Item 1A. Risk Factors
CREDIT RISK
Focus on lending to small to mid-sized community-based businesses may increase our credit risk.
Most of the Company’s commercial business and commercial real estate loans are made to small business or middle market customers. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the market areas in which the Company operates negatively impact this important customer sector, the Company’s results of operations and financial condition may be adversely affected. Moreover, a portion of these loans have been made by the Company in recent years and the borrowers may not have experienced a complete business or economic cycle since becoming borrowers of the Bank. The deterioration of the borrowers’ businesses may hinder their ability to repay their loans with the Company, which could have a material adverse effect on the Company’s financial condition and results of operations.
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The allowance for loan losses may not be adequate to cover actual losses.
In accordance with GAAP, an allowance for loan losses is maintained to provide for probable loan losses. The allowance for loan losses may not be adequate to cover actual credit losses, and future provisions for credit losses could materially and adversely affect operating results. The allowance for loan losses is based on prior experience as well as an evaluation of risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating, and other outside forces and conditions, including changes in interest rates, all of which are beyond the Company’s control; and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Company’s loans and allowance for loan losses. The Company also outsources independent loan review. While management believes that the allowance for loan losses is adequate to cover current probable losses, it cannot make assurances that it will not further increase the allowance for loan losses or that regulators will not require it to increase this allowance. Either occurrence could adversely affect earnings.
The allowance for loan losses requires management to make significant estimates that affect the consolidated financial statements. Due to the inherent nature of these estimates, management cannot provide assurance that it will not significantly increase the allowance for loan losses, which could materially and adversely affect earnings.
A decline in the condition of the local real estate market could negatively affect our business.
The Company offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, residential mortgages, home equity loans and lines of credit, consumer and other loans. Many of these loans are secured by real estate (both residential and commercial). As of December 31, 2022, 83.6% of all loans were secured by mortgages on real property. Substantially all of the Company’s real property collateral is located in its market area. If there is a decline in real estate values, especially in the Company’s market area, the collateral for loans would deteriorate and provide significantly less security to the Company. In the event the Company forecloses on a loan that is collateralized with property having reduced market value, the Company may suffer a recovery loss.
The Bank has a moderate concentration of credit exposure in commercial real estate, and loans with this type of collateral are viewed as having more risk of default.
As of December 31, 2022, the Bank had approximately $437,888 in loans secured by commercial real estate, representing approximately 51.3% of total loans outstanding at that date. The real estate consists primarily of multi-family housing, non-owner-operated properties and other commercial properties. These types of loans are generally viewed as having more risk of default than residential real estate loans. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the rental of the property to service the debt. Cash flows may be affected significantly by general economic conditions, and a downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because the Bank’s loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in the percentage of non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on the Company’s financial condition.
Nonperforming assets take significant time to resolve and adversely affect the Company’s results of operations and financial condition.
The Company’s nonperforming assets adversely affect its net income in various ways. The Company does not record interest income on nonaccrual loans, which adversely affects its income and increases credit administration costs. When the Company receives collateral through foreclosures and similar proceedings, it is required to mark the related asset to the then fair market value of the collateral less estimated selling costs, which may, and often does, result in a loss. An increase in the level of nonperforming assets also increases the Company’s risk profile and may impact the capital levels regulators believe are appropriate in light of such risks. The Company utilizes various techniques such as workouts and restructurings to manage problem assets. Increases in or negative adjustments in the value of these problem assets, the underlying collateral, or in the borrowers’ performance or financial condition, could adversely affect the Company’s business, results of operations and financial condition. In addition, the resolution of nonperforming assets requires significant commitments of time from management and staff, which can be detrimental to the performance of their other responsibilities, including generation of new loans. There can be no assurance that the Company will avoid increases in nonperforming loans in the future.
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The Company relies upon independent appraisals to determine the value of the real estate which secures a significant portion of its loans, and the values indicated by such appraisals may not be realizable if the Company is forced to foreclose upon such loans.
A significant portion of the Company’s loan portfolio consists of loans secured by real estate. The Company relies upon independent appraisers to estimate the value of such real estate. Appraisals are only estimates of value and the independent appraisers may make mistakes of fact or judgment which adversely affect the reliability of their appraisals. In addition, events occurring after the initial appraisal may cause the value of the real estate to increase or decrease. As a result of any of these factors, the real estate securing some of the Company’s loans may be more or less valuable than anticipated at the time the loans were made. If a default occurs on a loan secured by real estate that is less valuable than originally estimated, the Company may not be able to recover the outstanding balance of the loan and will suffer a loss.
MARKET RISK
If competition increases, our business could suffer, which could result in loan losses and adversely affect the Company’s financial condition and results of operations.
The financial services industry is highly competitive, with a number of commercial banks, credit unions, insurance companies, stockbrokers, financial technology companies and other nonbank financial service providers seeking to do business with our customers. If there is additional competition from new business or if our existing competitors focus more attention on our market, we could lose customers and our business could suffer.
Consumers may increasingly decide not to use the Bank to process their financial transactions, which would have a material adverse impact on the Company’s financial condition and operations.
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.
Transition away from the London Interbank Offered Rate ("LIBOR") to another benchmark rate could adversely affect operations.
The administrator of LIBOR announced that the most commonly used U.S. dollar LIBOR settings would cease to be published or cease to be representative after June 30, 2023. Management cannot predict whether or when LIBOR will actually cease to be available or what impact such a transition may have on the Company’s business, financial condition and results of operations.
The Adjustable Interest Rate (LIBOR) Act, enacted in March 2022, provides a statutory framework to replace LIBOR with a benchmark rate based on the Secured Overnight Funding Rate (“SOFR”) for contracts governed by U.S. law that have no or ineffective fallbacks. Although governmental authorities have endeavored to facilitate an orderly discontinuation of LIBOR, no assurance can be provided that this aim will be achieved or that the use, level, and volatility of LIBOR or other interest rates, or the value of LIBOR-based securities will not be adversely affected. There continues to be substantial uncertainty as to the ultimate effects of the LIBOR transition, including with respect to the acceptance and use of SOFR and other benchmark rates.
The Company has a small number of loans, purchased through participation with larger banks, with attributes that are either directly or indirectly dependent on LIBOR. Since proposed alternative rates are calculated differently, payments under contracts referencing new rates will differ from those referencing LIBOR. The transition from LIBOR could create additional cost and risk, with potential to adversely impact the Company’s financial condition and results of operations.
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INTEREST RATE RISK
When market interest rates change, our net interest income can be negatively affected in the short term.
The direction and speed of interest rate changes affect our net interest margin and net interest income. In the short term, rising interest rates may negatively affect our net interest income if our interest-bearing liabilities (generally deposits) reprice sooner than our interest-earning assets (generally loans). Falling interest rates may negatively affect our net interest income if our interest-earning assets reprice sooner than our interest-bearing liabilities.
LIQUIDITY RISK
The Company’s liquidity needs could adversely affect results of operations and financial condition.
The Company’s primary sources of funds are deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including, but not limited to, changes in economic conditions, reductions in real estate values or markets, availability of, and/or access to, sources of refinancing, business closings or lay-offs, and natural disasters. Additionally, deposit levels may be affected by a number of factors, including, but not limited to, rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to customers on alternative investments and general economic conditions. Accordingly, the Company may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include Federal Home Loan Bank of Atlanta (“FHLB”) advances, sales of securities and loans, federal funds lines of credit from correspondent banks and borrowings from the Federal Reserve Discount Window, as well as additional out-of-market time deposits and brokered deposits. While the Company believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands, particularly if the Company continues to grow and experiences increasing loan demand. The Company may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.
CYBERSECURITY RISK
Our information systems may experience an interruption or security breach.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions of our internet banking, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the possible failure, interruption or security breach of our information systems, there can be no assurance that any such failure, interruption or security breach will not occur or, if it does occur, that it will be adequately addressed.
In the ordinary course of business, the Company collects and stores sensitive data, including proprietary business information and personally identifiable information of its customers and employees, in systems and on networks. The secure processing, maintenance and use of this information is critical to the Company’s operations and business strategy. The Company has invested in industry-accepted technologies, and annually reviews its processes and practices that are designed to protect its networks, computers and data from damage or unauthorized access. Despite these security measures, the Company’s computer systems experienced two cyber-intrusions, one in May 2016 and one in January 2017, in which certain customer information was compromised, but which did not cause interruption to the Company’s normal operations. No losses were incurred by customers. The Company has implemented additional security measures since the breaches.
A breach of any kind could compromise systems and the information stored there could be accessed, damaged or disclosed. The occurrence of any failure, interruption or security breach of our communications and information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny or expose us to civil litigation and possible financial liability.
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Cybersecurity attacks may disarm and/or bypass system safeguards that are used by us and our vendors and service providers, and allow unauthorized access and misappropriation of financial data and assets.
As a financial institution, we are vulnerable to and are the target of cybersecurity attacks that attempt to access our digital technology systems, disarm and/or bypass system safeguards, access customer data and ultimately increase the risk of economic and reputational loss.
The Company experienced two cyber-intrusions, one in May 2016 and one in January 2017, in which certain customer information was compromised. The Company has strengthened its multi-faceted approach to reduce the exposure of our systems to cyber-intrusions, enhance our defenses against hackers and protect customer accounts and information relevant to customer accounts from unauthorized access. These tools include digital technology safeguards, internal policies and procedures, and employee training.
The Company believes its cybersecurity risk management program reasonably addresses the risk from cybersecurity attacks. However, it is not possible to fully eliminate exposure. We may experience human error or have unknown susceptibilities that allow our systems to become victim to a highly-sophisticated cyber-attack. If hackers gain entry to our systems, they may disable other safeguards that limit loss, including limits on the number, amount and frequency of ATM withdrawals, as well as other loss-prevention or detection measures.
We also face risks related to cybersecurity attacks and security breaches in connection with the use, transmission and storage of sensitive information regarding us and our customers by various vendors and service providers. Some of these vendors and service providers have been the target of cybersecurity attacks or suffered security breaches, and because they use systems that we do not control or secure, future cyber-attacks or security breaches affecting any of these vendors and service providers could impact us through no fault of our own. In some cases, we may have exposure and suffer losses relating to these companies. Although we assess the security of our higher risk vendors and service providers, we cannot be sure that the information security protocols of all companies we do business with are sufficient to withstand cyber-attacks or other security breaches.
Insurance may not cover losses from cybersecurity attacks.
The Company has invested in insurance related to cybersecurity. Insurance policies are necessary to protect the Company from major losses but may be written in such a way as to limit the protection from certain risks, including cyber risks. If the insurance carrier denies coverage of losses, the Company may litigate. Because of policy technicalities, litigation may not result in a favorable outcome for the Company. Litigation will result in additional legal expense.
OPERATIONAL RISK
The Company is dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect the Company’s operations and prospects.
The Company currently depends on the services of a number of key management personnel. The loss of key personnel could materially and adversely affect the results of operations and financial condition. The Company’s success also depends in part on the ability to attract and retain additional qualified management personnel. Competition for such personnel is strong and the Company may not be successful in attracting or retaining the personnel it requires.
The Company relies on other companies to provide key components of the Company’s business infrastructure.
Third parties provide key components of the Company’s business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, internet connections and network access. While the Company has selected these third party vendors carefully, it does not control their actions. Any problem caused by these third parties, including those resulting from disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher volumes, failures of a vendor to provide services for any reason or poor performance of services, could adversely affect the Company’s ability to deliver products and services to its customers and otherwise conduct its business. Financial or operational difficulties of a third party vendor could also hurt the Company’s operations if those difficulties interface with the vendor’s ability to serve the Company. Replacing these third party vendors could also create significant delay and expense and damage the Company’s ability to service its customers, resulting in a loss of customer goodwill. Accordingly, use of such third parties creates an unavoidable inherent risk to the Company’s business operations.
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The Company’s ability to operate profitably may be dependent on its ability to integrate or introduce various technologies into its operations.
The market for financial services, including banking and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, online banking and tele-banking. The Company’s ability to compete successfully in its market may depend on the extent to which it is able to exploit such technological changes. If the Company is not able to afford such technologies, properly or timely anticipate or implement such technologies, or effectively train its staff to use such technologies, its business, financial condition or results of operations could be adversely affected.
COMPLIANCE AND REGULATORY RISK
Additional laws and regulations, or revisions and rescission of existing laws and regulations, could lead to a significant increase in our regulatory burden.
Both federal and state governments could enact new laws and regulations affecting financial institutions that would further increase our regulatory burden and could negatively affect our profits. Likewise, revisions or rescission of existing laws and regulations already implemented may result in additional compliance costs, at least in the short term or, if done imprudently, could ultimately create economic risks negatively affecting our revenues.
Intense oversight by regulators could result in stricter requirements and higher overhead costs.
Regulators for the Company and the Bank are tasked with ensuring compliance with applicable laws and regulations. Laws and regulations are subject to a degree of interpretation. If financial industry regulators take more extreme interpretations, the Company’s earnings could be adversely impacted.
Regulatory capital standards may have an adverse effect on the Company’s profitability, lending, and ability to pay dividends.
The Company is subject to capital adequacy guidelines and other regulatory requirements specifying minimum amounts and types of capital that the Company and the Bank must maintain. From time to time, regulators implement changes to these regulatory capital adequacy guidelines. If the Company fails to meet these minimum capital guidelines and/or other regulatory requirements, its financial condition would be materially and adversely affected. The Basel III Capital Rules require bank holding companies and their subsidiaries to maintain significantly more capital as a result of higher required capital levels and more demanding regulatory capital risk weightings and calculations. While the Company is exempt from these capital requirements under the Statement, the Bank is not exempt and must comply. The Bank must also comply with the capital requirements set forth in the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act, as amended. Satisfying capital requirements may require the Company to limit its banking operations, retain net income or reduce dividends to improve regulatory capital levels, which could negatively affect its business, financial condition and results of operations.
Changes in accounting standards could impact reported earnings.
The authorities who promulgate accounting standards, including the Financial Accounting Standards Board (“FASB”), SEC, and other regulatory authorities, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s consolidated financial statements. These changes are difficult to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in the restatement of consolidated financial statements for prior periods. Such changes could also require the Company to incur additional personnel or technology costs. Notably, guidance issued in June 2016 requires a change in the calculation of credit reserves from using an incurred loss model to using the current expected credit losses model (“CECL”), effective January 1, 2023. To implement the standard, the Company incurred costs related to documentation, technology, training and increased audit expenses to validate the model. Adoption increased our credit reserves and reduced capital. Post adoption, other impacts to profit and loss and various financial metrics will also result.
The Company’s ability to pay dividends depends upon the results of operations of its subsidiaries.
The Company is a financial holding company and a bank holding company that conducts substantially all of its operations through NBB. As a result, the Company’s ability to make dividend payments on its common stock depends primarily on certain federal regulatory considerations and the receipt of dividends and other distributions from NBB. There are various regulatory restrictions on the ability of NBB to pay dividends or make other payments to the Company. Although the Company has historically paid a cash dividend to the holders of its common stock, holders of the common stock are not entitled to receive dividends, and regulatory or economic factors may cause the Company’s Board of Directors to consider, among other things, the reduction of dividends paid on the Company’s common stock.
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Climate change and related legislative and regulatory initiatives may result in operational changes and expenditures that could significantly impact the Company’s business.
The current and anticipated effects of climate change are creating an increasing level of concern for the state of the global environment. As a result, political and social attention to the issue of climate change has increased. Federal and state legislatures and regulatory agencies have continued to propose and advance numerous legislative and regulatory initiatives seeking to mitigate the effects of climate change. The federal banking agencies, including the OCC, have emphasized that climate-related risks are faced by banking organizations of all types and sizes and are in the process of enhancing supervisory expectations regarding banks’ risk management practices. In December 2021, the OCC published proposed principles for climate risk management by banking organizations with more than $100 billion in assets. The OCC also has appointed its first ever Climate Change Risk Officer and established an internal climate risk implementation committee in order to assist with these initiatives and to support the agency’s efforts to enhance its supervision of climate change risk management. Similar and even more expansive initiatives are expected, including potentially increasing supervisory expectations with respect to banks’ risk management practices, accounting for the effects of climate change in stress testing scenarios and systemic risk assessments, revising expectations for credit portfolio concentrations based on climate-related factors and encouraging investment by banks in climate-related initiatives and lending to communities disproportionately impacted by the effects of climate change. To the extent that these initiatives lead to the promulgation of new regulations or supervisory guidance applicable to the Company, the Company would likely experience increased compliance costs and other compliance-related risks.
LEGAL RISK
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
From time to time, customers make claims and take legal action pertaining to the performance of the Company’s fiduciary responsibilities. Whether customer claims and legal action related to the performance of the Company’s fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services, as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.
GENERAL RISK
We are subject to risks associated with proxy contests and other actions of activist shareholders.
In connection with the Company’s 2023 annual meeting of shareholders, Driver Management Company LLC (“Driver”) has nominated two candidates for election to the Company’s Board of Directors in opposition to two of the four nominees recommended by the Board of Directors. Driver filed preliminary proxy materials in support of its nominees on February 3, 2023. The Company’s aggregate expenses related to this proxy contest in excess of those normally spent for an annual meeting, and excluding salaries and wages of its regular employees and officers that have devoted time working on the proxy contest, are expected to be approximately $560. In addition, Driver has indicated that, if it is successful in its proxy solicitation, Driver intends to seek reimbursement from the Company for the expenses Driver incurs.
The proxy contest, or related activities on the part of Driver or another shareholder, may adversely affect our business for a number of reasons, including, without limitation, the following:
Changes in funding for local universities could materially affect our business.
Two major employers in the Company’s market area are Virginia Tech and Radford University, both state-supported institutions. If federal or state support for public colleges and universities wanes, our business may be adversely affected from declines in university programs, capital projects, employment, enrollment, sporting and cultural events, and other related factors.
If the economy suffers a recession, our credit risk will increase and there could be greater loan losses.
If the economy suffers a recession, it is likely to result in a higher rate of business closures and increased job losses in the region in which we do business. These factors would increase the likelihood that more of our customers would become delinquent or default on their loans. A higher level of loan defaults could result in higher loan losses, which could adversely affect our result of operations and financial condition.
Political, economic and social risks in the U.S. and the rest of the world could negatively affect the financial markets.
Political, economic and social risks in the U.S. and the rest of the world could affect financial markets and affect fiscal policy, which could negatively affect our investment portfolio and earnings.
While the Company’s common stock is currently traded on the Nasdaq Capital Market, it has less liquidity than stocks for larger companies quoted on a national securities exchange.
The trading volume in the Company’s common stock on the Nasdaq Capital Market has been relatively low when compared with larger companies listed on the Nasdaq Capital Market or other stock exchanges. There is no assurance that a more active and liquid trading market for the common stock will exist in the future. Consequently, stockholders may not be able to sell a substantial number of shares for the same price at which stockholders could sell a smaller number of shares. In addition, the Company cannot predict the effect, if any, that future sales of its common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of the common stock. Sales of substantial amounts of common stock in the market, or the potential for large amounts of sales in the market, could cause the price of the Company’s common stock to decline, or reduce the Company’s ability to raise capital through future sales of common stock.
Natural disasters, acts of war or terrorism, the impact of public health issues and other adverse external events could detrimentally affect our financial condition and results of operations.
Natural disasters, acts of war or terrorism, the impact of public health issues and other adverse external events could have a significant negative impact on our ability to conduct business or upon third parties who perform operational services for us or our customers. Such events also could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in lost revenue or cause us to incur additional expenses.
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Although the Company has business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective. In the event of a natural disaster, acts of war or terrorism, public health issues or other adverse external events, our business, services, asset quality, financial condition and results of operations could be adversely affected.
The effects of widespread public health emergencies may negatively affect our local economies or disrupt our operations, which would have an adverse effect on our business or results of operations.
Widespread health emergencies, such as the current COVID-19 pandemic, can disrupt our operations through their impact on our employees, customers and their businesses, and the communities in which we operate. Disruptions to our customers could result in increased risk of delinquencies, defaults, foreclosures and losses on our loans, negatively impact regional economic conditions, result in a decline in local loan demand, loan originations and deposit availability and negatively impact the implementation of our growth strategy. Any one or more of these developments could have a material adverse effect on our business, financial condition and results of operations.
The economic impact of the COVID-19 pandemic and measures intended to reduce the spread of the virus could adversely affect our business, financial condition, and operations.
Global health and economic concerns relating to the COVID-19 pandemic and government actions taken to reduce the spread of the virus have significantly disrupted the macroeconomic environment in the United States. Although the domestic and global economies have begun to recover from the COVID-19 pandemic as many health and safety restrictions have been lifted and vaccine distribution has increased, certain adverse consequences of the pandemic continue to impact the macroeconomic environment and may persist for some time, including labor shortages and disruptions of global supply chains. The growth in economic activity and in the demand for goods and services, coupled with labor shortages and supply chain disruptions, has also contributed to rising inflationary pressures and the risk of recession. Further, the COVID-19 pandemic could have long-lasting impacts on consumer behavior and business practices, including on remote work and business travel. The COVID-19 pandemic and related adverse economic consequences could cause adverse effects on the Company due to a number of operational factors impacting it or its customers or business partners, including but not limited to:
● loan losses resulting from financial stress experienced by our customers;
● decreased demand for our products and services;
The extent to which the COVID-19 pandemic and related economic consequences impact our business, liquidity, financial condition, and operations will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, if and when the virus can be fully controlled and abated and the extent of its lasting impacts on economic and operating conditions. The impact of the removal of most pandemic related economic stimulus programs is also unknown. To the extent any of the foregoing risks or other factors that develop as a result of COVID-19 and related economic consequences materialize, it could exacerbate the other risk factors discussed in this section, or otherwise materially and adversely affect our business, liquidity, financial condition, and results of operations.
Item 1B. Unresolved Staff Comments
There are no unresolved staff comments.
Item 2. Properties
NBB owns and has a branch bank in NBI’s headquarters building located at 101 Hubbard Street, Blacksburg, Virginia. NBB’s main office is at 100 South Main Street, Blacksburg, Virginia. NBB owns an additional eighteen branch offices and a private office location for support functions and it leases four branch locations and three loan production offices. As of December 31, 2022, there were no mortgages or liens against any properties. We believe that existing facilities are adequate for current needs and to meet anticipated growth. A list of all branch and ATM locations is available on our website at www.nbbank.com. Information contained on our website is not part of this report. For additional information, please see Note 6 of Notes to Consolidated Financial Statements.
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Item 3. Legal Proceedings
NBI, NBB, and NBFS are not currently involved in any material pending legal proceedings. There are no legal proceedings against the Company related to cybersecurity.
Item 4. Mine Safety Disclosures
Not applicable.
Part II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock Information and Dividends
NBI’s common stock is traded on the Nasdaq Capital Market under the symbol “NKSH.” As of December 31, 2022, there were 549 record stockholders of NBI common stock.
NBI’s primary source of funds for dividend payments is dividends from its bank subsidiary, NBB. Bank dividend payments are restricted by regulators, as more fully disclosed in “Regulation, Supervision and Government Policy” contained in Part I, Item 1, “Business” and Note 10 of Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data” of this Form 10-K.
In May 2022, NBI’s Board of Directors approved the repurchase of up to 250,000 shares of the Company’s common stock. The authorization extends from June 1, 2022 to May 31, 2023. During 2022, the Company repurchased 174,250 shares, of which 73,793 shares were repurchased under a prior repurchase plan in effect from June 1, 2021 to May 31, 2022 and 100,457 shares were repurchased under the plan that became effective June 1, 2022. The Company may yet repurchase 149,543 shares under the program. The Company’s share repurchase program does not obligate it to acquire any specific number of shares or any shares at all. During 2021, the Company repurchased 368,083 shares under prior repurchase authorizations.
Purchases of Equity Securities by the Issuer
Share repurchase activity during the fourth quarter of 2022 was as follows:
Item 6. [Reserved]
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
$ in thousands, except per share data.
The purpose of this discussion and analysis is to provide information about the results of operations, financial condition, liquidity and capital resources of the Company. The discussion should be read in conjunction with the material presented in Item 8, “Financial Statements and Supplementary Data,” of this Form 10-K.
Subsequent events have been considered through the date of this Form 10-K.
Cautionary Statement Regarding Forward-Looking Statements
We make forward-looking statements in this Form 10-K that are subject to significant risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals, and are based upon our management’s views and assumptions as of the date of this report. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements.
These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, effects of or changes in:
● interest rates,
● general and local economic conditions,
● unanticipated increases in the level of unemployment in the Company’s market,
● the quality or composition of the loan and/or investment portfolios,
● demand for loan products,
● deposit flows,
● competition,
● demand for financial services in the Company’s market,
● the real estate market in the Company’s market,
● laws, regulations and policies impacting financial institutions,
● technological risks and developments, and cyber-threats, attacks or events,
● the Company’s technology initiatives,
● performance by the Company’s counterparties or vendors,
● applicable accounting principles, policies and guidelines, and
These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report. This discussion and analysis should be read in conjunction with the description of our “Risk Factors” in Item 1A. of this Form 10-K.
Cybersecurity
The Company considers cybersecurity risk to be one of the greatest risks to its business. We have deployed a multi-faceted approach to limit the risk and impact of unauthorized access to customer accounts and to information relevant to customer accounts. We use digital technology safeguards, internal policies and procedures, and employee training to reduce the exposure of our systems to cyber-intrusions. The Company also requires assurances from key vendors regarding their cybersecurity.
We control functionalities of online and mobile banking to reduce risk. We do not offer online account openings or loan originations. We do not permit customers to submit address changes through online banking, and we limit the dollar amount of online banking transfers to other banks. We require a special vetting process for commercial customers who wish to originate ACH transfers and for customers who submit wire requests through online banking.
Further, the Company has a program to identify, mitigate and manage its cybersecurity risks. The program includes penetration testing and vulnerability assessment, technological defenses such as antivirus software, patch management, firewall management, email and web protections, an intrusion prevention system, a cybersecurity insurance policy which covers some but not all losses arising from cybersecurity breaches, as well as ongoing employee training. The cost of these measures was $418 for 2022 and $357 for 2021. These costs are included in various categories of noninterest expense.
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However, it is not possible to fully eliminate exposure. The potential for financial and reputational losses due to cyber-breaches is increased by the possibility of human error, unknown system susceptibilities, and the rising sophistication of cyber-criminals to attack systems, disable safeguards and gain access to accounts and related information. We maintain insurance for these risks but insurance policies are subject to exceptions, exclusions and terms whose applications have not been widely interpreted in litigation. Accordingly, insurance can provide less than complete protection against the losses that result from cybersecurity breaches and pursuing recovery from insurers can result in significant expense. In addition, some risks such as reputational damage and loss of customer goodwill, which can result from cybersecurity breaches, cannot be insured against.
Critical Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with GAAP. The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. Although the economics of the Company’s transactions may not change, the timing of events that would impact the transactions could change.
Critical accounting policies are most important to the portrayal of the Company’s financial condition or results of operations and require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. If conditions occur that differ from our assumptions, depending upon the severity of such differences, the Company’s financial condition or results of operations may be materially impacted. The Company has designated three policies as critical, including those governing the allowance for loan losses, goodwill and the pension plan. The Company evaluates its critical accounting estimates and assumptions on an ongoing basis and updates them as needed. Please refer to Note 1 of Notes to Consolidated Financial Statements for information on these and other accounting policies.
Non-GAAP Financial Measures
The Company prepares financial information in accordance with GAAP, with the exception of certain financial measures which are computed under a basis other than GAAP (“non-GAAP”). These measures include the efficiency ratio, the net interest margin and the noninterest margin. Management believes such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP.
Net Interest Margin
The Company uses the net interest margin to measure profit on interest generating activities, as a percentage of total interest-earning assets. The net interest margin is calculated by dividing fully taxable equivalent (“FTE”) net interest income by total average interest-earning assets. FTE net interest income is non-GAAP because it incorporates the tax benefit of interest income on loans and securities that is not subject to federal tax. The tax rate utilized in calculating the tax benefit is 21%. The reconciliation of FTE net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below.
Year ended December 31,
FTE net interest income (non-GAAP) $ 47,945 $ 42,850
Net interest margin (non-GAAP) 2.88 % 2.81 %
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Efficiency Ratio
The efficiency ratio is computed by dividing noninterest expense by the sum of FTE net interest income and noninterest income, excluding certain items management deems unusual or non-recurring. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. The components of the efficiency ratio calculation are summarized in the following table.
Year ended December 31,
FTE net interest income (non-GAAP) $ 47,945 $ 42,850
Less: partnership income (1) (367 ) (467 )
Less: realized securities gains - (6 )
Less: gain on sale of private equity investment (3,823 ) -
Total income for ratio calculation $ 56,156 $ 50,803
Performance Summary
The following table presents summary income and expenses for the years indicated:
Year ended December 31,
Provision for (recovery of) loan losses 706 (398 )
Net interest income after provision for (recovery of) loan losses 46,320 42,287
Net income in 2022 benefitted from expansion in net interest income and from the sale of a private equity investment, reflected in noninterest income. Key performance ratios provide a summary of the Company’s results and allow comparison with results from prior years. The following table presents NBI’s key performance ratios for the years indicated:
Year Ended December 31,
Return on average assets 1.52 % 1.26 %
Basic and fully diluted net earnings per common share $ 4.33 $ 3.28
Net interest margin (3) 2.88 % 2.81 %
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Change in Key Balances
Key balances are shown in the following table:
Change
Loans, net of unearned income and deferred fees and costs and the allowance for loan losses, grew when December 31, 2022 is compared with December 31, 2021 due to customer demand in the Company’s primary markets. During 2022, the Company expanded its lending footprint, opening two new loan production offices in Charlottesville and Staunton, Virginia.
Securities available for sale are reported at fair value, which moves inversely to interest rate changes. The Federal Reserve increased interest rates substantially during 2022, causing a decline in securities fair value when December 31, 2022 is compared with December 31, 2021.
Customer deposits increased when December 31, 2022 is compared with December 31, 2021, in all categories except for time deposits. Time deposit offering rates were set strategically low during 2022. During the fourth quarter of 2022, deposits decreased from the third quarter of 2022 due to competitive pressure.
When December 31, 2022 is compared with December 31, 2021, the decrease in total assets and in stockholders’ equity is primarily due to a decline in the market value of securities.
Asset Quality
Key indicators of NBI’s asset quality are presented in the following table:
Loans past due 90 days or more and accruing 8 90
Other real estate owned 662 957
Allowance for loan losses to loans(2) 0.96 % 0.96 %
Net charge-off ratio 0.02 % 0.05 %
(2) Loans are net of unearned income and deferred fees and costs.
The Company monitors asset quality indicators in managing credit risk and in determining the allowance and provision for loan losses. As of December 31, 2022, nonperforming loans, other real estate owned ("OREO"), and loans past due 90 days or more improved when compared with levels as of December 31, 2021. The net charge-off ratio decreased from 2021 to 2022.
The Company believes that sufficient resources have been dedicated to working out problem assets, and exposure to loss is somewhat mitigated because most of the nonperforming loans are collateralized. More information about nonaccrual and past due loans is provided in Note 1 and Note 5 of Notes to Consolidated Financial Statements. The Company continues to carefully monitor risk levels within the loan portfolio.
Income Statement
The following provides information on the results of operations for the years ended December 31, 2022 and December 31, 2021.
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Net Interest Income
The Company’s primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on customer deposits and other interest-bearing liabilities. Net interest income is affected by various factors, including the Federal Reserve’s monetary policy, U.S. fiscal policy, competitive pressure, the level and composition of the interest-earning assets and the composition of interest-bearing liabilities. Changes in the Federal Reserve’s target interest rate immediately affect the yield on the Company’s interest-bearing deposits in correspondent banks and affect other interest-earning assets over time. The primary source of funds used to support the Company’s interest-earning assets is deposits. When the interest rate environment changes, the Company assesses competition for deposits in determining changes to its offering rates.
The net interest margin for the year ended December 31, 2022 improved when compared with the year ended December 31, 2021. Federal Reserve rate increases during 2022 improved yields on interest-bearing deposits in correspondent banks and on adjustable-rate mortgage backed securities. The yield on loans decreased during 2022, due to PPP fees received in 2021, however the yield on loans originated or repriced after March of 2022 benefitted from the Federal Reserve rate increases. High levels of customer deposits and low competition during 2022 allowed the Company to maintain low interest expense for the year ended December 31, 2022, compared with the year ended December 31, 2021. During the fourth quarter of 2022, the Company experienced higher competition and pricing pressure on deposits, and expects this will continue into 2023.
The frequency and/or magnitude of future changes in market interest rates and legislative changes are difficult to predict and may have a greater short-term impact on net interest income than adjustments by management. Please refer to the section titled “Analysis of Changes In Interest Income and Interest Expense” for further information related to rate and volume changes.
Analysis of Net Interest Earnings
The following table shows the major categories of interest‐earning assets and interest‐bearing liabilities, the interest earned or paid, the average yield or rate on the daily average balance outstanding, net interest income and net yield on average interest‐earning assets for the years indicated.
Interest-earning assets:
Interest-bearing liabilities:
Net yield on average interest‐earning assets 2.88 % 2.81 %
(5) Nonaccrual loans are included in average balances for yield computations.
(6) Includes restricted stock.
The following table reconciles net interest income on an FTE basis to net interest income on a GAAP basis for the years indicated.
December 31,
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Analysis of Changes in Interest Income and Interest Expense
The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).
Changes Due To
Rates(2) Volume(2) Net Dollar Change
Interest income: (1)
Increase in income on interest-earning assets $ 840 $ 4,240 $ 5,080
Interest expense:
Interest-bearing demand deposits $ (175 ) $ 312 $ 137
Savings deposits (47 ) 21 (26 )
(1) FTE basis using a Federal income tax rate of 21%.
Total interest income increased when the year ended December 31, 2022 is compared with the year ended December 30, 2021, primarily due to volume. Rate-related income on loans fell when the year ended December 31, 2022 is compared with the year ended December 31, 2021 due to PPP fees that were received during 2021. However, increased volume offset much of the impact of lower income from rates.
Federal Reserve interest rate increases in 2022 improved yield on interest-bearing deposits and yield on variable-rate and new taxable securities, when the year ended December 31, 2022 is compared with the year ended December 31, 2021. Higher volume in taxable securities also increased interest income. Income on nontaxable securities decreased when the year ended December 31, 2022 is compared with the year ended December 31, 2021, as higher-yielding nontaxable securities matured and were not replaced.
Deposit volume increased interest expense that was mitigated by lower deposit offering rates, when the years ended December 31, 2022 and 2021 are compared.
The following table sets forth a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate), when the year ended December 31, 2021 is compared with the year ended December 31, 2020.
Changes Due To
Rates(2) Volume(2) Net Dollar Change
Interest income: (1)
Interest expense:
Interest-bearing demand deposits $ (1,789 ) $ 687 $ (1,102 )
(1) Taxable equivalent basis using a Federal income tax rate of 21%.
(2) Variances caused by the change in rate multiplied by the change in volume have been allocated to rate and volume changes proportional to the relationship of the absolute dollar amounts of the change in each.
The low interest rate environment reduced interest income when the year ended December 31, 2021 is compared with the year ended December 31, 2020. However, greater volume more than offset the impact of rates, resulting in a net increase in interest income.
The Company’s reduced deposit offering rates saved $3,178 in interest expense, slightly offset by increased expense for higher volume when the year ended December 31, 2021 is compared with the year ended December 31, 2020.
Interest Rate Sensitivity
Interest rate risk is the risk to earnings or capital arising from movements in market interest rates. When interest-earning assets and interest-bearing liabilities reprice at different times or in different degrees or when call options are exercised, in response to change in market interest rates, future net interest income is impacted. When interest-earning assets mature or re-price more quickly than interest-bearing liabilities, the balance sheet is considered “asset sensitive”. An asset sensitive position will produce relatively more net interest income when interest rates rise and less net interest income when rates decline. Conversely, when interest-bearing liabilities mature or re-price more quickly than interest-earning assets in a given period, the balance sheet is considered “liability sensitive”. A liability sensitive position will produce relatively more net interest income when interest rates fall and less net interest income when rates increase.
The Company considers interest rate risk to be a significant risk and manages its exposure through policies approved by its Asset Liability Committee ("ALCO") and Board of Directors. ALCO reviews periodic reports of the Company's interest rate risk position, including results of simulation analysis. Simulation analysis applies interest rate shocks, hypothetical immediate shifts in interest rates, to the Company’s financial instruments and determines the impact to projected one-year net interest income and other key measures.
The following table shows the results of rate shocks on net interest income projected for one year from the reporting date. For purposes of this analysis, noninterest income and expenses are assumed to be flat.
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Results of the net interest income simulation as of December 31, 2022 indicate that the Company is liability sensitive, a change from the asset sensitive position as of December 31, 2021. The simulation process requires certain estimates and assumptions including, but not limited to, asset growth, the mix of assets and liabilities, the interest rate environment and local and national economic conditions. Asset growth and the mix of assets can, to a degree, be influenced by management. Other areas, such as the interest rate environment and economic factors, cannot be controlled. In addition, competitive pressures can make it difficult to price deposits and loans in a manner that optimally minimizes interest rate risk. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes; changes in market conditions and customer behavior; and changes in management strategies.
