have an adverse impact on us in a number of ways related to credit quality, collateral values, customer demand, funding, operations, interest rate risk, and human capital.
Expansion, growth, and acquisitions could negatively impact earnings if not successful.
The Company may grow organically both by geographic expansion and through business line expansion, as well as through acquisitions. Success of these activities depends on the Company’s ability to continue to maintain and develop an infrastructure appropriate to support and integrate such growth. Success may also depends on acceptance of the Bank by customers in these new markets and, in the case of expansion through acquisitions, these factors include the long-term recruitment and retention of key personnel and acquired customer relationships. Profitability depends on whether the marginal revenue generated in the new markets will offset the increased expenses of operating a larger entity, with more staff, more locations, and more product offerings. Failure to achieve any of these success factors may have a negative impact on the Company’s financial condition and results of operations.
The Company may be adversely affected by continuous technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional operational efficiencies.
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The introduction of new products and services can entail significant time and resources. The Company’s failure to manage risks and uncertainties associated with new products and services exposes it to enhanced risk of operational lapses which may result in the recognition of financial statement liabilities. Regulatory and internal control requirements, capital requirements, competitive alternatives, vendor relationships and shifting market preferences may also determine if such initiatives can be brought to market in a manner that is timely and attractive to the Company’s clients. Products and services relying on internet and mobile technologies may expose the Company to fraud and cybersecurity risks. Failure to successfully manage these risks in the development and implementation of new products or services could have a material adverse effect on the Company’s business and reputation.
Strong competition within the Company’s markets may significantly impact profitability.
The Company competes with an ever-increasing array of financial service providers. See the section entitled “Competition” of Item 1 of this Annual Report on Form 10-K for additional competitor information. Competition from nationwide banks, as well as local institutions, continues to mount in the Company’s markets. To compete, the Company focuses on quality customer service, making decisions at the local level, maintaining long-term customer relationships, building customer loyalty, and providing products and services designed to address the specific needs of customers. Failure to perform in any of these areas could significantly weaken the Company’s competitive position, which could adversely affect growth and profitability.
Market changes may adversely affect demand for services and impact revenue, costs, and earnings.
Channels for servicing the Company’s customers are evolving rapidly, with less reliance on traditional branch facilities, increased use of e-commerce channels, and demand for universal bankers and other relationship managers who can service multiple product lines. The Company has an ongoing process for evaluating the profitability of its branch system and other office and operational facilities. The identification of unprofitable operations and facilities can lead to restructuring charges and introduce the risk of disruptions to revenues and customer relationships. The Company competes with larger financial institutions who are rapidly evolving their service channels and escalating the costs of evolving the service process.
Disruptions to the Company’s information systems and security breaches may adversely affect its business and reputation.
In the ordinary course of business, the Company relies on electronic communications and information systems to conduct its businesses and to store sensitive data, including financial information regarding its customers. The integrity of information systems are under significant threat from cyberattacks by third parties, including through coordinated attacks sponsored by foreign nations and criminal organizations to disrupt business operations and other compromises to data and systems for political or criminal purposes. The Company employs an in-depth, layered, defense approach that leverages people, processes and technology to manage and maintain cybersecurity controls. Notwithstanding the strength of defensive measures, the threat from cyberattacks is severe, attacks are sophisticated and attackers respond rapidly to changes in defensive measures. Cybersecurity risks may also occur with the Company’s third-party service providers, and may interfere with their ability to fulfill their contractual obligations to us, with additional potential for financial loss or liability that could adversely affect the Company’s financial condition or results of operations. The Company offers its customers the ability to bank remotely and provide other technology-based products and services, which services include the secure transmission of confidential information over the Internet and other remote channels. To the extent that the Company’s customers’ systems are not secure or are otherwise compromised, its network could be vulnerable to unauthorized access, malicious software, phishing schemes and other security breaches. To the extent that the Company’s activities or the activities of its clients or third-party service providers involve the storage and transmission of confidential information, security breaches and malicious software could expose the Company to claims, regulatory scrutiny, litigation and other possible liabilities.
While to date the Company has not experienced a significant compromise, significant data loss or material financial losses related to cybersecurity attacks, the Company’s systems and those of its customers and third-party service providers, are under constant threat and may experience a significant event in the future. The Company may suffer material financial losses related to these risks or be subject to liability for compromises to its customers or third-party providers. Any such losses or liabilities could adversely affect the Company’s financial condition or results of operations, and could expose us to reputation risk, the loss of client business, increased operational costs, as well as additional regulatory scrutiny, possible litigation, and related financial liability. These risks also include possible business interruption, including the inability to access critical information and systems.
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The Company’s operations is reliant on outside vendors.
The Company’s operations is dependent on the use of certain outside vendors for its day-to-day operations. The vendor may not perform in accordance with established performance standards required in its agreements for any number of reasons including a change in the vendor’s senior management, financial condition, product line or mix and how they support existing customers, or simply change their strategic focus putting the Company at risk. While the Company has a comprehensive policies and procedures in place to mitigate risk in all phases of vendor management from selection, to performance monitoring, the failure of a vendor to perform in accordance with contractual agreements could be disruptive to its business, which could have a material adverse effect on its financial condition and results of operations.
The Company is subject to a variety of operational risks, including reputational risk, and the risk of fraud or theft by employees or outsiders, which may adversely affect the Company’s business and results of operations.
The Company is exposed to many types of operational risks, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, and unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. If personal, non-public, confidential, or proprietary information of customers in the Company’s possession were to be mishandled or misused, the Company could suffer significant regulatory consequences, reputational damage, and financial loss.
Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. The Company’s necessary dependence upon automated systems to record and process transactions and its large transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. The Company may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (i.e., computer viruses or electrical or telecommunications outages, natural disaster, disease pandemics, or other damage to property or physical assets), which may give rise to disruption of service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees) and to the risk that the Company’s vendors’ business continuity and data security systems prove to be inadequate. The occurrence of any of these risks could result in a diminished ability to operate (i.e., by requiring the Company to expend significant resources to correct the defect), as well as potential liability to clients, reputational damage, and regulatory intervention.
The Company may be adversely affected by the soundness of other financial institutions.
The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Bank and non-bank financial services companies are interrelated as a result of trading, clearing, counterparty and other relationships. The Company has exposure to different industries and counterparties through transactions with counterparties in the bank and non-bank financial services industries, including brokers and dealers, commercial banks, investment banks and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more bank or non-bank financial services companies, or the bank or non-bank financial services industries generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. These losses or defaults could have an adverse effect on the Company’s business, financial condition and results of operations.
The Company may be unable to attract and retain key personnel.
The Company’s success depends, in large part, on its ability to attract and retain key personnel. Competition for qualified personnel in the financial services industry can be intense and the Company and its subsidiaries may not be able to hire or retain the key personnel that it depends upon for success. In addition, the Bank’s rural geographic marketplace, combined with relatively expensive real estate purchase prices in the many tourist communities the Company serves, create additional risks for the Company’s ability to attract and retain key personnel. The unexpected loss of key personnel could have an adverse impact on the Company’s business because of their skills, knowledge of the markets in which the Company operates, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
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The Company is subject to possible claims and litigation pertaining to fiduciary responsibilities.
From time to time, customers make claims and take legal action pertaining to the Company’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Company’s performance of fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a favorable manner, they may result in significant financial liability and/or adversely affect the market perception of the Company and products and services as well as impact customer demand for products and services.
Societal responses to climate change could adversely affect the Company’s business and performance, including indirectly through impacts on the Company’s customers.
Concerns over the long-term impacts of climate change have led and will continue to lead to governmental efforts around the world to mitigate those impacts. Consumers and businesses also may change their behavior on their own as a result of these concerns. The Company and its customers will need to respond to new laws and regulations as well as consumer and business preferences resulting from climate change concerns. The Company and its customers may face cost increases, asset value reductions and operating process changes, among other impacts. The impact on the Company’s customers will likely vary depending on their specific attributes. In addition, the Company could face reductions in creditworthiness on the part of some customers or in the value of assets securing loans. The Company’s efforts to take these risks into account in making lending and other decisions may not be effective in protecting the Company from the negative impact of new laws and regulations or changes in consumer or business behavior.
Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact the Company’s business and the business of its customers.
Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on the Company’s ability to conduct business. Such events could affect the stability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. In particular, such events may have a particularly negative impact upon the business of customers who are engaged in the hospitality in the Company’s market area, which could have a direct negative impact on the Company’s business and results of operations.
Risks Related to Liquidity
Reforms to London Interbank Offered Rate ("LIBOR") and other indices, and related uncertainty, may adversely affect our business, financial condition or results of operations.
