FDBC US Equity☆

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 credit losses. Management believes that the allowance for credit losses at December 31, 2023 is adequate and reasonable to cover expected losses. Given the subjective nature of identifying and estimating loan losses, it is likely that well-informed individuals could make different assumptions and could, therefore, calculate a materially different allowance amount. While management uses available information to recognize losses on loans, changes in economic conditions and reasonable and supportable forecasts 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 credit 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. On January 1, 2023, the company adopted ASU 2016-13 (Topic 326), which replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (or CECL) methodology.

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). Debt securities, for which the Company has the positive intent and ability to hold to maturity, are reported at amortized cost. On occasion, the Company may transfer securities from AFS to HTM at fair value on the date of transfer.

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.

The Company accounts for business combinations under the acquisition 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 recorded on the consolidated balance sheets as the excess of liabilities assumed over identifiable assets acquired on the acquisition date. Goodwill is recorded at its net carrying value which represents estimated fair value. Goodwill is tested for impairment on at least an annual basis. There was no goodwill impairment at December 31, 2023. 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, 2023 and 2022 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.

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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 considered 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, 2023, 2022, 2021, 2020 and 2019.

The following table reconciles the non-GAAP financial measures of FTE net interest income:

Interest income adjusted to FTE (non-GAAP) 96,685 81,410

Net interest income adjusted to FTE (non-GAAP) $ 64,897 $ 75,012

The efficiency ratio is non-interest expenses as a percentage of FTE net interest income plus non-interest income less gain/(loss) on sales of securities. The following table reconciles the non-GAAP financial measures of the efficiency ratio to GAAP:

Efficiency Ratio (non-GAAP)

Plus: taxable equivalent adjustment 2,850 2,738

Less: (Loss) gain on sales of securities (6,468 ) 4

Efficiency ratio (non-GAAP) 62.67 % 56.04 %

The following table provides a reconciliation of the tangible common equity (non-GAAP) and the calculation of tangible book value per share, tangible common equity ratio and adjusted tangible common equity ratio:

Tangible Book Value per Share (non-GAAP)

Less: Intangible assets, primarily goodwill (20,812 ) (21,168 )

Less: Intangible assets, primarily goodwill (20,812 ) (21,168 )

Tangible Common Book Value per Share (non-GAAP) $ 29.57 $ 25.18

Tangible Common Equity Ratio (non-GAAP) 6.79 % 6.01 %

Unrealized losses on held-to-maturity securities, net of tax (21,375 ) (28,017 )

Adjusted tangible common equity ratio (non-GAAP) 5.93 % 4.83 %

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The following tables provides a reconciliation of the Company’s earnings results under GAAP to comparative non-GAAP results excluding gain/loss on the sale of available-for-sale debt securities:

The following table provides a reconciliation of pre-provision net revenue (PPNR) to average assets (non-GAAP):

Pre-Provision Net Revenue to Average Assets

Plus: Provision for credit losses 1,326 2,087

Total pre-provision net revenue (non-GAAP) $ 21,582 $ 37,555

Pre-Provision Net Revenue to Average Assets (non-GAAP) 0.90 % 1.57 %

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Comparison of Financial Condition as of December 31, 2023

and 2022 and Results of Operations for each of the Years then Ended

Executive Summary

The Company generated $18.2 million in net income in 2023, or $3.19 diluted earnings per share, down $11.8 million, or 39%, from $30.0 million, or $5.29 diluted earnings per share, in 2022. The Company’s net interest income performance has been reduced by asset yields being outpaced by the rapid growth of rates paid on deposits. Federal Open Market Committee (FOMC) officials raised the federal funds rate 425 basis points during 2022 and another 100 basis points during 2023. The Company expects the fed funds rate cuts to begin during 2024 once inflation slows toward the Fed's target level to begin easing. For 2024, the Company currently maintains a loan pipeline which we expect will grow the loan portfolio which will be funded by borrowing capacity until the point deposit growth will be able to pay down these short-term borrowings. The focus is to manage net interest income through a declining forecasted rate cycle by exercising disciplined and proactive loan pricing and managing deposit costs to maintain a reasonable spread, to the extent possible, in order to address further margin compression. From a financial condition and performance perspective, our mission for 2024 will be to continue to strengthen our capital position through retained earnings to support growth initiatives by implementing strategic and targeted marketing and revenue enhancing strategies, continuing to improve loan yields while managing 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 rose from 3.5% at December 31, 2022 to 3.7% at December 31, 2023. The unemployment rates in the Scranton - Wilkes-Barre - Hazleton (market area north) and the Allentown – Bethlehem - Easton (market area south) Metropolitan Statistical Areas (local) decreased with both at a lower level than the national unemployment rate. According to the U.S. Bureau of Labor Statistics, the local unemployment rates at December 31, 2023 were 3.5% in the market area north and 3.3% in the market area south, respectively, a decrease of 1.0 and 0.4 percentage points from the 4.5% and 3.7%, respectively, at December 31, 2022. The rising rate environment and historically low inventory has reduced the amount of home purchases from 2022 levels. The median home values in the Scranton-Wilkes-Barre-Hazleton metro and Allentown-Bethlehem-Easton metro each increased 5.9% and 6.3% 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 5.8% and 5.4% 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 current elevated 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.

Due to volatility in the levels of borrowings during October 2023 and the increasing expected dependency on borrowing capacity from experiencing deposit fluctuations while funding loan growth, the Company evaluated a liquidity strategy to deleverage the reliance on short-term borrowings. As a result of this evaluation, in November 2023, the Company sold certain available-for-sale securities with a carrying value of $35.6 million for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities. The $29.1 million in proceeds received were used to pay down short-term borrowings that replenished available borrowing capacity at that time, while eliminating 425 basis points in negative spread as one means to improve future earnings.

Gains/losses on the sale of available-for-sale securities incurred during 2023 and 2022 were not a part of the Company’s normal operations. Excluding the gain/loss on the sale of securities of $5.1 million on a non-GAAP basis, net of tax, adjusted net income would have been $23.3 million, or $4.08 adjusted diluted earnings per share, for the year ended December 31, 2023, a $6.7 million decrease compared to adjusted net income for 2022. For more detail on adjusted net income which is a non-GAAP measurement, refer to the “Non-GAAP Financial Measures” located above within this management’s discussion and analysis.

For the years ended December 31, 2023 and 2022, tangible common book value per share (non-GAAP) was $29.57 and $25.18, respectively, an increase of 17.4%. The increase in tangible book value was due primarily to an increase in retained earnings from net income and improvements in accumulated other comprehensive income. 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 2023, the Company’s assets grew by 5% primarily from growth in the loan portfolio. In 2024, 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 currently expected to be used in 2024.

Non-performing assets represented 0.13% of total assets as of December 31, 2023, up from 0.12% at the prior year end. Non-performing assets to total assets were higher during 2023 mostly due to the amount (or dollar value) of non-performing assets increasing to a lesser extent than the 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 2024, the Company currently expects to operate in a modestly declining interest rate environment during the second half of the year. Management is primarily reliant on the Federal Open Market Committee's statements and forecast. The Company’s net interest income performance has been reduced by asset yields being outpaced by higher cost of funds compressing net interest spread. Although expectations are for the FOMC to reduce rates in the second half of 2024, the Company may continue to experience pressure to further increase rates paid on deposits in the near future. For 2024, the Company currently expects to maintain net interest margin at the same level as 2023.

Financial Condition

Consolidated assets increased $124.8 million, or 5%, to $2.5 billion as of December 31, 2023 from $2.4 billion at December 31, 2022. The increase in assets occurred primarily from loan portfolio growth and higher excess cash balances. The Company used short-term borrowings to fund loan growth and maintain excess cash balances. During 2023, the investment portfolio declined as the Company sold longer term available-for-sale securities as part of a liquidity and net interest margin enhancement strategy.

The following table is a comparison of condensed balance sheet data as of December 31:

(dollars in thousands)

Liabilities:

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 and held-to-maturity securities and restricted investments in bank stock excluding loans placed on non-accrual status.

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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.

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 $8.5 million, or less than 1%, to $2.2 billion at December 31, 2023 from $2.2 billion at December 31, 2022. Non-interest bearing checking accounts decreased $66.5 million primarily due to declines in personal and business checking accounts attributed to increases in consumer spending due to inflation, ongoing post-pandemic demand and the move to interest-bearing products. Money market accounts decreased $48.7 million primarily due to the transfer of trust sweep accounts with a balance of $69.2 million at the end of 2022 to interest-bearing checking accounts in 2023. Excluding this transfer, money market balances increased primarily due to a new relationship with an insurance company. Savings and club accounts also decreased $34.7 million primarily due to personal savings declines and shifts to CDs and money market accounts. Interest-bearing checking accounts increased $45.7 million during 2023 primarily due to the transfer of trust sweep accounts from a money market product to interest-bearing checking. Declines in other interest-bearing checking balances stemmed primarily from expected outflow of public funds from municipalities withdrawing American Rescue Plan Act funds along with personal and business account decreases. The Company focuses on obtaining a full-banking relationship with existing core operating 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 targeted programs for its customers to maintain and grow core deposits. For 2023, the Company experienced deposit balance declines as clients transferred their deposits to investments to earn higher interest and pay down debts and consumer spending. We currently expect this trend of cash usage, due to the impact of inflation on consumer and business spending and deposit mix shifts caused by the highly competitive interest rate environment, to continue throughout 2024. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset future deposit growth.

Partially offsetting these non-maturing deposit decreases, CDs increased $95.7 million, or 82%, during 2023. CD balances started to increase as promotional rate offerings expanded. Customers transferred approximately $52 million in balances from other products to CDs in 2023 to earn higher yields. The Company expects the highly competitive deposit environment to continue into early 2024 with promotional money market and CDs continuing to gain favor. As a result, the Company expects the majority of deposit growth in 2024 to stem from the CD portfolio.

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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 had $1.4 million and $0 in CDARs as of December 31, 2023 and 2022, respectively. As of December 31, 2023 and 2022, ICS reciprocal deposits represented $151.4 million and $26.3 million, or 7% and 1%, of total deposits which are included in interest-bearing checking accounts in the table above. The $125.1 million increase in ICS deposits is primarily due to several large business relationships that transferred deposits to ICS accounts from other interest-bearing checking and money market accounts held at the bank.

As of December 31, 2023, total uninsured deposits were estimated to be $820.6 million, or 38% of total deposits. 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. As of December 31, 2023, the ratio of uninsured and non-collateralized deposits to total deposits was approximately 23%. Collateralized deposits totaled $321.7 million, or 15%, of total deposits as of December 31, 2023.

The maturity distribution of certificates of deposit that meet or exceed the FDIC limit, by account, at December 31, 2023 is as follows:

(dollars in thousands)

Three months or less $ 12,310

More than three months to six months 15,546

More than six months to twelve months 28,085

More than twelve months 16,636

Approximately 77% of the CDs, with a weighted-average interest rate of 3.56%, are scheduled to mature in 2024 and an additional 20%, with a weighted-average interest rate of 3.60%, are scheduled to mature in 2025. 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. 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's 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 $117.0 million in short-term borrowings to fund loan growth and an increase in interest-bearing cash balances for 2023. The short-term borrowings included $57.0 million borrowed through the Federal Reserve Bank Term Funding Program (BTFP) up to one year with a weighted average rate of 4.49% by pledging $57.0 million in securities. As of December 31, 2023, the short-term borrowings also included $60.0 million from the Federal Reserve borrower-in-custody program. As of December 31, 2023, the Company had the ability to borrow an additional $70.4 million from the Federal Reserve borrower-in-custody program, full availability of $145.9 million in overnight borrowings with the FHLB open-repo line of credit and $20.0 million from lines of credit with correspondent banks.

In November 2023, the Company sold securities and used $29.1 million in proceeds received to pay down short-term borrowings that replenished available borrowing capacity at that time.

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.

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Secured borrowings

As of December 31, 2023 and 2022, the Company had 8 secured borrowing agreements with third parties with a carrying value of $7.4 million and $7.6 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 2024 from scheduled amortization and, when possible, early pay-offs.

FHLB advances

The Company had no FHLB advances as of December 31, 2023 and 2022. As of December 31, 2023, the Company had the ability to borrow up to $656.8 million from the FHLB, net of any overnight borrowings utilized. The Company does not expect to have any FHLB advances in 2024.

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, 2023, AOCI improved by $14.7 million primarily due to the change in fair value of the Company's investment securities.

On 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 yield curve and 35% of the tax-exempt municipal portfolio on the long end of the yield 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, recorded discount will be accreted into interest income, offset by the amortization of previously recognized losses in AOCI, over the life of the bonds. As of December 31, 2023, the carrying value of held-to-maturity securities was $224.2 million, net of $15.7 million in remaining transferred discount.

The Company utilized a fair value hedge to designate and swap a portion of the fixed rate AFS portfolio. The Company has an approved Derivative Policy that requires Board pre-approval on such balance sheet hedging activities as well as ongoing reporting to its ALCO Committee. The Board has approved up to $200 million in notional amount of pay-fixed interest rate swap and the Company has executed on $100 million to date.

During September 2023, the Company entered into a $100 million interest rate swap with a third-party financial institution to limit the risk to the investment portfolio of rising interest rates. The interest rate swap was designated as a fair value hedge and utilized a pay fixed interest rate swap to hedge the change in fair value attributable to the movement in the Secured Overnight Financing Rate ("SOFR"). The Company designated $50 million of the swap's notional balance as a hedge against the closed portfolio of 20-year mortgage-backed securities and $50 million as a hedge against the closed portfolio of tax-free municipal bonds. As of December 31, 2023, the Company recorded the fair value of the swap of $2.2 million in accrued interest payable and other liabilities on the consolidated balance sheet offset by a $2.2 million increase to the carrying value of designated investment securities.

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As of December 31, 2023, the carrying value of investment securities amounted to $568.3 million, or 23% of total assets, compared to $643.6 million, or 27% of total assets, as of December 31, 2022. On December 31, 2023, 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 $201.7 million ($182.8 million including the remaining net unrealized loss transferred on HTM securities) and taxable municipal bonds with a book value of $92.0 ($82.8 million including the remaining net unrealized loss transferred on HTM securities) million. The overall credit ratings of these municipal bonds was as follows: 36% AAA, 63% AA, and 1% A. For municipal securities HTM, the Company utilized a third-party model to analyze whether a credit loss reserve is needed for these bonds. The amount of the credit loss reserve calculated was immaterial because of the underlying strong credit quality of the municipal portfolio.

During 2023, the carrying value of total investments decreased $75.3 million, or 12%. The decline was primarily due to the sale of investment securities with an amortized cost of $66.8 million during 2023. Additionally, principal reductions during 2023 totaled $25.0 million. Partially offsetting these decreases, there was an improvement in the unrealized loss position of $16.3 million in the AFS portfolio. 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, to the extent possible.

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. The portfolio had no adjustable-rate instruments as of December 31, 2023 and 2022.

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Investment securities were comprised of AFS and HTM securities as of December 31, 2023 and December 31, 2022. The AFS securities were recorded with a net unrealized loss of $51.6 million and a net unrealized loss of $67.9 million as of December 31, 2023 and 2022, respectively. Of the $16.3 million net improvement; $10.6 million was attributable to municipal securities; $4.8 million was attributable to mortgage-backed securities and $0.9 million was attributable to agency securities. During 2022, securities with net unrealized losses totaling $23.9 million were transferred to HTM, of which $2.3 million and $1.7 million was accreted into other comprehensive income for the years ended December 31, 2023 and 2022. 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, 2023, the Company had $294.8 million in public deposits, or 14% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on public and trust deposits or otherwise obtain a FHLB letter of credit or FDIC insurance for these customers. The Company also pledges securities for derivative instruments and certain borrowed funds. As of December 31, 2023, the balance of pledged securities required was $380.7 million, or 67% of total securities.

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 credit losses on debt securities exist. 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 has credit losses. If a decline in value is deemed to be a credit loss, a contra-asset is recorded on both HTM and AFS securities, limited by the amount that the fair value is less than the amortized cost basis. During the year ended December 31, 2023, the Company did not incur any credit losses on debit securities from its investment securities portfolio.

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% at that time. Due to volatility in the levels of borrowings during October 2023 and the increasing expected dependency on borrowing capacity from experiencing deposit fluctuations while funding loan growth, the Company evaluated a liquidity strategy to deleverage the reliance on short-term borrowings. As a result of this evaluation, in November 2023, the Company sold longer term available-for-sale general market tax-free municipal securities with a carrying value of $35.6 million with a weighted average yield of 1.28% with a 13.5 year weighted average maturity as part of a liquidity and net interest margin enhancement strategy for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities. The $29.1 million in proceeds received were used to retire short-term borrowings with a cost of approximately 5.50%. While the Company has ample funding sources available, management felt it prudent to create additional capacity for the borrowings over the near term should the banking industry again experience funding pressures as it did in March of this past year. In addition, since the municipal securities sold were purchased in a much lower rate environment, there is an immediate improvement in net interest margin (NIM) of over 5 bps as a result of paying down the borrowing with the sale proceeds. The sale removes a 422 basis point negative spread and will contribute towards incrementally improving net interest income, earnings per share and NIM every year starting in 2024. The cost savings from paying down the advances with the sale of low yielding bonds will also allow the pre-tax loss of $6.5 million realized on the sale to be fully recouped prior to the term of the bonds sold.

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, 2023 and 2022. The balance in FHLB stock was $3.8 million and $5.2 million as of December 31, 2023 and 2022, respectively. The dividends received from the FHLB totaled $298 thousand and $164 thousand for the years ended December 31, 2023 and 2022, respectively.

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Loans and leases

As of December 31, 2023, the Company had gross loans and leases totaling $1.7 billion, an increase of $121.2 million, or 8%, compared to almost $1.6 billion at December 31, 2022.

During the twelve months ended December 31, 2023, the growth in the portfolio was primarily attributed to a $62.1 million increase in the commercial portfolio due to 3 originations totaling $40 million and standard portfolio growth and a $61.2 million increase in the residential portfolio, the result of a higher percentage of adjustable-rate mortgages recorded as held-for-investment during this period.

As management continues to identify ways to optimize the Company’s balance sheet, the focus is to lend in areas that provide better risk-adjusted returns and improved opportunities to deepen relationships with our customers. This could result in a change in the composition of the loan portfolio in future periods.

A comparison of loan originations, net of participations, is as follows for the periods indicated:

(dollars in thousands) Amount Amount

Loans:

Lines of credit:

For the twelve months ended December 31, 2023, the Company originated $531.0 million loans and lines of credit, a reduction of $103.4 million, or 16%, compared to the twelve months ended December 31, 2022.

The Company originated $337.6 million total loans in 2023, which was $33.9 million less than in 2022. Commercial and industrial loan origination increased by $18.1 million in 2023 compared to 2022, with growth attributed to municipal loans. Loan originations decreased in commercial real estate (both owner-occupied and non-owner occupied CRE) by $4.5 million to $73.0 million, consumer loans by $31.1 million to $70.3 million and residential loans by $16.4 million to $106.5 million. Rising interest rates impacted loan demand and reduced loan originations for these loan categories.

The Company originated $193.4 million total lines of credit in 2023, which was $69.5 million less than in 2022. Commercial line of credit origination decreased by $44.2 million to $141.5 million, residential construction by $17.3 million to $25.4 million and home equity and other consumer by $8.1 million to $26.5 million. Rising interest rates impacted loan demand and reduced line of credit originations.

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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 and industrial:

Commercial real estate:

Consumer:

Residential:

Less:

Commercial and industrial (C&I) and commercial real estate (CRE)

As of December 31, 2023, the commercial portfolio increased by $62.1 million, or 7%, to $903.2 million compared to the December 31, 2022 balance of $841.1 million due to growth of $33.3 million in total commercial and industrial loans and $28.8 million in growth in commercial real estate loans.

Commercial and industrial loans are generally secured with short-term assets; however, in many cases, additional collateral such as real estate is provided as additional security for the loan. Loan-to-value maximum values have been established by the Company and are specific to the type of collateral. Collateral values may be determined using invoices, inventory reports, accounts receivable aging reports, independent collateral appraisals, etc.

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For the twelve months ended December 31, 2023, commercial and industrial (non-municipal) loans increased $11.5 million, or 8%, from $141.1 million at December 31, 2022 to $152.6 million at December 31, 2023, which was the result of originations and advances outpacing scheduled payments and curtailments.

Municipal loans are secured by the full faith and credit of respective local government units located in the Commonwealth of Pennsylvania authorized in accordance with the Local Government Unit Debt Act. These loans have a long history of performance within contractual terms with no defaults noted.

For the twelve months ended December 31, 2023, municipal loans increased $21.7 million, or 30%, from $73.0 million at December 31, 2022 to $94.7 million at December 31, 2023, which was attributed to the origination of two loans to a single borrower totaling $21 million.

Commercial real estate loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions and the complexities involved in valuing the underlying collateral whose values tend to move inversely with interest rates. These loans are secured with mortgages, or commercial real estate mortgages (CREM) against the subject property. In underwriting commercial real estate construction loans, the Company performs a robust analysis of the financial condition of the borrower, the borrower’s credit history, and the reliability and predictability of the cash flow generated by the project using feasibility studies, market data, etc. Appraisals on properties securing commercial real estate loans originated by the Company are performed by independent appraisers consistent with Uniform Standards of Professional Appraisal Practice (USPAP) standards and compliant with Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).

Non-owner occupied CRE loans are commercial loans not occupied by their owners and thus rely on income from third parties, including multi-family residential tenants and commercial tenants representing various industries. Underwriting on non-owner occupied CRE loans evaluates cash flow derived from the respective tenants and the industries they occupy. As such, management considers non-owner occupied CRE loans as having a higher risk profile than owner occupied CRE loans. In keeping with its risk appetite and relationship management strategy, the Company avoids speculative commercial office space and prefers loans to projects that have sufficient equity, or loan to value, and have either S&P rated tenants with long term leases, loans structured with personal guarantees of owners whose personal financial strength provides meaningful cash flow support to supplement rental income volatility, residential projects with stable rents in desirable locations, or projects with sufficient diversity and industries proven to provide lower risk over the long term.

For the twelve months ended December 31, 2023, non-owner occupied commercial real estate decreased $6.7 million, or 2%, from $318.3 million at December 31, 2022 to $311.6 million at December 31, 2023, which was attributed to scheduled monthly payments.

Owner occupied commercial real estate loans rely on income generated from the respective owners’ businesses. Therefore, underwriting on owner occupied CRE loans emphasizes the owner’s cash flow and financial conditions while the real estate typically represents the owners' primary business location. As such, management considers owner occupied CRE loans as having a lower risk profile than non-owner occupied CRE loans.

For the twelve months ended December 31, 2023, owner occupied commercial real estate increased $19.7 million, or 7%, from $284.7 million on December 31, 2022, to $304.4 million at December 31, 2023. The increase was attributed to a $10 million origination to a single borrower and $12 million in reclassification of two construction loan projects that were completed during the fourth quarter.

Construction lending consists of commercial and residential site development loans, as well as commercial building construction and residential housing construction loans. Management prefers lending to well-established developers with a proven track record and strong business and guaranteed with owners’ personal financial conditions.

For the twelve months ended December 31, 2023, commercial construction increased $15.8 million, or 66%, from $24.0 million on December 31, 2022 to $39.8 million at December 31, 2023. This increase was attributed to $15 million in commercial construction commitments originated during the year.

Consumer

The consumer loan portfolio consisted of home equity installment, home equity line of credit, non-recourse auto loans, recourse auto loans, direct finance leases and other consumer loans.

As of December 31, 2023, the total consumer loan portfolio decreased by $2.0 million, or 1%, to $282.4 million compared to the December 31, 2022 balance of $284.4 million, primarily due to a strategic reduction in the indirect auto portfolio. For 2024, the Company expects maturities of approximately $51 million in the dealer portfolio with minimal originations.

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Residential

As of December 31, 2023, the residential loan portfolio increased by $61.2 million, or 14%, to $501.6 million compared to the December 31, 2022 balance of $440.4 million. The increase was due to a shift from mortgage loans sold in the secondary market to loans held-for-investment, primarily jumbo mortgages with rates fixed for 5, 7 or 10 years with adjustable rates thereafter.

The residential loan portfolio consisted primarily of held-for-investment residential loans for primary residences, including approximately $380 million in fixed-rate and $85 million in adjustable-rate mortgages as of December 31, 2023.

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.

The following table sets forth the maturity distribution of select commercial and construction components of the loan portfolio at December 31, 2023. 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 * 39,823 - - - 39,823

Residential real estate construction * 36,536 - - - 36,536

*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, 2023:

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.

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, 2023, approximately 75% of the gross loan portfolio was secured by real estate compared to 75% at December 31, 2022.

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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, 2023 and 2022, loans HFS consisted of residential mortgages with carrying amounts of $1.5 million and $1.6 million, respectively, which approximated their fair values. During the year ended December 31, 2023, residential mortgage loans with principal balances of $52.0 million were sold into the secondary market and the Company recognized net gains of $1.0 million, compared to $78.8 million and $1.6 million, respectively, during the year ended December 31, 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, 2023 and 2022, the servicing portfolio balance of sold residential mortgage loans was $477.7 million and $465.7 million, respectively, with mortgage servicing rights of $1.5 million and $1.6 million for the same periods, respectively.

Allowance for credit losses

Management continually evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for credit losses (ACL) on a quarterly basis. The allowance reflects management’s best estimate of the amount of expected credit losses in the loan portfolio. When estimating the net amount expected to be collected, Management considers the effects of past events, current conditions, and reasonable and supportable forecasts of the collectability of the Company’s financial assets. Those estimates may be susceptible to significant change. 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.

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The methodology to analyze the adequacy of the ACL is based on seven primary components:

o levels of and trends in delinquencies and non-accrual loans;

o levels of and trends in charge-offs and recoveries;

o trends in volume and terms of loans;

o changes in risk selection and underwriting standards;

o changes in lending policies and legal and regulatory requirements;

o experience, ability and depth of lending management;

o national and local economic trends and conditions;

o changes in credit concentrations; and

o changes in underlying collateral.

A key control related to the allowance is the Company’s Special Assets Committee. This 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 in payment. The assessment process also includes the review of all loans on a non-accruing basis as well as a review of certain loans to which the lenders or the Company’s 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 credit losses on loans and certain key ratios for the periods indicated:

Charge-offs:

Commercial and industrial (320 ) (371 )

Commercial real estate (91 ) (67 )

Residential - -

Recoveries:

Commercial and industrial 57 11

Commercial real estate 44 153

Residential 30 2

Impact of adopting ASC 326 618 -

Initial allowance on loans purchased with credit deterioration 126 -

Provision for credit losses on loans 1,491 2,100

Allowance for credit losses to total loans 1.12 % 1.10 %

Net charge-offs to average total loans outstanding 0.04 % 0.04 %

Loans 90 days or more past due and accruing $ 14 $ 33

Allowance for credit losses to non-accrual loans 5.69 x 6.76 x

Allowance for credit losses to non-performing loans 5.66 x 6.68 x

For the twelve months ended December 31, 2023, the allowance increased $1.6 million, or 10%, to $18.8 million from $17.2 million at December 31, 2022. The increase in the allowance was based on a $0.7 million adjustment related to the adoption of CECL on January 1, 2023 including a $0.1 million initial allowance on Purchase Credit Deteriorated (PCD) loans related to the reclassification of Purchase Credit Impaired (PCI) loans to PCD along with provisioning of $1.5 million partially offset by net charge-offs of $0.6 million.

The allowance for credit losses as a percentage of total loans increased to 1.12% as of December 31, 2023 compared to 1.10% at December 31, 2022 as the increase in the allowance (10%) outpaced the growth in the loan portfolio (8%).

Management believes that the current balance in the allowance for credit 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.

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Although key loss driver assumptions used in the ACL estimate remained largely stable from the day one estimate to the estimate as of December 31, 2023, the ACL estimate increased based on growth in the loan and lease portfolio and changes in the composition of the portfolio along with slower prepayment and curtailment rates. Key loss driver assumptions included the median Federal Open Market Committee (FOMC) National Gross Domestic Product (GDP) and unemployment rate forecasts, the Federal Housing Finance Agency (FHFA) House Price Index (HPI), prepayment and curtailment rates, and estimated remaining loan lives.

Qualitative factors for the ACL estimate as of December 31, 2023 were generally increased compared to the day one estimate related to an increase in delinquency, a moderate deterioration in local economic conditions, and a tougher legal and regulatory environment, which are all expected to have an adverse impact on estimated credit losses.

The allocation of net charge-offs among major categories of loans are as follows for the periods indicated:

Net charge-offs

Commercial and industrial $ (263 ) 45 % $ (360 ) 63 %

Commercial real estate (47 ) 8 86 (15 )

Residential 30 (5 ) 2 (1 )

For the year ended December 31, 2023, net charge-offs against the allowance totaled $578 thousand compared with net charge-offs of $575 thousand for the year ended December 31, 2022, representing a $3 thousand, or 1%, increase due to a $133 thousand increase in commercial real estate offset by a reduction of $97 thousand in commercial & industrial, a reduction of $5 thousand in consumer, and a reduction of $28 thousand in residential. Net charge-offs were unchanged as a percentage of the total loan portfolio at 0.04% for the twelve months ended December 31, 2023 compared to 0.04% for the twelve months ended December 31, 2022.

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 credit 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 credit 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.

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

% of % of

(dollars in thousands) Allowance Loans Allowance Loans

Category

Unallocated 36 - 67 -

As of December 31, 2023, the commercial loan portfolio, consisting of CRE and C&I loans, comprised 57% of the total allowance for credit losses compared with 59% on December 31, 2022. The commercial loan allowance allocation decreased based on the adoption of CECL and changes in how reserves are estimated compared to the previous incurred loss methodology.

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As of December 31, 2023, the consumer loan portfolio comprised 13% of the total allowance for credit losses compared with 17% on December 31, 2022. The consumer loan allowance allocation decreased based on the adoption of CECL and changes in how reserves are estimated compared to the previous incurred loss methodology.

As of December 31, 2023, the residential loan portfolio comprised 30% of the total allowance for credit losses compared with 24% on December 31, 2022. The residential loan allowance allocation increased based on the adoption of CECL and changes in how reserves are estimated compared to the previous incurred loss methodology.

As of December 31, 2023, 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 credit losses, unchanged from December 31, 2022.

Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, other real estate owned (ORE) and repossessed assets. Based on the Company’s adoption of ASU 2022-02, Financial Instruments-Credit Losses (Topic 326) Troubled Debt Restructurings and Vintage Disclosures, the recognition and measurement guidance related to troubled debt restructurings (TDR) has been eliminated. As such, TDRs were removed from non-performing assets at December 31, 2023 and all prior periods in the following table to adhere to this standard and provide better comparability.

The following table sets forth non-performing assets at December 31:

Loans past due 90 days or more and accruing $ 14 $ 33

Other real estate owned and repossessed assets 1 168

Total non-performing assets $ 3,323 $ 2,736

Non-accrual loans to total loans 0.20 % 0.16 %

Non-performing loans to total loans 0.20 % 0.16 %

Non-performing assets to total assets 0.13 % 0.12 %

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 0.13% of total assets at December 31, 2023 compared with 0.12% at December 31, 2022. The increase resulted from a $0.6 million, or 13%, increase in non-performing assets which outpaced the growth in total assets (5%) during this period. Non-performing assets increased due to the recognition of $1.5 million in Purchase Credit Deteriorated (PCD) loans, now classified as non-accrual loans, consistent with the changes in financial reporting under ASC Topic 326 (CECL). This was partially offset by a $0.7 million decrease in non-PCD non-accrual loans as well as a $0.2 million decrease in other real estate owned.

At December 31, 2023, there were a total of 32 non-accrual loans to 26 unrelated borrowers with balances that ranged from less than $1 thousand to $1.3 million, or $3.3 million in the aggregate. At December 31, 2022, there were a total of 39 non-accrual loans to 29 unrelated borrowers with balances that ranged from less than $1 thousand to $0.6 million, or $2.5 million in the aggregate.

Loans past due 90 days or more accruing totaled $14 thousand, which was comprised of one direct finance lease as of December 31, 2023 compared to one direct finance lease and one non-recourse auto loan totaling $33 thousand as of December 31, 2022. 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, 2023 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 and industrial:

Commercial real estate:

Construction 39,823 - - - -

Consumer:

Auto loans-Recourse 10,756 - - - -

Residential:

Construction 36,536 - - - -

Loans held-for-sale 1,457 - - - -

*Net of unearned lease revenue of $2.0 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, 2023 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $319 thousand.

Foreclosedassets held-for-sale

From December 31, 2022 to December 31, 2023, foreclosed assets held-for-sale (ORE) declined from $168 thousand to $1 thousand, a $167 thousand decrease, which was attributed to two ORE properties being transferred to non-accrual due to administrative errors. One property totaling $86 thousand was added to ORE and subsequently transferred to non-accrual during the year.

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 $ 168 2 $ 434 5

Pay downs - (6 )

Write downs - (17 )

Transfers (253 ) (2 ) -

Balance at end of period $ 1 1 $ 168 2

As of December 31, 2023, ORE consisted of one property totaling $1 thousand, which was added in 2017 and is listed for sale.

As of December 31, 2023 and December 31, 2022, the Company had no other repossessed assets held-for-sale.

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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 or decreases 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. 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 supports employee benefit cost increases which 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 received a 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.

Premises and equipment

Net of depreciation, premises and equipment increased $2.9 million during 2023. The Company purchased $1.9 million in fixed assets and added $5.1 million in construction in process during 2023. These increases were partially offset by $2.5 million in depreciation expense. The Company opened a new branch in Wilkes-Barre in 2023. The Company has continued the remodeling of the Main Branch located in Dunmore, PA and construction is expected to be completed in early 2024. The Company began corporate headquarters construction 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. As of December 31, 2023, the Company incurred $5.4 million in costs for the corporate headquarters and currently estimates net remaining costs could range from $19 million to $24 million. This range estimate may expand because it is subject to supply chain issues, commodities pricing and results of final planning spanning over approximately two years through early 2025. In addition, the Company currently is in the process of pursuing a federal historic preservation tax credit which would provide a 20% tax credit on qualified improvements on the historic property.

Other assets

During 2023, the $3.2 million decrease in other assets was due mostly to a $3.0 million decrease in deferred tax assets primarily from lower net unrealized losses in the investment portfolio.

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 credit 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.

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Net interest income, net interest rate margin, net interest rate spread and the efficiency ratio are presented in the Management'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, 2023, the Company generated net income of $18.2 million, or $3.19 per diluted share, compared to $30.0 million, or $5.29 per diluted share, for the year ended December 31, 2022. The $11.8 million, or 39%, decrease in net income stemmed from $10.2 million less net interest income along with $5.2 million lower non-interest income from losses recognized on the sale of investment securities. Partially offsetting these decreases were $3.4 million less in provision for income taxes and $0.8 million lower provision for credit losses on loans and unfunded loan commitments.

Due to volatility in the levels of borrowings during October 2023 and the increasing expected dependency on borrowing capacity from experiencing deposit fluctuations while funding loan growth, the Company evaluated a liquidity strategy to deleverage the reliance on short-term borrowings. As a result of this evaluation, in November 2023, the Company sold certain available-for-sale securities with a carrying value of $35.6 million for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities. The $29.1 million in proceeds received were used to pay down short-term borrowings that replenished available borrowing capacity at that time, while eliminating 425 basis points in negative spread as one means to improve future earnings.

For the year ended December 31, 2023, return on average assets (ROA) and return on average shareholders’ equity (ROE) were 0.76% and 10.56%, respectively, compared to 1.25% and 17.37% for the same period in 2022. The decrease in ROA and ROE was the result of the decline in net income during 2023. Pre-provision net revenue to average assets (non-GAAP) was 0.90% and 1.57% for the years ended December 31, 2023 and 2022, respectively. For more information on the calculation of pre-provision net revenue to average assets, see “Non-GAAP Financial Measures” located above within this management’s discussion and analysis. The decrease was primarily due to a decline in pre-provision net revenue.

Net interest income and interest sensitive assets / liabilities

Net interest income (FTE) decreased $10.1 million, or 13%, from $75.0 million for the year ended December 31, 2022 to $64.9 million for the year ended December 31, 2023, due to interest expense increasing more than the increase in interest income. Total average interest-earning assets increased $24.1 million while the FTE yields earned on these assets rose 62 basis points resulting in $15.3 million of growth in FTE interest income. The interest income growth stemmed from the loan portfolio due to average balance growth of $134.5 million and an additional 68 basis points in FTE yields which had the effect of producing $17.0 million more FTE interest income, despite $1.2 million less in fees earned under the Paycheck Protection Program (PPP) and $0.8 million less from fair value purchase accounting accretion during 2023. In the investment portfolio, the average balances of securities declined $67.1 million resulting in $1.4 million lower FTE interest income.

On the liability side, total interest-bearing liabilities grew $40.2 million in average balances with a 153 basis point increase in rates paid on these interest-bearing liabilities which caused interest expense to increase $25.4 million. Interest expense on deposits increased $22.8 million despite the balance of average interest-bearing deposits declining $7.3 million due to a 144 basis point increase in rates paid on these deposits. In addition, the Company utilized $48.8 million more in average short-term borrowings in 2023 at higher rates compared to 2022 resulting in $2.3 million more interest expense.

The FTE net interest rate spread decreased 91 basis points to 2.25% for the year ended December 31, 2023 compared to 3.16% for the year ended December 31, 2022. The FTE net interest rate margin decreased by 47 basis points, respectively, for the year ended December 31, 2023 compared to the year ended December 31, 2022. The rise in the rates paid on interest-bearing liabilities outpaced the increase in yields on interest-earning assets causing the net interest rate spread and margin to decrease. The overall cost of funds, which includes the impact of non-interest bearing deposits, increased 115 basis points for the year ended December 31, 2023 compared to the same period in 2022. The primary reason for the increase was the higher rates paid on deposits due to the increases in market interest rates during 2023.

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For 2024, the Company currently expects to operate in a modestly declining interest rate environment during the second half of the year. Management is primarily reliant on the Federal Open Market Committee's statements and forecast. The Company’s net interest income performance has been reduced by asset yields being outpaced by higher cost of funds compressing net interest spread. The risk to net interest income improvement is rapid acceleration of deposit rates in the Company's market area. The FOMC increased the federal funds rate by 425 basis points during 2022 and another 100 basis points in 2023, which had a disproportional effect on rates paid on interest-bearing liabilities in 2023. 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 and another 100 basis points through 2023. Consensus economic forecasts are predicting gradual declines in short-term rates throughout 2024. For 2024, the Company currently maintains a loan pipeline which we expect will grow the loan portfolio which will be funded by borrowing capacity until such time deposit growth will be able to pay down these short-term borrowings. The focus is to manage net interest income through an elevated forecasted rate cycle by exercising disciplined and proactive loan pricing and managing deposit costs to maintain a reasonable spread, to the extent possible, in order to mitigate further margin compression.

In November 2023, the Company sold longer term available-for-sale general market tax-free municipal securities with a carrying value of $35.6 million with a weighted average yield of 1.28% with a 13.5 year weighted average maturity as part of a liquidity and net interest margin enhancement strategy for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities. The $29.1 million in proceeds received were used to retire short-term borrowings with a cost of approximately 5.50%. While the Company has ample funding sources available, management felt it prudent to create additional capacity for the borrowings over the near term should the banking industry again experience funding pressures as it did in March of this past year. In addition, since the municipal securities sold were purchased in a much lower rate environment, there is an immediate improvement in net interest margin (NIM) of over 5 bps as a result of paying down the borrowing with the sale proceeds. The sale removes a 422 basis point negative spread and will contribute towards incrementally improving net interest income, earnings per share and NIM every year starting in 2024. The cost savings from paying down the advances with the sale of low yielding bonds will also allow the pre-tax loss of $6.5 million realized on the sale to be fully recouped prior to the term of the bonds sold.

The Company’s cost of interest-bearing liabilities was 1.93% for the year ended December 31, 2023, or 153 basis points higher than the cost for the year ended December 31, 2022. For the month of February 2024, the cost of interest-bearing liabilities was 58 basis points higher than 2023 at 2.51% which shows the higher costs are expected to continue. The increase in interest paid on deposits contributed to the higher cost of interest-bearing liabilities supplemented by the short-term borrowings utilized during 2023. The FOMC is expected to hold the federal funds rate in the immediate future, but 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 and generate new loan volumes. Strategically deploying relationship 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 service-driven branch and relationship managers, continue to develop prudent strategies that will grow the loan portfolio and accumulate relationship driven deposits at costs lower than borrowing costs to improve net interest income performance.

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 2023, 2022 and 2021, 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 credit losses. HELOC are included in the residential real estate category since they are secured by real estate. Net deferred loan (cost amortization)/ fee accretion of ($0.9 million) in 2023, $0.2 million in 2022 and $3.8 million in 2021, respectively, are included in interest income from loans. Merchants Bank of Bangor and Landmark Community Bank loan fair value purchase accounting adjustments of $2.5 million, $3.3 million and $3.0 million are included in interest income from loans and $32 thousand, $160 thousand and $154 thousand reduced interest expense on deposits and borrowings for 2023, 2022 and 2021. 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 /

Assets balance Interest rate balance Interest rate

Interest-earning assets

Investments:

Loans and leases:

Liabilities and shareholders' equity

Interest-bearing liabilities

Deposits:

Net interest spread 2.25 % 3.16 %

Net interest margin 2.81 % 3.28 %

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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:

Investments:

Loans and leases:

Interest expense:

Deposits:

FHLB advances - - - (26 ) - (26 )

Provision for credit losses

The provision for credit losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for credit losses to a level that represents management’s best estimate of expected credit 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 credit 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.

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Management continuously reviews the risks inherent in the loan portfolio. The determination of the amounts of the allowance for credit losses and the provision for credit losses is based on management’s current judgments about the credit quality of the Company’s financial assets and known and expected relevant internal and external factors that significantly affect collectability such as historical loss information, current conditions, and reasonable and supportable forecasts, including significant qualitative factors.

On January 1, 2023, the Company adopted Accounting Standard Update 2016-13, Financial Instruments - Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments (CECL) and recorded an increase of $0.7 million in the allowance for credit losses on loans and an increase of $1.1 million in the allowance for credit losses on unfunded loan commitments. Results for reporting periods beginning after January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP.

For the year ended December 31, 2023, the provision for credit losses on loans was $1.5 million due to the growth and change in composition of the loan portfolio along with slower prepayment speeds and curtailment rates, which are key assumptions used in the estimate. The provision for credit losses on unfunded loan commitments was a net benefit of $0.2 million due to a reduction in unfunded commitments during the year along with lower loss rates related to an improved economic forecast and updated probability of default models used in the estimate.

Due to the Company’s adoption of ASU 2016-13 on January 1, 2023, comparability of the prior period provision is not considered relevant.

The provision for credit losses derives from the reserve required from the allowance for credit losses calculation. The Company continued provisioning for the year ended December 31, 2023 to maintain an allowance level that management deemed adequate.

For a discussion on the allowance for credit losses, see “Allowance for credit 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, 2023, non-interest income amounted to $11.4 million, a $5.2 million, or 31%, decrease compared to $16.6 million recorded for the year ended December 31, 2022. The decrease was primarily due to $6.5 million in losses on the sale of investment securities in 2023 resulting from a liquidity strategy to deleverage reliance on short-term borrowings. Also contributing to the decrease was $0.7 million lower gains on loan sales and $0.3 million less loan service charges. Partially offsetting these decreases, trust fiduciary fees increased $0.5 million and deposit service charges grew $0.5 million. Additional increases were as follows: $0.3 million more in mortgage servicing fees, $0.3 million in recoveries from acquired charged-off loans, $0.3 million in additional commercial loans fees from interest rate hedges and $0.2 million more debit card interchange fees.

Other operating expenses

For the year ended December 31, 2023, total other operating expenses totaled $51.9 million, an increase of $0.5 million, or 1%, compared to $51.4 million for the year ended December 31, 2022. Premises and equipment expenses increased $1.2 million, or 15%, due primarily to higher expenses for equipment maintenance and rentals along with higher depreciation expense. The FDIC assessment expense increased $0.4 million due to the higher assessment rate for 2023. Fraud losses increased $0.5 million due to an increase in counterfeit checks. Professional service expenses increased $0.4 million due to additional consulting, legal, ICS fees and audit expenses. Partially offsetting these increases, salaries and employee benefit expenses declined $1.3 million, or 5%. The decrease was primarily due to less incentive expenses. PA shares tax expense was also $0.6 million lower from declines in shareholders' equity measured as of December 31, 2022.

The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, were 1.41% and 1.45%, respectively, at December 31, 2023 and 2022. The expense ratio decreased because of increased levels of average assets. The efficiency ratio increased from 56.04% at December 31, 2022 to 62.67% at December 31, 2023 due to the decline in revenue in 2023. For more information on the calculation of the efficiency ratio, see “Non-GAAP Financial Measures” located within this management’s discussion and analysis.

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Open positions and the cost of maintaining talent may increase salaries and employee benefit expenses, primarily salaries, incentives and group insurance, in 2024. 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 and expenditures by the Company.

Provision for income taxes

The provision for income taxes decreased $3.4 million, or 62%, for the year ended December 31, 2023 compared to the same 2022 period due to tax credits from plug-in hybrid electric vehicles and lower income before taxes. The Company’s effective income tax rate approximated 10.1% in 2023 and 15.4% in 2022. 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 decrease in the effective tax rate was primarily due to lower pre-tax income and the aforementioned tax credits. 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 increase net deferred tax assets with a corresponding decrease to provision for income taxes.

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, 2023, 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:

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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 18, “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.

Capital Resources

The Bank is 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 Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, 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. Since the Company (on a consolidated basis) is currently considered a small bank holding company, it is not subject to regulatory capital requirements.

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, 2023, total shareholders' equity increased $26.5 million, or 16%, due principally to $18.2 million in net income added into retained earnings. Capital was further enhanced by a $14.7 million after tax improvement in the net unrealized loss position in the Company’s investment portfolio, $1.6 million from the issuance of common stock through the DRP, $0.3 million from investments in the Company’s common stock via the Employee Stock Purchase Plan (ESPP) and $1.6 million from stock-based compensation expense from the ESPP and restricted stock. Partially offsetting these increases, there were $8.4 million of cash dividends declared on the Company’s common stock and a $1.3 million cumulative effect adjustment for adoption of ASU 2016-13. The Company’s dividend payout ratio, defined as the rate at which current earnings are paid to shareholders, was 46.1% and 25.7% for the years ended December 31, 2023 and 2022, respectively. 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 Total DRP Issuance of Changes in

Net dividends earnings earnings and ESPP common stock AOCI and Capital

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As of December 31, 2023, the Company reported a net unrealized loss position of $56.5 million, net of tax, from the securities portfolio compared to a net unrealized loss of $71.2 million as of December 31, 2022. The $14.7 million improvement during 2023 was from the $12.9 million reduction in net unrealized losses on AFS securities, net of tax, and $1.8 million in amortization of net unrealized losses on HTM securities transferred from AFS, net of tax. Lower unrealized losses on all types of securities and the sale of securities in a loss position during 2023 contributed to the reduction in 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 declining rate environment is expected and during the period of declining rates, the Company expects pricing in the bond portfolio to improve. 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 2023, the Company re-issued treasury shares 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.

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, IntraFi's ICS and 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, 2023, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.

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During the year ended December 31, 2023, the Company generated $82.9 million of cash. During the period, the Company’s operations provided approximately $29.7 million mostly from $66.2 million of net cash inflow from the components of net interest income partially offset by net non-interest expense/income related payments of $32.4 million and $2.6 million in quarterly estimated tax payments. Cash inflow from interest-earning assets, the sale of securities, short-term borrowings and loan payments were used to 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. As of December 31, 2023, the Company had $150.4 million in unpledged securities.

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. During November 2023, the Company sold certain available-for-sale securities with a carrying value of $35.6 million for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities as a liquidity strategy to deleverage the reliance on short-term borrowings. The sale removes a 422 basis point negative spread and will incrementally improve net interest income, earnings per share and NIM every year starting in 2024. 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 ("ARPA") 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. During 2023, the Company experienced an outflow of $66.6 million in ARPA funds, or approximately 68% of the balance of these funds from the end of 2022. As of December 31, 2023, the Company has approximately $30 million in remaining ARPA balances. The Company will continue to monitor deposit fluctuations for other significant changes.

As of December 31, 2023, the Company maintained $111.9 million in cash and cash equivalents and $345.5 million of investments AFS and loans HFS. Also as of December 31, 2023, the Company had approximately $656.8 million available borrowing capacity from the FHLB, $20.0 million from correspondent banks, $70.4 million from the FRB and $375.5 million from the IntraFi Network One-Way Buy program. The combined total of $1.6 billion represented 63% of total assets at December 31, 2023. Management believes this level of liquidity to be strong and adequate to support current operations.

For a discussion on the Company’s significant determinable contractual obligations and significant commitments, see “Off-Balance Sheet Arrangements and Contractual Obligations,” above.

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.

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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 in gauging the effects of 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, 2023, the Company maintained a one-year cumulative gap of negative (liability sensitive) $185.5 million, or -7%, 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, 2023:

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

Off-balance sheet:

Cumulative gap to total assets (12.1 )% (7.4 )% (9.2 )% 7.6 %

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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.

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, 2023 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, 2023 levels:

% change

Earnings at risk:

Net interest income (7.7 )% (3.5 )%

Economic value at risk:

Economic value of equity (23.1 ) 7.8

Economic value of equity as a percent of total assets (2.1 ) 0.7

In the scenarios in the above table, the Board-approved policy has the following guidelines: net interest income within +/- 10%, net income within +/- 25%, economic value of equity within +/- 25%, economic value of equity as a percent of total assets within +/-5%.

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, 2023, the Company’s risk-based capital ratio was 14.67%.

Given the existing economic and interest rate conditions along with the recent increase in earnings at risk exposure to rising rates, management is evaluating to pursue balance sheet hedging opportunities on both sides of balance sheet with an independent third-party vendor with derivative expertise in response to mitigate these interest rate risks on net interest income. The Company has a derivative policy in place and any balance sheet hedges require Board pre-approval along with quarterly monitoring requirements by the Company's ALCO Committee.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning January 1, 2024, 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

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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.

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

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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%.

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.

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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.

Corporate Governance. Dodd-Frank requires publicly traded companies to give shareholders a non-binding vote on executive compensation at least every three years, a non-binding vote regarding the frequency of the vote on executive compensation at least every six years, and a non-binding vote on “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders. The SEC has finalized the rules implementing these requirements. Additionally, Dodd-Frank directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether the company is publicly traded. Dodd-Frank also gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.

Prohibition Against Charter Conversions of Troubled Institutions. Dodd-Frank prohibits a depository institution from converting from a state to federal charter or vice versa while it is the subject of a cease and desist order or other formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter unless the appropriate federal banking agency gives notice of the conversion to the federal or state authority that issued the enforcement action and that agency does not object within 30 days. The notice must include a plan to address the significant supervisory matter. The converting institution must also file a copy of the conversion application with its current federal regulator which must notify the resulting federal regulator of any ongoing supervisory or investigative proceedings that are likely to result in an enforcement action and provide access to all supervisory and investigative information relating thereto.

Interstate Branching. Dodd-Frank authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted. Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks will be able to enter new markets more freely.

Limits on Interstate Acquisitions and Mergers. Dodd-Frank precludes a bank holding company from engaging in an interstate acquisition – the acquisition of a bank outside its home state – unless the bank holding company is both well capitalized and well managed. Furthermore, a bank may not engage in an interstate merger with another bank headquartered in another state unless the surviving institution will be well capitalized and well managed. The previous standard in both cases was adequately capitalized and adequately managed.

Limits on Interchange Fees. Dodd-Frank amends the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer. The interchange rules became effective on October 1, 2011.

Consumer Financial Protection Bureau. Dodd-Frank creates a new, independent federal agency called the Consumer Financial Protection Bureau (CFPB), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. Dodd-Frank authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, Dodd-Frank will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. Dodd-Frank permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

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In summary, the Dodd-Frank Act provides for sweeping financial regulatory reform and may have the effect of increasing the cost of doing business, limiting or expanding permissible activities and affect the competitive balance between banks and other financial intermediaries. While many of the provisions of the Dodd-Frank Act do not impact the existing business of the Company, the extension of FDIC insurance to all non-interest bearing deposit accounts and the repeal of prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts, will likely increase deposit funding costs paid by the Company in order to retain and grow deposits. In addition, the limitations imposed on the assessment of interchange fees have reduced the Company’s ability to set revenue pricing on debit and credit card transactions. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry as a whole. The Company will continue to monitor legislative developments and assess their potential impact on our business.

Department of Defense Military Lending Rule. In 2015, the U.S. Department of Defense issued a final rule which restricts pricing and terms of certain credit extended to active duty military personnel and their families. This rule, which was implemented effective October 3, 2016, caps the interest rate on certain credit extensions to an annual percentage rate of 36% and restricts other fees. The rule requires financial institutions to verify whether customers are military personnel subject to the rule. The impact of this final rule, and any subsequent amendments thereto, on the Company’s lending activities and the Company’s statements of income or condition has had little or no impact; however, management will continue to monitor the implementation of the rule for any potential side effects on the Company’s business.

Future Federal and State Legislation and Rulemaking

From time-to-time, various types of federal and state legislation have been proposed that could result in additional regulations and restrictions on the business of the Company and the Bank. We cannot predict whether legislation will be adopted, or if adopted, how the new laws would affect our business. As a consequence, we are susceptible to legislation that may increase the cost of doing business. Management believes that the effect of any current legislative proposals on the liquidity, capital resources and the results of operations of the Company and the Bank will be minimal.

It is possible that there will be regulatory proposals which, if implemented, could have a material effect upon our liquidity, capital resources and results of operations. In addition, the general cost of compliance with numerous federal and state laws does have, and in the future may have, a negative impact on our results of operations. As with other banks, the status of the financial services industry can affect the Bank. Consolidations of institutions are expected to continue as the financial services industry seeks greater efficiencies and market share. Bank management believes that such consolidations may enhance the Bank’s competitive position as a community bank.

Future Outlook

The Company is highly impacted by local economic factors that could influence the performance and strength of our loan portfolios and results of operations. Economic uncertainty continues due to inflationary pressures, fluctuating interest rates and global risks such as war, terrorism and geopolitical instability. A consensus of economists predicts falling short-term rates during the second half of 2024. Uncertainty surrounding the velocity and timing of rate decreases and the effect on the interest rate margin is the Company’s greatest interest rate risk. Earning-asset yields are expected to improve 10% throughout 2024 stemming from new loan originations but rates on interest-bearing liabilities are expected to rise to a similar extent. Jobs grew in December 2023 from a year earlier in the Scranton/Wilkes-Barre/Hazleton and Allentown/Bethlehem/Easton metropolitan statistical areas. We believe expanding our market area gives us opportunity for growth and we will continue to monitor the economic climate in our region, scrutinize growth prospects and proactively observe existing credits for early warning signs of risk deterioration.

In addition to the challenging economic environment, regulatory oversight has changed significantly in recent years. As described in more detail in the “supervision and regulation” section above, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The rules revise the quantity and quality of required minimum risk-based and leverage capital requirements and revise the calculation of risk-weighted assets.

Management believes that the Company is prepared to face the challenges ahead. We expect that there could be a decline in asset quality from the current historically low levels. Our conservative approach to loan underwriting we believe will help keep non-performing asset levels at bay. The Company expects to overcome the further inversion of the yield curve by cautiously growing the balance sheet to enhance financial performance. We intend to grow all lending portfolios in both the business and retail sectors using growth in market-place low costing deposits to stabilize net interest margin and to enhance revenue performance.

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ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by 7A is set forth at Item 7, under “Liquidity” and “Management of interest rate risk and market risk analysis,” contained within management’s discussion and analysis of financial condition and results of operations and incorporated herein by reference.

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ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors of Fidelity D & D Bancorp, Inc.

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheet of Fidelity D & D Bancorp, Inc. and subsidiary (the Company) as of December 31, 2023, the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for the year ended December 31, 2023, and the related notes to the consolidated financial statements (collectively, the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2023, and the results of its operations and its cash flows for the year ended December 31, 2023, in conformity with accounting principles generally accepted in the United States of America.

Change in Accounting Principle

As discussed in Note 1 to the financial statements, the Company has changed its method of accounting for the recognition and measurement of credit losses as of January, 1, 2023 upon the adoption of Accounting Standards Codification Topic 326, Financial Instruments – Credit Losses (ASC 326).

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audit included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion.

Critical AuditMatter

The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of a critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.

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Allowance for Credit Losses – Collectively Evaluated Loans

As described in Notes 1 and 5 to the financial statements, the Company has recorded an allowance for credit losses (“ACL”) in the amount of $18.8 million as of December 31, 2023, representing management’s estimate of credit losses over the remaining expected life of the Company’s loan portfolio as of that date. Upon adoption of ASC 326 on January 1, 2023, the Company recorded a cumulative effect adjustment to decrease opening retained earnings and increase the ACL by $1.7 million, net of related deferred income tax effects. Management determined these amounts, and corresponding provision for credit loss expense during the year ended December 31, 2023, pursuant to the application of ASC 326.

The Company’s methodology to determine its ACL incorporates the use of third-party software to arrive at an expected life-of-loan loss amount that incorporates either discounted cash flow or weighted average remaining life methodologies for the Company’s various loan segments. Both of these approaches use both industry-based and Company specific loss history and Company specific prepayment rates that are adjusted based on various current and forecasted economic factors including, as relevant, home price indices, gross domestic product forecasts and national and local unemployment rates which incorporate reasonable and supportable forecasts. The results of these calculations are then qualitatively adjusted by management based on portfolio specific attributes including changes in lending policies and procedures, changes in other economic conditions, changes in the nature and volume of loans, changes in experience of lending personnel, changes in credit quality and loan review results, changes in underlying collateral values, the existence of credit concentrations, and other portfolio relevant information including legal and regulatory changes. We determined that performing procedures relating to these components of the Company’s methodology is a critical audit matter.

The principal considerations for our determination are (i) the application of significant judgment and estimation on the part of management, which in turn led to a high degree of auditor judgment and subjectivity in performing procedures and evaluating audit evidence obtained, and (ii) significant audit effort was necessary in evaluating management’s methodology, significant assumptions and calculations.

How the Critical Audit Matter was addressed in the Audit

Following are some of the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls related to the Company’s measurement of the collective ACL, including controls over the:

● Methodologies used to calculate the estimate

● Completeness and accuracy of loan data

● Development of qualitative adjustments to model results

Addressing the above matters involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures also included, among others, reviewing the Company’s model validation ensuring appropriate recalculation of the models used along with management’s review of model validation results, testing various assumptions used in the calculation, testing management’s process for determining the qualitative reserve component, evaluating the appropriateness of management’s methodology relating to the qualitative reserve component and testing the completeness and accuracy of data utilized by management.

/s/ Wolf & Company, P.C.

Boston, Massachusetts

March 20, 2024

We have served as the Company's auditor since 2023.

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Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors of Fidelity D & D Bancorp, Inc. and Subsidiary

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheet of Fidelity D & D Bancorp, Inc. and Subsidiary (the Company) as of December 31, 2022, the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows, for the year then ended, and the related notes (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2022, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audit we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audit included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion.

/s/ RSM US LLP

We have served as the Company's auditor from 2015 to 2023.

Blue Bell, Pennsylvania

March 20, 2023

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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Balance Sheets

As of December 31,

Assets:

Interest-bearing deposits with financial institutions 83,000 25,549

Restricted investments in bank stock 3,905 5,268

Foreclosed assets held-for-sale 1 168

Leased property under finance leases, net 1,173 1,089

Cash surrender value of bank owned life insurance 54,572 54,035

Liabilities:

Deposits:

Allowance for credit losses on off-balance sheet credit exposures 944 49

Accrued interest payable and other liabilities 20,189 17,434

Commitments and contingencies (Notes 13 and 17)

Shareholders' equity:

Preferred stock authorized 5,000,000 shares with no par value; none issued - -

Accumulated other comprehensive loss (56,467 ) (71,152 )

See notes to consolidated financial statements

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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Income

Years Ended December 31,

(dollars in thousands except per share data) 2023 2022

Interest income:

Loans and leases:

Interest-bearing deposits with financial institutions 456 886

Restricted investments in bank stock 309 184

Investment securities:

U.S. government agency and corporations 5,973 6,321

States and political subdivisions (nontaxable) 4,690 5,466

States and political subdivisions (taxable) 1,778 1,795

Interest expense:

Other short-term borrowings 2,368 45

Provision for credit losses on loans 1,491 2,100

Net benefit for credit losses on unfunded loan commitments (165 ) (13 )

Net interest income after provision for credit losses 60,721 70,187

Other income:

Service charges on deposit accounts 3,996 3,475

Fees from trust fiduciary activities 3,003 2,481

Fees from financial services 941 955

Earnings on bank-owned life insurance 1,325 1,290

Gain (loss) on write-down, sale or disposal of:

Available-for-sale debt securities (6,468 ) 4

Premises and equipment (216 ) (195 )

Other expenses:

Data processing and communication 2,776 2,635

Automated transaction processing 1,758 1,557

Office supplies and postage 716 682

Other real estate owned 4 15

Per share data:

Net income - basic $ 3.21 $ 5.32

Net income - diluted $ 3.19 $ 5.29

See notes to consolidated financial statements

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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income

Years Ended December 31,

Other comprehensive gain (loss), before tax: