Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of Operations.
The following
discussion and analysis identifies significant factors that have affected our financial position and operating results during
the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction
with the financial statements and the related notes and the other statistical information also included in this Annual Report
on Form 10-K.
Overview
We are
headquartered in Lexington, South Carolina and serve as the bank holding company for the Bank. We engage in a general commercial
and retail banking business characterized by personalized service and local decision making, emphasizing the banking needs of
small to medium-sized businesses, professional concerns and individuals. We operate from our main office in Lexington, South Carolina,
and our 21 full-service offices located in the South Carolina counties of Lexington County (6 offices), Richland County (4 offices),
Newberry County (2 offices), Kershaw County (1 office), Aiken County (1 office), Greenville County (2 offices), Anderson County
(1 office), and Pickens County (1 office); and in the Georgia counties of Richmond County (2 offices) and Columbia County (1 office). On March 1, 2022, we announced the hiring of a team of experienced lenders in Rock Hill, South Carolina. We intend to establish a loan production office in Rock Hill, South Carolina, subject to prior notice and nonobjection from the Office of the Commissioner of Banking of South Carolina. Thereafter, we may open a full-service banking office in Rock Hill, South Carolina, subject to approval by our regulators.
The following
discussion describes our results of operations for 2021, as compared to 2020 and 2019, and also analyzes our financial condition
as of December 31, 2021, as compared to December 31, 2020. Like most community banks, we derive most of our income from interest
we receive on our loans and investments. A primary source of funds for making these loans and investments is our deposits, on
which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference
between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities,
such as deposits and borrowings.
We have included
a number of tables to assist in our description of these measures. For example, the “Average Balances” table shows
the average balance during 2021, 2020 and 2019 of each category of our assets and liabilities, as well as the yield we earned
or the rate we paid with respect to each category. A review of this table shows that our loans typically provide higher interest
yields than do other types of interest earning assets, which is why we intend to channel a substantial percentage of our earning
assets into our loan portfolio. Similarly, the “Rate/Volume Analysis” table helps demonstrate the impact of changing
interest rates and changing volume of assets and liabilities during the years shown. We also track the sensitivity of our various
categories of assets and liabilities to changes in interest rates, and we have included a “Sensitivity Analysis Table”
to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans,
and our deposits and other borrowings.
There
are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that
may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating
earnings. In the following section, we have included a detailed discussion of this process, as well as several tables describing
our allowance for loan losses and the allocation of this allowance among our various categories of loans.
In addition
to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We
describe the various components of this noninterest income, as well as our noninterest expense, in the following discussion. The
discussion and analysis also identifies significant factors that have affected our financial position and operating results during
the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction
with the financial statements and the related notes and the other statistical information also included in this report.
COVID-19 Pandemic
The COVID-19
pandemic and variants of the virus continue to create disruptions to the global economy and financial markets and to businesses
and the lives of individuals throughout the world. The impact of the COVID-19 pandemic and its related variants is fluid and continues
to evolve, adversely affecting many of our customers. Our business, financial condition and results of operations generally rely
upon the ability of our borrowers to repay their loans, the value of collateral underlying our secured loans, and demand for loans
and other products and services we offer, which are highly dependent on the business environment in our primary markets where
we operate and in the United States as a whole. The unprecedented and rapid spread of COVID-19 and its variants and their associated
impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending,
and other economic activities have resulted and continue to result in less economic activity, and volatility and disruption in
financial markets.
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Commercial activity
has improved, but has not returned to the levels existing before the outbreak of the pandemic, which may result in our borrowers’
inability to meet their loan obligations. Economic pressures and uncertainties related to the COVID-19 pandemic have also resulted
in changes in consumer spending behaviors, which may negatively impact the demand for loans and other services we offer. In addition,
our loan portfolio includes customers in industries such as hotels, restaurants and assisted living facilities, all of which have
been significantly impacted by the COVID-19 pandemic. We recognize that these industries may take longer to recover as consumers
may be hesitant to return to full social interaction or may change their spending habits on a more permanent basis as a result
of the pandemic. We continue to monitor these customers closely.
In addition,
due to the COVID-19 pandemic, market interest rates declined to historical lows; however, market interest rates are expected to
increase in 2022 and future periods. The reductions in interest rates, low interest rate environment, and the other effects of
the COVID-19 pandemic have had, and are expected to continue to have, adverse effects on our business, financial condition and
results of operations.
As the COVID-19
pandemic has evolved from its emergence in early 2020, so has its impact. While vaccine availability and uptake has increased,
the longer-term macro-economic effects on global supply chains, inflation, labor shortages and wage increases continue to impact
many industries, including the collateral underlying certain of our loans. Moreover, with the potential for new strains of COVID-19
to emerge, governments and businesses may re-impose aggressive measures to help slow its spread in the future. For this reason,
among others, as the COVID-19 pandemic continues, the potential or lasting impacts on our business, financial condition and results
of operations remains uncertain and difficult to assess.
Lending Operations and Accommodations
to Borrowers; Impact of COVID-19 on Asset Quality and Value of Investment Securities
Beginning in
March 2020, we proactively offered payment deferrals for up to 90 days to our loan customers regardless of the impact of the pandemic
on their business or personal finances. As a result of payments being resumed at the conclusion of their payment deferral
period, loans in which payments were being deferred decreased from the peak of $206.9 million to $175.0 million at June 30, 2020,
to $27.3 million at September 30, 2020, to $16.1 million at December 31, 2020, to $8.7 million at March 31, 2021, to $4.5 million
at June 30, 2021, to $4.1 million at September 30, 2021, and to zero at December 31, 2021. We had no loans on which payments have
been deferred at December 31, 2021 compared to $16.1 million at December 31, 2020.
We were also
a small business administration approved lender and participated in the PPP, established under the CARES Act. During 2020 and
2021, we originated 1,417 PPP loans totaling $88.5 million, which includes 843 PPP loans totaling $51.2 million originated in
2020 and 574 PPP loans totaling $37.3 million originated in 2021. Furthermore, during 2020, we facilitated the origination of
111 PPP loans totaling $31.2 million for our customers through a third party prior to establishing our own PPP platform. As of
December 31, 2021, 1,406 PPP loans totaling $87.0 million (840 PPP loans totaling $51.2 million originated in 2020 and 566 PPP
loans totaling $35.8 million originated in 2021) were forgiven through the SBA PPP forgiveness process.
Our asset quality
metrics as of December 31, 2021 remained sound. At December 31, 2021, our non-performing assets were not yet materially
impacted by the economic pressures of the COVID-19 pandemic. The non-performing asset ratio was 0.09% of total assets with the
nominal level of $1.4 million in non-performing assets at December 31, 2021 compared to 0.50% and $7.0 million at December 31,
2020. The decline in the non-performing asset ratio was related to the successful resolution of several non-accrual and accruing
loans past due of 90 days or more. Non-accrual loans declined $4.3 million to $250 thousand at December 31, 2021 from $4.6 million
at December 31, 2020. We had no accruing loans past due 90 days or more at December 31, 2021 compared to $1.3 million at December
31, 2021. Loans past due 30 days or more represented 0.03% of the loan portfolio at December 31, 2021 compared to 0.23% at December
31, 2020. The ratio of classified loans plus OREO and repossessed assets declined to 6.27% of total bank regulatory risk-based
capital at December 31, 2021 from 6.89% at December 31, 2020. During the twelve months ended December 31, 2021, we experienced
net loan recoveries of $478 thousand and net overdraft charge-offs of $22 thousand.
We are also monitoring
the impact of the COVID-19 pandemic on the operations and value of our investments. We mark to market our available-for-sale investments
and review our investment portfolio for impairment at, a minimum, quarterly. We do not consider any securities in our investment
portfolio to be other-than-temporarily impaired at December 31, 2021. However, because of changing economic and market conditions
affecting issuers, we may be required to recognize future impairments on the securities we hold as well as reductions in other
comprehensive income. We cannot currently determine the ultimate impact of the pandemic on the long-term value of our portfolio.
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Capital and Liquidity
Our capital remained
strong. Each of the regulatory capital ratios for the Bank exceeds the well capitalized minimum levels currently required
by regulatory statute at December 31, 2021 and December 31, 2020. Based on our strong capital, conservative underwriting, and
internal stress testing, we expect to remain well capitalized throughout the COVID-19 pandemic. However, the Bank’s reported
regulatory capital ratios could be adversely impacted by future credit losses related to the COVID-19 pandemic. We intend to monitor
developments and potential impacts on our capital.
We believe that
we have ample liquidity to meet the needs of our customers through our low cost deposits, our ability to borrow against approved
lines of credit (federal funds purchased) from correspondent banks, and our ability to obtain advances secured by certain securities
and loans from the Federal Home Loan Bank (“FHLB”).
Critical Accounting Estimates
We have adopted
various accounting policies that govern the application of accounting principles generally accepted in the United States and with
general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies
are described in the notes to our consolidated financial statements in this report.
Certain
accounting policies inherently involve a greater reliance on the use of estimates, assumptions and judgments and, as such, have
a greater possibility of producing results that could be materially different than originally reported, which could have a material
impact on the carrying values of our assets and liabilities and our results of operations. We consider these accounting policies
and estimates to be critical accounting policies. We have identified the determination of the allowance for loan losses and income
taxes and deferred tax assets, to be the accounting areas that require the most subjective or complex judgments and, as such,
could be most subject to revision as new or additional information becomes available or circumstances change, including overall
changes in the economic climate and/or market interest rates. Therefore, management has reviewed and approved these critical accounting
policies and estimates and has discussed these policies with our Audit and Compliance Committee.
Allowance for Loan Losses
We believe
the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used
in preparation of our consolidated financial statements. The allowance for loan losses represents an amount which we believe will
be adequate to absorb probable losses on existing loans that may become uncollectible. Our judgment as to the adequacy of the
allowance for loan losses is based on assumptions about future events, which we believe to be reasonable, but which may or may
not prove to be accurate. Our determination of the allowance for loan losses is based on evaluations of the credit worthiness
of borrowers, collectability of loans, including consideration of factors such as the balance of impaired loans, the quality,
mix, and size of our overall loan portfolio, the knowledge and depth of lending personnel, economic conditions (local and national)
that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans, our historical
loan loss experience, and a review of specific problem loans. We also consider qualitative factors such as changes in the lending
policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity
of problem loans, quality of loan review and board of director oversight, and concentrations of credit. During the first quarter
of 2020, we added a new qualitative factor related to the economic uncertainties caused by the COVID-19 pandemic. We charge recognized
losses to the allowance and add subsequent recoveries back to the allowance for loan losses. There can be no assurance that charge-offs
of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions
for loan losses will not be significant to a particular accounting period, especially considering the uncertainties related to
the COVID-19 pandemic.
As discussed
above, the CECL model will become effective for us on January 1, 2023. However, for now, we account for our allowance for loan
losses under the incurred loss model. We perform an analysis quarterly to assess the risk within the loan portfolio. The portfolio
is segregated into similar risk components for which historical loss ratios are calculated and adjusted for identified changes
in current portfolio characteristics. Historical loss ratios are calculated by product type and by regulatory credit risk classification
(See Note 4 to the Consolidated Financial Statements). The annualized weighted average loss ratios over the last 36 months for
loans classified as substandard, special mention and pass have been approximately 0.18%, 0.03% and 0.00%, respectively. The allowance
consists of an allocated and unallocated allowance. The allocated portion is determined by types and ratings of loans within the
portfolio. The unallocated portion of the allowance is established for losses that exist in the remainder of the portfolio and
compensates for uncertainty in estimating the loan losses. The allocated portion of the allowance is based on historical loss
experience as well as certain qualitative factors as explained above. The qualitative factors have been established based on certain
assumptions made as a result of the current economic conditions and are adjusted as conditions change to be directionally consistent
with these changes. The unallocated portion of the allowance is composed of factors based on management’s evaluation of
various conditions that are not directly measured in the estimation of probable losses through the experience formula or specific
allowances.
41
The
allowance represents management’s best estimate, [and we believe our estimate has been reasonably accurate in determining
allowance for loan loss adequacy], but significant downturns in circumstances relating to loan quality and economic conditions
could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may
allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results
of operations. In addition, regulatory agencies, as an integral part of their examination process, periodically review our allowance
for loan losses. Such agencies may require us to recognize additions to the allowances based on their judgments about information
available to them at the time of their examination.
Income Taxes, Deferred Tax Assets,
and Deferred Tax Liabilities
We are subject
to the income tax laws of the U.S., its states, and the municipalities in which we operate. These tax laws are complex and subject
to different interpretations by the taxpayer and the relevant government taxing authorities.
Income taxes
are provided for the tax effects of the transactions reported in our consolidated financial statements and consist of taxes currently
due plus deferred taxes related to differences between the tax basis and accounting basis of certain assets and liabilities, including
available-for-sale securities, allowance for loan losses, write-downs of OREO properties, write-downs on premises held-for-sale,
accumulated depreciation, net operating loss carry forwards, accretion income, deferred compensation, intangible assets, and pension
plan and post-retirement benefits. The deferred tax assets and liabilities represent the future tax return consequences of those
differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax
assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities
are expected to be realized or settled. A valuation allowance is recorded when it is “more likely than not” that a
deferred tax asset will not be realized. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are
adjusted through the provision for income taxes.
In establishing
our provision for income taxes, our deferred tax assets and liabilities, and our valuation allowance, we must make judgments and
interpretations about the application of these inherently complex tax laws. We must also make estimates about when in the future
certain items will affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be
subject to review/adjudication by the court systems of the various tax jurisdictions or may be settled with the taxing authority
upon examination or audit. Although we believe that the judgments and estimates used are reasonable, and we believe our estimates
have been reasonably accurate, actual results could differ, and we may be exposed to losses or gains that could be material. To
the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves,
our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement
would result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement would result
in a reduction in our effective income tax rate in the period of resolution.
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Financial Highlights
As of or For the Years Ended December 31,
(Dollars in thousands except per share amounts) 2021 2020 2019
Balance Sheet Data:
Results of Operations:
Per Share Data:
Basic earnings per common share $ 2.06 $ 1.36 $ 1.46
Diluted earnings per common share 2.05 1.35 1.45
Tangible book value at period end (non-GAAP) 16.62 16.08 13.99
Asset Quality Ratios:
Non-performing assets to total assets(3) 0.09 % 0.50 % 0.32 %
Non-performing loans to period end loans 0.03 % 0.69 % 0.31 %
Net charge-offs (recoveries) to average loans (0.05 )% (0.01 )% (0.03 )%
Allowance for loan losses to period-end total loans 1.29 % 1.23 % 0.90 %
Allowance for loan losses to non-performing assets 789.98 % 148.10 % 177.23 %
Selected Ratios:
Return on average common equity: 11.22 % 7.84 % 9.38 %
Return on average tangible common equity (non-GAAP): 12.65 % 8.94 % 10.91 %
Noninterest income to operating revenue(2) 23.49 % 25.60 % 24.16 %
Net interest margin (tax equivalent) 3.23 % 3.37 % 3.65 %
(2) Operating revenue is defined as net interest income plus noninterest income.
(5) Includes loans held for sale.
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Certain financial information
presented above is determined by methods other than in accordance with GAAP. These non-GAAP financial measures include “efficiency
ratio,” “tangible book value at period end,” “return on average tangible common equity” and “tangible
common shareholders’ equity to tangible assets.” The “efficiency ratio” is defined as non-interest expense
less merger expenses, divided by the sum of net interest income on a tax equivalent basis and non-interest income, excluding gains
(losses) on sales of securities and other assets, write-downs on premises held-for-sale, non-recurring bank owned life insurance
(BOLI) income, losses on early extinguishment of debt, gains on insurance proceeds, and collection of summary judgments on loans
charged off at a bank we acquired. The efficiency ratio is a measure of the relationship between operating expenses and net revenue.
“Tangible book value at period end” is defined as total equity reduced by recorded intangible assets divided by total
common shares outstanding. “Tangible common shareholders’ equity to tangible assets” is defined as total common
equity reduced by recorded intangible assets divided by total assets reduced by recorded intangible assets. Our management believes
that these non-GAAP measures are useful because they enhance the ability of investors and management to evaluate and compare our
operating results from period-to-period in a meaningful manner. Non-GAAP measures have limitations as analytical tools, and investors
should not consider them in isolation or as a substitute for analysis of our results as reported under GAAP.
The table below provides a
reconciliation of non-GAAP measures to GAAP for the five years ended December 31:
Tangible common equity per common share (non-GAAP) $ 16.62 $ 16.08 $ 13.99
Effect to adjust for intangible assets 2.06 2.10 2.17
Return on average tangible common equity
Return on average tangible common equity (non-GAAP) 12.65 % 8.94 % 10.91 %
Effect to adjust for intangible assets (1.43 )% (1.10 )% (1.53 )%
Return on average common equity (GAAP) 11.22 % 7.84 % 9.38 %
Tangible common shareholders’ equity to tangible assets
Tangible common equity to tangible assets (non-GAAP) 8.00 % 8.74 % 9.02 %
Effect to adjust for intangible assets 0.90 % 1.03 % 1.25 %
Common equity to assets (GAAP) 8.90 % 9.77 % 10.27 %
44
Results of Operations
Year Ended December 31, 2021 and
2020
Our
net income for the twelve months ended December 31, 2021 was $15.5 million, or $2.05 diluted earnings per common share, as compared
to $10.1 million, or $1.35 diluted earnings per common share, for the twelve months ended December 31, 2020. The $5.4 million
increase in net income between the two periods is primarily due to a $5.3 million increase in net interest income, a $135 thousand
increase in non-interest income, and a $3.3 million reduction in provision for loan losses partially offset by a $1.7 million
increase in non-interest expense and $1.7 million increase in income tax expense.
45
Year Ended December 31, 2020 and
2019
Our net income
for the twelve months ended December 31, 2020 was $10.1 million, or $1.35 diluted earnings per common share, as compared to $11.0
million, or $1.45 diluted earnings per common share, for the twelve months ended December 31, 2019. The $872 thousand decrease
in net income between the two periods is primarily due to increases in provision for loan losses expense of $3.5 million and non-interest
expense of $2.9 million, partially offset by an increase in net interest income of $3.2 million, an increase in non-interest income
of $2.0 million, and a decrease in income tax expense of $362 thousand.
Net Interest Income
Net interest
income is our primary source of revenue. Net interest income is the difference between income earned on assets and interest paid
on deposits and borrowings used to support such assets. Net interest income is determined by the rates earned on our interest-earning
assets and the rates paid on our interest-bearing liabilities, the relative amounts of interest-earning assets and interest-bearing
liabilities, and the degree of mismatch and the maturity and repricing characteristics of our interest-earning assets and interest-bearing
liabilities.
Year Ended December 31, 2021 and
2020
Net interest
income increased $5.3 million, or 13.1%, to $45.3 million for the twelve months ended December 31, 2021 from $40.0 million for
the twelve months ended December 31, 2020. Our net interest income has been trending up over the last two years as net interest
income totaled $45.3 million in 2021, $40.0 million in 2020, and $36.8 million in 2019. The yield on earning assets was 3.35%,
3.65%, and 4.19% in 2021, 2020, and 2019, respectively. The rate paid on interest-bearing liabilities was 0.24%, 0.46%, and 0.80%
in 2021, 2020, and 2019, respectively. The fully taxable equivalent net interest margin was 3.23% in 2021, 3.37% in 2020, and
3.65% in 2019.
Loans typically
provide a higher yield than other types of earning assets and, thus, one of our goals continues to be growing the loan portfolio
as a percentage of earning assets in order to improve the overall yield on earning assets and the net interest margin. Our average
loan portfolio (including loans held-for-sale) as a percentage of average earning assets was 62.6% in 2021, 69.7% in 2020, and
72.2% in 2019. Loans held-for-investment as a percentage of earning assets declined to 58.2% at December 31, 2021 from 65.1% at
December 31, 2020. Our loan (including loans held-for-sale) to deposit ratio on average during 2021 was 68.8%, as compared to
76.8% during 2020, and 78.7% during 2019. The loan to deposit ratio declined to 64.0% at December 31, 2021 as compared to 74.8%
at December 31, 2020. This decline was due to our deposit growth of $171.9 million exceeding our loan (including loans held-for-sale)
decline of $18.4 million and loan (excluding loans held-for-sale) growth of $19.5 million from December 31, 2020 to December 31,
2021.
46
Our net interest
margin declined by 15 basis points to 3.19% during the twelve months ended December 31, 2021 from 3.34% during the twelve months
ended December 31, 2020. Our net interest margin, on a taxable equivalent basis, was 3.23% for the twelve months ended December
31, 2021 compared to 3.37% for the twelve months ended December 31, 2020. Average earning assets increased $220.3 million, or
18.4%, to $1.4 billion for the twelve months ended December 31, 2021 compared to $1.2 billion in the same period of 2020. The
increase in net interest income was due to a higher level of average earning assets partially offset by lower net interest margin.
The increase in average earning assets was due to increases in loans, securities, and other short-term investments primarily due
to Non-PPP loan growth, PPP loans, organic deposit growth, and excess liquidity from PPP loan proceeds and other stimulus funds
related to the COVID-19 pandemic. The decline in net interest margin was primarily due to the Federal Reserve reducing the target
range of the federal funds rate twice totaling 150 basis points during the first quarter of 2020 and the excess liquidity generated
from PPP loan proceeds and other stimulus funds related to the COVID-19 pandemic being deployed in lower yielding securities and
other short-term investments. Lower market rates, the competitive loan pricing environment, and the COVID-19 pandemic put downward
pressure on our net interest margin during 2020 and 2021.
The net interest
margin was positively affected by PPP loans and a $140 thousand interest recovery on a non-accrual loan that was successfully
resolved during the twelve months ended December 31, 2021. We earned $3.3 million in PPP loan interest income, which includes
$3.0 million in accretion of PPP deferred fees net of deferred costs, on an average balance of $36.8 million during the twelve
months ended December 31, 2021 compared to $1.1 million in PPP loan interest income, which includes $738 thousand in accretion
of PPP deferred loan fees net of deferred costs, on an average balance of $32.3 million during the twelve months ended December
31, 2020. Excluding PPP loans, our net margin declined by 31 basis points to 3.03% during the twelve months ended December 31,
2021 from 3.34% during the twelve months ended December 31, 2020. Excluding PPP loans, our net interest margin, on a taxable equivalent
basis, was 3.07% for the twelve months ended December 31, 2021 compared to 3.37% for the twelve months ended December 31, 2020.
Average loans
increased $53.9 million, or 6.5%, to $889.0 million for the twelve months ended December 31, 2021 from $835.1 million for the
same period in 2020. Average PPP loans increased $4.5 million to $36.8 million and average Non-PPP loans increased $49.4 million
to $852.1 million for the twelve months ended December 31, 2021. Average loans represented 62.6% of average earning assets during
the twelve months ended December 31, 2021 compared to 69.7% of average earning assets during the same period in 2020. The decline
in average loans as a percentage of average earning assets was primarily due to increases in deposits of $205.3 million and securities
sold under agreements to repurchase of $12.7 million. The growth in our deposits and securities sold under agreements to repurchase
was higher than the growth in our loans, which resulted in the excess funds being deployed in our securities portfolio and other
short-term investments and to reduce the amount of our FHLB advances. The yield on loans increased two basis points to 4.46% during
the twelve months ended December 31, 2021 from 4.44% during the same period in 2020. Excluding PPP loans, the yield on Non-PPP
loans declined 22 basis points to 4.26% during the twelve months ended December 31, 2021 from 4.48% during the same period in
2020. The yield on loans during the twelve months ended December 31, 2021 also included $140 thousand in interest recoveries on
a non-accrual relationship that was successfully resolved during the third quarter of 2021. The yield on PPP loans was 9.07% during
the twelve months ended December 31, 2021 compared to 3.32% during the same period in 2020. PPP loans declined to $1.5 million
at December 31, 2021 from $42.2 million at December 31, 2020 due to PPP loans forgiven through the SBA PPP forgiveness process.
When PPP loans are forgiven any remaining deferred fees net of deferred costs are recognized in interest income through accelerated
accretion of the deferred fees net of deferred costs. Interest income on PPP loans increased $2.3 million to $3.3 million during
the twelve months of 2021 from $1.1 million during the same period in 2020. The $3.3 million in interest income on PPP loans during
the twelve months ended December 31, 2021 includes $3.0 million in accretion of deferred fees net of deferred costs.
Average securities
and average other short-term investments for the twelve months ended December 31, 2021 increased $155.9 million and $10.5 million,
respectively, from the prior year period. The yield on our securities portfolio declined to 1.69% for the twelve months ended
December 31, 2021 from 2.15% for the same period in 2020; and the yield on our other short-term investments declined to 0.18%
for the twelve months ended December 31, 2021 from 0.44% for the same period in 2020. These declines were primarily related to
the Federal Reserve reducing the target range of the federal funds rate as described above. The yield on earning assets for the
twelve months ended December 31, 2021 and 2020 was 3.35% and 3.65%, respectively. The cost of interest-bearing liabilities was
at 24 basis points during the twelve months ended December 31, 2021 compared to 46 basis points during the same period in 2020.
The cost of deposits,
including demand deposits, was 13 basis points during the twelve months ended December 31, 2021 compared to 28 basis points during
the same period in 2020. The cost of funds, including demand deposits, was 16 basis points during the twelve months ended December
31, 2021 compared to 33 basis points during the same period in 2020. We continue to focus on growing our pure deposits (demand
deposits, interest-bearing transaction accounts, savings deposits, money market accounts, and IRAs) as these accounts tend to
be low-cost deposits and assist us in controlling our overall cost of funds. During the twelve months ended December 31, 2021,
these deposits averaged 90.1% of total deposits as compared to 87.4% during the same period of 2020. This increase was due to
PPP loan proceeds, other stimulus funds related to the COVID-19 pandemic, and organic deposit growth.
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Year Ended December 31, 2020 and
2019
Net interest
income increased $3.2 million, or 8.6%, to $40.0 million for the twelve months ended December 31, 2020 from $36.8 million for
the twelve months ended December 31, 2019. Our net interest margin declined by 28 basis points to 3.34% during the twelve months
of 2020 from 3.62% during the twelve months of 2019. Our net interest margin, on a taxable equivalent basis, was 3.37% for the
twelve months of 2020 compared to 3.65% for the twelve months of 2019. Average earning assets increased $180.4 million, or 17.7%,
to $1.2 billion for the twelve months ended December 31, 2020 as compared to $1.0 billion in the same period of 2019. The increase
in net interest income was primarily due to a higher level of average earning assets partially offset by lower net interest margin.
The increase in average earning assets was due to increases in loans, securities, and other short-term investments primarily due
to Non-PPP loan growth, PPP loans, organic deposit growth, and excess liquidity from PPP loan proceeds and other stimulus funds
related to the COVID-19 pandemic. The decline in net interest margin was primarily due to the Federal Reserve reducing the target
range of the federal funds rate three times totaling 75 basis points during 2019 and two times totaling 150 basis points during
the first quarter of 2020, lower yields on PPP loans, and the excess liquidity generated from PPP loan proceeds and other stimulus
funds related to the COVID-19 pandemic being deployed in lower yielding securities and other short-term investments. Lower market
rates, the competitive loan pricing environment, and the COVID-19 pandemic put downward pressure on our net interest margin during
2020.
Average loans
increased $99.7 million, or 13.6%, to $835.1 million for the twelve months of 2020 from $735.3 million for the twelve months of
2019. Average PPP loans increased $32.3 million and average Non-PPP loans increased $67.4 million to $32.3 million and $802.8
million, respectively, for the twelve months of 2020. We had no PPP loans at December 31, 2019. Average loans represented 69.7%
of average earning assets during the twelve months of 2020 compared to 72.2% of average earning assets during the twelve months
of 2019. The decline in average loans as a percentage of average earning assets was primarily due to increases in deposits of
$152.5 million and securities sold under agreements to repurchase of $14.1 million. The growth in our deposits and securities
sold under agreements to repurchase was higher than the growth in our loans, which resulted in the excess funds being deployed
in our securities portfolio and other short-term investments and to reduce our Federal Home Loan Bank advances. The yield on loans
declined 38 basis points to 4.44% in the twelve months of 2020 from 4.82% in the twelve months of 2019. The yield on PPP loans
was 3.32% and the yield on Non-PPP loans was 4.48% in the twelve months of 2020. Average securities and average other short-term
investments for the twelve months ended December 31, 2020 increased $43.3 million and $37.3 million, respectively, from the prior
year period.
The yield on
our securities portfolio declined to 2.15% for the twelve months ended December 31, 2020 from 2.58% for the same period in 2019
while the yield on our other short-term investments declined to 0.44% for the twelve months ended December 31, 2020 from 2.14%
for the same period in 2019. These declines were primarily related to the Federal Reserve reducing the target range of the federal
funds rate as described above. The yield on earning assets for the twelve months ended December 31, 2020 and 2019 was 3.65% and
4.19%, respectively. The cost of interest-bearing liabilities was at 46 basis points in the twelve months of 2020 compared to
80 basis points in the twelve months of 2019. We continue to focus on growing our pure deposits (demand deposits, interest-bearing
transaction accounts, savings deposits and money market accounts) as these accounts tend to be low-cost deposits and assist us
in controlling our overall cost of funds. In the twelve months of 2020, these deposits averaged 84.7% of total deposits as compared
to 81.1% in the same period of 2019.
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Average Balances,
Income Expenses and Rates. The following table depicts, for the periods indicated, certain information related to our average
balance sheet and our average yields on assets and average costs of liabilities. Such yields are derived by dividing income or
expense by the average balance of the corresponding assets or liabilities. Average balances have been derived from daily averages.
Year ended December 31,
Assets
Earning assets
Liabilities
Interest-bearing liabilities
(3) Based on a 21.0% marginal tax rate.
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The following
table presents the dollar amount of changes in interest income and interest expense attributable to changes in volume and the
amount attributable to changes in rate. The combined effect related to volume and rate which cannot be separately identified,
has been allocated proportionately, to the change due to volume and the change due to rate.
(In thousands) Volume Rate Net Volume Rate Net
Assets
Earning assets
Interest-bearing liabilities
Market Risk and Interest
Rate Sensitivity
Market risk reflects
the risk of economic loss resulting from adverse changes in market prices and interest rates. The risk of loss can be measured
in either diminished current market values or reduced current and potential net income. Our primary market risk is interest rate
risk. We have established an Asset/Liability Management Committee (the “ALCO”) to monitor and manage interest rate
risk. The ALCO monitors and manages the pricing and maturity of our assets and liabilities in order to diminish the potential
adverse impact that changes in interest rates could have on our net interest income. The ALCO has established policy guidelines
and strategies with respect to interest rate risk exposure and liquidity.
We employ
a monitoring technique to measure of our interest sensitivity “gap,” which is the positive or negative dollar difference
between assets and liabilities that are subject to interest rate repricing within a given period of time. Simulation modeling
is performed to assess the impact varying interest rates and balance sheet mix assumptions will have on net interest income. We
model the impact on net interest income for several different changes, to include a flattening, steepening and parallel shift
in the yield curve. For each of these scenarios, we model the impact on net interest income in an increasing and decreasing rate
environment of 100 and 200 basis points. We also periodically stress certain assumptions such as loan prepayment rates, deposit
decay rates and interest rate betas to evaluate our overall sensitivity to changes in interest rates. Policies have been established
in an effort to maintain the maximum anticipated negative impact of these modeled changes in net interest income at no more than
10% and 15%, respectively, in a 100 and 200 basis point change in interest rates over a 12-month period. Interest rate sensitivity
can be managed by repricing assets or liabilities, selling securities available-for-sale, replacing an asset or liability at maturity
or by adjusting the interest rate during the life of an asset or liability. Managing the amount of assets and liabilities repricing
in the same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest
rates. Neither the “gap” analysis or asset/liability modeling are precise indicators of our interest sensitivity position
due to the many factors that affect net interest income including, the timing, magnitude and frequency of interest rate changes
as well as changes in the volume and mix of earning assets and interest-bearing liabilities.
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The following
table illustrates our interest rate sensitivity at December 31, 2021.
Interest Sensitivity Analysis
Assets
Earning assets
Liabilities
Interest bearing liabilities
Interest bearing deposits
(2) Securities based on amortized cost.
Based
on the many factors and assumptions used in simulating the effect of changes in interest rates, the following table estimates
the hypothetical percentage change in net interest income at December 31, 2021 and 2020 over the subsequent 12 months. At December
31, 2021, we are asset sensitive. As a result, our modeling reflects an increase in net interest income in a rising interest rate
environment and a reduction in net interest income in a declining interest rate environment. In a declining rate environment,
the decline in net interest income is primarily due to the current level of interest rates being paid on our interest bearing
transaction accounts as well as money market accounts. The interest rates on these accounts are at a level where they cannot be
repriced in proportion to the change in interest rates. The increase and decrease of 100 and 200 basis points, respectively, reflected
in the table below assume a simultaneous and parallel change in interest rates along the entire yield curve.
Net
Interest Income Sensitivity
Flat — —
During the second 12-month period
after 100 basis point and 200 basis point simultaneous and parallel increases in interest rates along the entire yield curve,
our net interest income is projected to increase 7.82% and 15.00%, respectively.
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We perform a
valuation analysis projecting future cash flows from assets and liabilities to determine the Present Value of Equity (“PVE”)
over a range of changes in market interest rates. The sensitivity of PVE to changes in interest rates is a measure of the sensitivity
of earnings over a longer time horizon. At December 31, 2021 and 2020, the PVE exposure in a plus 200 basis point increase in
market interest rates was estimated to be 9.73% and 11.47%, respectively. The PVE exposure in a down 100 basis point decrease
was estimated to be (9.86)% at December 31, 2021 compared to (14.32)% at December 31, 2020.
Provision and Allowance
for Loan Losses
We account for
our allowance for loan losses under the incurred loss model. At December 31, 2021, the allowance for loan losses was $11.2 million,
or 1.29% of total loans (excluding loans held-for-sale), compared to $10.4 million, or 1.23% of total loans (excluding loans held-for-sale)
at December 31, 2020. Excluding PPP loans and loans held-for-sale, the allowance for loan losses was 1.30% of total loans at December
31, 2021 compared to 1.30% of total loans at December 31, 2020. The increase in the allowance for loan losses compared to December
31, 2020 is primarily related to loan growth of $19.5 million; $455 thousand in net recoveries; an increase in our economic conditions
qualitative factor by four basis points during 2021 due to higher inflation, supply chain bottlenecks, and labor shortages in
certain industries; and a one basis point increase in our change in legal or regulatory requirements qualitative factor. These
increases were partially offset by a reduction in the loss emergence period assumption on our COVID-19 qualitative factor, which
was added to our allowance for loan losses methodology during 2020, to 21 months at December 31, 2021 from 24 months at December
31, 2020. At June 30, 2021, we reduced the loss emergence period in the COVID-19 qualitative factor to 18 months from 24 months
due to a reduction in the number of COVID-19 related cases, hospitalizations, and deaths within our markets. However, we increased
the loss emergence period to 21 months at December 31, 2021 due to the prevalence of the highly transmittable COVID-19 Omicron
variant.
Loans that we
acquired in our acquisition of Cornerstone Bancorp, otherwise referred to herein as Cornerstone, in 2017 as well as in our acquisition
of Savannah River Financial Corp., otherwise referred to herein as Savannah River, in 2014 are accounted for under FASB ASC 310-30.
These acquired loans were initially measured at fair value, which includes estimated future credit losses expected to be incurred
over the life of the loans. The credit component on loans related to cash flows not expected to be collected is not subsequently
accreted (non-accretable difference) into interest income. Any remaining portion representing the excess of a loan’s or
pool’s cash flows expected to be collected over the fair value is accreted (accretable difference) into interest income.
At December 31, 2021 and December 31, 2020, the remaining credit component on loans attributable to acquired loans in the Cornerstone
and Savannah River transactions was $130 thousand and $264 thousand, respectively.
Our provision
for loan losses was $335 thousand for the twelve months ended December 31, 2021 compared to $3.7 million during the same period
in 2020. The decline in the provision for loan losses is primarily related to an increase during the twelve months of 2020 in
the qualitative factors in our allowance for loan losses methodology related to the deteriorating economic conditions and economic
uncertainties caused by the COVID-19 pandemic. As discussed above, during the twelve months of 2020, we added a qualitative factor
for the COVID-19 pandemic to our allowance for loan losses methodology. This new qualitative factor was based on the dollar amount
of our deferrals and a one-year loss emergence period based on the highest period of annual historical loss rate since the Bank’s
inception. As the pandemic worsened, we added our exposure to certain industry segments most impacted by the COVID-19 pandemic
(hotels, restaurants, assisted living, and retail) to the COVID-19 qualitative factor and we extended the loss emergence period
to two years based on the highest two periods of annual historical loss rates since the Bank’s inception. At December 31,
2021, the COVID-19 qualitative factor represented $1.9 million of our allowance for loan losses.
We also recognized
$455 thousand in net recoveries during the twelve months ended December 31, 2021. These items were partially offset by $19.5 million
in loan growth; a four basis points increase (two basis points at June 30, 2021 and two basis points at September 30, 2021) in
our qualitative factor related to economic conditions due to an increase in inflation, supply chain bottlenecks, and labor shortages
in our markets; and a one basis point increase in our change in legal or regulatory requirements qualitative factor at December
31, 2021 due to the resignation of the Chair of the FDIC on December 31, 2021, which may lead to regulatory changes that negatively
affect banks.
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The allowance
for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become
uncollectible. Our judgment as to the adequacy of the allowance for loan losses is based on assumptions about future events, which
we believe to be reasonable, but which may or may not prove to be accurate. Our determination of the allowance for loan losses
is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans,
the quality, mix, and size of our overall loan portfolio, the knowledge and depth of lending personnel, economic conditions (local
and national) that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans,
our historical loan loss experience, and a review of specific problem loans. We also consider qualitative factors such as changes
in the lending policies and procedures, changes in the local or national economies, changes in volume or type of credits, changes
in volume/severity of problem loans, quality of loan review and board of director oversight, and concentrations of credit. We
charge recognized losses to the allowance and add subsequent recoveries back to the allowance for loan losses. There can be no
assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point
in time or that provisions for loan losses will not be significant to a particular accounting period, especially considering the
uncertainties related to the COVID-19 pandemic.
We perform an
analysis quarterly to assess the risk within the loan portfolio. The portfolio is segregated into similar risk components for
which historical loss ratios are calculated and adjusted for identified changes in current portfolio characteristics. Historical
loss ratios are calculated by product type and by regulatory credit risk classification (See Note 4 to the Consolidated Financial
Statements). The annualized weighted average loss ratios over the last 36 months for loans classified as substandard, special
mention and pass have been approximately 0.18%, 0.03% and 0.00%, respectively. The allowance consists of an allocated and unallocated
allowance. The allocated portion is determined by types and ratings of loans within the portfolio. The unallocated portion of
the allowance is established for losses that exist in the remainder of the portfolio and compensates for uncertainty in estimating
the loan losses. The allocated portion of the allowance is based on historical loss experience as well as certain qualitative
factors as explained above. The qualitative factors have been established based on certain assumptions made as a result of the
current economic conditions and are adjusted as conditions change to be directionally consistent with these changes. The unallocated
portion of the allowance is composed of factors based on management’s evaluation of various conditions that are not directly
measured in the estimation of probable losses through the experience formula or specific allowances. The overall risk as measured
in our three-year lookback, both quantitatively and qualitatively, does not encompass a full economic cycle. Net charge-offs in
the 2009 to 2011 period averaged 63 basis points annualized in our loan portfolio. Over the most recent three-year period, our
net charge-offs have experienced a modest net recovery. We currently believe the unallocated portion of our allowance represents
potential risk associated throughout a full economic cycle; however, the COVID-19 pandemic and the government and economic responses
thereto may materially affect the risk within our loan portfolios.
We have a significant
portion of our loan portfolio with real estate as the underlying collateral. At December 31, 2021 and December 31, 2020,
approximately 90.9% and 87.5%, respectively, of the loan portfolio had real estate collateral. The increase in the percent of
our loan portfolio with real estate as the underlying collateral is due to a $46.1 million increase in loans with real estate
as the underlying collateral and a $40.8 million decline in PPP loans, which declined to $1.5 million at December 31, 2021 from
$42.2 at December 31, 2020. When loans, whether commercial or personal, are granted, they are based on the borrower’s ability
to generate repayment cash flows from income sources sufficient to service the debt. Real estate is generally taken to reinforce
the likelihood of the ultimate repayment and as a secondary source of repayment. We work closely with all our borrowers that experience
cash flow or other economic problems, and we believe that we have the appropriate processes in place to monitor and identify problem
credits. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as
estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period. The
allowance is also subject to examination and testing for adequacy by regulatory agencies, which may consider such factors as the
methodology used to determine adequacy and the size of the allowance relative to that of peer institutions. Such regulatory agencies
could require us to adjust our allowance based on information available to them at the time of their examination.
The non-performing
asset ratio was 0.09% of total assets with the nominal level of $1.4 million in non-performing assets at December 31, 2021 compared
to 0.50% and $7.0 million at December 31, 2020. The decline in the non-performing asset ratio was related to the successful resolution
of several non-accrual and accruing loans past due of 90 days or more. Non-accrual loans declined $4.3 million to $250 thousand
at December 31, 2021 from $4.6 million at December 31, 2020. Accruing loans past due 90 days or more declined to none at December
31, 2021 from $1.3 million at December 31, 2020. Loans past due 30 days or more represented 0.03% of the loan portfolio at December
31, 2021 compared to 0.23% at December 31, 2020. The ratio of classified loans plus OREO and repossessed assets declined
to 6.27% of total bank regulatory risk-based capital at December 31, 2021 from 6.89% at December 31, 2020.
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We continue to
monitor the impact of the COVID-19 pandemic on our customer base of local businesses and professionals. There were seven loans
totaling $250 thousand (0.03% of total loans) included on non-performing status (non-accrual loans and loans past due 90 days and
still accruing) at December 31, 2021. All seven of these loans were on non-accrual status. The largest loan included on non-accrual
status is in the amount of $103 thousand. The average balance of the remaining six loans on non-accrual status is approximately $25
thousand with a range between $3 and $87 thousand, and the majority of these loans are secured by first mortgage liens. Furthermore,
we had $1.4 million in accruing trouble debt restructurings, or TDRs, at December 31, 2021 compared to $1.6 million at December 31,
2020. We consider a loan impaired when, based on current information and events, it is probable that we will be unable to collect
all amounts due, including both principal and interest, according to the contractual terms of the loan agreement. Nonaccrual loans
and accruing TDRs are considered impaired. At December 31, 2021, we had 10 impaired loans totaling $1.7 million compared to 23
impaired loans totaling $6.1 million at December 31, 2020. These loans were measured for impairment under the fair value of
collateral method or present value of expected cash flows method. For collateral dependent loans, the fair value of collateral
method is used and the fair value is determined by an independent appraisal less estimated selling costs. At December 31, 2021, we
had loans totaling $235 thousand that were delinquent 30 days to 89 days representing 0.03% of total loans compared to $665 thousand
or 0.08% of total loans at December 31, 2020.
Beginning in
March 2020, we proactively offered payment deferrals for up to 90 days to our loan customers regardless of the impact of the pandemic
on their business or personal finances. As a result of payments being resumed at the conclusion of their payment deferral
period, loans in which payments were being deferred decreased from the peak of $206.9 million to $175.0 million at June 30, 2020,
to $27.3 million at September 30, 2020, to $16.1 million at December 31, 2020, to $8.7 million at March 31, 2021, to $4.5 million
at June 30, 2021, to $4.1 million at September 30, 2021, and to zero at December 31, 2021. We had no loans on which payments have
been deferred at December 31, 2021 compared to $16.1 million at December 31, 2020. The $16.1 million in deferrals at December
31, 2020 consisted of seven loans on which only principal was being deferred. Our management continuously monitors non-performing,
classified and past due loans to identify deterioration regarding the condition of these loans and given the ongoing and uncertain
impact of the COVID-19 pandemic, we will continue to monitor our loan portfolio for potential risks.
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The following