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.
During 2021, management decided to hold mortgages HFS longer to earn interest income. Management completed a $13 million transfer of mortgages HFS to the held-for-investment portfolio during the first quarter of 2022.
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The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market. MSRs are retained so that the Company can foster personal relationships. At December 31, 2021 and 2020, the servicing portfolio balance of sold residential mortgage loans was $430.9 million and $366.5 million, respectively, with mortgage servicing rights of $1.7 million and $1.3 million for the same periods, respectively.
Allowance for loan losses
For the twelve months ended December 31, 2021, the allowance increased $1.4 million, or 10%, to $15.6 million from $14.2 million at December 31, 2020 due to provisioning of $2.0 million partially offset by $0.6 million in net charge-offs. The allowance for loan and lease losses decreased as a percentage of total loans to 1.09% from 1.27% at December 31, 2020 as the growth in the loan portfolio (28%) outpaced the growth in the allowance for loan losses (10%) during the same period.
During the first quarter of 2021, 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.
During the second quarter of 2021, management increased the qualitative factors associated with its commercial & industrial portfolio related to the rising delinquency observed during this period, which was on a worsening trend on both a quarter-over-quarter and year-over-year basis.
During the third quarter of 2021, management reduced the qualitative factors associated with its commercial, consumer, and residential portfolios related to the improvement in the economic environment compared to the prior period, which was attributed to the improving key risk indicators used in the analysis including national unemployment rate, personal consumer expenditures, industrial production and consumer sentiment.
During the fourth quarter of 2021, management reduced the qualitative factors associated with its commercial, consumer, and residential portfolios related to the sustained, low level of delinquency in these portfolios observed during the year and improvement compared to the year earlier period. Management also reduced the qualitative factors associated with its commercial portfolio related to the improvement in the key risk indicators used in the analysis including national unemployment rate, personal consumer expenditures, and industrial production.
For the twelve months ended December 31, 2021, net charge-offs against the allowance totaled $578 thousand compared with net charge-offs of $795 thousand for the twelve months ended December 31, 2020, representing a $217 thousand, or 27%, decrease. This decrease was attributed to general economic improvement and continued high levels of liquidity for the Company’s customers.
As of December 31, 2021, the commercial loan portfolio, consisting of CRE and C&I loans, comprised 62% of the total allowance for loan losses compared with 62% on December 31, 2020. The commercial loan allowance allocation remained unchanged due to the greater inherent risk in this portfolio.
As of December 31, 2021, the consumer loan portfolio comprised 15% of the total allowance for loan losses compared with 18% on December 31, 2020. The 3-percentage point decrease in the consumer loan allowance allocation was the result of the relative reduction in this loan category, which declined from 19% as of December 31, 2020 to 18% as of December 31, 2021.
As of December 31, 2021, the residential loan portfolio comprised 22% of the total allowance for loan losses compared with 19% on December 31, 2020. The 3-percentage point increase was the result of the relative increase in this loan category, which increased from 22% as of December 31, 2020 to 25% as of December 31, 2021.
As of December 31, 2021, 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 compared with less than 1% of the total allowance for loan losses on December 31, 2020.
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Non-performing assets
Non-performing assets represented 0.27% of total assets at December 31, 2021 compared with 0.39% at December 31, 2020 with the improvement resulting from the $0.2 million, or 3%, decrease in non-performing assets, specifically non-accrual loans, coupled with the $720 million, or 42%, increase in total assets to $2.4 billion at December 31, 2021.
From December 31, 2020 to December 31, 2021, non-accrual loans declined $0.8 million, or 21%, from $3.8 million to $3.0 million. The $0.8 million decline in non-accrual loans was the result of $1.3 million in payments, $0.7million in charge-offs, $0.2 million in moves to ORE, and $0.2 million in moves back to accrual offset by $1.6 million in additions. 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. At December 31, 2020, there were a total of 46 loans to 38 unrelated borrowers with balances that ranged from less than $1 thousand to $0.5 million.
There were two direct finance leases totaling $64 thousand that were over 90 days past due as of December 31, 2021 compared to two direct finance leases totaling $61 thousand that were over 90 days past due as of December 31, 2020. The delinquent direct finance leases are fully guaranteed under a formal recourse agreement with the originating auto dealer and were in process of orderly collection.
If the non-accrual loans that were outstanding as of December 31, 2021 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $169 thousand.
From December 31, 2020 to December 31, 2021, TDRs increased $0.3 million, or 10%, primarily due to the addition of a $0.5 million commercial real estate TDR in the fourth quarter offset by paydowns of $0.1 million and charge-offs for two non-accrual commercial real estate TDRs to a single borrower totaling $0.1 million. At December 31, 2020, there were a total of 12 TDRs by 9 unrelated borrowers with balances that ranged from $1 thousand to $1.3 million, and 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, 2021, there were three TDRs totaling $0.6 million that were on non-accrual status compared to four TDRs totaling $0.7 million at December 31, 2020.
Beginning the week of March 16, 2020, the Company began receiving requests for temporary modifications to the repayment structure for borrower loans. Modification terms included interest only or full payment deferral for up to 6 months. As of December 31, 2021, the Company had no COVID-related modifications outstanding.
Foreclosedassets held-for-sale
From December 31, 2020 to December 31, 2021, foreclosed assets held-for-sale (ORE) increased from $256 thousand to $435 thousand, a $179 thousand increase, which was primarily attributed to one $236 thousand ORE property that was added during the first quarter of 2021.
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As of December 31, 2021, ORE consisted of five properties securing loans to five unrelated borrowers totaling $435 thousand. Four properties ($434 thousand) to four unrelated borrowers were added in 2021 and one property ($1 thousand) was added in 2017. Of the five properties, three properties are under agreement of sale and two properties are listed for sale.
As of December 31, 2021 and December 31, 2020, the Company had no other repossessed assets held-for-sale.
Cash surrender value of bank owned life insurance
In March 2019, the Company invested $2.0 million in additional BOLI as a source of funding for additional life insurance benefits that provides for payments upon death for officers and employee benefit expenses related to the Company’s non-qualified SERP implemented for certain executive officers. In December 2020, the Company invested $6 million in BOLI and $5 million in BOLI with taxable annuity rider investments. As a result of the Landmark acquisition, the Company acquired $7.2 million in BOLI during the third quarter of 2021.
Premises and equipment
Net of depreciation, premises and equipment increased $1.7 million during 2021. The Company added $3.4 million in fixed assets from the Landmark merger and purchased $2.2 million in fixed assets throughout 2021. These increases were partially offset by $2.2 million in depreciation expense and $1.5 million in transfers to other assets held-for-sale.
Other assets
During 2021, the $3.2 million, or 57%, increase in other assets was due mostly to a $3.1 million increase in deferred tax assets primarily from the reduction in unrealized gains in the investment portfolio.
Results of Operations
Overview
For the year ended December 31, 2021, the Company generated net income of $24.0 million, or $4.48 per diluted share, compared to $13.0 million, or $2.82 per diluted share, for the year ended December 31, 2020. The $11.0 million, or 84%, increase in net income stemmed from $17.6 million more net interest income, $3.6 million in additional non-interest income and $3.3 million lower provision for loan losses which more than offset an $11.8 million rise in non-interest expenses and $1.7 million higher provision for income taxes.
For the year ended December 31, 2021, return on average assets (ROA) and return on average shareholders’ equity (ROE) were 1.13% and 12.69%, respectively, compared to 0.87% and 9.06% for the same period in 2020. The increase in ROA and ROE was the result of the growth in net income relative to the increase in average assets and equity during 2021.
Net interest income and interest sensitive assets / liabilities
Net interest income (FTE) increased $18.7 million, or 41%, from $45.3 million for the year ended December 31, 2020 to $64.0 million for the year ended December 31, 2021, due to the higher interest income and lower interest expense. Total average interest-earning assets increased $607.3 million while the FTE yields earned on these assets declined 27 basis points resulting in $17.0 million of growth in FTE interest income. The loan portfolio contributed the most to this growth due to average balance growth of $280.6 million which had the effect of producing $12.2 million more FTE interest income, including $2.0 million in additional fees earned under the Paycheck Protection Program (PPP). In the investment portfolio, an increase in the average balances of municipal securities was the biggest driver of interest income growth. The average balance of total securities grew $291.1 million producing $4.8 million in additional FTE interest income despite a decrease of 44 basis points in yields earned on investments. On the liability side, total interest-bearing liabilities grew $392.7 million in average balances with a 27 basis point decrease in rates paid on these interest-bearing liabilities. Growth in average interest-bearing deposits of $442.4 million was offset by the effect of a 26 basis point reduction in rates paid on these deposits lowering interest expense by $1.3 million. In addition, the Company utilized $49.7 million less in average borrowings in 2021 compared to 2020 resulting in $0.4 million less interest expense from borrowings.
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The FTE net interest rate spread was unchanged at 3.16% for the years ended December 31, 2021 and 2020. The FTE net interest rate margin decreased by 7 basis points, respectively, for the year ended December 31, 2021 compared to the year ended December 31, 2020. The yields earned on interest-earning assets declined at the same pace as the decline in the rates paid on interest-bearing liabilities causing the net interest rate spread to remain flat. The decrease in net interest rate margin was due to the higher average balance of interest-bearing cash. The overall cost of funds, which includes the impact of non-interest bearing deposits, decreased 21 basis points for the year ended December 31, 2021 compared to the same period in 2020. The primary reason for the decline was the reduction in rates paid on deposits coupled with the increased average balances of non-interest bearing deposits.
The Company’s cost of interest-bearing liabilities was 0.26% for the year ended December 31, 2021, or 27 basis points lower than the cost for the year ended December 31, 2020. The decrease in interest paid on both deposits and borrowings contributed to the lower cost of interest-bearing liabilities.
Provision for loan losses
For the twelve months ended December 31, 2021 and 2020, the Company recorded a provision for loan losses of $2.0 million and $5.3 million, respectively, a $3.3 million, or 62%, decrease. The decrease in the provision for loan losses from the year earlier period was primarily attributed to the COVID-related provisioning that occurred during the twelve months ended December 31, 2020, which was not similarly warranted during the twelve months ended December 31, 2021 due to the higher level of economic certainty in the Company’s operating area when compared to the year earlier period.
Other income
For the year ended December 31, 2021, non-interest income amounted to $18.3 million, a $3.6 million, or 25%, increase compared to $14.7 million recorded for the year ended December 31, 2020. Interchange fees grew $1.1 million due to a higher volume of debit card transactions. Wealth management fees (fees from trust fiduciary activities and financial services) increased $0.7 million year-over-year as assets under management and administration grew from $364 million to $427 million. Gains on loan sales were $0.6 million higher for the year ended December 31, 2021 than the year earlier period due to the higher dollar amount of loans sold. Service charges on deposits increased $0.5 million. Earnings on bank-owned life insurance increased $0.4 million from the larger amount of BOLI due to the Landmark acquisition. Service charges on loans were $0.3 million higher in 2021 compared to 2020 primarily driven by more fees for commercial loans.
Other operating expenses
For the year ended December 31, 2021, total other operating expenses totaled $50.1 million, an increase of $11.8 million, or 31%, compared to $38.3 million for the year ended December 31, 2020. Merger related expenses were $0.5 million of this increase. Salaries and employee benefits contributed the most to the increase rising $5.4 million, or 27%, in 2021 compared to 2020. The basis of the increase includes $3.0 million higher salaries with more full-time equivalent employees, $1.7 million increase in employee bonuses, $0.8 million more in group insurance and $0.5 million higher commissions. These increases in salaries and employee benefits were partially offset by $0.9 million more in loan origination costs deferred. Premises and equipment expenses were $1.4 million higher due to an increase in depreciation, equipment maintenance and rental expenses. Advertising and marketing increased $1.0 million due to more advertising and donations in 2021. Professional services were $0.5 million higher due to pandemic-related expenses and higher consulting and audit expenses. The FDIC assessment was $0.4 million higher due to the larger average assets. Automated transaction processing expenses increased $0.3 million. Data processing and communications expense increased $0.3 million during 2021 compared to 2020 because of additional costs for data center services from more accounts and additional branches.
The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at December 31, 2021 and 2020 were 1.50% and 1.58%, respectively. The expense ratio decreased because of increased levels of average assets. The efficiency ratio decreased from 63.92% at December 31, 2020 to 60.92% at December 31, 2021 due to revenue increasing faster than expenses in 2021.
Provision for income taxes
The Company’s effective income tax rate approximated 14.3% in 2021 and 14.7% in 2020. 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 $1.8 million, or 78%, from $2.2 million at December 31, 2020 to $4.0 million at December 31, 2021. The increase was primarily due to higher pre-tax income in 2021 which partially offset the effect of higher tax-exempt interest income.
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Off-Balance Sheet Arrangements and Contractual Obligations
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy. These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk. In accordance with GAAP, these instruments are either not recorded in the consolidated financial statements or are recorded in amounts that differ from the notional amounts. Such instruments primarily include lending commitments and lease obligations.
Lending commitments include commitments to originate loans and commitments to fund unused lines of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
In addition to lending commitments, the Company has contractual obligations related to operating lease and capital lease commitments. Operating lease commitments are obligations under various non-cancelable operating leases on buildings and land used for office space and banking purposes. Capital lease commitments are obligations on buildings and equipment.
The following table presents, as of December 31, 2022, the Company’s significant determinable contractual obligations and significant commitments by payment date. The payment amounts represent those amounts contractually due to the recipient, excluding interest:
Over one Over three
One year year through years through Over
(dollars in thousands) or less three years five years five years Total
Contractual obligations:
Commitments:
Related Party Transactions
Information with respect to related parties is contained in Note 16, “Related Party Transactions”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.
Impact of Accounting Standards and Interpretations
Information with respect to the impact of accounting standards is contained in Note 19, “Recent Accounting Pronouncements”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.
Impact of Inflation and Changing Prices
The consolidated financial statements and notes thereto presented herein have been prepared in accordance with U.S. GAAP, which requires the measurement of the Company’s financial condition and results of operations in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial businesses, most all of the Company’s assets and liabilities are financial in nature. As a result, interest rates have a greater impact on our performance than do the effects of general levels of inflation as interest rates do not necessarily move in the same direction or, to the same extent, as the price of goods and services.
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Capital Resources
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. The guidelines require all banks and bank holding companies to maintain minimum ratios for capital adequacy purposes. Refer to the information with respect to capital requirements contained in Note 15, “Regulatory Matters”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.
During the year ended December 31, 2022, total shareholders' equity decreased $48.8 million, or 23%, due principally to a $71.3 million after tax reduction in the net unrealized gain position to a net unrealized loss position in the Company’s investment portfolio, $7.7 million of cash dividends declared on the Company’s common stock and $1.3 million in treasury stock purchases. Partially offsetting these decreases, capital was enhanced by $30.0 million in net income added into retained earnings, $0.3 million from investments in the Company’s common stock via the Employee Stock Purchase Plan (ESPP) and $1.3 million from stock-based compensation expense from the ESPP and restricted stock and SSARs. The Company’s dividend payout ratio, defined as the rate at which current earnings are paid to shareholders, was 25.7% for the year ended December 31, 2022. The balance of earnings is retained to further strengthen the Company’s capital position. The Company’s sources (uses) of capital during the previous five years are indicated below:
Cash Other retained DRP Issuance of Changes in
Net dividends earnings Earnings and ESPP common stock AOCI and Capital
As of December 31, 2022, the Company reported a net unrealized loss position of $71.1 million, net of tax, from the securities AFS portfolio compared to a net unrealized gain of $0.2 million as of December 31, 2021. The $71.3 million decline during 2022 was from the $53.8 million reduction in net unrealized gains to net unrealized losses on AFS securities, net of tax, and $17.5 million in net unrealized losses on HTM securities transferred from AFS, net of tax. Lower unrealized gains and higher unrealized losses on all types of securities contributed to the net unrealized losses in investment portfolio. Management believes that changes in fair value of the Company’s securities are due to changes in interest rates and not in the creditworthiness of the issuers.
Generally, when U.S. Treasury rates rise, investment securities’ pricing declines and fair values of investment securities also decline. While volatility has existed in the yield curve within the past twelve months, a rising rate environment is expected and during the period of rising rates, the Company expects pricing in the bond portfolio to decline. There is no assurance that future realized and unrealized losses will not be recognized from the Company’s portfolio of investment securities.
To help maintain a healthy capital position, the Company can issue stock to participants in the DRP and ESPP plans. The DRP affords the Company the option to acquire shares in open market purchases and/or issue shares directly from the Company to plan participants. During 2022, the Company acquired shares in the open market to fulfill the needs of the DRP. Both the DRP and the ESPP plans have been a consistent source of capital from the Company’s loyal employees and shareholders and their participation in these plans will continue to help strengthen the Company’s balance sheet.
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See the section entitled “Supervision and Regulation”, below for a discussion on regulatory capital changes and other recent enactments, including a summary of the federal banking agencies final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act.
Liquidity
Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities, facility expansion and normal operating expenses. Sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans HFS, investments AFS, growth of core deposits, utilization of borrowing capacities from the FHLB, correspondent banks, ICS and IntraFi Network One-Way Buy program, the Discount Window of the Federal Reserve Bank of Philadelphia (FRB), Atlantic Community Bankers Bank (ACBB) and proceeds from the issuance of capital stock. Though regularly scheduled investment and loan payments are dependable sources of daily liquidity, sales of both loans HFS and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions including the interest rate environment. During low and declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity that can be used to invest in other interest-earning assets but at lower market rates. Conversely, in periods of high or rising interest rates, prepayments from interest-sensitive assets tend to decelerate causing prepayment cash flows from mortgage loans and mortgage-backed securities to decrease. Rising interest rates may also cause deposit inflow but priced at higher market interest rates or could also cause deposit outflow due to higher rates offered by the Company’s competition for similar products. The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.
The Company’s contingency funding plan (CFP) sets a framework for handling liquidity issues in the event circumstances arise which the Company deems to be less than normal. The Company established guidelines for identifying, measuring, monitoring and managing the resolution of potentially serious liquidity crises. The CFP outlines required monitoring tools, acceptable alternative funding sources and required actions during various liquidity scenarios. Thus, the Company has implemented a proactive means for the measurement and resolution for handling potentially significant adverse liquidity conditions. At least quarterly, the CFP monitoring tools, current liquidity position and monthly projected liquidity sources and uses are presented and reviewed by the Company’s Asset/Liability Committee. As of December 31, 2022, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.
During the year ended December 31, 2022, the Company utilized $67.8 million of cash. During the period, the Company’s operations provided approximately $49.4 million mostly from $73.3 million of net cash inflow from the components of net interest income plus $11.9 million in proceeds over originations of loans HFS partially offset by net non-interest expense/income related payments of $33.1 million and $3.1 million in quarterly estimated tax payments. Cash inflow from interest-earning assets, short-term borrowings and loan payments were used to purchase investment securities and replace maturing and cash runoff of securities, fund the loan portfolio, invest in bank premises and equipment and make net dividend payments. The Company received a large amount of public deposits over the past six years. The seasonal nature of deposits from municipalities and other public funding sources requires the Company to be prepared for the inherent volatility and the unpredictable timing of cash outflow from this customer base, including maintaining the requirements to pledge investment securities. Accordingly, the use of short-term overnight borrowings could be used to fulfill funding gap needs. The CFP is a tool to help the Company ensure that alternative funding sources are available to meet its liquidity needs.
During January 2023, the Company sold $31.2 million in AFS securities to generate liquidity in order to pay down overnight borrowings which will result in interest expense savings. Management will continue to execute strategies to generate liquidity when it makes sense for the Company's operations.
During 2021 and 2022, the Company also experienced deposit inflow resulting from businesses and municipalities that received relief from the CARES Act, American Rescue Plan Act and other government stimulus. There is uncertainty about the length of time that these deposits will remain which could require the Company to maintain elevated cash balances. 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. The Company will continue to monitor deposit fluctuation for other significant changes.
As of December 31, 2022, the Company maintained $29.1 million in cash and cash equivalents and $422.5 million of investments AFS and loans HFS. Also as of December 31, 2022, the Company had approximately $602.2 million available to borrow from the FHLB, $31.0 million from correspondent banks, $112.0 million from the FRB and $365.4 million from the IntraFi Network One-Way Buy program. The combined total of $1,562.2 million represented 66% of total assets at December 31, 2022. Management believes this level of liquidity to be strong and adequate to support current operations.
On March 12, 2023, the Federal Reserve Board announced the creation of a new Bank Term Funding Program (BTFP). The Company would be able to borrow advances through the BTFP using certain types of securities as collateral. The qualifying assets used as collateral would be valued at par.
For a discussion on the Company’s significant determinable contractual obligations and significant commitments, see “Off-Balance Sheet Arrangements and Contractual Obligations,” above.
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Management of interest rate risk and market risk analysis
The adequacy and effectiveness of an institution’s interest rate risk management process and the level of its exposures are critical factors in the regulatory evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy. Management believes the Company’s interest rate risk measurement framework is sound and provides an effective means to measure, monitor, analyze, identify and control interest rate risk in the balance sheet.
The Company is subject to the interest rate risks inherent in its lending, investing and financing activities. Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity. Interest rate risk management is an integral part of the asset/liability management process. The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position. Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations. The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.
Asset/Liability Management. One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income. The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and members of the board of directors. ALCO meets quarterly to monitor the relationship of interest sensitive assets to interest sensitive liabilities. The process to review interest rate risk is a regular part of managing the Company. Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect. In addition, there is an annual process to review the interest rate risk policy with the board of directors which includes limits on the impact to earnings from shifts in interest rates.
Interest Rate Risk Measurement. Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation. While each of the interest rate risk measurements has limitations, collectively, they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.
Static Gap. The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.
To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or re-price within given time intervals. A positive gap (asset sensitive) indicates that more assets will re-price during a given period compared to liabilities, while a negative gap (liability sensitive) indicates the opposite effect. The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest-sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread. At December 31, 2022, the Company maintained a one-year cumulative gap of negative (liability sensitive) $105.5 million, or -4%, of total assets. The effect of this negative gap position provided a mismatch of assets and liabilities which may expose the Company to interest rate risk during periods of rising interest rates. Conversely, in a decreasing interest rate environment, net interest income could be positively impacted because more liabilities than assets will re-price downward during the one-year period.
Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table. Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table amounts. The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.
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The following table reflects the re-pricing of the balance sheet or “gap” position at December 31, 2022:
More than three More than
Three months months to one year More than
(dollars in thousands) or less twelve months to three years three years Total
Cumulative gap to total assets (12.1 )% (4.4 )% (7.0 )% 6.9 %
Earnings at Risk and Economic Value at Risk Simulations. The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.
Earnings at Risk. An earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.
Economic Value at Risk. An earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.
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The following table illustrates the simulated impact of an immediate 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity). This analysis assumed that the adjusted interest-earning asset and interest-bearing liability levels at December 31, 2022 remained constant. The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the December 31, 2022 levels:
% change
Earnings at risk:
Net interest income (4.4 )% (2.5 )%
Net income (7.5 ) (5.9 )
Economic value at risk:
Economic value of equity (12.0 ) 1.6
Economic value of equity as a percent of total assets (1.8 ) 0.2
Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%. At December 31, 2022, the Company’s risk-based capital ratio was 14.35%.
The table below summarizes estimated changes in net interest income over a twelve-month period beginning January 1, 2023, under alternate interest rate scenarios using the income simulation model described above:
Net interest $ %
(dollars in thousands) income variance variance
Simulated change in interest rates
Simulation models require assumptions about certain categories of assets and liabilities. The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity. MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Company uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and interest-bearing checking accounts do not have stated maturities or re-pricing terms and can be withdrawn or re-price at any time. This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates. As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.
Supervision and Regulation
The following is a brief summary of the regulatory environment in which the Company and the Bank operate and is not designed to be a complete discussion of all statutes and regulations affecting such operations, including those statutes and regulations specifically mentioned herein. Changes in the laws and regulations applicable to the Company and the Bank can affect the operating environment in substantial and unpredictable ways. We cannot accurately predict whether legislation will ultimately be enacted, and if enacted, the ultimate effect that legislation or implementing regulations would have on our financial condition or results of operations. While banking regulations are material to the operations of the Company and the Bank, it should be noted that supervision, regulation and examination of the Company and the Bank are intended primarily for the protection of depositors, not shareholders.
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Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act (SOX), also known as the “Public Company Accounting Reform and Investor Protection Act,” was established in 2002 and introduced major changes to the regulation of financial practice. SOX represents a comprehensive revision of laws affecting corporate governance, accounting obligations, and corporate reporting. SOX is applicable to all companies with equity or debt securities that are either registered, or file reports under the Securities Exchange Act of 1934. In particular, SOX establishes: (i) requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Principal Executive Officer and Principal Financial Officer of the reporting company; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) increased civil and criminal penalties for violations of the securities laws.
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
The FDICIA established five different levels of capitalization of financial institutions, with “prompt corrective actions” and significant operational restrictions imposed on institutions that are capital deficient under the categories. The five categories are:
● well capitalized;
● adequately capitalized;
● undercapitalized;
● significantly undercapitalized, and
● critically undercapitalized.
To be considered well capitalized, an institution must have a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 8%, a leverage capital ratio of at least 5%, and must not be subject to any order or directive requiring the institution to improve its capital level. An institution falls within the adequately capitalized category if it has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 6%, and a leverage capital ratio of at least 4%. Institutions with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized, depending on their actual capital levels. In addition, the appropriate federal regulatory agency may downgrade an institution to the next lower capital category upon a determination that the institution is in an unsafe or unsound condition, or is engaged in an unsafe or unsound practice. Institutions are required under the FDICIA to closely monitor their capital levels and to notify their appropriate regulatory agency of any basis for a change in capital category.
Regulatory oversight of an institution becomes more stringent with each lower capital category, with certain “prompt corrective actions” imposed depending on the level of capital deficiency.
Recent Legislation and Rulemaking
Regulatory Capital Changes
In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations began on January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) began compliance on January 1, 2014. The final rules call for the following capital requirements:
● A minimum ratio of common tier 1 capital to risk-weighted assets of 4.5%.
● A minimum ratio of tier 1 capital to risk-weighted assets of 6%.
● A minimum leverage ratio of 4%.
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In addition, the final rules established a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments.
The final rules will not have a material impact on the Company’s capital, operations, liquidity and earnings.
JOBS Act
The Jumpstart Our Business Startups Act (the “JOBS Act”) is aimed at facilitating capital raising by smaller companies and banks and bank holding companies by implementing the following changes:
The JOBS Act did not have any immediate application to the Company. However, management continues to monitor the implementation rules for potential effects which might benefit the Company.
Dodd-Frank Wall Street Reform and Consumer Protection Act.
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) became law. Dodd-Frank is intended to effect a fundamental restructuring of federal banking regulation. Among other things, Dodd-Frank creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. Dodd-Frank additionally creates a new independent federal regulator to administer federal consumer protection laws. Dodd-Frank is expected to have a significant impact on our business operations as its provisions take effect. Overtime, it is expected that at a minimum they will increase our operating and compliance costs and could increase our interest expense. Among the provisions that are likely to affect us and the community banking industry are the following:
Holding Company Capital Requirements. Dodd-Frank requires the Federal Reserve to apply consolidated capital requirements to bank holding companies that are no less stringent than those currently applied to depository institutions. Under these standards, pooled trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. Dodd-Frank additionally requires that bank regulators issue countercyclical capital requirements so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction, consistent with safety and soundness.
Deposit Insurance. Dodd-Frank permanently increases the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, and extended unlimited deposit insurance to non-interest bearing transaction accounts through December 31, 2012. Dodd-Frank also broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution. Dodd-Frank requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. Dodd-Frank also eliminated the federal statutory prohibition against the payment of interest on business checking accounts.
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