In July 2017, the U.K. Financial Conduct Authority announced that after 2021 it will no longer persuade or require banks to submit rates for LIBOR. This announcement, and, more generally, financial benchmark reforms and changes in the interbank lending markets, have resulted in uncertainty about the future of LIBOR and certain other rates or indices that are used as interest rate benchmarks. These actions may result in future changes in the rules or methodologies used to calculate benchmarks or in the discontinuance or unavailability of certain benchmarks. The possible impact of these actions is uncertain and cannot be predicted at this time, and the potential or actual discontinuance of benchmark quotes may have a material, adverse effect on the value of, return on and trading market for our financial assets and liabilities that are based on or are linked to benchmarks, including our hedge contracts, or our financial condition or results of operations. In addition, we cannot assure that we and other market participants will adequately be prepared for a discontinuation of LIBOR or other benchmarks, and such discontinuation may have an unpredictable impact on our contracts and/or cause significant disruption to financial markets that are relevant to our business, which may have a material, adverse effect on our financial condition or results of operations.
Wholesale funding sources may prove insufficient to replace deposits, support operations and future growth.
The Company and banking subsidiaries must maintain sufficient funds to respond to the needs of customers. To manage liquidity, the Company draws upon a number of funding sources in addition to core deposit growth, loan repayments and maturities of loans and securities. These sources include FHLB and FRB advances, proceeds from the sale of securities and loans and liquidity resources at the holding company. The Company’s ability to manage liquidity will be severely constrained if unable to maintain access to funding or if adequate financing is not available to accommodate future growth at acceptable costs. In addition, if the Company is required to rely more heavily on more expensive funding sources to support future growth, revenues may not increase proportionately to cover costs. In this case, operating margins and profitability would be adversely affected.
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The Company’s access to funds from subsidiaries may be restricted.
Bar Harbor Bankshares is a separate and distinct legal entity from the Bank and non-banking subsidiaries. Bar Harbor Bankshares depends on dividends, distributions and other payments from its banking and non-banking subsidiaries to fund dividend payments on its common stock, debt service of subordinated borrowings, fund stock repurchase program and to fund strategic initiatives or other obligations. The Company’s subsidiaries are subject to laws that authorize regulatory bodies to block or reduce the flow of funds from those subsidiaries to Bar Harbor Bankshares based on assertion that certain payments from subsidiaries are considered an unsafe or unsound practice.
Changes in the general economy or the financial markets could adversely affect financial performance.
A deterioration of general economic conditions could adversely affect local economies and have a negative impact on results of operations and financial condition. Deterioration or defaults made by issuers of the underlying collateral of investment securities may cause additional credit-related other-than-temporary impairment charges to the income statement. The Company’s ability to borrow from other financial institutions or to access the debt or equity capital markets on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events, including actions by rating agencies or deteriorating investor expectations.
Monetary Policy and Economic Environment
The earnings of the Company are significantly affected by the monetary and fiscal policies of governmental authorities, including the Federal Reserve Board. Among the instruments of monetary policy used by the Federal Reserve Board to implement these objectives are open-market operations in U.S. Government securities and federal funds, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments, and deposits, and the interest rates charged on loans and paid for deposits. The Federal Reserve Board frequently uses these instruments of monetary policy, especially its open-market operations and the discount rate, to influence the level of interest rates, thereby affecting the strength of the economy, the level of inflation, or the price of the dollar in foreign exchange markets. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of banking institutions in the past and are expected to continue to do so in the future. It is not possible to predict the nature of future changes in monetary and fiscal policies, or the effect which they may have on the Company’s business and earnings.
Interest rate volatility could significantly reduce the Company’s profitability.
The Bank’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-bearing assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions, demand for loans, securities and deposits, policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, or the slope of the yield curve could influence not only the interest received on loans and securities and the amount of interest paid on deposits and borrowings, but such changes could also affect (i) the ability to originate loans and obtain deposits, (ii) the fair value of the Company’s financial assets and liabilities, and (iii) the average duration of loans and securities that are collateralized by mortgages. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. If interest rates decline, the Bank’s higher- rate loans and investments may be subject to prepayment risk, which could negatively impact its net interest margin. Conversely, if interest rates increase, the Bank’s loans and investment securities may be subject to extension risk, which could negatively impact its net interest margin as well.
Loss of deposits or a change in deposit mix could increase the cost of funding.
Deposits are a low cost and stable source of funding. The Company competes with banks and other financial institutions for deposits. Funding costs may increase if deposits are lost and are forced to replace them with more expensive sources of funding, if customers shift their deposits into higher cost products or if the Company needs to raise interest rates to avoid losing deposits. Higher funding costs reduce the net interest margin, net interest income and net income.
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Risks Related to Regulatory Matters
The Company is subject to extensive government regulation and supervision, which may interfere with the ability to conduct business and may negatively impact financial results.
The Company is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, the Federal Deposit Insurance Fund and the safety and soundness of the banking system as a whole, not stockholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer, and/or limit the pricing the Company may charge on certain banking services, among other things. Compliance personnel and resources may increase costs of operations and adversely impact earnings.
Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition and results of operations. While the Company has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
Changes in tax laws and regulations and differences in interpretation of tax laws and regulations may adversely impact the Company’s financial statements.
Federal, state, and local tax authorities may change tax laws and regulations, which could result in a decrease or increase to net deferred tax assets. In December 2017, the Company recognized a write-down of $4.0 million in net deferred tax assets in connection with the adoption of the Tax Cuts and Jobs Act of 2017 ("TCJA"). Federal, state, and local tax authorities may interpret tax laws and regulations differently and challenge tax positions that the Company has taken on tax returns. This may result in differences in the treatment of revenues, deductions, credits and/or differences in the timing of these items. The differences in treatment may result in payment of additional taxes, interest or penalties that could have a material adverse effect on results.
Goodwill from acquisitions could become impaired.
Applicable accounting standards require that the purchase method of accounting be used for all business combinations. Under purchase accounting, if the purchase price of an acquired company exceeds the fair value of the acquired company’s net assets, the excess is carried on the balance sheet as goodwill, by the acquirer. A significant decline in expected future cash flows, a continuing period of market disruption, market capitalization to book value deterioration, or slower growth rates may require the Company to record charges in the future related to the impairment of goodwill. If the Company concludes that a future write-down is necessary, the impact could have an adverse effect on financial condition and results of operations.
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ITEM 2. PROPERTIES
The Company’s principal executive office is in a building owned by the Company located at 82 Main Street, Bar Harbor, Maine. The Bank provides full-banking services at 53 locations throughout Maine, New Hampshire and Vermont, of which 33 are owned and 20 are leased. The Bank also has one stand-alone drive-up window in Vermont. In addition to banking offices, the Company also has Operations Centers located in Ellsworth, Maine, and Newport, New Hampshire that house the Company’s operations and data processing centers, as well as leased space in Hampden, Maine, Portland, Maine and Manchester, New Hampshire and owned space in Ellsworth, Maine, where back office support for multiple lines of business and related functions are located. Additionally, the Bank has 1 leased and 2 owned Wealth Management offices in New Hampshire. In the opinion of management, the physical properties of the Company and the Bank are considered adequate to meet the needs of customers in the communities served.
ITEM 3. LEGAL PROCEEDINGS
From time to time the Company may become involved in legal proceedings or may be subject to claims arising in the ordinary course of business. Although the results of litigation and claims cannot be predicted with certainty, the Company currently believes that the final outcome of these ordinary course matters will not have a material adverse effect on business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense and settlement costs, diversion of management resources and other factors.
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
The common stock of the Company is traded on the NYSE American, under the trading symbol "BHB". As of March 5, 2021, there were 14,938,697 shares of Bar Harbor Bankshares common stock, par value $2.00 per share, outstanding and approximately 1,530 shareholders of record, as obtained through the Company’s transfer agent.
Recent Sale of Unregistered Securities and Use of Proceeds from Registered Securities
No unregistered equity securities were sold by the Company during the year ended December 31, 2020.
The following table provides certain information with regard to shares repurchased by the Company in the fourth quarter of 2020:
Total number of shares Maximum number of
purchased as a part of shares that may yet be
Total number of Average price publicly announced purchased under
On March 12, 2020, the Company's Board of Directors approved a twelve-month plan to repurchase up to 5% of its outstanding common stock, representing 781,000 shares and expires on March 20, 2021.
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Common Stock Performance Graph
The following graph illustrates the estimated yearly change in value of the Company’s cumulative total stockholder return on its common stock for each of the last five years. Total shareholder return is computed by taking the difference between the ending price of the common stock at the end of the previous year and the current year, plus any dividends paid divided by the ending price of the common stock at the end of the previous year. For purposes of comparison, the graph also matches Bar Harbor Bankshares’ cumulative 5-Year total shareholder return on common stock with the cumulative total returns of the NYSE American Composite index, and the SNL Bank $1B to $5B Index. The graph tracks the performance of a $100 investment in the Company’s common stock and in each index (with the reinvestment of all dividends) from December 31, 2015 to December 31, 2020.
Period Ending
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ITEM 6. SELECTED FINANCIAL DATA
The following summary data is based in part on the consolidated financial statements and accompanying notes, and other schedules appearing elsewhere in this Form 10-K. Historical data is also based in part on, and should be read in conjunction with, prior filings with the SEC.
At or For the Years Ended December 31,
Financial Condition Data:
Operating Data:
Total interest and dividend income $ 126 $ 135 $ 127 $ 116 $ 57
Provision for loan losses 6 2 3 3 1
Total non-interest expense 95 90 76 72 36
Income tax expense(3) 8 4 8 17 6
Ratios and Other Data:
Per Common Share Data
Common stock price:
Weighted average common shares outstanding (in thousands):
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At or For the Years Ended December 31,
Performance Ratios:(4)
Organic Growth Ratios:
Total commercial loans 17 % 6 % 1 % 24 % 9 %
Asset Quality and Condition Ratios:
Capital Ratios:
(2) Net revenue is defined as net interest income plus non-interest income.
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AVERAGE BALANCES AND AVERAGE YIELDS/RATES
The following table presents average balances and average rates and yields on a fully taxable equivalent basis for the periods included:
Average Yield/ Average Yield/ Average Yield/
Assets
Loans:
Cash and due from banks 27 64 42
Other assets 353 279 248
Total assets $ 3,760 $ 3,648 $ 3,525
Liabilities
Non-interest bearing demand deposits 481 394 355
Other liabilities 63 34 28
Total shareholders' equity 407 389 357
Net interest income $ 105 $ 92 $ 93
Net interest margin 2.97 2.77 2.86
(2) The average balance for securities is based on amortized cost.
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(5) Core net interest margin excludes Paycheck Protection Program loans.
RATE/VOLUME ANALYSIS
The following table presents the effects of rate and volume changes on the fully taxable equivalent net interest income. Tax exempt interest revenue is shown on a tax-equivalent basis for proper comparison. For each category of interest- earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to (1) changes in rate (change in rate multiplied by prior year volume), (2) changes in volume (change in volume multiplied by prior year rate), and (3) changes in volume/rate (change in rate multiplied by change in volume) have been allocated proportionately based on the absolute value of the change due to the rate and the change due to volume.
Increases (Decreases) due to Increases (Decreases) due to
(in thousands) Rate Volume Net Rate Volume Net
Interest income:
Loans:
Paycheck protection program — 4,569 4,569 — — —
Interest expense:
Deposits:
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NON-GAAP FINANCIAL MEASURES
This document contains certain non-GAAP financial measures in addition to results presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These non-GAAP measures are intended to provide the reader with additional supplemental perspectives on operating results, performance trends, and financial condition. Non-GAAP financial measures are not a substitute for GAAP measures; they should be read and used in conjunction with the Company’s GAAP financial information. A reconciliation of non-GAAP financial measures to GAAP measures is provided below. In all cases, it should be understood that non-GAAP measures do not depict amounts that accrue directly to the benefit of shareholders. An item that management excludes when computing non- GAAP adjusted earnings can be of substantial importance to the Company’s results for any particular quarter or year. The Company’s non-GAAP adjusted earnings information set forth is not necessarily comparable to non- GAAP information that may be presented by other companies. Each non-GAAP measure used by the Company in this report as supplemental financial data should be considered in conjunction with the Company’s GAAP financial information.
The Company utilizes the non-GAAP measure of adjusted earnings in evaluating operating trends, including components for adjusted revenue and expense. These measures exclude amounts that the Company views as unrelated to its normalized operations, including gains/losses on securities, premises, equipment and other real estate owned, acquisition costs, restructuring costs, legal settlements, and systems conversion costs. Non-GAAP adjustments are presented net of an adjustment for income tax expense.
The Company also calculates adjusted earnings per share based on its measure of adjusted earnings. The Company views these amounts as important to understanding its operating trends, particularly due to the impact of accounting standards related to acquisition activity. Analysts also rely on these measures in estimating and evaluating the Company’s performance. Management also believes that the computation of non-GAAP adjusted earnings and adjusted earnings per share may facilitate the comparison of the Company to other companies in the financial services industry. The Company also adjusts certain equity related measures to exclude intangible assets due to the importance of these measures to the investment community.
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RECONCILIATION OF NON-GAAP FINANCIAL MEASURES
The following table summarizes the reconciliation of non-GAAP items for the time periods presented:
At or For The Years Ended December 31,
(Gain) loss on sale of securities, net (5,445) (237) 924
(Gain) loss on sale of premises and equipment, net (32) 18 —
Loss on other real estate owned 355 166 20
Loss on debt extinguishment 1,351 1,096 —
Acquisition, conversion and other expenses 5,801 8,317 1,728
(Gain) loss on sale of securities, net (5,445) (237) 924
Gain (loss) on sale of premises and equipment, net 32 (18) —
Loss on other real estate owned (355) (166) (20)
Loss on debt extinguishment (1,351) (1,096) —
Acquisition, conversion and other expenses (5,801) (8,317) (1,728)
(in millions)
Average paycheck protection program (PPP) loans (R) 109 — —
Average earning assets, excluding PPP loans (S) 3,288 3,320 3,249
Average shareholders' equity (G) 407 389 357
Average tangible shareholders' equity(2)(3) (H) 279 280 249
Tangible shareholders' equity, period-end(2)(3) (I) 284 269 263
(in thousands)
Adjusted earnings per share, diluted (A/L) $ 2.28 $ 1.91 $ 2.25
Tangible book value per share, period-end(2) (I/K) 19.05 17.30 16.94
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At or For The Years Ended December 31,
Performance ratios(5)
GAAP Return on assets 0.88 % 0.62 % 0.93 %
Adjusted return on assets(2) (A/F) 0.92 0.82 0.99
GAAP Return on equity 8.17 5.82 9.22
Adjusted return on equity(2) (A/G) 8.48 7.65 9.79
Adjusted return on tangible equity(2) (A+Q)/H 12.63 10.86 14.29
Net interest margin(2) (B+P)/E 2.97 2.77 2.86
Adjusted net interest margin(7) (B+P-T)/S 2.93 2.77 2.86
Supplementary data (in thousands)
Franchise taxes included in non-interest expense (O) 477 469 479
Intangible amortization (Q) 1,024 861 828
Interest and fees on PPP loans (T) 4,569 — —
(2) Non-GAAP financial measure.
(7) Core net interest margin excludes Paycheck Protection Program loans.
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Management’s discussion and analysis is intended to assist in understanding the financial condition and results of operations of the Company. The information in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes contained in this Form 10-K.
EXECUTIVE SUMMARY
The Company is focused on providing core banking products and services, including customized and innovative banking and lending solutions, designed to cater to the unique needs of its diverse communities, businesses and entrepreneurs through over 50 locations throughout Maine, New Hampshire and Vermont. Through over 500 dedicated professionals, the Company is committed to servicing and building enduring relationships by providing a higher standard of banking. The Company offers a variety of financial products and services designed around our target clients in order to serve all of their banking and financial needs. The Company continues to focus on three main initiatives designed to improve its franchise and profitability on an ongoing basis: attracting noninterest-bearing deposits and reducing our cost of deposits, optimizing the balance sheet to focus on higher-margin products while managing credit risk, and appropriately managing down expenses to the size and complexity of the business. Through these efforts, the Company continues to transform its franchise into a relationship-focused business bank within its footprint.
Financial Highlights
Bar Harbor Bankshares recorded 2020 net income of $33 million, or $2.18 per diluted share, compared to $23 million, or $1.45 per diluted share, in 2019. Adjusted income (non-GAAP measure) in 2020 was $35 million, or $2.26 per diluted share, and $30 million, or $1.91 per diluted share, for the same period of 2019. Non-recurring expenses in 2020 included swap termination costs and profitability initiative costs while 2019 included acquisition, conversion and balance sheet optimization costs.
Non-interest income reached record levels in 2020 driven by mortgage banking income, gains on sold securities and other fee income. The Company sold fixed rate residential mortgage production in the secondary market in lieu of taking interest rate and credit risk on the balance sheet, producing $7 million in fee revenue. The Company also took advantage of unrealized gains in the securities portfolio by selling certain investments for a net gain of $5 million. Customer service fees increased 12% on an expanded customer base from the prior year acquisition and a significant number of organic accounts opened throughout 2020. Additionally, the Company’s continued focus on commercial customers generated higher derivative and treasury income in 2020, and produced cross-sell opportunities within the retail and wealth management lines.
Wealth management remains a significant contributor to fee income in 2020; increasing 11% and serving as a foundation for deepening customer relationships with $2.3 billion in assets under management. During the year the Company consolidated leadership and combined operations onto a common platform in its wealth management business. This consolidation allowed for unified policies under one environment driven by best practices.
In 2020, the Company maintained its earning assets through commercial loan growth of $212 million or 17% through its strategy to grow variable rate loans. Non-maturity deposits grew $445 million or 25% through new accounts and the impacts of government stimulus. Excess liquidity generated from deposits was used to further delever the Company’s balance sheet by reducing wholesale funding $520 million or 49%. The reduction in wholesale funding consisted of repayments of $195 million in senior borrowings and maturities of $325 million in brokered deposits. These collective actions reduced the Company’s overall loan to deposit ratio to 88% at year-end 2020 compared to 98% in the prior year.
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The Company maintains a strong capital position; building tangible equity excluding security adjustments (non-GAAP measure) in 2020 to a higher level than before the branch acquisition in the fourth quarter of 2019. The Company furthered its return on capital programs in 2020 in the form of stock purchases and dividend payments. Stock repurchases during the year totaled 720 thousand shares at a cost of $13.9 million. An additional 61 thousand shares remain available to be repurchased before the plan expires in 2021. The Company distributed regular cash dividends on its common stock in the aggregate amount of $13 million representing a payout ratio of 40%.
Return on assets in 2020 was 0.88% compared to 0.62% in 2019, while adjusted return on assets (non-GAAP measure) was 0.92% in 2020 compared to 0.82% in 2019. In a similar trend, return on equity was 8.17% in 2020 from 5.82% in 2019 and adjusted return on equity (non-GAAP measure) was 8.48% in 2020 from 7.65% in 2019.
COVID-19 Pandemic
On March 13, 2020, a national emergency was announced related to the COVID-19 pandemic, which has since been extended. The COVID-19 pandemic has resulted in significant economic uncertainties that have had, and could continue to have, an adverse impact on the Company's operating income, financial condition and cash flows. The extent to which the COVID-19 pandemic will impact the Company's operations and financial results during 2021 cannot be reasonably or reliably estimated at this time. The Company has taken careful measures in an effort to ensure the safety of its employees and customers. That includes restricting nonessential employee travel, expanding remote access availability, distancing work stations, professional cleaning of its facilities, and signs and distancing reminders for customers in the banking centers. Further, the Company remains committed to providing uninterrupted and reliable banking service and has business continuity plans and protocols in place to ensure critical operations are able to continue without disruption. See further discussion in Item 1A – Risk Factors of this Form 10-K.
Credit Quality
The Company has experienced continuous positive trends in credit quality in 2020. Disciplined risk management has guided the Company through volatility created by the pandemic while also allowing the Company to focus on long-term goals. The Company had low levels of non-performing assets at 0.33% and past dues at 0.58% by year end 2020 including a 34% decrease in commercial loan delinquencies.
Starting in the second quarter 2020, the Company began stress testing the loan portfolio in addition to normal migration analysis. The stress testing of commercial loans included the most affected industries by COVID-19 within the Company’s footprint, specifically hospitality. However, the Company’s customers in the hospitality industry benefited from a better than expected summer tourism season for Northern New England. Testing results throughout the year affirm the Company’s risk-based credit philosophy with no significant risk-rating downgrades or changes to reserves.
Paycheck Protection Program Loans
In response to the COVID-19 pandemic the CARES Act went into law on March 27, 2020, which provides assistance for American workers, families and small businesses. The Paycheck Protection Program ("PPP"), established by the CARES Act and implemented by the Small Business Administration ("SBA") provides small businesses with funds to pay payroll costs, pay interest on mortgages, rent, and utilities and are 100% guaranteed by the SBA. PPP loans have a two year term, carry an interest rate at 1% and earn an amortizing SBA fee between 1 to 5% depending of the size of the loan. These loans are recorded on the Company’s balance sheet as commercial and industrial loans. In 2020, the Company obtained SBA approvals on approximately $132 million with $5 million of fees on 1,900 PPP loans. As of December 31, 2020, the Company had an outstanding balance of loans totaling $54 million and $1 million of deferred fees. The Company expects the majority of remaining forgiveness to occur by the end of the second quarter 2021.
On December 27, 2020, the Consolidated Appropriations Act of 2021 ("CAA") was signed into law, which extended certain provisions of the CARES Act and provided additional funding. The CAA extended the PPP application period to March 31, 2021 and permits eligible companies to obtain a second PPP loan with a maximum amount of $2.0 million. This second round of loans carry similar terms and conditions as the first round and lenders are eligible for the same range of SBA processing fees. The Company plans to continue the PPP program into the first quarter of 2021.
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Loan Modifications
Also in response to the COVID-19 pandemic the Company has supported its customers through loan deferrals. Under the CARES Act and the CAA Act, banks may deem that loan modifications do not result in troubled debt restructurings if they are (1) related to COVID-19; (2) executed on a loan that was not more than 30 days past due as of December 31, 2019; and (3) executed between March 1, 2020, and the earlier of (A) 60 days after the date of termination of the COVID-19 national emergency declaration by the President of the United States or (B) January 1, 2022. Additionally, other short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not troubled debt restructurings under ASC Subtopic 310-40 and federal banking agencies' interagency guidance.
Over the course of the year the Company modified over 800 loans totaling about $400 million, which were mostly temporary principal deferrals with normal interest accruals. The loans modified under deferment plans are still accruing interest and all contractual principal and interest is expected to be collected. As of December 31, 2020, the Company had 69 COVID-19 modified loans totaling $69 million.
CECL
In 2020, the Company implemented the CECL methodology and ran it concurrently with the historical incurred method. Under a provision provided by the CARES Act of 2020, the Company elected to delay the adoption of the CECL standard. On December 27, 2020, the Consolidated Appropriations Act, 2021 was signed into law. This law extended relief for troubled debt restructurings and provided for further delay of the current expected credit losses adoption under the CARES Act to January 1, 2022, with early adoption permitted. The Company elected to remain on the incurred loan loss methodology for 2020 and will adopt the CECL standard during the first quarter of 2021, effective January 1, 2021. Had the Company adopted CECL at year end 2020, the loan loss reserve as a percentage of total loans would have been 95 basis points compared to 74 basis points reported under the incurred loss model. The 95 basis points may change in the first quarter of 2021 based primarily on any changes in economic forecasts.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2020 AND 2019
Summary
The Company offers a competitive mix of loan and deposit products to serve the retail and commercial markets in its footprint. Loans and investment securities are the Company’s primary earning assets and net interest income from these products is its primary revenue source. Funding of the Company’s earning assets is achieved through its management of liabilities, attempting to provide stable and flexible sources of funding within well-defined credit, investment, interest rate and liquidity guidelines. The Company’s objective is to optimize its balance sheet position and enhance profitability with controlled risk. The Company maintains adequate liquidity under both prevailing and forecasted economic conditions achieved primarily through an appropriate mix of deposits and borrowed funds. Total assets were $3.7 billion in 2020, remaining steady with 2019.
Cash and Cash Equivalents
The Company maintains cash vaults and teller drawers to service customers along with transactional cash accounts to service the needs of the Company and its subsidiaries that are non-interest bearing. Interest-bearing deposits are maintained with other banks such as the Federal Reserve Bank, Federal Home Loan Bank, and other correspondent banks. These accounts are used to fund reserve requirements, debt service on senior borrowings, and serve as collateral for correspondent bank relationships. In addition, these accounts hold any excess liquidity used to fund higher earning assets. The Company continuously monitors cash levels to ensure compliance with applicable regulatory requirements, including liquidity and reserve requirements.
Total cash and cash equivalents at December 31, 2020 were $226 million, compared to $57 million at December 31, 2019. The increase in cash and cash equivalent balances of $169 million between periods was driven by unanticipated extensive growth in non-maturity deposits from new accounts and government stimulus outpacing the growth in other earning assets. The biggest portion of the growth is in Federal Reserve balances reflected in interest bearing deposits with other banks that grew by $168 million. The average earning yield on interest bearing deposits in 2020 is 0.15% compared to 0.96% in 2021, which reduces net interest margin 16 basis points and one basis point, respectively from excess liquidity.
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Securities
The Company maintains a relatively high quality and liquid securities portfolio primarily consisting of US Government-sponsored enterprises and US Government agency mortgage-backed securities, obligations of states and political subdivisions, corporate bonds, and to a much lesser extent other asset backed securities and non-agency mortgage securities. The securities portfolio is managed in accordance with achieving the Company’s asset-liability objectives which includes managing liquidity, funding, capital, and structural interest rate risks. Investments are evaluated within this framework and policy guidelines which have been established by the Company’s Board of Directors. The Company continuously evaluates and monitors the securities portfolio tied to credit, liquidity, duration, suitability and other metrics. Included in the Company’s total securities is FHLB stock which is a non-marketable equity security and, therefore, is reported at cost.
Securities in 2020 decreased $85 million as the Company focused on meeting overall asset-liability objectives when interest rates increase from their current low levels. Securities activity during the year included purchases of $216 million offset by maturities, calls and pay downs of $152 million and sales of $153 million. The proceeds from sales and amortizing securities supported asset-liability objectives to increase liquidity, reduce prepayment and reinvestment risk, and improve risk adjusted returns.
The Company monitors our securities portfolio to ensure adequate credit support. As of December 31, 2020, the Company has identified no credit impairment. There is no current intent to sell securities with a fair value below amortized cost at December 31, 2020, and it is more likely than not that the Company will not be required to sell such securities prior to the recovery of their amortized cost basis. We consider the lowest credit rating and industrial analysis for identification of potential credit impairment.
In 2020, the Company sold securities of $153 million with a net gain of $5 million. The sales strategy took advantage of favorable market conditions with attractive prices allowing the Company to sell securities projected to have sub-optimal returns and lower liquidity profiles at sizable gains. The Company was then able to repurchase more liquid securities with reduced prepayment risk and improved risk adjusted returns. The execution of the fourth quarter trades led to slight increase in profitability metrics and availability to pledge additional securities with the FHLB. Although the sales generating realized gains the Company still improved December 31, 2020 unrealized gains, net of tax to $10 million compared to $6 million at December 31, 2019.
The weighted average yield on the Company’s securities portfolio was 2.96% in 2020 compared to 3.42% in the prior year. The weighted average life of the securities portfolio at December 31, 2020 was estimated to be 4.8 years, with a duration of approximately 4.3 years. These metrics compare with an estimated weighted average life of 5.0 years, with a duration of approximately 3.6 years for the portfolio at December 31, 2019.
Loans Held For Sale
Held for sale loans increased by $18 million to $24 million at December 31, 2020 from $6 million at December 31, 2019 as a result of strong mortgage refinancing demand in response to the low interest rate environment. This asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market. In 2020, the Company’s strategy was to sell most of its residential mortgage originations on the secondary market. Proceeds from sales totaled $223 million in 2020, $63 million in 2019 and $58 million in 2018.
Loans
The Company’s loan portfolio is comprised of the following segments: commercial real estate, commercial and industrial, residential real estate, and consumer loans. Commercial real estate loans include multi-family, commercial construction and land development, and other commercial real estate classes. Commercial and industrial loans include loans to commercial businesses and tax exempt entities including PPP loans to small businesses. Residential real estate loans consist of mortgages for 1-4 family housing. Consumer loans include home equity loans, lines of credit and auto and other installment lending.
During 2020 total loans decreased $72 million to $2.6 billion. Given the current economic environment, the Company selectively grew total commercial loans to $1.5 billion or at a pace of 17%. Commercial and industrial loans grew 18%
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during the year, and 2% excluding PPP loans as the Company closely monitored risk associated with growth prospects in the portfolio. Commercial loan growth was offset by a decline in residential loan balances of $221 million or 20% as the Company strategically moved a majority of production to the secondary market platform to generate fee income. Residential loan production was led by refinancing activity given the lower interest rate environment and originations totaled $246 million in 2020 compared to $67 million in 2019.
The Company offered PPP loans in an effort to assist its business partners and communities. The Company will continue the program with the second round of PPP loans authorized by the new stimulus bill in 2021. The Company originated over 1,900 first-round PPP loans totaling $132 million, of which many have been submitted for forgiveness by the SBA. The remaining first round PPP loans total $54 million with an associated $1 million of deferred fees not yet recognized in income and are expected to be forgiven by the end of the second quarter 2021. The Company also offered borrowers COVID-19 loan modifications consisting mostly of temporary deferrals with normal interest accruals. The modifications totaled over 800 loans or about $400 million over the course of the year.
The Company’s loan portfolio remains diverse among many different industries over several geographies. However, commercial loans represent 60% of the total portfolio and typically involve larger balances and gives rise to concentration risk.
All commercial loans are assigned Standard Industrial Classification codes, North American Industry Classification System codes, and state and county codes. The following table summarizes the major industries of the Company’s commercial loan portfolio as of December 31, 2020:
(in thousands) Amount Percent of Portfolio
Real estate rental and leasing $ 644,994 42 %
Health care and social assistance 91,989 6
Agriculture, forestry, fishing and hunting 41,271 3
Arts, entertainment, and recreation 22,137 1
Professional, scientific, and technical services 16,463 1
Management of companies and enterprises 15,324 1
Transportation and warehousing 15,038 1
The largest concentrations in the commercial loan portfolio are commercial real estate and hospitality representing 42% and 18%, respectively. Concentrations are managed through a serious of loan policy limits and stringent underwriting requirements to minimize exposures. Loan policy limits are based on Tier 1 Risk Based Capital (TRBC) as computed in quarterly regulatory reporting. At December 31, 2020, none of these TRBC thresholds were exceeded. In regard to stringent underwriting requirements the Company has established minimum thresholds for loan to value ratios, debt service coverage rations, and requirements for personal guarantees. The Company also performs a borrower revenue/margin sensitively analysis on current financials to determine the impact of decreases in borrower revenues on cash flow and ability to cover debt service.
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Allowance for loan losses
The determination of the allowance for loan losses is a critical accounting estimate. The Company’s methodologies for determining the loan loss allowance are discussed in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements.
The year-end 2020 allowance for loan losses increased to $19 million from $15 million in 2019 largely due to commercial loan growth and increased qualitative economic factors associated with the pandemic. The allowance for loan losses to total loans ratio expanded at year-end 2020 to 0.74% from 0.58% at year-end 2019. As noted above the Company has adopted CECL as of January 1, 2021 which will result in a higher allowance coverage ratio. Non-accruing loans in 2020 decreased primarily due to $2 million in commercial and residential payoffs during the fourth quarter.
Due to the impacts of the pandemic the Company began and expanded quarterly stress testing of its commercial loan portfolio throughout 2020. Fourth quarter testing covered 54% of the portfolio including the top 50 relationships, all criticized loans greater than $1.0 million, hospitality loans greater than $250 thousand, all loans over $150 thousand with a pandemic modification and any seasonal payment, restaurant, or 2021 maturing term loans greater than $500 thousand. Results of the stress testing led to no significant downgrades or changes to reserves.
Other Assets
The Company identifies on its balance sheet premises and equipment, other real estate owned, goodwill, other intangible assets, bank-owned life insurance, net deferred tax assets and other assets consisting of derivative fair values, right of use asset, community investments, and receivables. These collective assets totaled $333 million at the end of 2020 compared to $303 million as of December 31, 2019. The increase is primarily from the $26 million gross up of the fair value in customer loan derivatives and $3 million in community limited partnership investments made during 2020 reflected in the cash flow from investing activities. Community limited partnership investments provide affordable loans or equity funding typically for multifamily or residential real estate in qualified community reinvestment areas, some of which may involve low income housing tax credits. Partnerships can also include loans for commercial purposes used in economic development in qualified community reinvestment areas.
Deposits
The Company views its customer relationships as key to building its core funding platform. The Company offers competitive deposit products with local convenience including accounts with cash-back rewards. Historically, the Company’s deposit market experiences some seasonality, with lower deposits in the winter and spring months and higher deposits in the summer and autumn months.
Total deposits increased $210 million to $2.9 billion in 2020 from $2.7 billion in 2019. Non-maturity deposits grew by $445 million or 25%, with the Company’s retail team opening 13,250 new accounts for the year and impacts of government stimulus. Time deposits decreased $235 million given a $325 million reduction in brokered deposits offset by $90 million of growth in customer time deposits. Lower interest rates and the divergence in brokered deposit spreads provided an opportunity to lock into favorable rates with longer maturities in early 2020. The Company improved its loan-to-deposit ratio to 88% at year-end from 98% at the end of 2019 primarily as a result of deposit growth and residential loan sales.
Borrowings
Borrowed funds provide a means to help manage balance sheet interest rate risk, given the Company’s ability to select desired amounts, terms and maturities on a daily basis. Senior borrowings principally consist of advances from the FHLB and, to a lesser extent, securities sold under agreements to repurchase. Advances from the FHLB are secured by stock in the FHLB, investment securities, certain commercial real estate loans, and blanket liens on qualifying mortgage loans and home equity loans. Subordinated borrowings consist of notes issued to accredited investors and provides a stable source of funding and capital to the Company. Contingency lines of credit are also maintained with the Federal Reserve Bank of Boston and a correspondent bank.
At December 31, 2020 total borrowings were $336 million with a weighted average rate of 1.41% compared to $531 million with a weighted average rate of 2.11% at year-end 2019. Prior to the pandemic the Company’s borrowings strategy centered around managing seasonal drops in core deposit funding while neutralizing fixed rate asset growth which involved locking into favorable rates on longer maturities. As a result 2020 long-term borrowings increased by $59 million with a
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weighted average rate of 2.37% at December 31, 2020 compared to 2.87% at December 31, 2019. Following the onset of the pandemic the Company changed strategy to leverage funds from strong core deposit growth to offset maturing short-term borrowings. Overall borrowings decreased $195 million or 37% from year-end 2019 primarily as excess liquidity was used to pay down borrowings. Short-term borrowings were reduced during the year by $254 million to $93 million with a weighted average rate of 0.44% compared to 1.73% at December 31, 2019.
Derivative Financial Instruments and Hedging Activities
The Company utilizes derivative instruments to minimize fluctuations in earnings and cash flows caused by interest rate volatility. The notional balance of derivative financial instruments increased to $877 million at the end of 2020 from $580 million at year-end 2019. The increase is primarily due to $300 million in customer loan derivatives sold on commercial loans with matching hedges using a national bank counterparty. The net fair value of total derivatives was a net asset of $52 thousand at the end of 2020 compared to a net liability of $743 thousand at year-end 2019.
Cash flow hedges reflected a new $25 million notional amount hedge on wholesale funding in April 2020. Based on direct and indirect events resulting from COVID-19 pandemic, the Company determined that $50 million of wholesale funding was no longer necessary. A hedge the Company placed in March 2019 with a $50 million notional amount and fixed rate of 2.46% was terminated in October 2020. As a result of the termination a $4 million loss recognized in acquisition, conversion, and other expenses as a result of the reclassification of the unrealized loss from other comprehensive income.
Stockholders’ Equity
Total equity was $411 million at year-end 2020, compared with $396 million at year-end 2019. The Company’s book value per share increased $2.10 to $27.58 from year-end 2019. The increase was primarily due to strong net income of $33 million and a $7 million improvement in other comprehensive income offset by $13 million in dividends and $14 million in stock repurchases. The Company evaluates changes in tangible book value, a non-GAAP financial measure that is a commonly used valuation metric in the investment community, which parallels some regulatory capital measures. Tangible book value per share increased to $19.05 per share at year-end 2020 up from $17.30 per share at year-end 2019.
During 2020 and 2019, the Company declared and distributed regular cash dividends on its common stock in the aggregate amount of $13 million for both periods. The Company’s 2020 dividend payout ratio amounted to 40%, compared with 59% in 2019. Total cash dividends paid in 2020 was $0.88 per common share of stock, compared with $0.86 in 2019.
On March 12, 2020, the Company’s Board of Directors authorized a share repurchase plan (the “Plan”). Under the terms of the Plan, the Company is authorized to repurchase up to 5% of its outstanding common stock, representing approximately 781,000 shares. The Plan is authorized for twelve months expiring on March 20, 2021 and authorized based on the strength of the Company’s balance sheet and capital position, and the Company’s belief in the intrinsic value of the Company’s common stock. Given the current market for bank stock prices, the Company believes this program is another tool to enhance long-term shareholder value. As of December 31, 2020, the Company has purchased 720,043 shares.
The Company and the Bank remained well-capitalized under regulatory guidelines at period end as further described in Note 13 - Shareholders’ Equity and Earnings Per Common Share on the Consolidated Financial Statements.
COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019
Summary
Net income in 2020 was $33 million compared to $23 million in 2019. The non-GAAP measure of adjusted earnings in 2020 was $35 million compared to $30 million in 2019 and included acquisition, conversion and other expense charges of $6 million and $8 million, respectively. Net income and adjusted earnings benefited from an expanded net interest margin and higher non-interest income.
Net Interest Income
Net interest income is the principal component of the Company’s income stream and represents the difference or spread between interest generated from earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations
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in market interest rates as well as volume and mix changes in earning assets and interest-bearing liabilities can materially impact net interest income.
Net interest income for 2020 was $99 million compared with $90 million in 2019 primarily due to a lower cost of funds resulting from increased liquidity from growth in non-maturity deposits. The net interest margin expanded to 2.97% in 2020 compared to 2.77% in the prior year. Purchase loan accretion contributed 11 and 10 basis points to the margin in 2020 and 2019, respectively. Cost of deposits and borrowings also benefited from the Federal Reserve rate cuts in 2020 and changes in other key indexes in response to the pandemic. In total cost of funds decreased 65 basis points to 0.96% compared to 1.61% in 2019 due to the shift in funding sources to core deposits. Total interest-bearing deposit rates improved to 0.78% compared to 1.27% in 2019 from growth in core deposits and reductions in time deposits during 2020. Borrowing costs improved to 1.75% from 2.61% in 2019, on reduced borrowing levels and interest rates.
The yield on earning assets was 3.87% compared to 4.14% in 2019 reflecting loan originations and repricing of variable rate products in a lower interest rate environment. Both securities yields and loan yields dropped 22 basis points to 3.20% and 4.16%, respectively for 2020. The 2020 adjusted net interest margin (non-GAAP measure), which excludes PPP loans was 2.93% compared to 2.77% for 2019, which included a drag of 16 basis points and one basis point, respectively from excess liquidity reflected in interest-bearing deposits with other banks.
Loan Loss Provision
The level of the allowance is a critical accounting estimate, which is subject to uncertainty. The provision for loan losses is a charge to earnings in an amount sufficient to maintain the allowance for loan losses at a level deemed adequate by the Company. The provision was $6 million in 2020 compared to $2 million in 2019. Credit quality metrics improved with decreases in non-accruing and past due loans. Overall credit quality remains strong, the increase in the provision is indicative of commercial loan growth and higher economic adjustments reflecting elevated risk from COVID-19.
Non-Interest Income
Non-interest income are fees that are fundamental to the Company’s profitability through revenue diversification in the forms of trust and treasury management services, customer service fees, customer loan derivatives, and secondary market mortgage sales.
Non-interest income in 2020 increased to $43 million from $29 million in 2019 driven primarily by increases in mortgage banking income and gains on sold securities. The $5 million increase in mortgage banking income is associated with secondary market sales of $223 million compared to $63 million in 2019. The Company took advantage of unrealized gains in the securities portfolio in 2020 by selling certain investments for a net gain of $5 million. Customer loan derivative income also contributed to non-interest income as demand for these products remained strong within the commercial loan pipeline throughout the year. Customer services fees increased by over $1 million to $11 million resulting from expanded operations into Central Maine offset by impacts of the pandemic on these services. Wealth management income grew over $1 million to $13 million in 2020. The increase reflects a full year of having assets under management acquired in the fourth quarter of 2019 totaling $218 million.
Non-Interest Expense
Non-interest expense was $95 million in 2020 compared to $90 million in 2019. The increase is primarily a result of a $4 million higher salary and benefit expense due to the expanded branch model and wealth management business. Salary and benefit expense was also impacted by larger accruals for incentives on improved performance metrics and post-retirement plan costs based on lower discount rates. Additionally, occupancy and equipment costs increased by $3 million based on the expanded footprint in central Maine. Operating expenses remained controlled as the efficiency ratio (non-GAAP) improved to 61.71% in 2020 from 64.95% in 2019. Non-recurring expenses in 2020 primarily consisted of a $4 million loss on termination of a $50.0 million swap on wholesale borrowings and a $1 million loss on extinguishment of debt on longer-term and higher cost FHLB borrowings. The remaining represents costs for profitability initiatives including trust system conversion and consolidation. Non-recurring expenses in 2019 included a $3 million loss on interest rate cap terminations, $3 million related to the branch acquisition, and $2 million related to branch optimization and other strategic initiatives.
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Income Tax Expense
The amount of federal and state income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income and the amount of other nondeductible expenses. Income tax expense was $8 million for the year ended December 31, 2020, compared with $4 million for the year ended December 31, 2019. The effective tax rate increased to 20.2% in 2020 from 15.7% in 2019, reflecting the higher level of taxable income and lower level of non-tax advantaged income in 2020. This reflects higher income in 2020 from the Company’s expanded customer base in the state of Maine along with higher core deposits that carry a lower cost of funds.
COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2019 AND 2018
Summary
Net income in 2019 was $23 million compared to $33 million in 2018 and included acquisition, restructuring and other expense charges of $8 million and $2 million, respectively. The non-GAAP measure of adjusted earnings in 2019 was $30 million compared to $35 million in 2018. Net income and adjusted earnings in 2019 benefited from expanded yields on earning assets and non-interest income growth, offset by higher cost of funds. Results for 2019 include operations from the branch acquisition as of the October 25, 2019 effective date.
Net Interest Income
Net interest income for 2019 was $90 million compared with $91 million in 2018. Interest income was $135 million, up 6% from $127 million in 2018 as average earning assets grew $70 million. The net interest margin was 2.78% in 2019 compared to 2.87% in the prior year. Purchase loan accretion contributed 10 and 11 basis points to the margin in 2019 and 2018, respectively. Yields expanded across all loan categories as variable rate products in the first half of 2019 repriced to higher rates driven by the 2018 short-term hikes. The 2019 yield on securities improved by 19 basis points reflecting the benefit of portfolio remix strategies and associated security sales in the second half of 2019. These improvements in interest from earning assets were offset by a higher cost of interest bearing liabilities, especially in the first half of 2019, which was also driven by short-term rate hikes in late 2018. While the cost of interest bearing liabilities increased 30 basis points to 1.61% on a year-over-year basis, the same costs improved to 1.42% in the fourth quarter due to executing deleveraging strategies associated with the branch acquisition and securities sales.
Loan Loss Provision
The level of the allowance is a critical accounting estimate, which is subject to uncertainty. The provision for loan losses is a charge to earnings in an amount sufficient to maintain the allowance for loan losses at a level deemed adequate by the Company. The provision was $2 million in 2019 compared to $3 million in 2018. The decrease is primarily due to lower charge-offs in 2019 as compared to prior year reflecting continued improvement in credit quality.
Non-Interest Income
Non-interest income for 2019 increased to $29 million from $28 million in 2018 driven primarily by customer loan derivative income, which increased to $2 million in 2019 compared to $860 thousand in 2018. The increase in these fees is attributable to the Company’s continued focus on the complexity of the financial needs of its customers and related commercial loan growth in 2019. Customer service fees also contributed to the overall increase in non-interest income growing by $589 thousand in 2019. The increase is due to higher transaction volume principally from the deposit base obtained through the branch acquisition. Trust and investment management fee income in 2019 was relatively flat with 2018. However, assets under management increased to $2.0 billion in 2019 compared to $1.7 billion in 2018 primarily due wealth management accounts that were obtained through the branch acquisition.
Non-Interest Expense
Non-interest expense was $90 million in 2019 compared to $76 million in 2018. The increase in 2019 includes $3 million related to the branch acquisition, a $3 million reclassification of losses on the interest rate cap derivative from other comprehensive income and $3 million related to branch optimization and other strategic review expenses. Salary and employee benefits expenses increased by $4 million due to postretirement benefit revaluations on lower discount rates and an increase in full time equivalent employees (“FTEs”). FTEs totaled 531 at the end of 2019 compared with 445 at the end of 2018, which includes employees from the branch acquisition.
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Income Tax Expense
The effective tax rate decreased to 15.7% in 2019 from 18.7% in 2018 due to a higher proportion of tax-advantaged income to taxable income, which was driven by overall lower net income in 2019 as compared to 2018.
Expected Replacement of London Interbank Offered Rate
The Alternative Reference Rates Committee continues its work in finding suitable replacements for LIBOR. It is expected that a transition away from the widespread use of LIBOR to alternative reference rates and other potential interest rate benchmark reforms will occur beginning potentially in 2022. Although the full impact of such reforms and actions, together with any transition away from LIBOR remains unclear, the Company is preparing to transition from the LIBOR to an alternative reference rate.
The Company’s transition plan includes a number of key steps, including engagement with central bank and industry working groups and regulators, active client engagement, internal operational readiness, and risk management, among other things, to promote the transition to alternative reference rates. The Company is identifying on-balance sheet and off-balance sheet references to LIBOR, determining appropriate language to replace the LIBOR index language, and determining disclosures necessary for customers, with appropriate procedures and schedules to complete the LIBOR transition.
However, there is a number of unknown factors regarding the transition from LIBOR or interest rate benchmark reforms that could impact the Company’s business, including, for example, the pace of the transition to replacement or reformed rates, the specific terms and parameters for and market acceptance of the alternative reference rates, prices of and the liquidity of trading markets for products based on the alternative reference rates, and ability to transition to and develop appropriate systems and analytics for one or more alternative reference rates.
For a further discussion of the various risks the Company faces in connection with the expected replacement of LIBOR and reform of interest rate benchmarks on operations, see Item 1A of this Form 10K – “Risk Factors,” paragraph for “Reforms to London Interbank Offered Rate ("LIBOR") and other indices, and related uncertainty, may adversely affect our business, financial condition or results of operations.”
LIQUIDITY AND CASH FLOWS
Liquidity is measured by the Company’s ability to meet short-term cash needs at a reasonable cost or minimal loss. The Company seeks to obtain favorable sources of liabilities and to maintain prudent levels of liquid assets in order to satisfy varied liquidity demands. Besides serving as a funding source for maturing obligations, liquidity provides flexibility in responding to customer initiated needs. Many factors affect the Company’s ability to meet liquidity needs, including variations in the markets served by its network of offices, its mix of assets and liabilities, reputation and credit standing in the marketplace, and general economic conditions.
The Bank actively manages its liquidity position through target ratios established under its Asset Liability Management Policy. Continual monitoring of these ratios, by using historical data and through forecasts under multiple rate and stress scenarios, allows the Bank to employ strategies necessary to maintain adequate liquidity. The Bank’s policy is to maintain a liquidity position of at least 4% of total assets. A portion of the Bank’s deposit base has been historically seasonal in nature, with balances typically declining in the winter months through late spring, during which period the Bank’s liquidity position tightens.
The Bank maintains a liquidity contingency plan approved by the Bank’s Board of Directors. This plan addresses the steps that would be taken in the event of a liquidity crisis, and identifies other sources of liquidity available to the Company. Company management believes that the level of liquidity is sufficient to meet current and future funding requirements. However, changes in economic conditions, including consumer savings habits and availability or access to the brokered deposit market could potentially have a significant impact on the Company’s liquidity position.
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The Company believes the existing cash and cash equivalents (including an interest-bearing deposit at the FRB Boston), securities available for sale and cash flows from operating activities will be sufficient to meet anticipated cash needs for at least the next twelve months. Future working capital needs will depend on many factors, including the rate of business and revenue growth. To the extent cash and cash equivalents, securities available for sale and cash flows from operating activities are insufficient to fund future activities, the Company may need to raise additional funds through debt arrangements or public or private debt or equity financings. The Company also may need to raise additional funds in the event it is determined in the future to effect one or more acquisitions of banks or businesses. If additional funding is required, the Company may not be able to obtain debt arrangements or to effect an equity or debt financing on terms acceptable to the Company or at all.
Capital Resources
Consistent with its long-term goal of operating a sound and profitable organization, at December 31, 2020, the Company maintained its strong capital position and continued to be a “well-capitalized” financial institution according to applicable regulatory standards. Management believes this to be vital in promoting depositor and investor confidence and providing a solid foundation for future growth.
The Company’s liquidity position remains strong. During the quarter we initiated pandemic-specific liquidity stress tests to analyze potential impacts from payment deferrals, unanticipated use of committed lines of credit, as well as the possibility of required servicer advances on sold loans. At December 31, 2020, available same-day liquidity totaled approximately $1.1 billion, including cash, borrowing capacity at FHLB and the Federal Reserve Discount Window and various lines of credit. Additional sources of liquidity include cash flows from operations, wholesale deposits, cash flow from the Company's amortizing securities and loan portfolios. The Company had unused borrowing capacity at the FHLB of $511.9 million, unused borrowing capacity at the Federal Reserve of $81.1 million and unused lines of credit totaling $71.9 million, in addition to over $200.0 million in unencumbered, liquid investment portfolio assets. The Company has also utilized the Federal Reserve's Paycheck Protection Program Liquidity Facility to provide liquidity to fund PPP loans.
Contractual Obligations
The Company is a party to certain contractual obligations under which it is obligated to make future payments. These principally include borrowings from the FHLB, consisting of short-term and long-term fixed rate borrowings, and collateralized by all stock in the FHLB; a blanket lien on qualified collateral consisting primarily of loans with first and second mortgages secured by one-to-four family properties; and certain pledged investment securities. The Company has an obligation to repay all borrowings from the FHLB.
In the normal course of conducting its banking and financial services business, and in connection with providing products and services to its customers, the Company has entered into a variety of traditional third-party contracts for support services. Examples of such contractual agreements include, but are not limited to: services providing core banking systems, ATM and debit card processing, trust services software, accounting software and the leasing of T-1 telecommunication lines and other technology infrastructure supporting the Company’s network.
The following table summarizes the Company’s contractual obligations at December 31, 2020:
Less than One One to Three Three to Five After Five
(in thousands) Total Year Years Years Years
EFFECTS OF INFLATION
Inflation and changing prices have not had a material effect on the Company’s business, and the Company does not expect that they will materially affect the business in the foreseeable future. Any impact of inflation on cost of revenue and
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operating expenses, especially employee compensation costs, may not be readily recoverable in the price of the Company product offerings.
OFF-BALANCE SHEET ARRANGEMENTS
The Company is a party to certain off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that may be material to investors.
At December 31, 2020 and 2019, the Company’s off-balance sheet arrangements were limited to customer obligations, in the normal course of business to meet customer’s financing needs. These financial arrangements include commitments to extend credit, unused or unadvanced loan funds, and letters of credit. The Company uses the same lending policies and procedures to make such commitments as it uses for other lending products. Customers’ creditworthiness is evaluated on a case-by-case basis.
Commitments to originate loans, including unused or unadvanced loan funds, are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the customer to pay a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Standby letters of credit generally become payable upon the failure of the customer to perform according to the terms of the underlying contract with the third party, while commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and a third party. The contractual amount of these letters of credit represents the maximum potential future payments guaranteed by the Company. Typically these letters of credit expire if unused; therefore the total amounts do not necessarily represent future cash requirements. For further detail see Note 12 - Other Commitments, Contingencies and Off-Balance Sheet Activities of the Consolidated Financial Statements.
IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
Please refer to the notes on Recently Adopted Accounting Principles and Future Application of Accounting Pronouncements in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ACCOUNTING ESTIMATES, AND RECENT ACCOUNTING PRONOUNCEMENTS
The Company’s significant accounting policies are described in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements in this Annual Report on Form 10-K. The preparation of the consolidated financial statements in accordance with GAAP and practices generally applicable to the financial services industry requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and to disclose contingent assets and liabilities. Actual results could differ from those estimates.
Management has identified the Company’s most critical accounting policies as related to:
● Allowance for Loan Losses
● Acquired Loans
● Income Taxes
● Goodwill and Identifiable Intangible Assets
● Determination of Other-Than-Temporary Impairment of Securities
● Fair Value of Financial Instruments
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices, such as interest rates, foreign currency exchange rates, commodity prices and equity prices. Interest rate risk is the most significant market risk affecting the Company. Other types of market risk do not arise in the normal course of the Company’s business activities.
The responsibility for interest rate risk management oversight is the function of the Bank’s Asset and Liability Committee (“ALCO”), chaired by the Chief Financial Officer and composed of various members of senior management. ALCO meets regularly to review balance sheet structure, formulate strategies in light of current and expected economic conditions, adjust product prices as necessary, implement policy, monitor liquidity, and review performance against guidelines established to control exposure to the various types of inherent risk.
Interest Rate Risk: Interest rate risk can be defined as an exposure to movement in interest rates that could have an adverse impact on the Bank's net interest income. Interest rate risk arises from the imbalance in the re-pricing, maturity and/or cash flow characteristics of assets and liabilities. Management's objectives are to measure, monitor and develop strategies in response to the interest rate risk profile inherent in the Bank's balance sheet. The objectives in managing the Bank's balance sheet are to preserve the sensitivity of net interest income to actual or potential changes in interest rates, and to enhance profitability through strategies that promote sufficient reward for understood and controlled risk.
The Bank's interest rate risk measurement and management techniques incorporate the re-pricing and cash flow attributes of balance sheet and off-balance sheet instruments as each relate to current and potential changes in interest rates. The level of interest rate risk, measured in terms of the potential future effect on net interest income, is determined through the use of modeling and other techniques under multiple interest rate scenarios. Interest rate risk is evaluated in depth on a quarterly basis and reviewed by ALCO and the Company’s Board of Directors.
The Bank's Asset Liability Management Policy, approved annually by the Bank’s Board of Directors, establishes interest rate risk limits in terms of variability of net interest income under rising, flat, and decreasing rate scenarios. It is the role of the ALCO to evaluate the overall risk profile and to determine actions to maintain and achieve a posture consistent with policy guidelines.
Interest Rate Sensitivity Modeling: The Bank utilizes an interest rate risk model widely recognized in the financial industry to monitor and measure interest rate risk. The model simulates the behavior of interest income and expense for all balance sheet and off-balance sheet instruments, under different interest rate scenarios together with a dynamic future balance sheet. Interest rate risk is measured in terms of potential changes in net interest income based upon shifts in the yield curve.
The interest rate risk sensitivity model requires that assets and liabilities be broken down into components as to fixed, variable, and adjustable interest rates, as well as other homogeneous groupings, which are segregated as to maturity and type of instrument. The model includes assumptions about how the balance sheet is likely to evolve through time and in different interest rate environments. The model uses contractual re-pricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposit accounts, such as money market accounts, that are subject to re-pricing based on current market conditions. Re-pricing margins are also determined for adjustable rate assets and incorporated in the model. Investment securities and borrowings with option provisions are examined on an individual basis in each rate environment to estimate the likelihood of exercise. Prepayment assumptions for mortgage loans are calibrated using specific Bank experience while mortgage-backed securities are developed from industry standard models of prepayment speeds, based upon similar coupon ranges and degree of seasoning. Cash flows and maturities are then determined, and for certain assets, prepayment assumptions are estimated under different interest rate scenarios. Interest income and interest expense are then simulated under several hypothetical interest rate conditions including:
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Changes in net interest income based upon the foregoing simulations are measured against the flat interest rate scenario and actions are taken to maintain the balance sheet interest rate risk within established policy guidelines.
In 2020, behavioral assumptions regarding both core deposits and residential loans were modified to incorporate the results of a third party model to better reflect the Bank’s unique position and geographic footprint. As of December 31, 2020, interest rate sensitivity modeling results indicate that the Bank’s balance sheet was asset sensitive over the one- and two-year horizons.
The following table presents the changes in sensitivities on net interest income for the years ended December 31, 2020 and 2019:
(in thousands, except ratios) $ Change % Change $ Change % Change
Assuming short-term and long-term interest rates decline 100 basis points from current levels (i.e., a parallel yield curve shift) and the Bank’s balance sheet structure and size remain at current levels, management believes net interest income will deteriorate over the one year horizon while deteriorating further from that level over the two-year horizon.
Assuming the Bank’s balance sheet structure and size remain at current levels and the Federal Reserve increases short-term interest rates by 200 basis points with the balance of the yield curve shifting in parallel with these increases, management believes net interest income will improve over both the one and two-year horizons.
As compared to December 31, 2019, the year-one sensitivity in the down 100 basis points scenario is down with the year-two sensitivities in the down 100 basis points scenario lower as well. In the year-one and year-two up 200 basis points scenario, results are meaningfully improved on a year-over-year basis.
The preceding sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including: the nature and timing of interest rate levels and yield curve shape, prepayment speeds on loans and securities, deposit rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cash flows, and renegotiated loan terms with borrowers. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
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As market conditions vary from those assumed in the sensitivity analysis, actual results may also differ due to: prepayment and refinancing levels deviating from those assumed; the impact of interest rate changes, caps or floors on adjustable rate assets; the potential effect of changing debt service levels on customers with adjustable rate loans; depositor early withdrawals and product preference changes; and other such variables. The sensitivity analysis also does not reflect additional actions that the Bank’s Senior Executive Team and Board of Directors might take in responding to or anticipating changes in interest rates, and the anticipated impact on the Bank’s net interest income.
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ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Directors of Bar Harbor Bankshares and Subsidiaries
Opinion on the Internal Control Over Financial Reporting
We have audited the accompanying consolidated balance sheets of Bar Harbor Bankshares and Subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013, and our report dated March 10, 2021 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Qualitative Reserve in the Allowance for Loan Losses
As described in Notes 1 and 4 of the consolidated financial statements, the Company’s allowance for loan losses totaled $19.1 million as of December 31, 2020. The allowance is comprised of four distinct reserve components: (1) specific reserves related to loans individually evaluated; (2) quantitative reserves related to loans collectively evaluated; (3) qualitative reserves related to loans collectively evaluated; and (4) an estimate is made for losses incurred during the loss emergence period for each loan category within the collectively evaluated pools. As of December 31, 2020, specific reserves related to loans individually evaluated totaled $730 thousand and the reserve associated with loans collectively evaluated, including the quantitative, qualitative and loss emergence period estimates, totaled, $18.4 million.
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For loans that are collectively evaluated, the Company segregates loans into two general loan pools: substandard and pass rated by loan type. The reserve for loans collectively evaluated is established through historical loss experience of the loan pools over their respective loss emergence periods which are then adjusted for potential risks factors that could result in actual losses deviating from prior loss experience. The Company has considered these qualitative risk factors to be: (1) lending policies and procedures, (2) business conditions, (3) volume and nature of the loan portfolio, (4) experience, ability and depth of lending management, (5) problem loan trends, (6) quality of the Company’s loan review system, (7) concentrations in the loan portfolio, (8) competition, legal, and regulatory environment, and (9) collateral coverage and loan to value. Arriving at an appropriate level of allowance for loan losses, specifically the qualitative reserve, involves a high degree of judgment by management and future adjustments may be necessary if there are significant changes in conditions.
We identified the qualitative reserve for loans collectively evaluated in the allowance for loan losses as a critical audit matter due to the high degree of auditor judgment required in order to evaluate the subjective assumptions made by management within the reserve. Our audit procedures related to management’s evaluation and establishment of the qualitative reserve for loans collectively evaluated in the allowance for loan losses include the following, among others:
Goodwill Impairment Assessment
As described in Notes 1 and 6 of the consolidated financial statements, the Company’s goodwill balance was $119.5 million as of December 31, 2020. The Company performs a goodwill impairment test annually as of September 30, or whenever certain triggering events occur or there are circumstances that would more likely than not reduce the fair value of the reporting unit below its carrying amount are identified. Management estimates the fair value of the reporting unit by considering multiple valuation techniques, which include the income approach (discounted cash flow method) and the market approach (combination of comparable public companies and acquisition transactions). These valuation techniques consider various assumptions about projected financial results, business plans, discount rates, valuation multiples, and growth rates, among others.
We identified the impairment assessment of goodwill as a critical audit matter due to the high degree of auditor judgement, subjectivity, and effort in order to evaluate the fair value of the reporting unit due to the judgements made by management in the estimation of the Company’s future cash flows (including consideration of projected financial results and business plans), the components used in determining the discount and growth rates, the valuation multiples used, and the market data used. In addition, the audit effort involved the use of internal professionals with specialized skill and knowledge in the field of business valuation.
Our audit procedures related to the goodwill impairment assessments performed throughout the year included the following:
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/s/ RSM US LLP
We have served as the Company's auditor since 2015.
Boston, Massachusetts
March 10, 2021
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) December 31, 2020 December 31, 2019
Assets
Cash and cash equivalents:
Interest-bearing deposits with other banks 198,441 30,425
Securities:
Less: Allowance for loan losses (19,082) (15,353)
Other real estate owned — 2,236
Cash surrender value of bank-owned life insurance 77,870 75,863
Liabilities
Deposits:
Borrowings:
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(in thousands, except share data) December 31, 2020 December 31, 2019
Shareholders’ equity
Accumulated other comprehensive income 11,016 3,911
The accompanying notes are an integral part of these consolidated financial statements.
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
(in thousands, except earnings per share data) 2020 2019 2018
Interest and dividend income
Interest expense
Net interest income after provision for loan losses 93,555 87,493 88,103
Non-interest income
Gain (loss) on sales of securities, net 5,445 237 (924)
Non-interest expense
(Gain) loss on premises and equipment, net (32) 18 —
Amortization of intangible assets 1,024 861 828
Loss on debt extinguishment 1,351 1,096 —
Acquisition, conversion and other expenses 5,801 8,317 1,728
Earnings per share:
Weighted average common shares outstanding: