ITEM 1A:RISK FACTORS
An investment in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company’s common stock could decline significantly, and you could lose all or part of your investment.
Risks Related to the Company’s Business
The short-term and long-term effects of inflation and rising costs may adversely affect the Company’s financial performance.
Inflation, both in the short-term and/or in the long-term, may adversely affect the Company’s business in that it may increase our overall costs even if it does not adversely affect every aspect of our business evenly. The Company employs various strategies to manage its costs but there is no assurance that these strategies will be successful in containing costs as higher rates of inflation may result in increased costs for goods and services, including employee salaries and benefits, which may adversely affect the Company’s results of operation and financial performance. Inflation may also increase the cost of doing business for the Company’s borrowers thereby affecting the creditworthiness of current or prospective customers.
The Company’s business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.
Changes in the interest rate environment may reduce profits. The Company’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. As prevailing interest rates change, net interest spreads are affected by the difference between the maturities and re-pricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. An increase in the general level of interest rates may also adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially adversely affect the Company’s net interest spread, asset quality, loan origination volume and overall profitability.
The Company is subject to lending risk.
There are inherent risks associated with the Company’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Company operates as well as those across the Commonwealth of Pennsylvania and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company.
Commercial, commercial real estate and real estate construction loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because these loans generally have larger balances than residential real estate loans and consumer loans, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company’s financial condition and results of operations.
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The Company’s allowance for possible loan losses may be insufficient.
The Company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company’s control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Company’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Further, if charge-offs in future periods exceed the allowance for possible loan losses, the Company will need additional provisions to increase the allowance for possible loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and capital and may have a material adverse effect on the Company’s financial condition and results of operations.
The Financial Accounting Standards Board ("FASB") has recently issued an accounting standard update that will result in a significant change in how we recognize credit losses and may have a material impact on our financial condition or results of operations.
In June 2016, FASB issued an accounting standard update (“ASU”) entitled “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,” which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the Current Expected Credit Loss (“CECL”) model. Under the CECL model, banks will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current generally accepted accounting principles (“GAAP”), which delays recognition until it is probable a loss has been incurred.
The new CECL standard was originally expected to become effective for the Company on January 1, 2020, and for interim periods within that year. In November 2019, FASB agreed to delay implementation of the new CECL standard for certain companies, including those companies that qualify as a smaller reporting company under SEC rules, until January 1, 2023. The Company adopted the new CECL standard as of January 1, 2023. The CECL model may create more volatility in the level of the allowance for loan losses. If the Company is required to materially increase the level of its allowance for credit losses and reserve for unfunded commitments for any reason, such increase could adversely affect its business, financial condition and results of operations. The Company is currently assessing the impact of CECL. This is discussed further in Footnote 18, "Recent Accounting Pronouncements," of Part II, Item 8 “Financial Statements and Supplementary Data”, which is incorporated herein by reference.
If we conclude that the decline in value of any of our investment securities is other-than-temporary, we will be required to write down the credit-related portion of the impairment of that security through a charge to earnings.
We review our investment securities portfolio at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other-than-temporary. If we conclude that the decline is other-than-temporary, we will be required to write down the credit-related portion of the impairment of that security through a charge to earnings.
The Basel III capital requirements may require us to maintain higher levels of capital, which could reduce our profitability.
Basel III targets higher levels of base capital, certain capital buffers and a migration toward common equity as the key source of regulatory capital. Although the new capital requirements are phased in over the next decade and may change substantially before final implementation, Basel III signals a growing effort by domestic and international bank regulatory agencies to require financial institutions, including depository institutions, to maintain higher levels of capital. The direction of the Basel III implementation activities or other regulatory viewpoints could require additional capital to support our business risk profile prior to final implementation of the Basel III standards. If the Company and the Bank are required to maintain higher levels of capital, the Company and the Bank may have fewer opportunities to invest capital into interest-earning assets, which could limit the profitable business operations available to the Company and the Bank and adversely impact our financial condition and results of operations.
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The Company may need or be compelled to raise additional capital in the future, but that capital may not be available when it is needed and on terms favorable to current shareholders.
Federal banking regulators require the Company and Bank to maintain adequate levels of capital to support their operations. These capital levels are determined and dictated by law, regulation and banking regulatory agencies. In addition, capital levels are also determined by the Company’s management and board of directors based on capital levels that they believe are necessary to support the Company’s business operations. The Company is evaluating its present and future capital requirements and needs, is developing a comprehensive capital plan and is analyzing capital raising alternatives, methods and options. Even if the Company succeeds in meeting the current regulatory capital requirements, the Company may need to raise additional capital in the near future to support possible loan losses during future periods or to meet future regulatory capital requirements.
Further, the Company’s regulators may require it to increase its capital levels. If the Company raises capital through the issuance of additional shares of its common stock or other securities, it may dilute the ownership interests of current investors and may dilute the per-share book value and earnings per share of its common stock. Furthermore, it may have an adverse impact on the Company’s stock price. New investors may also have rights, preferences and privileges senior to the Company’s current shareholders, which may adversely impact its current shareholders. The Company’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside its control, and on its financial performance. Accordingly, the Company cannot assure you of its ability to raise additional capital on terms and time frames acceptable to it or to raise additional capital at all. If the Company cannot raise additional capital in sufficient amounts when needed, its ability to comply with regulatory capital requirements could be materially impaired. Additionally, the inability to raise capital in sufficient amounts may adversely affect the Company’s operations, financial condition and results of operations.
The Company is subject to environmental liability risk associated with lending activities.
A significant portion of the Company’s loan portfolio is secured by real property. During the ordinary course of business, the Company may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Company to incur substantial expense and may materially reduce the affected property’s value or limit the Company’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Company’s exposure to environmental liability. Although the Company has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s profitability depends significantly on economic conditions in the Commonwealth of Pennsylvania and the local regions in which it conducts business.
The Company’s success depends primarily on the general economic conditions of the Commonwealth of Pennsylvania and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in Lackawanna and Luzerne Counties in Northeastern Pennsylvania and Northampton County in Eastern Pennsylvania. The local economic conditions in these areas have a significant impact on the demand for the Company’s products and services as well as the ability of the Company’s customers to repay loans, the value of the collateral securing loans and the stability of the Company’s deposit funding sources. A significant decline in general economic conditions caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic occurrences or instability, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Company’s financial condition and results of operations.
There is no assurance that the Company will be able to successfully compete with others for business.
The Company competes for loans, deposits and investment dollars with numerous regional and national banks and other community banking institutions, as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions, mortgage brokers and private lenders. Many competitors have substantially greater resources than the Company does, and operate under less stringent regulatory environments. The differences in resources and regulations may make it more difficult for the Company to compete profitably, reduce the rates that it can earn on loans and on its investments, increase the rates it must offer on deposits and other funds, and adversely affect its overall financial condition and earnings.
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The Company is subject to extensive government regulation and supervision.
The Company, primarily through the Bank, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Federal or commonwealth 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 increase the ability of non-banks to offer competing financial services and products, among other things. 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.
The Company’s controls and procedures may fail or be circumvented.
Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.
New lines of business or new products and services may subject the Company to additional risks.
From time-to-time, the Company may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Company may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Company’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Company’s business, results of operations and financial condition.
The Company’s future acquisitions could dilute your ownership and may cause it to become more susceptible to adverse economic events.
The Company may use its common stock to acquire other companies or make investments in banks and other complementary businesses in the future. The Company may issue additional shares of common stock to pay for future acquisitions, which would dilute your ownership interest in the Company. Future business acquisitions could be material to the Company, and the degree of success achieved in acquiring and integrating these businesses into the Company could have a material effect on the value of the Company’s common stock. In addition, any acquisition could require it to use substantial cash or other liquid assets or to incur debt. In those events, it could become more susceptible to economic downturns and competitive pressures.
The Company may not be able to attract and retain skilled people.
The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Company can be intense and the Company may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
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The Company’s information systems may experience an interruption or breach in security.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems. The Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, however there can be no assurance that any such failures, interruptions or security breaches will not occur. The occurrence of any failures, interruptions or security breaches of the Company’s information systems could damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.
The Company continually encounters 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 efficiencies in the Company’s operations. Many of the Company’s competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business and, in turn, the Company’s financial condition and results of operations.
The operations of our business, including our interaction with customers, are increasingly done via electronic means, and this has increased our risks related to cyber security.
We are exposed to the risk of cyber-attacks in the normal course of business. In general, cyber incidents can result from deliberate attacks or unintentional events. We have observed an increased level of attention in the industry focused on cyber-attacks that include, but are not limited to, gaining unauthorized access to digital systems for purposes of misappropriating assets or sensitive information, corrupting data, or causing operational disruption. To combat against these attacks, policies and procedures are in place to prevent or limit the effect of the possible security breach of our information systems and we have insurance against some cyber-risks and attacks. While we have not incurred any material losses related to cyber-attacks, nor are we aware of any specific or threatened cyber-incidents as of the date of this report, we may incur substantial costs and suffer other negative consequences if we fall victim to successful cyber-attacks. Such negative consequences could include remediation costs that may include liability for stolen assets or information and repairing system damage that may have been caused; deploying additional personnel and protection technologies, training employees, and engaging third party experts and consultants; lost revenues resulting from unauthorized use of proprietary information or the failure to retain or attract customers following an attack; litigation; and reputational damage adversely affecting customer or investor confidence.
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
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 its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.
Pennsylvania Business Corporation Law and various anti-takeover provisions under our articles and bylaws could impede the takeover of the Company.
Various Pennsylvania laws affecting business corporations may have the effect of discouraging offers to acquire the Company, even if the acquisition would be advantageous to shareholders. In addition, we have various anti-takeover measures in place under our articles of incorporation and bylaws, including a supermajority vote requirement for mergers, a staggered board of directors, and the absence of cumulative voting. Any one or more of these measures may impede the takeover of the Company without the approval of our board of directors and may prevent our shareholders from taking part in a transaction in which they could realize a premium over the current market price of our common stock.
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The Company is a holding company and relies on dividends from its banking subsidiary for substantially all of its revenue and its ability to make dividends, distributions, and other payments.
As a bank holding company, the Company’s ability to pay dividends depends primarily on its receipt of dividends from its subsidiary bank. Dividend payments from the bank are subject to legal and regulatory limitations, generally based on net profits and retained earnings, imposed by bank regulatory agencies. The ability of the bank to pay dividends is also subject to profitability, financial condition, regulatory capital requirements, capital expenditures and other cash flow requirements. There is no assurance that the bank will be able to pay dividends in the future or that the Company will generate cash flow to pay dividends in the future. The Company’s failure to pay dividends on its common stock may have a material adverse effect on the market price of its common stock.
The Company’s banking subsidiary may be required to pay higher FDIC insurance premiums or special assessments which may adversely affect its earnings.
The Company generally is unable to control the amount of premiums or special assessments that its subsidiary is required to pay for FDIC insurance. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on our results of operations, financial condition, and our ability to continue to pay dividends on our common stock at the current rate or at all.
Severe weather, natural disasters, acts of war or terrorism, global instability, pandemics and other external events could significantly impact the Company’s business.
Severe weather, natural disasters, acts of war or terrorism, global instability, pandemics 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 the Company’s deposit base, impair the ability 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 the Company to incur additional expenses. Severe weather or natural disasters, acts of war or terrorism, global instability, pandemics or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.
The increasing use of social media platforms presents new risks and challenges and our inability or failure to recognize, respond to and effectively manage the accelerated impact of social media could materially adversely impact our business.
There has been a marked increase in the use of social media platforms, including weblogs (blogs), social media websites, and other forms of Internet-based communications which allow individuals access to a broad audience of consumers and other interested persons. Social media practices in the banking industry are evolving, which creates uncertainty and risk of noncompliance with regulations applicable to our business. Consumers value readily available information concerning businesses and their goods and services and often act on such information without further investigation and without regard to its accuracy. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information posted on such platforms at any time may be adverse to our interests and/or may be inaccurate. The dissemination of information online could harm our business, prospects, financial condition, and results of operations, regardless of the information’s accuracy. The harm may be immediate without affording us an opportunity for redress or correction.
Other risks associated with the use of social media include improper disclosure of proprietary information, negative comments about our business, exposure of personally identifiable information, fraud, out-of-date information, and improper use by employees and customers. The inappropriate use of social media by our customers or employees could result in negative consequences including remediation costs including training for employees, additional regulatory scrutiny and possible regulatory penalties, litigation or negative publicity that could damage our reputation adversely affecting customer or investor confidence.
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Risks Associated with the Company’s Common Stock
The Company’s stock price can be volatile.
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. The Company’s stock price can fluctuate significantly in response to a variety of factors including, among other things:
● Actual or anticipated variations in quarterly results of operations.
● Recommendations by securities analysts.
● Perceptions in the marketplace regarding the Company and/or its competitors.
● New technology used, or services offered, by competitors.
● Changes in government regulations.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Company’s stock price to decrease regardless of operating results.
The trading volume in the Company’s common stock is less than that of other larger financial services companies.
The Company’s common stock is listed for trading on Nasdaq and the trading volume in its common stock is less than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Company’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Company has no control. Given the lower trading volume of the Company’s common stock, significant sales of the Company’s common stock, or the expectation of these sales, could cause the Company’s stock price to fall.
Furthermore, from time to time, the Company’s common stock may be included in certain and various stock market indices. Inclusion in these indices may positively impact the price, trading volume, and liquidity of the Company’s common stock, in part, because index funds or other institutional investors often purchase securities that are in these indices. Conversely, if the Company’s market capitalization falls below the minimum necessary to be included in any of the indices at any annual reconstitution date, the opposite could occur. Further, the Company’s inclusion in indices may be weighted based on the size of its market capitalization, so even if the Company’s market capitalization remains above the amount required to be included on these indices, if its market capitalization is below the amount it was on the most recent reconstitution date, the Company’s common stock could be weighted at a lower level, holders attempting to track the composition of these indices will be required to sell the Company’s common stock to match the reweighting of the indices.
Risks Associated with the Company’s Industry
Future governmental regulation and legislation could limit the Company’s future growth.
The Company is a registered bank holding company, and its subsidiary bank is a depository institution whose deposits are insured by the FDIC. As a result, the Company is subject to various regulations and examinations by various regulatory authorities. In general, statutes establish the corporate governance and eligible business activities for the Company, certain acquisition and merger restrictions, limitations on inter-company transactions such as loans and dividends, capital adequacy requirements, requirements for anti-money laundering programs and other compliance matters, among other regulations. The Company is extensively regulated under federal and state banking laws and regulations that are intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole. Compliance with these statutes and regulations is important to the Company’s ability to engage in new activities and consummate additional acquisitions.
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In addition, the Company is subject to changes in federal and state tax laws as well as changes in banking and credit regulations, accounting principles and governmental economic and monetary policies. The Company cannot predict whether any of these changes may adversely and materially affect it. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on the Company’s activities that could have a material adverse effect on its business and profitability. While these statutes are generally designed to minimize potential loss to depositors and the FDIC insurance funds, they do not eliminate risk, and compliance with such statutes increases the Company’s expense, requires management’s attention and can be a disadvantage from a competitive standpoint with respect to non-regulated competitors.
The earnings of financial services companies are significantly affected by general business and economic conditions.
The Company’s operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which the Company operates, all of which are beyond the Company’s control. Deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for the Company’s products and services, among other things, any of which could have a material adverse impact on the Company’s financial condition and results of operations.
Financial services companies depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions, the Company may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. The Company may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on the Company’s business and, in turn, the Company’s financial condition and results of operations.
Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.
A protracted government shutdown or issues relating to debt and the deficit may adversely affect the Company.
Extended shutdowns of parts of the federal government could negatively impact the financial performance of certain customers and could impact customers’ future access to certain loan and guarantee programs. As a result, this could impact the Company’s business, financial condition and results of operations.
As a result of past difficulties of the federal government to reach agreement over federal debt and issues connected with the debt ceiling, certain rating agencies placed the United States government's long-term sovereign debt rating on their equivalent of negative watch and announced the possibility of a rating downgrade. The rating agencies, due to constraints related to the rating of the United States, also placed government-sponsored enterprises in which the Company invests and receives lines of credit on negative watch and a downgrade of the United States government's credit rating would trigger a similar downgrade in the credit rating of these government-sponsored enterprises. Furthermore, the credit rating of other entities, such as state and local governments, may also be downgraded should the United States government's credit rating be downgraded. The impact that a credit rating downgrade may have on the national and local economy could have an adverse effect on the Company’s financial condition and results of operations.
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The regulatory environment for the financial services is being significantly impacted by financial regulatory reform initiatives in the United States and elsewhere, including Dodd-Frank and regulations promulgated to implement it.
The Dodd-Frank Act comprehensively reforms the regulation of financial institutions and their products and services. Dodd-Frank requires various federal regulatory agencies to implement numerous rules and regulations. Because federal agencies are granted broad discretion in drafting these rules and regulations, many of the details and the full impact of Dodd-Frank may not be known for many months or years.
Dodd-Frank, like other financial industry reforms, has had and will continue to have a significant effect on our entire industry. Although it is difficult to predict with certainty the magnitude and extend of these effects at this time, we believe compliance with Dodd-Frank, its interpretive regulations, rules, and initiatives will negatively impact revenue and increase the cost of doing business. Additional expenses associated with compliance with the Act, currently and on an ongoing basis, are likely to continue and the effects of full implementation of the Act may limit our ability to pursue certain business opportunities.
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ITEM 1B:UNRESOLVED STAFF COMMENTS
None
ITEM 2:PROPERTIES
As of December 31, 2022, the Company and the Bank operated 21 full-service banking offices, of which eleven were owned and ten were leased. The Pittston branch property is subject to a lease with a company of which director, William J. Joyce, Sr., is a partner. With the exception of the Pittston branch, none of the lessors of the properties leased by the Company are affiliated with the Company and all of the properties are located in the Commonwealth of Pennsylvania. The Company is headquartered at its owner-occupied main branch located on the corner of Blakely and Drinker Streets in Dunmore, PA. Executive and administrative, commercial lending, trust and asset management services are located at the Main Branch. The Company also operates a financial center in downtown Scranton, PA. Executive, mortgage and consumer lending, finance, operations and a full-service call center are located in this building. During 2022, the Company purchased the Scranton Electric Building for a future corporate headquarters in Scranton, PA, which is in the process to be placed on the National Register of Historic Places. Demolition of non-historical interior improvements is currently underway to allow for the next phase of planned remodeling with the expected completion ready for 2025. We believe each of our facilities is suitable and adequate to meet our current operational needs and intended purposes.
The Company also operates a wealth management office in Minersville, PA under a short-term lease agreement.
Additionally, the Company has a limited production office in Scranton, PA that is currently leased for certain commercial lenders and credit department employees.
The Company currently owns a property in Wilkes-Barre, PA that will become a full-service branch during 2023.
The Company acquired a leased building in Scranton from the merger with Landmark. The branch in the building was closed in September 2021 and the building was converted into a training center during 2022.
Foreclosed assets held-for-sale includes other real estate owned (ORE). The Company had two ORE properties as of December 31, 2022, which stemmed from two unrelated borrowers. Upon possession, foreclosed properties are recorded on the Company’s balance sheet at the lower of cost or fair value. For a further discussion of ORE properties, see “Foreclosed assets held-for-sale”, located in the comparison of financial condition section of managements’ discussion and analysis.
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ITEM 3: LEGAL PROCEEDINGS
The nature of the Company’s business generates some litigation involving matters arising in the ordinary course of business. However, in the opinion of the Company after consulting with legal counsel, no legal proceedings are pending, which, if determined adversely to the Company or the Bank, would have a material effect on the Company’s undivided profits or financial condition or results of operations. No legal proceedings are pending other than ordinary routine litigation incidental to the business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated any material legal actions against the Company or the Bank.
ITEM 4: MINE SAFETY DISCLOSURES
Not Applicable
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PART II
ITEM 5:MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The common stock of the Company is listed on Nasdaq and traded on The NASDAQ Global Market under the symbol “FDBC.” Shareholders requesting information about the Company’s common stock may contact:
Salvatore R. DeFrancesco, Jr., Treasurer
Fidelity D & D Bancorp, Inc.
Blakely and Drinker Streets
Dunmore, PA 18512
(570) 342-8281
Dividends are determined and declared by the Board of Directors of the Company. The Company expects to continue to pay cash dividends in the future; however, future dividends are dependent upon earnings, financial condition, capital strength and other factors of the Company. For a further discussion of regulatory capital requirements see Note 15, “Regulatory Matters,” contained within the notes to the consolidated financial statements, incorporated by reference in Part II, Item 8.
The Company offers a dividend reinvestment plan (DRP) for its shareholders. The DRP provides shareholders with a convenient and economical method of investing cash dividends payable on their common stock and the opportunity to make voluntary optional cash payments to purchase additional shares of the Company’s common stock. Participants pay no brokerage commissions or service charges when they acquire additional shares of common stock through the DRP. The administrator may purchase shares directly from the Company, in the open market, in negotiated transactions with third parties or using a combination of these methods.
The Company had approximately 1,663 shareholders at December 31, 2022 and 1,681 shareholders as of February 28, 2023. The number of shareholders is the actual number of distinct shareholders of record. Each security depository is considered a single shareholder for purposes of determining the approximate number of shareholders.
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Performance graph
The following graph and table compare the cumulative total shareholder return on the Company’s common stock against the cumulative total return of the NASDAQ Composite and KBW NASDAQ Bank index (the KBW NASDAQ index) for the period of five fiscal years commencing January 1, 2018, and ending December 31, 2022. The graph illustrates the cumulative investment return to shareholders, based on the assumption that a $100 investment was made on December 31, 2017, in each of: the Company’s common stock, the NASDAQ Composite and the KBW NASDAQ index. As of December 31, 2022, the KBW NASDAQ index consisted of 24 banks. A listing of the banks that comprise the KBW NASDAQ index can be found on the Company’s website at www.bankatfidelity.com and then on the bottom of the page clicking on, Investor Relations, Stock Info, The KBW NASDAQ Bank index in the drop-down menu. All cumulative total returns are computed assuming the reinvestment of dividends into the applicable securities. The shareholder return shown on the graph and table below is not necessarily indicative of future performance:
Period Ending
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Purchases of equity securities by the issuer and affiliated purchasers
The following information describes the Company's stock repurchases during the fourth quarter of the fiscal year ended December 31, 2022.
(a) (b) (c) (d)
On May 18, 2022, the Company announced that the Board of Directors approved a plan to purchase, in open market and privately negotiated transactions, up to 3% of its outstanding common stock in accordance with all applicable securities laws and regulations, including SEC Rule 10b-18 of the Exchange Act. The plan shall terminate on the earlier of the date an aggregate of $5,000,000 of stock have been purchased or August 9, 2023.
ITEM 6: [Reserved]
ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATION
Critical accounting policies
The presentation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses at December 31, 2022 is adequate and reasonable. Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make different assumptions and could, therefore, calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgment of information available to them at the time of their examination.
Another material estimate is the calculation of fair values of the Company’s investment securities. Fair values of investment securities are determined by pricing provided by a third-party vendor, who is a provider of financial market data, analytics and related services to financial institutions. Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services. Accordingly, when selling investment securities, price quotes may be obtained from more than one source. As described in Notes 1 and 4 of the consolidated financial statements, incorporated by reference in Part II, Item 8, the Company’s investment securities are classified as available-for-sale (AFS) or held-to-maturity (HTM). AFS securities are carried at fair value on the consolidated balance sheets, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity as a component of accumulated other comprehensive income (loss) (AOCI).
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The fair value of residential mortgage loans, classified as held-for-sale (HFS), is obtained from the Federal National Mortgage Association (FNMA) or the Federal Home Loan Bank (FHLB). Generally, the market to which the Company sells residential mortgages it originates for sale is restricted and price quotes from other sources are not typically obtained. On occasion, the Company may transfer loans from the loan portfolio to loans HFS. Under these circumstances, pricing may be obtained from other entities and the loans are transferred at the lower of cost or market value and simultaneously sold. For a further discussion on the accounting treatment of HFS loans, see the section entitled “Loans held-for-sale,” contained within this management’s discussion and analysis.
We account for business combinations under the purchase method of accounting. The application of this method of accounting requires the use of significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed in order to properly allocate purchase price consideration between assets that are amortized, accreted or depreciated from those that are recorded as goodwill. Estimates of the fair values of assets acquired and liabilities assumed are based upon assumptions that management believes to be reasonable.
Goodwill is tested at least annually at November 30 for impairment, or more often if events or circumstances indicate there may be impairment. Impairment write-downs are charged to the consolidated statement of income in the period in which the impairment is determined. In testing goodwill for impairment, the Company performed a qualitative assessment, resulting in the determination that the fair value of its reporting unit exceeded its carrying amount. Accordingly, there is no goodwill impairment at December 31, 2022. Other acquired intangible assets that have finite lives, such as core deposit intangibles, are amortized over their estimated useful lives and subject to periodic impairment testing.
All significant accounting policies are contained in Note 1, “Nature of Operations and Summary of Significant Accounting Policies”, within the notes to consolidated financial statements and incorporated by reference in Part II, Item 8.
The following discussion and analysis presents the significant changes in the financial condition and in the results of operations of the Company as of December 31, 2022 and 2021 and for each of the years then ended. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this report.
Non-GAAP Financial Measures
The following are non-GAAP financial measures which provide useful insight to the reader of the consolidated financial statements but should be supplemental to GAAP used to prepare the Company’s financial statements and should not be read in isolation or relied upon as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Company’s tax rate used to calculate the fully-taxable equivalent (FTE) adjustment was 21% at December 31, 2022, 2021, 2020, 2019 and 2018.
The following table reconciles the non-GAAP financial measures of FTE net interest income:
The efficiency ratio is non-interest expenses as a percentage of FTE net interest income plus non-interest income. The following table reconciles the non-GAAP financial measures of the efficiency ratio to GAAP:
Efficiency Ratio (non-GAAP)
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The following table provides a reconciliation of the tangible common equity (non-GAAP) and the calculation of tangible book value per share:
Tangible Book Value per Share (non-GAAP)
The following tables provides a reconciliation of the Company’s earnings results under GAAP to comparative non-GAAP results excluding merger-related expenses and an FHLB prepayment penalty:
Add: Merger-related expenses - - - -
Add: FHLB prepayment penalty - - - -
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Comparison of Financial Condition as of December 31, 2022
and 2021 and Results of Operations for each of the Years then Ended
Executive Summary
The Company generated $30.0 million in net income in 2022, or $5.29 diluted earnings per share, up $6.0 million, or 25%, from $24.0 million, or $4.48 diluted earnings per share, in 2021. During 2022, rising interest rates and a well-diversified balance sheet contributed to the success of our earnings performance. Federal Open Market Committee (FOMC) officials raised the federal funds rate 425 basis points during 2022 and another 25 basis points in February 2023. The Company expects the fed funds rate to continue to rise during 2023 as the level of inflation and the labor market remains strong. The 2023 focus is to manage net interest income through a rising forecasted rate cycle by exercising disciplined and proactive loan pricing and managing deposit costs to maintain a reasonable spread. From a financial condition and performance perspective, our mission for 2023 will be to continue to strengthen our capital position through retained earnings by implementing creative marketing and revenue enhancing strategies, continuing to manage the cost of deposits, growing and cultivating more of our wealth management and business services and managing credit risk at tolerable levels thereby maintaining overall asset quality.
Nationally, the unemployment rate fell from 3.9% at December 31, 2021 to 3.5% at December 31, 2022. The unemployment rates in the Scranton - Wilkes-Barre - Hazleton (market area north) and the Allentown – Bethlehem - Easton (market area south) Metropolitan Statistical Areas (local) also decreased but the market area north remained at a higher level than the national unemployment rate. According to the U.S. Bureau of Labor Statistics, the local unemployment rates at December 31, 2022 were 4.3% in the market area north and 3.3% in the market area south, respectively, a decrease of 0.5 and 0.7 percentage points from the 4.8% and 4.0%, respectively, at December 31, 2021. The national and local unemployment rates have decreased as a result of the improving economic environment. The median home values in the Scranton-Wilkes-Barre-Hazleton metro and Allentown-Bethlehem-Easton metro each increased 6.0% and 10.7% from a year ago, according to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets, and values are expected to grow 3.0% and 0.8% in the next year. In light of these expectations, we are uncertain if real estate values could continue to increase at these levels with the continued rising rate environment, however we will continue to monitor the economic climate in our region and scrutinize growth prospects with credit quality as a principal consideration.
On May 1, 2020, the Company completed its acquisition of MNB Corporation (“MNB”). The merger expanded the Company’s full-service footprint into Northampton County, PA and the Lehigh Valley. Non-recurring costs to facilitate the merger and integrate systems of $2.5 million were incurred during 2020.
On July 1, 2021, the Company completed its acquisition of Landmark Bancorp, Inc. (“Landmark”). Non-recurring costs to facilitate the merger and integrate systems of $3.0 million were incurred during 2021.
Non-recurring merger-related costs and a FHLB prepayment penalty incurred during 2021 and 2020 are not a part of the Company’s normal operations. There were no non-recurring costs during 2022.
For the years ended December 31, 2022 and 2021, tangible common book value per share (non-GAAP) was $25.18 and $33.68, respectively, a decrease of 25.2%. The decrease in tangible book value was due to the decline in tangible common equity resulting within AOCI from the after-tax net unrealized losses on available-for-sale securities. These non-GAAP measures should be reviewed in connection with the reconciliation of these non-GAAP ratios. See “Non-GAAP Financial Measures” located above within this management’s discussion and analysis.
During 2022, the Company’s assets declined by 2% primarily from unrealized losses in the investment portfolio. In 2023, we expect total loans to increase and a decline in the investment portfolio. The increase in the loan portfolio is expected to be funded primarily by deposit growth supplemented by short-term borrowings, when necessary. No long-term FHLB advances are expected in 2023.
Non-performing assets represented 0.17% of total assets as of December 31, 2022, down from 0.27% at the prior year end. Non-performing assets to total assets was lower during 2022 mostly due to the amount (or dollar value) of non-performing assets decreasing while there was growth in total assets.
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Branch managers, relationship bankers, mortgage originators and our business service partners are all focused on developing a mutually profitable full banking relationship with our clients. We understand our markets, offer products and services along with financial advice that is appropriate for our community, clients and prospects. The Company continues to focus on the trusted financial advisor model by utilizing the team approach of experienced bankers that are fully engaged and dedicated towards maintaining and growing profitable relationships.
During 2023, the Company expects to operate in a higher interest rate environment. The Company’s balance sheet is positioned to improve its net interest income performance, but increases in yields may not keep pace with higher cost of funds which may compress net interest spread. Expectations are for short-term rates to continue to increase throughout 2023, which could continue to increase deposit rate pricing. The Company currently expects net interest margin to remain unchanged for 2023.
Financial Condition
Consolidated assets decreased $40.7 million, or 2%, to $2.4 billion as of December 31, 2022 from $2.4 billion at December 31, 2021. The decrease in assets occurred primarily from a decrease in the investment portfolio and a reduction in excess cash balances. Loan portfolio growth was funded by utilizing cash balances and short-term borrowings.
The following table is a comparison of condensed balance sheet data as of December 31:
(dollars in thousands)
Liabilities:
Short-term borrowings 12,940 0.5 - - - -
FHLB advances - - - - 5,000 0.3
A comparison of net changes in selected balance sheet categories as of December 31, are as follows:
Earning Other FHLB
(dollars in thousands) Assets % assets* % Deposits % borrowings % advances %
* Earning assets include interest-bearing deposits with financial institutions, gross loans and leases, loans held-for-sale, available-for-sale securities and restricted investments in bank stock excluding loans placed on non-accrual status.
For more information about the Company's capital, see Footnote 15, "Regulatory Matters," of Part II, Item 8 “Financial Statements and Supplementary Data”, which is incorporated herein by reference and the "Capital Resources" section of management’s discussion and analysis contained herein.
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Funds Provided:
Deposits
The Company is a community based commercial depository financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Generally, deposits are obtained from consumers, businesses and public entities within the communities that surround the Company’s 21 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law. Deposit products consist of transaction accounts including: savings; clubs; interest-bearing checking; money market and non-interest bearing checking (DDA). The Company also offers short- and long-term time deposits or certificates of deposit (CDs). CDs are deposits with stated maturities which can range from seven days to ten years. Cash flow from deposits is influenced by economic conditions, changes in the interest rate environment, pricing and competition. To determine interest rates on its deposit products, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as short-term borrowings and FHLB advances.
The following table represents the components of total deposits as of December 31:
(dollars in thousands) Amount % Amount %
Total deposits decreased $3.0 million, or less than 1%, to $2.2 billion at December 31, 2022 from $2.2 billion at December 31, 2021. During 2022, the Company accepted various Fidelity Bank wealth managed trust accounts into a money market account pledged by its securities portfolio which increased total deposits by $69.2 million at December 31, 2022. Money market accounts grew $69.0 million due to the $69.2 million from trust accounts along with a $24.0 million transfer from an interest-bearing checking account partially offset by outflows from personal and public accounts. Non-interest bearing checking accounts increased $12.3 million primarily due to increases in business checking accounts. Savings and clubs also increased $3.4 million due to personal savings growth. Interest-bearing checking accounts decreased $66.2 million during 2022 primarily from one large public customer that withdrew $30.8 million and the aforementioned $24.0 million transfer to a money market account plus declines in personal and business account balances. The Company focuses on obtaining a full-banking relationship with existing checking account customers as well as forming new customer relationships. The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop creative programs for its customers to maintain and grow core deposits. For 2022, the Company experienced deposit balance declines as clients transferred their deposits to investments to earn higher interest and pay down debts. We currently expect this trend to continue throughout 2023. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset future deposit growth. The Company had approximately $97 million in American Rescue Plan Act funds in public deposit accounts at December 31, 2022 that may be disbursed during 2023 resulting in declines in public deposits.
Partially offsetting these non-maturing deposit increases, CDs decreased $21.6 million, or 16%, during 2022. CD balances continue to decline as rates lagged capital market rate increases and CDs with promotional rates reached maturity. Some maturing CDs were closed as customers could earn higher yields by investing the money into other products. The Company will continue to pursue strategies to grow and retain retail and business customers with an emphasis on deepening and broadening existing and creating new relationships.
The Company uses the Certificate of Deposit Account Registry Service (CDARS) reciprocal program and Insured Cash Sweep (ICS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum insured amount of $250,000. The Company did not have any CDARs as of December 31, 2022 and 2021. As of December 31, 2022 and 2021, ICS reciprocal deposits represented $26.3 million and $27.6 million, or 1% each, of total deposits which are included in interest-bearing checking accounts in the table above. The $1.3 million decrease in ICS deposits is primarily due to business deposit transfers from ICS accounts to other interest-bearing checking accounts.
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As of December 31, 2022, total uninsured deposits were estimated to be $985.2 million. The estimate of uninsured deposits is based on the same methodologies and assumptions used for regulatory reporting requirements. The Company aggregates deposit products by taxpayer identification number and classifies into ownership categories to estimate amounts over the FDIC insurance limit.
The maturity distribution of certificates of deposit that meet or exceed the FDIC limit, by account, at December 31, 2022 is as follows:
(dollars in thousands)
Three months or less $ 2,168
More than three months to six months 3,377
More than six months to twelve months 6,340
More than twelve months 9,239
Approximately 65% of the CDs, with a weighted-average interest rate of 0.51%, are scheduled to mature in 2023 and an additional 21%, with a weighted-average interest rate of 1.49%, are scheduled to mature in 2024. Renewing CDs are currently expected to re-price to higher market rates depending on the rate on the maturing CD, the pace and direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative, non-term products. The Company plans to continue to address repricing CDs in the ordinary course of business on a relationship pricing basis and is prepared to match rates when prudent to maintain relationships. Growth in CD accounts is challenged by the current and expected rate environment and clients’ preference for short-term rates. The Company will continue to develop CD promotional programs when the Company deems that it is economically feasible to do so or when demand exists. The Company will consider the needs of the customers and simultaneously be mindful of the liquidity levels, borrowing rates and the interest rate sensitivity exposure of the Company.
Short-term borrowings
Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Company will borrow under advances from the FHLB of Pittsburgh and other correspondent banks for asset growth and liquidity needs.
Short-term borrowings may include overnight balances with FHLB line of credit and/or correspondent bank’s federal funds lines which the Company may require to fund daily liquidity needs such as deposit outflow, loan demand and operations. The Company used $12.9 million in short-term borrowings to fund loan growth as of December 31, 2022. As of December 31, 2022, the Company had the ability to borrow $112.0 million from the Federal Reserve borrower-in-custody program, $145.9 million in overnight borrowings with the FHLB and $31.0 million from lines of credit with correspondent banks.
Information with respect to the Company’s short-term borrowing’s maximum and average outstanding balances and interest rates are contained in Note 8, “Short-term Borrowings,” of the notes to consolidated financial statements incorporated by reference in Part II, Item 8.
Secured borrowings
As of December 31, 2022 and 2021, the Company had 9 and 11 secured borrowing agreements with third parties with a fair value of $7.6 million and $10.6 million, respectively, related to certain sold loan participations that did not qualify for sales treatment acquired from Landmark. Secured borrowings are expected to decrease for 2023 from scheduled amortization and, when possible, early pay-offs.
FHLB advances
The Company had no FHLB advances as of December 31, 2022 and 2021. As of December 31, 2022, the Company had the ability to borrow an additional $602.2 million from the FHLB, including any overnight borrowings. The Company does not expect to have any FHLB advances in 2023.
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Funds Deployed:
Investment Securities
The Company’s investment policy is designed to complement its lending activities, provide monthly cash flow, manage interest rate sensitivity and generate a favorable return without incurring excessive interest rate and credit risk while managing liquidity at acceptable levels. In establishing investment strategies, the Company considers its business, growth strategies or restructuring plans, the economic environment, the interest rate sensitivity position, the types of securities in its portfolio, permissible purchases, credit quality, maturity and re-pricing terms, call or average-life intervals and investment concentrations. The Company’s policy prescribes permissible investment categories that meet the policy standards and management is responsible for structuring and executing the specific investment purchases within these policy parameters. Management buys and sells investment securities from time-to-time depending on market conditions, business trends, liquidity needs, capital levels and structuring strategies. Investment security purchases provide a way to quickly invest excess liquidity in order to generate additional earnings. The Company generally earns a positive interest spread by assuming interest rate risk using deposits or borrowings to purchase securities with longer maturities.
At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (AFS) or held-to-maturity (HTM). To date, management has not purchased any securities for trading purposes. Some of the securities the Company purchases are classified as AFS even though there is no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions. Debt securities AFS are carried at fair value on the consolidated balance sheets with unrealized gains and losses, net of deferred income taxes, reported separately within shareholders’ equity as a component of accumulated other comprehensive income (AOCI). Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity. For the year ended December 31, 2022, AOCI was reduced by $71.3 million due to the change in fair value of the Company's investment securities.
Effective April 1, 2022, the Company transferred agency and municipal bonds with a book value of $245.5 million from AFS to HTM in order to apply the accounting for securities HTM to mitigate the effect AFS accounting has on the balance sheet. The bonds that were transferred had the highest price volatility and consisted of fixed-rate securities representing 70% of the agency portfolio, 70% of the taxable municipal portfolio each laddered out on the short to intermediate part of the curve and 35% of the tax-exempt municipal portfolio on the long end of the curve were identified as the best candidates given the Company’s ability to hold those bonds to maturity. The market value of the securities on the date of the transfer was $221.7 million, after netting unrealized losses totaling $18.9 million. The $18.9 million, net of deferred taxes, will be accreted into other comprehensive income over the life of the bonds.
As of December 31, 2022, the carrying value of investment securities amounted to $643.6 million, or 27% of total assets, compared to $739.0 million, or 31% of total assets, at December 31, 2021. On December 31, 2022, 34% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential or mortgage-backed securities) that amortize and provide monthly cash flow that the Company can use for reinvestment, loan demand, unexpected deposit outflow, facility expansion or operations. The mortgage-backed securities portfolio includes only pass-through bonds issued by Fannie Mae, Freddie Mac and the Government National Mortgage Association (GNMA).
The Company’s municipal (obligations of states and political subdivisions) portfolio is comprised of tax-free municipal bonds with a book value of $254.0 million and taxable municipal bonds with a book value of $86.3 million. The overall credit ratings of these municipal bonds was as follows: 37% AAA, 62% AA, and 1% A.
During 2022, the carrying value of total investments decreased $95.4 million, or 13%. Purchases for 2022 totaled $42.1 million, while principal reductions totaled $40.7 million, the decline in unrealized gain/loss was $68.1 million in the AFS portfolio and $23.9 million in unrealized losses were transferred to the HTM portfolio. The purchases were funded principally by cash flow generated from the portfolio and excess overnight liquidity. The Company attempts to maintain a well-diversified and proportionate investment portfolio that is structured to complement the strategic direction of the Company. Its growth typically supplements the lending activities but also considers the current and forecasted economic conditions, the Company’s liquidity needs and interest rate risk profile. During January 2023 with the 10-year U.S. Treasury yield declining, $31.2 million of securities were able to be sold yielding 3.62% (FTE yield of 4.33%) at a breakeven level. These proceeds were used to pay down FHLB overnight borrowings costing 4.80%.
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A comparison of total investment securities as of December 31 follows:
HTM securities:
AFS debt securities:
The investment securities portfolio contained no private label mortgage-backed securities, collateralized mortgage obligations, collateralized debt obligations, or trust preferred securities, and no off-balance sheet derivatives were in use. The portfolio had no adjustable-rate instruments as of December 31, 2022 and 2021.
Investment securities were comprised of AFS and HTM securities as of December 31, 2022 and AFS securities as of December 31, 2021. The AFS securities were recorded with a net unrealized loss of $67.9 million and a net unrealized gain of $0.2 million as of December 31, 2022 and 2021, respectively. Of the $68.1 million net decline; $30.1 million was attributable to municipal securities; $35.9 million was attributable to mortgage-backed securities and $2.1 million was attributable to agency securities. During the second quarter of 2022, securities with net unrealized losses totaling $23.9 million were transferred to HTM of which subsequently $1.7 million was accreted against other comprehensive income. The direction and magnitude of the change in value of the Company’s investment portfolio is attributable to the direction and magnitude of the change in interest rates along the treasury yield curve. Generally, the values of debt securities move in the opposite direction of the changes in interest rates. As interest rates along the treasury yield curve rise, especially at the intermediate and long end, the values of debt securities tend to decline. Whether or not the value of the Company’s investment portfolio will change above or below its amortized cost will be largely dependent on the direction and magnitude of interest rate movements and the duration of the debt securities within the Company’s investment portfolio. Management does not consider the reduction in value attributable to changes in credit quality. Correspondingly, when interest rates decline, the market values of the Company’s debt securities portfolio could be subject to market value increases.
As of December 31, 2022, the Company had $350.7 million in public deposits, or 16% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on these public deposits or otherwise obtain a FHLB letter of credit or FDIC insurance for these customers. As of December 31, 2022, the balance of pledged securities required for public and trust deposits was $407.2 million, or 63% of total securities.
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Quarterly, management performs a review of the investment portfolio to determine the causes of declines in the fair value of each security. The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio. Inputs provided by the third parties are reviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed to determine whether impairment exists and whether the impairment is temporary or other-than-temporary. Considerations such as the Company’s intent and ability to hold the securities until or sell prior to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, the receipt of amounts contractually due and whether or not there is an active market for the securities, for example, are applied, along with an analysis of the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security is other-than-temporarily impaired. If a decline in value is deemed to be other-than-temporary, the amortized cost of the security is reduced by the credit impairment amount and a corresponding charge to current earnings is recognized. During the year ended December 31, 2022, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.
Restricted investments in bank stock
Investment in Federal Home Loan Bank (FHLB) stock is required for membership in the organization and is carried at cost since there is no market value available. The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB of Pittsburgh. Excess stock is repurchased from the Company at par if the amount of borrowings decline to a predetermined level. In addition, the Company earns a return or dividend based on the amount invested. Atlantic Community Bankers Bank (ACBB) stock totaled $82 thousand as of December 31, 2022 and 2021. The balance in FHLB stock was $5.2 million and $3.1 million as of December 31, 2022 and 2021, respectively. The dividends received from the FHLB totaled $164 thousand and $130 thousand for the years ended December 31, 2022 and 2021, respectively.
Loans and leases
As of December 31, 2022, the Company had gross loans and leases, including originated and acquired loans and leases, totaling $1.6 billion compared to $1.4 billion at December 31, 2021, an increase of $131.4 million, or 9%.
During the year ended December 31, 2022, the growth in the portfolio was primarily attributed to the $79.6 million increase in the residential portfolio, including $13 million in mortgage loans originated during 2021 as available-for-sale but reclassified to the held-for-investment portfolio during the first quarter 2022. The Company elected to reclassify the mortgage loans, which meet FNMA underwriting guidelines and are considered high quality, to realize the better yields than those alternately available during the first quarter of 2022. This growth was supplemented by a $29.7 million increase in the consumer portfolio and a $22.1 million increase in the commercial portfolio during 2022.
A comparison of loan originations, net of participations is as follows for the periods indicated:
(dollars in thousands) Amount Amount
Loans:
Lines of credit:
Commercial and industrial originations decreased by $59 million, or 46%, to $70 million in 2022. This occurred because the Company recorded PPP loans in the commercial and industrial category. PPP loan originations were $77 million in 2021 and there were no PPP loan originations in 2022.
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Commercial and industrial (C&I) and commercial real estate (CRE)
As of December 31, 2022, the commercial loan portfolio increased by $22.1 million to $841.1 million compared to the December 31, 2021 balance of $819.0 million due to the $23.9 million increase in the commercial real estate portfolio partially offset by the $1.8 million decrease in the commercial and industrial portfolio, which was attributed to a $38.5 million reduction in PPP loans (net of deferred fees). Excluding the reduction in PPP loans (net of deferred fees) during the year ended December 31, 2022, the commercial portfolio grew $60.6 million with the growth stemming from both the C&I and CRE portfolios.
Excluding PPP loans, C&I loans grew $36.7 million primarily due to a focus on tax-free and municipal lending in 2022 with the addition of a public finance department. Other C&I loan originations in various industries were offset by scheduled and unscheduled paydowns in the portfolio.
CRE loans increased $23.9 million primarily due to growth of $22.1 million in owner occupied CRE primarily due to one fixed commercial loan and one floating commercial loan to unrelated borrowers during 2022.
Paycheck Protection Program Loans
The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act provided over $2.0 trillion in emergency economic relief to individuals and businesses impacted by the COVID-19 pandemic. The CARES Act authorized the Small Business Administration (SBA) to temporarily guarantee loans under a new 7(a) loan program called the Paycheck Protection Program (PPP).
As a qualified SBA lender, the Company was automatically authorized to originate PPP loans, and during the second and third quarters of 2020, the Company originated 1,551 loans totaling $159 million under the Paycheck Protection Program.
Under the PPP, the entire principal amount of the borrower’s loan, including any accrued interest, is eligible to be reduced by the loan forgiveness amount, so long as the employer maintains or quickly rehires employees and maintains salary levels and 60% of the loan proceeds are used for payroll expenses, with the remaining 40% of the loan proceeds used for other qualifying expenses.
As part of the Economic Relief Act, an additional $284 billion of federal resources was allocated to a reauthorized and revised PPP. On January 19, 2021, the Company began processing and originating PPP loans for this second round, which subsequently ended on May 31, 2021, and during this round, the Company originated 1,022 loans totaling $77 million.
Beginning in the fourth quarter of 2020 and continuing during 2022, the Company submitted PPP forgiveness applications to the SBA, and through December 31, 2022, the Company received forgiveness or paydowns of $235.2 million, or 99%, of the original PPP loan balances of $236.3 million with $32.1 million occurring during the year ended December 31, 2022.
As a PPP lender, the Company received fee income of approximately $9.9 million with $9.9 million recognized to date, including $1.2 million recognized during 2022. Unearned fees attributed to PPP loans, net of fees paid to referral sources as prescribed by the SBA under the PPP, were $33 thousand as of December 31, 2022.
The PPP loans originated by size were as follows as of December 31, 2022:
The table above does not include the $20.3 million in PPP loans acquired because of the merger with Landmark during the third quarter of 2021. As of December 31, 2022, the balance of outstanding acquired PPP loans was $0.2 million.
Consumer
The consumer loan portfolio consisted of home equity installment, home equity line of credit, automobile, direct finance leases and other consumer loans.
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As of December 31, 2022, the consumer loan portfolio increased by $29.7 million, or 12%, to $284.4 million compared to the December 31, 2021 balance of $254.7 million, primarily due to growth in the home equity installment, auto and direct finance lease portfolios. Auto loans grew $13.9 million from continued demand for higher priced automobiles and new dealer relationships. Direct finance leases increased $7.0 million primarily due to higher residual values and more automobile leases added than expired. Home equity installment loans also grew $11.5 million from the spring and fall home equity campaigns.
Residential
As of December 31, 2022, the residential loan portfolio increased by $79.6 million, or 22%, to $440.4 million compared to the December 31, 2021 balance of $360.8 million. The increase was due in part to a strategic reclassification of $13 million in available-for-sale mortgages booked during 2021 to held-for-investment loans during the first quarter of 2022. The remainder of the increase was due to a shift from mortgage loans sold to loans held-for-investment due to increased jumbo loans and the pricing of loans in the secondary market and more adjustable rate mortgages which are not being sold in the secondary market.
The residential loan portfolio consisted primarily of held-for-investment residential loans for primary residences. Management expects the sudden historic rise in interest rates to impact demand for residential mortgages for 2023.
A comparison of loans and related percentage of gross loans, at December 31, for the five previous periods is as follows:
(dollars in thousands) Amount % Amount %
Commercial real estate:
Consumer:
Residential:
Less:
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(dollars in thousands) Amount % Amount % Amount %
Commercial real estate:
Consumer:
Residential:
Less:
The following table sets forth the maturity distribution of select commercial and construction components of the loan portfolio at December 31, 2022. The determination of maturities is based on contractual terms. Non-contractual rollovers or extensions are included in one year or less category of the maturity classification. Excluded from the table are residential real estate and consumer loans:
More than More than
One year one year to five years to More than
(dollars in thousands) or less five years fifteen years fifteen years Total
Commercial real estate construction * 18,941 - - - 18,941
Residential real estate construction * 42,232 - - - 42,232
*In the table above, both residential and CRE construction loans are included in the one year or less category since, by their nature, these loans are converted into residential and CRE loans within one year from the date the real estate construction loan was consummated. Upon conversion, the residential and CRE loans would normally mature after five years.
The following table sets forth the total amount of C&I and CRE loans due after one year which have predetermined interest rates (fixed) and floating or adjustable interest rates (variable) as of December 31, 2022:
One to five Five to Over
(dollars in thousands) years fifteen years fifteen years Total
Non-refundable fees and costs associated with all loan originations are deferred. Using either the interest method or straight-line amortization, the deferral is released as credits or charges to loan interest income over the life of the loan.
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There are no concentrations of loans or customers to several borrowers engaged in similar industries exceeding 10% of total loans that are not otherwise disclosed as a category in the tables above. There are no concentrations of loans that, if resulted in a loss, would have a material adverse effect on the business of the Company. The Company’s loan portfolio does not have a material concentration within a single industry or group of related industries or customers that is vulnerable to the risk of a near-term severe negative business impact. As of December 31, 2022, approximately 75% of the gross loan portfolio was secured by real estate compared to 75% at December 31, 2021 and 66% at December 31, 2020.
The Company considers its portfolio segmentation, including the real estate secured portfolio, to be normal and reasonably diversified. The banking industry is affected by general economic conditions including, among other things, the effects of real estate values. The Company ensures that its mortgage lending adheres to standards of secondary market compliance. Furthermore, the Company’s credit function strives to mitigate the negative impact of economic conditions by maintaining strict underwriting principles for all loan types.
Loans held-for-sale
Upon origination, most residential mortgages and certain Small Business Administration (SBA) guaranteed loans may be classified as held-for-sale (HFS). In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In declining interest rate environments, the Company would be exposed to prepayment risk as rates on fixed-rate loans decrease, and customers look to refinance loans. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as HFS. Occasionally, residential mortgage and/or business loans may be transferred from the loan portfolio to HFS. The carrying value of loans HFS is based on the lower of cost or estimated fair value. If the fair values of these loans decline below their original cost, the difference is written down and charged to current earnings. Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.
As of December 31, 2022 and 2021, loans HFS consisted of residential mortgages with carrying amounts of $1.6 million and $31.7 million, respectively, which approximated their fair values. During the year ended December 31, 2022, residential mortgage loans with principal balances of $78.8 million were sold into the secondary market and the Company recognized net gains of $1.6 million, compared to $159.8 million and $4.1 million, respectively, during the year ended December 31, 2021. During the year ended December 31, 2021, the Company also sold one SBA guaranteed loan with a principal balance of $0.2 million and recognized a net gain of $24 thousand.
Management completed $13 million in transfers of mortgages HFS at December 31, 2021 to the held-for-investment portfolio during 2022.
The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market. MSRs are retained so that the Company can foster relationships. At December 31, 2022 and 2021, the servicing portfolio balance of sold residential mortgage loans was $465.7 million and $430.9 million, respectively, with mortgage servicing rights of $1.6 million and $1.7 million for the same periods, respectively.
Allowance for loan losses
Management evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for loan losses (allowance) on a quarterly basis. The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio. Management’s judgment is based on the evaluation of individual loans, experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans. Those estimates may be susceptible to significant change. The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.
Management applies two primary components during the loan review process to determine proper allowance levels. The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:
● identification of specific impaired loans by loan category;
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A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk grading of individual commercial loans. Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower. Upon review, the commercial loan credit risk grade is revised or reaffirmed. The credit risk grades may be changed at any time management determines an upgrade or downgrade may be warranted. The credit risk grades for the commercial loan portfolio are considered in the reserve methodology and loss factors are applied based upon the credit risk grades. The loss factors applied are based upon the Company’s historical experience as well as what management believes to be best practices and within common industry standards. Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs. The changes in allocations in the commercial loan portfolio from period-to-period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.
Acquired loans are initially recorded at their acquisition date fair values with no carryover of the existing related allowance for loan losses. Fair values are based on a discounted cash flow methodology that involves assumptions and judgements as to credit risk, expected lifetime losses, environmental factors, collateral values, discount rates, expected payments and expected prepayments. Upon acquisition, in accordance with GAAP, the Company has individually determined whether each acquired loan is within the scope of ASC 310-30. These loans are deemed purchased credit impaired loans and the excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loan. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable discount.
Acquired ASC 310-20 loans, which are loans that did not meet the criteria of ASC 310-30, were pooled into groups of similar loans based on various factors including borrower type, loan purpose, and collateral type. These loans are initially recorded at fair value and include credit and interest rate marks associated with purchase accounting adjustments. Purchase premiums or discounts are subsequently amortized as an adjustment to yield over the estimated contractual lives of the loans. There is no allowance for loan losses established at the acquisition date for acquired performing loans. An allowance for loan losses is recorded for any credit deterioration in these loans after acquisition.
Each quarter, management performs an assessment of the allowance for loan losses. The Company’s Special Assets Committee meets quarterly, and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount, if applicable, based on current accounting guidance. The Special Assets Committee’s focus is on ensuring the pertinent facts are considered regarding not only loans considered for specific reserves, but also the collectability of loans that may be past due. The assessment process also includes the review of all loans on non-accrual status as well as a review of certain loans to which the lenders or the Credit Administration function have assigned a criticized or classified risk rating.
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The following table sets forth the activity in the allowance for loan losses and certain key ratios for the periods indicated:
Charge-offs:
Recoveries:
Loans 90 days or more past due and accruing $ 33 $ 64 $ 61 $ - $ 1
For the twelve months ended December 31, 2022, the allowance increased $1.5 million, or 10%, to $17.1 million from $15.6 million at December 31, 2021 due to provisioning of $2.1 million partially offset by $0.6 million in net charge-offs. The allowance for loan and lease losses increased as a percentage of total loans at 1.10% as of December 31, 2022 compared to 1.09% at December 31, 2021 because the growth in the allowance (10%) outpaced the growth in the total loans (9%) through 2022.
Loans acquired from the Merchants and Landmark mergers (performing and non-performing) were initially recorded at their acquisition-date fair values. Since there is no initial credit valuation allowance recorded under this method, the Company established a post-acquisition allowance for loan losses to record losses which may subsequently arise on the acquired loans.
PPP loans made to eligible borrowers have a 100% SBA guarantee. Given this guarantee, no allowance for loan and lease losses was recorded for these loans.
Management believes that the current balance in the allowance for loan losses is sufficient to meet the identified potential credit quality issues that may arise and other issues unidentified but inherent to the portfolio. Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more.
During the first quarter of 2022, management increased the qualitative factors associated with its commercial, consumer, and residential portfolios related to the rise in rates that occurred during the quarter, and the adverse impact that these increased rates are anticipated to have on estimated credit losses.
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During the second quarter of 2022, management increased the qualitative factors associated with its commercial, consumer, and residential portfolios related to the rise in rates that occurred during the quarter, and the adverse impact that these increased rates are anticipated to have on estimated credit losses. These increases were partially offset by a reduction in the qualitative factors for the owner occupied CRE and residential real estate portfolios related to the historically low delinquency observed in these portfolios.
During the third quarter of 2022, management decreased the qualitative factors associated with its commercial, consumer, and residential portfolios related to changes in the Company’s loan policy that were expected to reduce credit losses.
During the fourth quarter of 2022, management decreased the qualitative factors for the term and nature of its loans. Reduction of the 10 Year Constant Treasury Rate and 30 Year Fixed Mortgage Rate lowered the risk of loss in its commercial, consumer, and residential portfolios.
The Company has determined its CECL methodologies, validated the CECL model and ran it concurrently for the fourth quarter of 2022. Upon adoption of CECL on January 1, 2023, the Company estimated an adjustment for the allowance for credit losses (ACL) which resulted in an increase in the allowance for loan losses of $0.7 million and reserve for unfunded commitments of $1.1 million. The Company will finalize the adoption during the first quarter of 2023.
The allocation of net charge-offs among major categories of loans are as follows for the periods indicated:
Net charge-offs
Commercial and industrial $ (360 ) 63 % $ (107 ) 18 %
For the year ended December 31, 2022, net charge-offs against the allowance totaled $575 thousand compared with net charge-offs of $578 thousand for the year ended December 31, 2021, representing a $3 thousand decline as decreases in residential and commercial real estate net charge offs were offset by increases in commercial & industrial and consumer net charge offs. Net charge offs were unchanged as a percentage of the total loan portfolio at 0.04% for both the years ended December 31, 2022 and 2021.
For a discussion on the provision for loan losses, see the “Provision for loan losses,” located in the results of operations section of management’s discussion and analysis contained herein.
The allowance for loan losses can generally absorb losses throughout the loan portfolio. However, in some instances an allocation is made for specific loans or groups of loans. Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Company, as previously explained. The changes in the allocations from period-to-period are based upon quarter-end reviews of the loan portfolio.
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Allocation of the allowance among major categories of loans for the periods indicated, as well as the percentage of loans in each category to total loans, is summarized in the following table. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends. When present, the portion of the allowance designated as unallocated is within the Company’s guidelines:
Category Category Category Category Category
% of % of % of % of % of
Category
As of December 31, 2022, the commercial loan portfolio, consisting of CRE and C&I loans, comprised 59% of the total allowance for loan losses compared with 62% on December 31, 2021. The commercial loan allowance allocation declined due to the payoff of a commercial real estate loan to a single borrower with a large specific impairment during the first quarter of 2022 and the relative decrease in this loan category, which decreased to 54% as of December 31, 2022 from 57% at December 31, 2021.
As of December 31, 2022, the consumer loan portfolio comprised 16% of the total allowance for loan losses compared with 15% on December 31, 2021 due to the relative growth in the consumer portfolio.
As of December 31, 2022, the residential loan portfolio comprised 24% of the total allowance for loan losses compared with 22% on December 31, 2021. The two percentage point increase was the result of the relative increase in this loan category, which increased to 28% as of December 31, 2022 from 25% as of December 31, 2021.
As of December 31, 2022, the unallocated reserve, representing the portion of the allowance not specifically identified with a loan or groups of loans, was less than 1% of the total allowance for loan losses, unchanged from December 31, 2021.
Non-performing assets
The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, troubled debt restructurings (TDRs), other real estate owned (ORE) and repossessed assets.
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The following table sets forth non-performing assets at December 31:
Loans past due 90 days or more and accruing $ 33 $ 64 $ 61 $ - $ 1
* In the table above, the amount includes non-accrual TDRs of $0.2 million, $0.6 million, $0.7 million, $0.6 million and $1.7 million as of 2022, 2021, 2020, 2019 and 2018, respectively.
Management continually monitors the loan portfolio to identify loans that are either delinquent or are otherwise deemed by management unable to repay in accordance with contractual terms. Generally, loans of all types are placed on non-accrual status if a loan of any type is past due 90 or more days or if collection of principal and interest is in doubt. Further, unsecured consumer loans are charged-off when the principal and/or interest is 90 days or more past due. Uncollected interest income accrued on all loans placed on non-accrual is reversed and charged to interest income.
Non-performing assets represented 0.17% of total assets at December 31, 2022 compared with 0.27% at December 31, 2021. The improvement resulted from a $2.4 million, or 37%, decrease in non-performing assets. Non-performing assets decreased due to a $1.7 million reduction in accruing troubled debt restructurings, a $0.4 reduction in non-performing loans, and a $0.3 million reduction in other real estate owned and repossessed assets.
From December 31, 2021 to December 31, 2022, non-accrual loans decreased $0.4 million, or 14%, from $2.9 million to $2.5 million. The $0.4 million decrease in non-accrual loans was primarily the result of $1.5 million in payments, $0.7 million in moves to ORE, $0.5 million in charge offs, and $0.1 million in moves to accrual partially offset by $2.3 million in additions and $0.1 million in advances.
At December 31, 2022, there were a total of 39 loans to 29 unrelated borrowers with balances that ranged from less than $1 thousand to $0.6 million. At December 31, 2021, there were a total of 31 loans to 28 unrelated borrowers with balances that ranged from less than $1 thousand to $0.7 million.
There was one direct finance lease and one non-recourse auto loan totaling $33 thousand that were over 90 days past due as of December 31, 2022 compared to two direct finance leases totaling $64 thousand that were over 90 days past due as of December 31, 2021. All loans were well secured and in the process of collection.
The Company seeks payments from all past due customers through an aggressive customer communication process. Unless well-secured and in the process of collection, past due loans will be placed on non-accrual at the 90-day point when it is deemed that a customer is non-responsive and uncooperative to collection efforts.
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The composition of non-performing loans as of December 31, 2022 is as follows:
Past due
Gross 90 days or Non- Total non- % of
loan more and accrual performing gross
(dollars in thousands) balances still accruing loans loans loans
Commercial real estate:
Construction 18,941 - - - -
Consumer:
Home equity installment 59,118 - - - -
Residential:
Construction 42,232 - - - -
Loans held-for-sale 1,637 - - - -
*Net of unearned lease revenue of $1.4 million.
Payments received from non-accrual loans are recognized on a cost recovery method. Payments are first applied to the outstanding principal balance, then to the recovery of any charged-off loan amounts. Any excess is treated as a recovery of interest income. If the non-accrual loans that were outstanding as of December 31, 2022 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $160 thousand.
The following tables set forth the activity in accruing and non-accruing TDRs as of the period indicated:
As of and for the years ended December 31, 2022
Accruing Non-accruing
Commercial Commercial Commercial
(dollars in thousands) real estate real estate & industrial Total
Troubled Debt Restructures:
Additions - - - -
Charge offs - - - -
Number of loans 6 1 - 7
As of and for the year ended December 31, 2021
Accruing Non-accruing
Commercial Commercial Commercial
(dollars in thousands) real estate real estate & industrial Total
Troubled Debt Restructures:
Charge offs - - (65 ) (65 )
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The Company reviews changes to loans to determine if they meet the definition of a TDR, as modifications occur. TDRs arise when a borrower experiences financial difficulty and the Company grants a concession that it would not otherwise grant based on current underwriting standards to maximize the Company’s recovery.
From December 31, 2021 to December 31, 2022, TDRs declined $2.0 million, or 57%, primarily due to the payoff of two commercial real estate TDRs to a single borrower totaling $1.6 million and the payoff of two C&I TDRs to a single borrower totaling $0.1 million.
At December 31, 2022, there were a total of 7 TDRs by 6 unrelated borrowers with balances that ranged from $87 thousand to $0.5 million. At December 31, 2021, there were a total of 11 TDRs by 8 unrelated borrowers with balances that ranged from $50 thousand to $1.3 million.
Loans modified in a TDR may or may not be placed on non-accrual status. At December 31, 2022, there was one TDR totaling $0.2 million that was on non-accrual status compared to three TDRs totaling $0.6 million at December 31, 2021.
Foreclosedassets held-for-sale
From December 31, 2021 to December 31, 2022, foreclosed assets held-for-sale (ORE) declined from $434 thousand to $168 thousand, a $266 thousand decrease, which was primarily attributed to two ORE properties totaling $283 thousand that were sold during the first quarter. Two properties totaling $595 thousand were also added to ORE and sold during 2022.
The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale:
(dollars in thousands) Amount # Amount #
Balance at beginning of period $ 434 5 $ 256 6
Pay downs (6 ) -
Write downs (17 ) (16 )
As of December 31, 2022, ORE consisted of two properties securing loans to two unrelated borrowers totaling $168 thousand. One property ($167 thousand) was added in 2022 and one property ($1 thousand) was added in 2017. Both properties are listed for sale.
As of December 31, 2022 and December 31, 2021, the Company had no other repossessed assets held-for-sale.
Cash surrender value of bank owned life insurance
The Company maintains bank owned life insurance (BOLI) for a chosen group of employees at the time of purchase, namely its officers, where the Company is the owner and sole beneficiary of the policies. BOLI is classified as a non-interest earning asset. Increases in the cash surrender value are recorded as components of non-interest income. The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance and its tax-free advantage to the Company. This profitability is used to offset a portion of current and future employee benefit costs. As a result of the Landmark acquisition, the Company acquired $7.2 million in BOLI during the third quarter of 2021. The BOLI cash surrender value build-up can be liquidated if necessary, with associated tax costs. However, the Company intends to hold this pool of insurance, because it provides income that enhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value. The Company was notified of a pending death benefit claim on two owned policies and received $0.8 million in return of cash surrender value and $0.1 million in other income during the first quarter of 2023.
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Premises and equipment
Net of depreciation, premises and equipment increased $2.0 million during 2022. The Company purchased $1.8 million in fixed assets and added $3.7 million in construction in process during 2022. The increase in construction in process was primarily due to the purchase of the Scranton Electric Building for a new headquarters in Scranton, PA. These increases were partially offset by $2.2 million in depreciation expense and $1.2 million in transfers to other assets held-for-sale. The Company is planning to open a new branch in Wilkes-Barre in 2023. The Company has recently begun remodeling the Main Branch located in Dunmore, PA and estimated costs for the project are currently $3.9 million. The Company began corporate headquarters planning which may continue to increase construction in process and is evaluating its branch network looking for consolidation that makes sense for more efficient operations.
On December 23, 2020, the Commonwealth of Pennsylvania authorized the release of $2.0 million in Redevelopment Assistance Capital Program (RACP) funding for the Company’s headquarters project in Lackawanna County. On December 2, 2021, the Company announced it would be receiving an additional $2.0 million in RACP funding in support of the project. The $4.0 million in total RACP grant funds will be allocated to the renovation and rehabilitation of the historic building located in downtown Scranton which will be used for the new corporate headquarters. The Company currently estimates net remaining costs for the corporate headquarters could range from $15 million to $20 million. This range estimate is subject to supply chain issues, commodities pricing and results of final planning over approximately two years through the end of 2024. In addition, the Company currently intends to pursue a federal historic preservation tax credit which would provide a 20% tax credit on qualified improvements on the historic property.
Other assets
During 2022, the $17.9 million increase in other assets was due mostly to a $16.5 million increase in deferred tax assets primarily from net unrealized losses in the investment portfolio and $0.7 million increase in prepaid dealer reserve.
Results of Operation
Earnings Summary
The Company’s earnings depend primarily on net interest income. Net interest income is the difference between interest income and interest expense. Interest income is generated from yields earned on interest-earning assets, which consist principally of loans and investment securities. Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is determined by the Company’s interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Interest rate spread is significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in the marketplace.
The Company’s earnings are also affected by the level of its non-interest income and expenses and by the provisions for loan losses and income taxes. Non-interest income mainly consists of: service charges on the Company’s loan and deposit products; interchange fees; trust and asset management service fees; increases in the cash surrender value of the bank owned life insurance and from net gains or losses from sales of loans and securities. Non-interest expense consists of: compensation and related employee benefit costs; occupancy; equipment; data processing; advertising and marketing; FDIC insurance premiums; professional fees; loan collection; net other real estate owned (ORE) expenses; supplies and other operating overhead.
Net interest income, net interest rate margin, net interest rate spread and the efficiency ratio are presented in the Mangement's Discussion & Analysis on a fully-taxable equivalent (FTE) basis. The Company believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.
Overview
For the year ended December 31, 2022, the Company generated net income of $30.0 million, or $5.29 per diluted share, compared to $24.0 million, or $4.48 per diluted share, for the year ended December 31, 2021. The $6.0 million, or 25%, increase in net income stemmed from $10.4 million more net interest income which more than offset $1.6 million lower non-interest income, $1.2 million rise in non-interest expenses and $1.4 million higher provision for income taxes.
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For the year ended December 31, 2022, return on average assets (ROA) and return on average shareholders’ equity (ROE) were 1.25% and 17.37%, respectively, compared to 1.13% and 12.69% for the same period in 2021. The increase in ROA was the result of the growth in net income relative to the increase in average assets during 2022. ROE increased due to net income growth as well as average equity decreases during 2022.
Net interest income and interest sensitive assets / liabilities
Net interest income (FTE) increased $11.0 million, or 17%, from $64.0 million for the year ended December 31, 2021 to $75.0 million for the year ended December 31, 2022, due to interest income increasing more than the increase in interest expense. Total average interest-earning assets increased $310.0 million while the FTE yields earned on these assets rose 14 basis points resulting in $13.8 million of growth in FTE interest income. The loan portfolio contributed the most to this growth due to average balance growth of $200.8 million which had the effect of producing $8.7 million more FTE interest income, despite $3.9 million less in fees earned under the Paycheck Protection Program (PPP). In the investment portfolio, an increase in the average balances of securities was the biggest driver of interest income growth. The average balance of total securities grew $167.2 million supplemented by a 13 basis point increase in yields producing $4.3 million in additional FTE interest income. Interest income on interest-bearing cash also increased $0.7 million due to an increase in yields.
On the liability side, total interest-bearing liabilities grew $217.3 million in average balances with a 14 basis point increase in rates paid on these interest-bearing liabilities which caused interest expense to increase $2.8 million. Growth in average interest-bearing deposits of $217.4 million and a 14 basis point increase in rates paid on these deposits resulted in increasing interest expense by $2.7 million. In addition, the Company utilized more in average overnight borrowings in 2022 at higher rates and had more interest expense on secured borrowings compared to 2021 resulting in $0.1 million more interest expense from borrowings.
The FTE net interest rate spread was unchanged at 3.16% for the years ended December 31, 2022 and 2021. The FTE net interest rate margin increased by 5 basis points, respectively, for the year ended December 31, 2022 compared to the year ended December 31, 2021. The yields earned on interest-earning assets grew at the same pace as the increase in the rates paid on interest-bearing liabilities causing the net interest rate spread to remain flat. The increase in net interest rate margin was due to the higher average balance of non-interest bearing deposits. The overall cost of funds, which includes the impact of non-interest bearing deposits, increased 10 basis points for the year ended December 31, 2022 compared to the same period in 2021. The primary reason for the increase was the higher rates paid on deposits.
During 2023, the Company expects to operate in a rising short-term interest rate environment. A rate environment with rising interest rates positions the Company to improve its interest income performance from new and repricing earning assets. For 2023, the Company anticipates net interest income to grow at a slower pace as growth in interest income would likely help mitigate an adverse impact of rate movements on the cost of funds. The risk to continuing net interest income improvement is rapid acceleration of deposit rates in the Company's marketplace. The FOMC began increasing the federal funds rate during 2022, the first moves since they cut rates during the first quarter of 2020, which began to have an effect on rates paid on interest-bearing liabilities. On the asset side, the prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans was also increased 425 basis points during 2022. Consensus economic forecasts are predicting increases in short-term rates throughout 2023. The 2023 focus is to manage net interest income and control deposit costs through a forecasted rising short-term rate cycle for primarily overnight to 12-month rates. Continued growth in the loan portfolios is expected to boost interest income, and when coupled with a proactive relationship approach to deposit cost setting strategies should help stop spread compression and contain the interest rate margin, preventing further reductions below acceptable levels.
The Company’s cost of interest-bearing liabilities was 0.40% for the year ended December 31, 2022, or 14 basis points higher than the cost for the year ended December 31, 2021. The increase in interest paid on deposits contributed to the higher cost of interest-bearing liabilities. Management currently believes the FOMC is expected to continue to raise the federal funds rate in the immediate future, so the Company may continue to experience pressure to further increase rates paid on deposits. To help mitigate the impact of the imminent change to the economic landscape, the Company has successfully developed and will continue to strengthen its association with existing customers, develop new business relationships, generate new loan volumes, and retain and generate higher levels of average non-interest bearing deposit balances. Strategically deploying no- and low-cost deposits into interest earning-assets is an effective margin-preserving strategy that the Company expects to continue to pursue and expand to help stabilize net interest margin.
The Company’s Asset Liability Management (ALM) team meets regularly to discuss among other things, interest rate risk and when deemed necessary adjusts interest rates. ALM is actively addressing the Company's sensitivity to a changing rate environment to ensure interest rate risks are contained within acceptable levels. ALM also discusses revenue enhancing strategies to help combat the potential for a decline in net interest income. The Company’s marketing department, together with ALM, and relationship managers, continue to develop prudent strategies that will grow the loan portfolio and accumulate low-cost deposits to improve net interest income performance.
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The table that follows sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and rates for the years indicated. Within the table, interest income was FTE adjusted, using the corporate federal tax rate of 21% for 2022, 2021 and 2020, to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. See “Non-GAAP Financial Measures” within this management’s discussion and analysis for the FTE adjustments. This treatment allows a uniform comparison among yields on interest-earning assets. Loans include loans held-for-sale (HFS) and non-accrual loans but exclude the allowance for loan losses. HELOC are included in the residential real estate category since they are secured by real estate. Net deferred loan fee accretion of $0.2 million in 2022, $3.8 million in 2021 and $2.1 million in 2020, respectively, are included in interest income from loans. MNB and Landmark loan fair value purchase accounting adjustments of $3.3 million, $3.0 million and $0.6 million are included in interest income from loans and $160 thousand, $154 thousand and $213 thousand reduced interest expense on deposits and borrowings for 2022, 2021 and 2020. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Residual values for direct finance leases are included in the average balances for consumer loans. Net interest margin is calculated by dividing net interest income-FTE by total average interest-earning assets. Cost of funds includes the effect of average non-interest bearing deposits as a funding source:
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Average Yield / Average Yield / Average Yield /
Assets balance Interest rate balance Interest rate balance Interest rate
Interest-earning assets
Investments:
Loans and leases:
Liabilities and shareholders' equity
Interest-bearing liabilities
Deposits:
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Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in volumes of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change. The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate. Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis:
Years ended December 31,
Increase (decrease) due to
Volume Rate Total Volume Rate Total
Interest income:
Restricted investments in bank stock 17 40 57 7 (42 ) (35 )
Investments:
Other - - - (1 ) (2 ) (3 )
Loans and leases:
Interest expense:
Deposits:
Provision for loan losses
The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses (the allowance) to a level that represents management’s best estimate of known and inherent losses in the Company’s loan portfolio. Loans determined to be uncollectible are charged off against the allowance. The required amount of the provision for loan losses, based upon the adequate level of the allowance, is subject to the ongoing analysis of the loan portfolio. The Company’s Special Assets Committee meets periodically to review problem loans. The committee is comprised of management, including credit administration officers, loan officers, loan workout officers and collection personnel. The committee reports quarterly to the Credit Administration Committee of the board of directors.
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Management continuously reviews the risks inherent in the loan portfolio. Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:
• specific loans that could have loss potential;
• levels of and trends in delinquencies and non-accrual loans;
• levels of and trends in charge-offs and recoveries;
• trends in volume and terms of loans;
• changes in risk selection and underwriting standards;
• changes in lending policies and legal and regulatory requirements;
• experience, ability and depth of lending management;
• national and local economic trends and conditions; and
• changes in credit concentrations.
For the year ended December 31, 2022 and 2021, the provision for loan losses was $2.1 million, a $0.1 million increase compared to $2.0 million for the year ended December 31, 2021. This amount of provisioning reflected the loan growth achieved during 2022 and what management deemed necessary to maintain the allowance for loan and lease losses at an adequate level.
The provision for loan losses derives from the reserve required from the allowance for loan losses calculation. The Company continued provisioning for the year December 31, 2022 to maintain an allowance level that management deemed adequate.
For a discussion on the allowance for loan losses, see “Allowance for loan losses,” located in the comparison of financial condition section of management’s discussion and analysis contained herein.
Other income
For the year ended December 31, 2022, non-interest income amounted to $16.6 million, a $1.6 million, or 9%, decrease compared to $18.2 million recorded for the year ended December 31, 2021. The decrease was primarily due to $2.5 million lower gains on loan sales and $0.7 million less loan service charges due to scaled back demand for mortgages. Partially offsetting these decreases, service charges on deposits increased $0.9 million. Interchange fees grew $0.2 million due to a higher volume of debit card transactions. Fees from trust fiduciary activities increased $0.2 million year-over-year.
Other operating expenses
For the year ended December 31, 2022, total other operating expenses totaled $51.3 million, an increase of $1.2 million, or 2%, compared to $50.1 million for the year ended December 31, 2021. Non-interest expenses would have increased $3.4 million more if not for $3.0 million in merger-related expenses and a $0.4 million FHLB prepayment penalty incurred by the Company during 2021. Salaries and employee benefit expenses grew $2.9 million, or 12%. The increase was primarily due to less deferred loan origination costs reducing salaries and employee benefits expense from a lower volume of originations from mortgages and PPP loans. Additionally, salaries and employee benefits were higher from new positions added and merit increases and higher group insurance from a larger amount of claims. Premises and equipment expenses increased $0.6 million, or 9%, due to higher expenses for lease payments, equipment maintenance and rental and other expenses related to premises and equipment acquired from the merger with Landmark. PA shares tax expense was $0.3 million higher from growth in equity.
The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at December 31, 2022 and 2021 were 1.45% and 1.50%, respectively. The expense ratio decreased because of increased levels of average assets. The efficiency ratio decreased from 60.92% at December 31, 2021 to 56.02% at December 31, 2022 due to revenue increasing faster than expenses in 2022. For more information on the calculation of the efficiency ratio, see “Non-GAAP Financial Measures” located within this management’s discussion and analysis.
Open positions and the cost of maintaining talent may increase salaries and employee benefit expenses in 2023. Additionally, the Company's technology platforms continue to evolve and require periodic upgrades. Therefore, the Company continues to devote financial resources and personnel necessary to maintain and improve the information technology systems and platforms for optimal operational efficiency, customer convenience and compliance with applicable laws, regulations and regulatory guidance within a secure environment. Although these costs are expected, the costs of software and software subscriptions continue to rise and our ability to attract and retain qualified information technology personnel during a historically tight labor market may require further investment by the Company.
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Provision for income taxes
The Company’s effective income tax rate approximated 15.4% in 2022 and 14.3% in 2021. The difference between the effective rate and the enacted statutory corporate rate of 21% is due mostly to the effect of tax-exempt income in relation to the level of pre-tax income. The provision for income taxes increased $1.4 million, or 36%, from $4.0 million at December 31, 2021 to $5.4 million at December 31, 2022. The increase was primarily due to higher pre-tax income in 2022. If the federal corporate tax rate is increased, the Company’s net deferred tax liabilities and deferred tax assets will be re-valued upon adoption of the new tax rate. A federal tax rate increase will decrease net deferred tax assets with a corresponding decrease to provision for income taxes.
Comparison of Financial Condition as of December 31, 2021
and 2020 and Results of Operations for each of the Years then Ended
Executive Summary
The Company generated $24.0 million in net income in 2021, or $4.48 diluted earnings per share, up $11.0 million, or 84%, from $13.0 million, or $2.82 diluted earnings per share, in 2020. In 2021, our larger and well diversified balance sheet from organic and inorganic growth contributed to the success of our earnings performance. Federal Open Market Committee (FOMC) officials dropped the federal funds rate down to 0%-0.25% during the first quarter of 2020 at the start of the pandemic where it remained through 2021.
Nationally, the unemployment rate fell from 6.7% at December 31, 2020 to 3.9% at December 31, 2021. The unemployment rates in the Scranton - Wilkes-Barre - Hazleton and the Allentown – Bethlehem - Easton Metropolitan Statistical Areas (local) decreased but remained at a higher level than the national unemployment rate. According to the U.S. Bureau of Labor Statistics, the local unemployment rates at December 31, 2021 were 4.8% and 4.0%, respectively, a decrease of 3.2 and 2.6 percentage points from the 8.0% and 6.6%, respectively, at December 31, 2020. The national and local unemployment rates have decreased as a result of the improving economic environment. The pandemic-related business restrictions had been lifted in our local area and employees started heading back to work. Stimulus payments and enhanced unemployment benefits supported the economy throughout 2020 and 2021. The median home values in the Scranton-Wilkes-Barre-Hazleton metro and Allentown-Bethlehem-Easton metro each increased 20.4% and 17.9% from a year ago, according to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets.
Non-recurring merger-related costs and a FHLB prepayment penalty incurred during 2021 and 2020 are not a part of the Company’s normal operations. If these expenses had not occurred, adjusted net income (non-GAAP) for the years ended December 31, 2021 and 2020 would have been $26.8 million and $15.4 million, respectively. Adjusted diluted EPS (non-GAAP) would have been $5.00 and $3.34 for the years ended December 31, 2021 and 2020. For the same time periods, adjusted ROA (non-GAAP) would have been 1.27% and 1.03%, respectively, and adjusted ROE (non-GAAP) would have been 14.18% and 10.73%, respectively.
For the years ended December 31, 2021 and 2020, tangible common book value per share (non-GAAP) was $33.68 and $31.72, respectively, an increase of 6.2%.
During 2021, the Company’s assets grew by 42% primarily from assets acquired from the merger with Landmark and additional growth in deposits, which were used to fund growth in the loan and security portfolios. Non-performing assets represented 0.27% of total assets as of December 31, 2021, down from 0.39% at the prior year end. Non-performing assets to total assets was lower during 2021 mostly due to the amount (or dollar value) of non-performing assets decreasing while there was growth in total assets.
Financial Condition
Consolidated assets increased $719.6 million, or 42%, to $2.4 billion as of December 31, 2021 from $1.7 billion at December 31, 2020. The increase in assets occurred primarily from assets acquired in the merger with Landmark and deposit inflow. The asset growth was funded by utilizing growth in deposits of $660.4 million.
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Funds Provided:
Deposits
Total deposits increased $660.4 million, or 44%, from $1.5 billion at December 31, 2020 to $2.2 billion at December 31, 2021. Non-interest bearing and interest-bearing checking accounts contributed the most to the deposit growth with increases of $182.8 million and $276.7 million, respectively. The growth in non-interest bearing checking accounts was primarily due to accounts acquired from the Landmark merger supplemented by business and personal account growth. The increase in interest-bearing checking accounts was primarily due to accounts from the Landmark merger, seasonal tax cycles, business activity, federal pandemic relief funds and shifts from maturing CDs. Money market accounts also increased $134.8 million, mostly due to acquired Landmark accounts, higher balances of personal and business accounts and shifts from other types of deposit accounts. The Company focuses on obtaining a full-banking relationship with existing checking account customers as well as forming new customer relationships. Savings accounts increased $55.1 million due to accounts added from the Landmark merger and also an increase in personal account balances.
Additionally, CDs also increased $11.0 million due to CDs acquired from the merger with Landmark. Otherwise, CD balances continue to decline as rates dropped during 2020 and 2021 and previous years' promotional CDs reached maturity. Of the balance of outstanding CDs at December 31, 2021, $70.8 million, or 51%, had a balance at December 31, 2020. The majority of the remaining maturing CD balances were transferred to transactional accounts primarily interest-bearing checking and money market accounts. During the third quarter of 2021, $12.0 million in CDs from one public customer was transferred to an interest-bearing checking account.
The Company did not have any CDARs as of December 31, 2021 and 2020. As of December 31, 2021 and 2020, ICS reciprocal deposits represented $27.6 million and $46.2 million, or 1% and 3%, of total deposits which are included in interest-bearing checking accounts in the table above. The $18.6 million decrease in ICS deposits is primarily due to public funds deposit transfers from ICS accounts to other interest-bearing checking accounts partially offset by ICS accounts acquired from Landmark.
As of December 31, 2021, total uninsured deposits were estimated to be $919.3 million.
Short-term borrowings
There were no short-term borrowings as of December 31, 2021 and 2020 as growth in deposits funded asset growth. As of December 31, 2021, the Company had the ability to borrow $91.7 million from the Federal Reserve borrower-in-custody program and $31.0 million from lines of credit with correspondent banks.
Secured borrowings
As of December 31, 2021, the Company had secured borrowings with a fair value of $10.6 million related to certain sold loan participations that did not qualify for sales treatment acquired from Landmark.
FHLB advances
The Company had no FHLB advances as of December 31, 2021. During the first quarter of 2021, the Company paid off $5 million in FHLB advances with a weighted average interest rate of 3.07%. During the third quarter of 2021, the Company acquired $4.5 million in FHLB advances from the Landmark merger that was subsequently paid off. As of December 31, 2021, the Company had the ability to borrow an additional $568.9 million from the FHLB.
Funds Deployed:
Investment Securities
As of December 31, 2021, the carrying value of investment securities amounted to $739.0 million, or 31% of total assets, compared to $392.4 million, or 23% of total assets at December 31, 2020.
The Company’s municipal (obligations of states and political subdivisions) portfolio is comprised of tax-free municipal bonds with a book value of $267.5 million and taxable municipal bonds with a book value of $93.2 million. The overall credit ratings of these municipal bonds was as follows: 36% AAA, 62% AA, 1% A and 1% escrowed.
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During 2021, the carrying value of total investments increased $346.6 million, or 88%. Purchases for the year totaled $411.4 million, while maturities and principal reductions totaled $54.2 million and proceeds from sales were $44.5 million. The purchases were funded principally by cash flow generated from the portfolio and excess overnight liquidity. The growth in the investment portfolio was due to the increase in low earning cash that was used to purchase higher yielding securities. As a result of the acquisition of Landmark, the Company acquired $49.4 million in securities of which $16.5 million was retained and the remaining securities were liquidated and reinvested.
The investment securities portfolio contained no private label mortgage-backed securities, collateralized mortgage obligations, collateralized debt obligations, or trust preferred securities, and no off-balance sheet derivatives were in use. The portfolio had no adjustable-rate instruments as of December 31, 2021 and 2020.
Investment securities were comprised of AFS securities as of December 31, 2021 and 2020. The AFS securities were recorded with a net unrealized gain of $0.2 million and a net unrealized gain of $11.3 million as of December 31, 2021 and 2020, respectively. Of the net decline in the unrealized gain position of $11.1 million: $3.3 million was attributable to municipal securities; $5.1 million was attributable to mortgage-backed securities and $2.7 million was attributable to agency securities.
As of December 31, 2021, the Company had $417.8 million in public deposits, or 19% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on these public deposits or otherwise obtain a FHLB letter of credit or FDIC insurance for these customers. As of December 31, 2021, the balance of pledged securities required for public and trust deposits was $394.3 million, or 53% of total securities.
During the year ended December 31, 2021, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.
Restricted investments in bank stock
Atlantic Community Bankers Bank (ACBB) stock totaled $82 thousand and $45 thousand as of December 31, 2021 and 2020. ACBB stock totaling $37 thousand was acquired from the merger with Landmark in 2021. The dividends received from the FHLB totaled $130 thousand and $203 thousand for the years ended December 31, 2021 and 2020, respectively. The balance in FHLB and ACBB stock was $3.2 million and $2.8 million as of December 31, 2021 and 2020, respectively.
Loans and leases
As of December 31, 2021, the Company had gross loans and leases, including originated and acquired loans and leases, totaling $1.4 billion compared to $1.1 billion at December 31, 2020, an increase of $314 million, or 28%.
Growth in the portfolio was attributed to a $118 million, or 13%, increase in the originated portfolio and a $196 million, or 93%, increase in the acquired portfolio. Growth in the originated portfolio was primarily attributed to the $83 million increase in the commercial real estate portfolio, resulting from the origination of several large commercial real estate loans during 2021, and the $95 million increase in the residential portfolio, stemming from the strength of the housing market in the Company’s service area and the low interest rate environment along with management’s decision to retain a greater percentage of potentially saleable mortgages. Growth in the acquired portfolio was attributed to the $299 million in loans added to the Company’s balance sheet from the Landmark merger, which closed in the third quarter of 2021.
Commercial and industrial originations decreased by $70 million, or 35%, to $129 million in 2021. This occurred because the Company recorded PPP loans in the commercial and industrial category. PPP loan originations decreased from $159 million in 2020 to $77 million in 2021.
Commercial and industrial and commercial real estate
As of December 31, 2021, the commercial loan portfolio increased by $156 million, or 24%, to $819 million over the December 31, 2020 balance of $663 million due to $145 million in growth in the acquired portfolio and $11 million in growth in the originated portfolio. Excluding the $98 million reduction in originated PPP loans (net of deferred fees) during the twelve months ended December 31, 2021, the originated commercial portfolio grew $110 million due to the origination of several large CRE loans during the year along with increased overall lending activity due to the Company’s larger size and market area.
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The commercial loan portfolio consisted of $513 million in originated loans, including $32 million in originated PPP loans, and $306 million in loans acquired from MNB and Landmark, including $8 million in acquired PPP loans,
as of December 31, 2021.
Paycheck Protection Program Loans
Beginning in the fourth quarter of 2020 and continuing during 2021, the Company submitted PPP forgiveness applications to the SBA, and through December 31, 2021, the Company received forgiveness or paydowns of $203 million, or 86%, of the original PPP loan balances of $236 million with $176 million occurring during the twelve months ended December 31, 2021.
As a PPP lender, the Company received fee income of approximately $9.9 million with $8.7 million recognized to date, including $3.3 million of PPP fee income recognized during 2020 and $5.4 million recognized during 2021. Unearned fees attributed to PPP loans, net of $0.1 million in fees paid to referral sources as prescribed by the SBA under the PPP, were $1.2 million as of December 31, 2021.
The PPP loans originated by size were as follows as of December 31, 2021:
The table above does not include the $20.3 million in PPP loans acquired because of the merger with Landmark during the third quarter of 2021. As of December 31, 2021, the balance of outstanding acquired PPP loans was $7.9 million.
Consumer
As of December 31, 2021, the consumer loan portfolio increased by $39 million, or 18%, to $255 million compared to the December 31, 2020 balance of $216 million, due to $27 million in growth in the acquired portfolio, primarily automobile, related to the Landmark merger and $12 million in growth in the originated portfolio, specifically from the home equity line of credit and direct finance lease portfolios.
Residential
As of December 31, 2021, the residential loan portfolio increased by $119 million, or 49%, to $361 million compared to the December 31, 2020 balance of $242 million. For the twelve months ended December 31, 2021, $25 million in growth was attributed to loans acquired in the Landmark merger and $94 million in growth originated mainly in the Company’s service area spurred by a historically low interest rate environment, strong demand for residential loans and management’s decision to retain potentially saleable mortgages.
The residential loan portfolio consisted primarily of held-for-investment residential loans for primary residences. Originated loans totaled $298 million and acquired loans totaled $63 million as of December 31, 2021 compared to originated loans of $204 million and acquired loans of $38 million as of December 31, 2020.
Loans held-for-sale
As of December 31, 2021 and 2020, loans HFS consisted of residential mortgages with carrying amounts of $31.7 million and $29.8 million, respectively, which approximated their fair values. During the year ended December 31, 2021, residential mortgage loans with principal balances of $159.8 million were sold into the secondary market and the Company recognized net gains of $4.1 million, compared to $155.1 million and $3.5 million, respectively, during the year ended December 31, 2020. During the year ended December 31, 2021, the Company also sold one SBA guaranteed loan with a principal balance of $0.2 million and recognized a net gain of $24 thousand compared to one SBA guaranteed loan with a principal balance of $0.6 million and recognized a net gain on the sale of $93 thousand during the year ended December 31, 2020.