While the asset/liability management program is designed to protect the Company over the long term, it does not provide near-term protection from interest rate shocks, as interest rate sensitive assets and liabilities do not by their nature move up or down in tandem in response to changes in the overall rate environment. The Company’s profitability in the near term may be temporarily negatively affected in a period of rapidly rising or rapidly falling rates, because it takes some time for the Company’s portfolio to reflect changes to offering rates in response to a new interest rate environment.
Provision for (Recovery of) Loan Loss
Provision for loan loss for the year ended December 31, 2022 was $706, compared with a recovery of $398 for the year ended December 31, 2021. The ratio of the allowance for loan loss to total loans was 0.96% as of December 31, 2022 and December 31, 2021. The provision for the year ended December 31, 2022 reflects loan portfolio growth and changes in factors detailed in “Balance Sheet – Loans – Allowance for Loan Losses” below. The recovery in 2021 reflected improved economic indicators from those in 2020. More information about the level and calculation methodology of the allowance for loan losses is provided in Notes 1 and 5 of Notes to Consolidated Financial Statements.
Noninterest Income
The following table presents the Company’s noninterest income for the years indicated.
Year Ended December 31, Change
Realized securities gains, net - 6 (6 ) (100.00 )%
Service charges on deposit accounts increased when the year ended December 31, 2022 is compared with the year ended December 31, 2021, primarily due to fees generated from increased customer use of the Bank’s overdraft program. Service charges on deposit accounts also include account maintenance fees, ATM fees and wire transfer fees.
Other service charges and fees increased due to higher volume of letters of credit and associated fees, when the year ended December 31, 2022 is compared with the year ended December 31, 2021. Other service charges and fees also include charges for official checks, income from the sale of checks to customers, safe deposit box rent, and income from commissions on the sale of credit life, accident and health insurance.
Increased transaction volume improved credit card fees when the year ended December 31, 2022 is compared with the year ended December 31, 2021. Credit card fees are presented net of certain processing expenses and are dependent on the volume of transactions.
Trust income increased when the year ended December 31, 2022 is compared with the year ended December 31, 2021. Trust fees are generated from a number of different types of accounts, including estates, personal trusts, employee benefit trusts, investment management accounts, attorney-in-fact accounts and guardianships. Trust income varies depending on the number and type of accounts under management and financial market conditions.
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The Company purchased an additional $5,000 in bank-owned life insurance (“BOLI”) during 2021, contributing to increased income compared with 2021.
The Federal Reserve’s rate increases in 2022 slowed the level of consumer real estate purchase and refinance activity, decreasing the sale of mortgage loans when compared to 2021.
The Company held an ownership interest in Infinex Investments, Inc. (“Infinex”), through which NBFS provides investment services. During the fourth quarter of 2022, the Company recognized a gain on the sale of its shares when Infinex was acquired by a larger holding company. Infinex continues as a division of its new parent company and NBFS continues to work through Infinex to provide investment services .
Other income includes dividends and increases in the Company’s equity-method investments, which decreased when the year ended December 31, 2022 is compared with the year ended December 31, 2021. Other income also includes net gains from the sale of fixed assets and revenue from investment and insurance sales.
Noninterest Expense
The following table presents the Company’s noninterest expense for the years indicated.
Year Ended December 31, Change
Salaries and employee benefits expense, which includes payroll taxes, health insurance, contributions to the employee stock ownership plan and employee 401(k), pension expense, incentives and salary continuation increased when 2022 is compared with 2021, due to normal compensation and staffing decisions.
When the year ended December 31, 2022 is compared with the year ended December 31, 2021, occupancy, furniture and fixtures expense and data processing and ATM expense increased slightly, as did FDIC assessment expense. The FDIC assessment is accrued based on a method provided by the FDIC.
Net costs of OREO include write-downs, maintenance costs, and net gains or losses on the sale of OREO property. This expense category varies with the number of foreclosed properties owned by NBB and with the costs associated with each. During 2022, the Company wrote down a property by $295 to reflect reduction in list price taken as part of a marketing strategy. Other costs for these properties in 2022 were $30. In 2021, the Company recorded a loss on sale of $26 and other expenses of $25.
Franchise tax expense increased when the years ended December 31, 2022 and 2021 are compared. Franchise taxes are levied by the states in which NBB operates and are based upon NBB’s total equity at the prior year-end, adjusted for real estate taxes and certain other items.
The category of other operating expenses includes noninterest expense items such as professional services, stationery and supplies, telephone costs, non-service pension cost and charitable donations. Other operating expenses decreased when the years ended December 31, 2022 and 2021 are compared, primarily due to a decrease of $597 in non-service pension cost. Non-service pension cost is determined by actuarial assumptions and projections. During 2022 and 2021, the calculations resulted in a credit to expense, due to the expected return on plan assets. For more information on non-service pension cost, please refer to Note 8 of Notes to Consolidated Financial Statements.
Income Taxes
Income tax expense for 2022 was $5,831 compared to $4,251 in 2021. The Company’s statutory tax rate was 21% for such years. The Company’s effective tax rates for 2022 and 2021 were 18.36% and 17.26%, respectively. The expected income tax expense based on the Company’s statutory tax rate differs from the actual income tax expense due to tax exempt income on municipal securities and loans. See Note 9 of Notes to Consolidated Financial Statements for information relating to income taxes.
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Balance Sheet
The following provides information on the Company’s financial position as of December 31, 2022 and December 31, 2021.
Loans
The Company’s loan categorization reflects its approach to loan portfolio management and includes six groups. Real estate construction loans include construction loans for residential and commercial properties, as well as land. Consumer real estate loans include conventional and junior lien mortgages, equity lines and investor-owned residential real estate. Commercial real estate loans are comprised of owner-occupied and leased nonfarm, nonresidential properties, multi-family residence loans and farmland. Commercial non real estate loans include agricultural loans, operating capital lines and loans secured by capital assets. Public sector and industrial development authority (“IDA”) loans are extended to municipalities. Consumer non-real estate loans include automobile loans, personal loans, credit cards and consumer overdrafts.
A. Maturities and Interest Rate Sensitivities
The following table presents maturities and interest rate sensitivities for total loans, loans with predetermined interest rates and loans with adjustable interest rates. Predetermined interest rates do not adjust throughout the life of the loan. Loans are presented on a gross basis.
< 1 Year 1 – 5 Years 6-15 Years >15 Years Total
Total loans:
Loans with predetermined interest rates:
Loans with adjustable interest rates:
B. Modifications
In the ordinary course of business the Company modifies loan terms on a case-by-case basis, including consumer and commercial loans, for a variety of reasons. Modifications may include rate reductions, payment extensions of varying lengths of time, a change in amortization term or method or other arrangements. Payment extensions allow borrowers temporary payment relief and result in extending the original contractual maturity by the number of months for which the extension was granted. The Company may grant payment extensions to borrowers who have demonstrated a willingness and ability to repay their loan but who are experiencing consequences of a specific unforeseen temporary hardship. If the temporary event is not expected to impact a borrower’s ability to repay the debt, and if the Company expects to collect all amounts due including interest accrued at the contractual interest rate for the extension period at contractual maturity, the modification is not designated a TDR.
Modifications to consumer loans generally involve short-term payment extensions to accommodate specific, temporary circumstances. Modifications to commercial loans may include, but are not limited to, changes in interest rate, maturity, amortization and financial covenants. If the modified terms are consistent with competitive market conditions and representative of terms the borrower could otherwise obtain in the open market, the modified loan is not categorized as a TDR. The Company codes modifications to assist in identifying TDRs.
During the year ended December 31, 2022, the Company provided modifications for competitive reasons to 840 loans totaling $120,241. During the year ended December 31, 2021, the Company provided modifications for competitive reasons to 875 loans totaling $112,718. The modifications were not TDRs and were not related to COVID-19.
During 2021, the Company provided modifications to borrowers experiencing COVID-19 related hardship. The modification met criteria specified by the CARES Act, the CAA and regulatory guidance and were not designated TDR, including 37 payment extensions to loans totaling $16,426 and 8 amortizing loans granted temporary interest-only periods totaling $22,135. The Company followed its normal risk rating and nonaccrual designation procedures and did not automatically downgrade or designate as nonaccrual if the loan was modified for COVID-19 related difficulty.
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C. TDRs
Modifications are evaluated to determine whether they meet requirements for designation as TDR. Please refer to Notes 1 and 5 of Notes to Consolidated Financial Statements for information on designation of TDRs during the reporting periods and the effect of default on the allowance for loan losses. The Company’s TDRs, by delinquency status, are presented below:
TDR Delinquency Status as of December 31, 2022
Accruing
Total TDR Loans Current 30-89 Days Past Due 90+ Days Past Due Nonaccrual
Consumer real estate $ 186 $ - $ 186 $ - $ -
Commercial non real estate 263 - - - 263
TDR Delinquency Status as of December 31, 2021
Accruing
Total TDR Loans Current 30-89 Days Past Due 90+ Days Past Due Nonaccrual
Consumer real estate $ 191 $ 191 $ - $ - $ -
Commercial non real estate 301 - - - 301
D. Summary of Loan Loss Experience
The following table provides information about the allowance for loan losses, nonperforming assets and accruing loans past due 90 days or more:
December 31,
Allowance for loan losses $ 8,225 $ 7,674
Total loans, net of unearned income and deferred fees 852,744 803,248
Nonaccrual loans $ 91 $ -
TDR loans in nonaccrual status 2,756 2,873
Total nonperforming loans $ 2,847 $ 2,873
Other real estate owned, net 662 957
Total nonperforming assets $ 3,509 $ 3,830
Allowance for loan losses to nonperforming loans 288.90 % 267.11 %
Allowance for loan losses to nonperforming assets 234.40 % 200.37 %
Accruing loans past due 90 days or more $ 8 $ 90
More information about the level and calculation methodology of the allowance for loan losses is provided in the sections “Allowance for Loan Losses” as well as Notes 1 and 5 of Notes to Consolidated Financial Statements.
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E. Analysis of Net Charge-Offs
The following tables show net charge-offs, average loan balance and the percentage of charge-offs to average loan balance for each of the Company’s loan segments at the end of each period. Average loans are presented net of unearned income and net deferred fees.
Real estate construction $ - $ 67,197 -
Commercial non real estate (9 ) 53,742 (0.02 )%
Public Sector and IDA - 48,112 -
Real estate construction $ - $ 45,463 -
Public Sector and IDA - 45,829 -
The Company charges off commercial real estate loans at the time that a loss is confirmed. When delinquency status or other information indicates that the borrower will not repay the loan, the Company considers collateral value based upon a current appraisal or internal evaluation. Any loan amount in excess of collateral value is charged off and the collateral is taken into OREO.
F. Allowance for Loan Losses
The Company’s risk analysis as of December 31, 2022 determined an allowance for loan losses of $8,225 or 0.96% of loans net of unearned income and deferred fees and costs. The allowance as of December 31, 2021 was $7,674 or 0.96% of loans net of unearned income and deferred fees and costs. To determine the appropriate level of the allowance for loan losses, the Company considers credit risk for certain loans designated as impaired and for non-impaired (“collectively evaluated”) loans.
Individually Evaluated Impaired Loans
Individually evaluated impaired loans decreased from December 31, 2021 to December 31, 2022, due to the payoff of one relationship. As of December 31, 2022 individually evaluated loans were $3,032 on a gross basis and $3,033 net of unearned income and deferred fees and costs. Individually evaluated impaired loans as of December 31, 2021 were $5,878 gross and $5,880 net of unearned income and deferred fees and costs. Measurement as of December 31, 2022 and December 31, 2021 did not result in specific allocations to the allowance for loan losses.
Collectively Evaluated Loans
Collectively evaluated loans totaled $850,161 gross and $849,711 net of unearned income and deferred fees and costs, with an allowance of $8,225 or 0.97% of collectively evaluated loans net of unearned income and deferred fees and costs as of December 31, 2022. As of December 31, 2021, collectively evaluated loans totaled $797,851 gross and $797,368 net of unearned income and deferred fees and costs, with an allowance of $7,674 or 0.96% of collectively evaluated loans net of unearned income and deferred fees and costs.
Collectively evaluated loans are divided into classes based upon risk characteristics. In order to calculate the allowance for collectively evaluated loans, the Company applies to each loan class a historical net charge-off rate for the class, adjusted for qualitative factors that influence credit risk. Qualitative factors evaluated for impact to credit risk include economic measures, asset quality indicators, loan characteristics, and changes to internal Company policies and management.
Net Charge-Offs
Increases in the net charge-off rate require the allowance for collectively evaluated loans to be increased, while decreases in the net charge-off rate require the allowance for collectively evaluated loans to be decreased. On a portfolio level, net charge-offs were $155 for the year ended December 31, 2022, or 0.02% of average loans. For the year ended December 31, 2021, net charge-offs were $409 or 0.05% of average loans. The 8-quarter average historical loss rate was 0.03% for the year ended December 31, 2022 and 0.05% for the year ended December 31, 2021.
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Economic Factors
Economic factors influence credit risk and impact the allowance for loan loss. The Company sources economic data pertinent to its market from the most recently available publications, including unemployment, business and personal bankruptcy filings, the residential vacancy rate and the inventory of new and existing homes.
As of December 31, 2022, the unemployment rate for the Company’s market area was measured as of November 2022 and increased from the measurement available as of December 31, 2021, leading management to increase the allocation to the allowance for loan losses.
Business and personal bankruptcy filing data was available as of September 2022. Higher bankruptcy filings indicate heightened credit risk and increase the allowance for loan losses, while lower bankruptcy filings have a beneficial impact on credit risk. Compared with data available as of December 31, 2021, business bankruptcy filings slightly decreased and personal bankruptcy filings slightly increased.
Residential vacancy rates and housing inventory impact the Company’s residential construction customers and the consumer real estate market. Higher levels increase credit risk. The residential vacancy rate as of December 31, 2022 was measured as of the third quarter of 2022 and worsened slightly from the data incorporated into the December 31, 2021 calculation, resulting in a higher allocation. Housing inventory data was available as of December 31, 2022. The level was slightly higher than as of December 31, 2021, resulting in a higher allocation.
Economic factors in 2021 included an allocation for national unemployment filings. This factor was added early in the COVID-19 pandemic to capture risk that may not have been reflected by the Company’s standard economic indicators. By the beginning of 2022, national unemployment filings had returned to pre-pandemic levels for a sustained period and the Company removed the allocation.
Asset Quality Indicators
Asset quality indicators, including past due levels, nonaccrual levels and internal risk ratings, are evaluated at the class level. Loans past due and loans designated nonaccrual indicate heightened credit risk. Increases in past due and nonaccrual loans increase the required level of the allowance for loan losses and decreases in past due and nonaccrual loans reduce the required level of the allowance for loan losses.
Accruing loans past due 30-89 days were 0.16% of total loans net of unearned income and deferred fees and costs as of December 31, 2022, an increase from 0.12% as of December 31, 2021. As of December 31, 2022, accruing loans past due 90 days were $8, compared with $90 or 0.01% of total loans, net of unearned income and deferred fees and costs as of December 31, 2021. Nonaccrual loans as a percentage of total loans net of unearned income and deferred fees and costs were 0.33% as of December 31, 2022 and 0.36% as of December 31, 2021.
Loans rated special mention and classified (together, “criticized assets”) indicate heightened credit risk. Higher levels of criticized assets increase the required level of the allowance for collectively evaluated loans, while lower levels of criticized assets reduce the required level of the allowance for collectively evaluated loans. There were no collectively evaluated loans rated special mention as of December 31, 2022, compared with $3,728 as of December 31, 2021, due to improvement in credit quality of a large relationship. Collectively evaluated loans rated classified were $1,393 as of December 31, 2022 and $1,064 as of December 31, 2021.
Other Factors
The Company considers other factors that impact credit risk, including the interest rate environment, the competitive, legal and regulatory environments, changes in lending policies and loan review, changes in management, and high risk loans.
The interest rate environment impacts variable rate loans. When interest rates increase, the payment on variable rate loans increases, which may increase credit risk. The Federal Reserve increased the target Fed Funds rate seven times, totaling 425 basis points during 2022, resulting in an increased allocation for December 31, 2022 compared with the allocation for December 31, 2021.
The competitive, legal and regulatory environments were evaluated for changes that would impact credit risk. Higher competition for loans may increase credit risk, while lower competition may decrease credit risk. Competition remained at a similar level to that as of December 31, 2021. The legal and regulatory environments remain in a similar posture to that as of December 31, 2021.
Lending policies, loan review procedures and management’s experience influence credit risk. During 2022, appraisal requirements on residential real estate changed, resulting in an increased allocation from December 31, 2021. Loan review procedures remained similar to those as of December 31, 2021 and no allocation was taken. The allocation for management experience declined from December 31, 2021 to December 31, 2022, due to the hiring of a seasoned Chief Credit Officer to replace the former Chief Credit Officer who left at the end of 2021.
Levels of high risk loans are considered in the determination of the level of the allowance for loan loss. A decrease in the level of high risk loans within a class decreases the required allocation for the loan class, and an increase in the level of high risk loans within a class increases the required allocation for the loan class. Total high risk loans decreased 7.67% from the level as of December 31, 2021.
Unallocated Surplus
The unallocated surplus as of December 31, 2022 was $179 or 2.23% in excess of the calculated requirement. The unallocated surplus as of December 31, 2021 was $361 or 4.94% in excess of the calculated requirement. The surplus provides some mitigation of current economic uncertainty that may impact credit risk.
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Conclusion
The calculation of the appropriate level for the allowance for loan losses incorporates analysis of multiple factors and requires management’s prudent and informed judgment. The Company augmented the calculated requirement with an unallocated surplus. Based on analysis of historical indicators, asset quality and economic factors, management believes the level of allowance for loan losses is reasonable for the credit risk in the loan portfolio as of December 31, 2022.
Please refer to Note 5 of Notes to Consolidated Financial Statements for further information on collectively evaluated loans, individually evaluated impaired loans and the unallocated portion of the allowance for loan losses.
G. Allocation of the Allowance for Loan Losses
The allowance for loan losses has been allocated according to the amount deemed necessary to provide for anticipated losses within the categories of loans as of the dates indicated. Loans are presented net of unearned income and net deferred fees and costs.
An analysis of the allowance for loan losses by impairment basis follows. Loans are presented on a gross basis.
December 31,
Allowance related to impaired loans - -
Allowance to impaired loans - -
Allowance related to non-impaired loans 8,225 7,674
Allowance to non-impaired loans 0.97 % 0.96 %
Less: unearned income and deferred fees and costs (449 ) (481 )
Loans, net of unearned income and deferred fees and costs 852,744 803,248
Allowance for loan losses, total 8,225 7,674
Please refer to the discussion under “Allowance for Loan Losses” for additional information on the determination of the allowance for loan loss.
Securities
The Company's securities are designated as available for sale and as such, are reported at fair value. The following table presents information on securities available for sale as of the dates indicated.
Change
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The securities portfolio is subject to the volatility and risk in the financial markets. The risk in financial markets, including interest rate risk and credit risk, affects the Company in the same way that it affects other institutional and individual investors. The fair value of available for sale securities is reflected on the Company's balance sheet. The unrealized loss in the Company’s investment portfolio is due to interest rate risk, the result of increases in the Federal Reserve’s target interest rate during 2022. The Company’s Asset Liability Management Committee is closely monitoring all of the Company’s financial assets and liabilities in order to manage interest rate risk.
Credit risk in the Company’s investment portfolio is evaluated on an individual security basis. The Company’s investment portfolio includes corporate bonds. If the corporate issuers were to default, there could be a delay in the payment of interest, or there could be a loss of principal and accrued interest. To date, there have been no defaults in any of the corporate bonds held in the portfolio. The Company’s investment portfolio also contains a large percentage of municipal bonds. If economic forces reduce the ability of states and municipalities to make scheduled principal and interest payments on their outstanding indebtedness, or if their income from taxes and other sources declines significantly, states and municipalities could default on their bond obligations. There have been no defaults among the municipal bonds in the Company’s investment portfolio. As of December 31, 2022, there are no credit risk concerns with any of the Company’s securities.
The majority of mortgage-backed securities and collateralized mortgage obligations were backed by U.S. government agencies. Certain holdings are required to be periodically subjected to the Federal Financial Institution Examination Council’s (FFIEC) high risk mortgage security test. These tests address possible fluctuations in the average life and variances caused by the change in rate times the change in volume that have been allocated to rate and volume changes proportional to the relationship of the absolute dollar amounts of the change in each.
In making investment decisions, management follows internal policy guidelines that help to limit risk by specifying parameters for both security quality and industry and geographic concentrations. Management regularly monitors the quality of the investment portfolio and tracks changes in financial markets. The value of individual securities will be written down if a decline in fair value is considered to be other than temporary, given the totality of the circumstances.
Additional information about securities available for sale can be found in Note 3 of Notes to Consolidated Financial Statements.
Deposits
The following table presents deposits by category:
Change
Deposits, including noninterest-bearing demand deposits, interest-bearing deposits and interest-bearing time deposits are obtained in the Company’s markets through traditional marketing techniques. The Company’s deposits do not include any brokered deposits. Time deposits decreased due to decreased offering rates. All other categories of deposits increased, due in large part to government stimulus funds received by municipal depositors and other depositors.
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A. Average Amounts of Deposits and Average Rates Paid
Average amounts and average rates paid on deposit categories are presented below:
Year Ended December 31,
Average Amounts Average Rates Paid Average Amounts Average Rates Paid
B. Uninsured Deposits
FDIC insurance covers deposits of up to $250 per depositor. As of December 31, 2022, $665,002 of the Bank’s deposits were uninsured. The following table sets forth time deposits that exceed $250.
Derivatives and Market Risk Exposures
The Company engages in derivative financial instruments associated with its secondary market operation. The derivatives are recorded within other assets and other liabilities. Please refer to Note 1 of Notes to Consolidated Financial Statements for information on derivative valuation. The Company is not a party to derivatives with off-balance sheet risks such as futures, forwards, swaps, and options.
The Company is a party to financial instruments with off-balance sheet risks such as commitments to extend credit, standby letters of credit, and recourse obligations in the normal course of business to meet the financing needs of its customers. See Note 13 of Notes to Consolidated Financial Statements for additional information relating to financial instruments with off-balance sheet risk. Management does not plan any future involvement in high risk derivative products.
The Company’s investments in mortgage-backed securities are primarily through the Government National Mortgage Association and Federal National Mortgage Association. See Note 3 of Notes to Consolidated Financial Statements for additional information relating to securities.
The Company’s securities and loans are subject to credit and interest rate risk, and its deposits are subject to interest rate risk. Management considers credit risk when a loan is granted and monitors credit risk after the loan is granted. The Company maintains an allowance for loan losses to absorb losses in the collection of its loans. See Note 5 of Notes to Consolidated Financial Statements for information relating to the allowance for loan losses. See Note 14 of Notes to Consolidated Financial Statements for information relating to concentrations of credit risk.
The effects of changing interest rates are primarily managed through adjustments to the loan portfolio and deposit base, to the extent competitive factors allow. Adjustments for asset and liability management are made when securities are called or mature and funds are subsequently reinvested. Securities may be sold for reasons related to credit quality, to maintain compliance with regulatory limitations or for interest rate risk management. No trading activity is planned in the foreseeable future.
See Interest Rate Sensitivity for further details on asset liability management and Note 15 of Notes to Consolidated Financial Statements for information relating to fair value of financial instruments.
Liquidity
Liquidity measures the Company’s ability to meet its financial commitments at a reasonable cost. Demands on the Company’s liquidity include funding additional loan demand and accepting withdrawals of existing deposits. The Company has diverse liquidity sources, including customer and purchased deposits, customer repayments of loan principal and interest, sales, calls and maturities of securities, Federal Reserve discount window borrowing, short-term borrowing, and FHLB advances. As of December 31, 2022, the Bank did not have purchased deposits, discount window borrowings, short-term borrowings, or FHLB advances. To assure that short-term borrowing is readily available, the Company tests accessibility annually.
The Company considers its security portfolio for typical liquidity needs, within accounting, legal and strategic parameters. Portions of the securities portfolio are pledged to meet state requirements for public funds deposits. Discount window borrowings also require pledged securities. Increased/decreased liquidity from public funds deposits or discount window borrowings results in increased/decreased liquidity from pledging requirements. The Company monitors public funds pledging requirements and unpledged available for sale securities accessible for liquidity needs.
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Regulatory capital levels determine the Company’s ability to use purchased deposits and the Federal Reserve discount window. As of December 31, 2022, the Company is considered well capitalized and does not have any restrictions on purchased deposits or borrowing ability at the Federal Reserve discount window.
The Company monitors factors that may increase its liquidity needs. Some of these factors include deposit trends, large depositor activity, maturing deposit promotions, interest rate sensitivity, maturity and repricing timing gaps between assets and liabilities, the level of unfunded loan commitments and loan growth. As of December 31, 2022, the Company’s liquidity is sufficient to meet projected trends.
To monitor and estimate liquidity levels, the Company performs stress testing under varying assumptions on credit sensitive liabilities and the sources and amounts of balance sheet and external liquidity available to replace outflows. The Company’s Contingency Funding Plan sets forth avenues for rectifying liquidity shortfalls. As of December 31, 2022, the analysis indicated adequate liquidity under the tested scenarios.
The Company utilizes several other strategies to maintain sufficient liquidity. Loan and deposit growth are managed to keep the loan to deposit ratio within the Company’s internally-set target range. As of December 31, 2022, the loan to deposit ratio was 55.28%. The investment strategy takes into consideration the term of the investment, and securities in the available for sale portfolio are laddered based upon projected funding needs.
In the normal course of business, we enter into certain contractual obligations, including obligations to make future payments on lease arrangements, contractual commitments with depositors, and service contracts. The table below presents our significant contractual obligations, except for pension and other postretirement benefit plans, which are included in Note 8 of Notes to Consolidated Financial Statements.
December 31, 2022 Payments Due by Period
Total Less Than 1 Year 1-3 Years 4-5 Years More Than 5 Years
(1) Includes contracts with a minimum annual payment of $100.
As of December 31, 2022, the Company was not aware of any other known trends, events or uncertainties that have or are reasonably likely to have a material impact on our liquidity. As of December 31, 2022, the Company has no material commitments for long term debt or for capital expenditures.
Capital Resources
Total stockholders’ equity as of December 31, 2022 was $122,687, a decrease of $69,064, or 36.02%, from $191,751 as of December 31, 2021. The decline in stockholders’ equity is due to the change in market value of the securities portfolio, which was in a gain position as of December 31, 2021 and ended December 31, 2022 in a loss position. Unrealized gains and losses in the securities portfolio are reflected in the equity component, accumulated other comprehensive income (loss). The largest component of stockholders’ equity, retained earnings, increased from $188,229 as of December 31, 2021 to $199,091 as of December 31, 2022. The increase stemmed from net income of $25,932, offset by dividends of $8,950 and repurchases of shares of $6,120.
The Company qualifies as a small bank holding company under the Federal Reserve’s Small Bank Holding Company Policy Statement, which exempts bank holding companies with less than $3 billion in assets from reporting consolidated regulatory capital ratios and from minimum regulatory capital requirements. NBB is subject to various capital requirements administered by banking agencies, including an additional capital conservation buffer in order to make capital distributions or discretionary bonus payments. Risk-based capital ratios are calculated in compliance with OCC rules based on the Basel III Capital Rules. The Bank’s ratios are well above the required minimums as of December 31, 2022 and December 31, 2021. Risk based capital ratios for NBB are shown in the following tables.
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Off-Balance Sheet Arrangements
The Company’s off-balance sheet arrangements as of December 31, 2022 are detailed in the table below.
Payments Due by Period
Total Less Than 1 Year 1-3 Years 4-5 Years More Than 5 Years
Mortgage loans with potential recourse 8,654 8,654 - - -
In the normal course of business the Company’s banking affiliate extends lines of credit to its customers. Amounts drawn upon these lines vary at any given time depending on the business needs of the customers.
Standby letters of credit are also issued to the Bank’s customers. There are two types of standby letters of credit. The first is a guarantee of payment to facilitate customer purchases. The second type is a performance letter of credit that guarantees a payment if the customer fails to perform a specific obligation. Revenue from these letters was approximately $71 in 2022.
While it would be possible for customers to fully draw on approved lines of credit and for beneficiaries to call all letters of credit, historically this has not occurred. In the event of a sudden and substantial draw on these lines, the Company has its own lines of credit from which it can draw funds. A sale of loans or investments would also be an option to meet liquidity demands.
The Company sells mortgages on the secondary market subject to recourse agreements. The mortgages originated must meet strict underwriting and documentation requirements for the sale to be completed. The Company estimates a potential loss reserve for recourse provisions. The amount is not material as of December 31, 2022. To date, no recourse provisions have been invoked.
Operating leases are for buildings used in the Company’s day-to-day operations.
Recent Accounting Pronouncements
See Note 1 of Notes to Consolidated Financial Statements for information relating to recent accounting pronouncements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
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Item 8. Financial Statements and Supplementary Data
Consolidated Balance Sheets December 31,
$ in thousands, except per share data 2022 2021
Assets
Restricted stock, at cost 941 845
Mortgage loans held for sale - 615
Loans:
Less unearned income and deferred fees and costs (449 ) (481 )
Loans, net of unearned income and deferred fees and costs 852,744 803,248
Less allowance for loan losses (8,225 ) (7,674 )
Other real estate owned, net 662 957
Liabilities and Stockholders’ Equity
Accrued interest payable 106 48
Commitments and contingencies
Stockholders’ equity:
Accumulated other comprehensive loss, net (83,766 ) (4,058 )
The accompanying notes are an integral part of these consolidated financial statements.
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Consolidated Statements of Income Year ended December 31,
$ in thousands, except per share data 2022 2021
Interest Income
Interest on interest-bearing deposits 1,353 170
Interest and dividends on securities – taxable 12,788 7,960
Interest on securities – nontaxable 1,715 1,934
Interest Expense
Provision for (recovery of) loan losses 706 (398 )
Net interest income after provision for (recovery of) loan losses 46,320 42,287
Noninterest Income
Service charges on deposit accounts 2,425 2,045
Other service charges and fees 214 179
Credit and debit card fees, net 1,916 1,869
Gain on sale of mortgage loans 157 364
Gain on sale of private equity investment 3,823 -
Realized securities gains, net - 6
Noninterest Expense
Occupancy, furniture and fixtures 1,934 1,842
Net costs of other real estate owned 325 51
Basic and fully diluted net income per common share $ 4.33 $ 3.28
The accompanying notes are an integral part of these consolidated financial statements.
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Consolidated Statements of Comprehensive (Loss) Income Year ended December 31,
Other Comprehensive Loss, Net of Tax
Total Comprehensive (Loss) Income $ (53,776 ) $ 13,304
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Changes in Stockholders’ Equity
Other comprehensive loss, net of tax of ($1,881) - - (7,078 ) (7,078 )
The accompanying notes are an integral part of these consolidated financial statements.
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Consolidated Statements of Cash Flows Year ended December 31,
Cash Flows from Operating Activities
Adjustment to reconcile net income to net cash provided by operating activities:
Provision for (recovery of) loan losses 706 (398 )
Deferred income tax (benefit) expense (109 ) 152
Depreciation of premises and equipment 609 636
Amortization of premiums and accretion of discounts, net 1,257 1,688
Gain on disposal of fixed assets (9 ) -
Gain on calls and sales of securities available for sale, net - (6 )
Loss and write-down on other real estate owned 295 25
Income on investment in BOLI (958 ) (910 )
Gain on sale of mortgage loans held for sale (157 ) (364 )
Origination of mortgage loans held for sale (7,882 ) (17,672 )
Sale of mortgage loans held for sale 8,654 18,287
Net change in:
Accrued interest receivable (897 ) (76 )
Accrued interest payable 58 (8 )
Net cash provided by operating activities 29,500 22,882
Cash Flows from Investing Activities
Proceeds from repayments of mortgage-backed securities 32,664 44,881
Purchases of securities available for sale (117,341 ) (219,331 )
Net change in restricted stock (96 ) 434
Purchases of loan participations (19,051 ) (25,167 )
Loan originations and principal collections, net (52,271 ) (25,289 )
Proceeds from disposal of other real estate owned - 621
Proceeds from disposal of repossessed assets - 11
Recoveries on loans charged off 212 346
Purchase of BOLI - (5,000 )
Additions to premises and equipment (1,258 ) (323 )
Proceeds from sale of premises and equipment 9 -
Cash Flows from Financing Activities
Net cash provided by financing activities 32,850 175,284
Net change in cash and due from banks (67,360 ) 4,917
Cash and due from banks at end of year $ 71,429 $ 138,789
Supplemental Disclosures of Cash Flow Information
Interest paid on deposits and borrowed funds $ 3,025 $ 3,106
Supplemental Disclosures of Noncash Activities
Loans charged against the allowance for loan losses $ 367 $ 755
Loans transferred to other real estate owned - 50
Loans transferred to repossessed assets 7 11
Unrealized loss on securities available for sale (106,678 ) (13,054 )
Minimum pension liability adjustment 5,781 4,095
The accompanying notes are an integral part of these consolidated financial statements.
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Notes to Consolidated Financial Statements
$ in thousands, except per share data.
Note 1: Summary of Significant Accounting Policies
The consolidated financial statements include the accounts of National Bankshares, Inc. and its wholly-owned subsidiaries, the National Bank of Blacksburg, and National Bankshares Financial Services, Inc. All intercompany balances and transactions have been eliminated in consolidation.
The accounting and reporting policies of the Company conform to GAAP and to general practices within the banking industry. Subsequent events have been considered through the date of this Form 10-K. The following summarizes significant accounting policies.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and amounts due from banks.
Interest-Bearing Deposits
The Company invests over-night funds in interest-bearing deposits at other banks, including the FHLB, the Federal Reserve and other entities. Interest-bearing deposits are carried at cost.
Securities
Certain debt securities that management has the positive intent and ability to hold to maturity may be classified as “held to maturity” and recorded at amortized cost. Trading securities are recorded at fair value with changes in fair value included in earnings. Securities not classified as held to maturity or trading, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive loss. The Company uses the interest method to recognize purchase premiums and discounts in interest income over the term of the securities. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
The Company follows the accounting guidance related to recognition and presentation of other–than-temporary impairment (“OTTI”). The guidance specifies that if (a) an entity does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that the entity will not have to sell the debt security prior to recovery, the security would not be considered OTTI, unless there is a credit loss. When criteria (a) and (b) are met, the entity will recognize the credit component of an OTTI of a debt security in earnings and the remaining portion in other comprehensive loss.
Equity securities with readily-determinable fair values are measured at fair value using the “exit price notion”. Changes in fair value are recognized in net income. Equity securities without readily-determinable fair values are recorded as other assets at cost less impairment, if any, and adjusted for changes resulting from observable price changes in orderly transactions for identical or similar investment of the same issuer.
Loans Held for Sale
Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value on an individual loan basis. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. The Company releases mortgage servicing rights when loans are sold on the secondary market.
Loans
The Company, through its banking subsidiary, provides mortgage, commercial, and consumer loans to customers. Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoff, are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses, any purchase premium or discount, unearned income and deferred fees or costs. Interest income is accrued on the unpaid principal balance. Unearned income on dealer-originated loans and loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Purchase premium or discount is recognized as an adjustment of the related loan yield using the interest method.
The Bank’s loan policy is updated and approved by the Board of Directors annually and disseminated to lending and loan portfolio management personnel to ensure consistent lending practices. The policy communicates the Company’s risk tolerance by prescribing underwriting guidelines and procedures, including approval limits and hierarchy, documentation standards, requirements for collateral and loan-to-value limits, debt coverage, overall creditworthiness and guarantor support. Of primary consideration is the repayment ability of the borrowers and (if secured) the collateral value in relation to the principal balance. Collateral lowers risk and may be used as a secondary source of repayment. The credit decision must be supported by documentation appropriate to the type of loan, including current financial information, income verification or cash flow analysis, tax returns, credit reports, collateral information, guarantor verification, title reports, appraisals (where appropriate) and other documents.
The Company’s loans are grouped into six segments: real estate construction, consumer real estate, commercial real estate, commercial non real estate, public sector and IDA, and consumer non-real estate. Each segment is subject to certain risks that influence pricing, loan structures, approval requirements, reserves, and ongoing credit management.
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Real Estate Construction Loans. Real estate construction loans are subject to general risks from changing commercial building and housing market trends and economic conditions that may impact demand for completed properties and the costs of completion. Completed properties that do not sell or become leased within originally expected timeframes may impact the borrower’s ability to service the debt. Construction loans are underwritten against projected cash flows from rental income, business and/or personal income from an owner-occupant or the sale of the property to an end-user. Associated risks may be mitigated by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements. Risks specific to the borrower are also evaluated, including previous repayment history, debt service ability, and current and projected loan-to value ratios for the collateral.
Consumer Real Estate Loans. The Bank offers a variety of first mortgage and junior lien loans secured by primary residences within our markets. The credit quality of consumer real estate is subject to risks associated with the borrower’s repayment ability and collateral value. Credit decisions are primarily based on loan-to-value (“LTV”) ratios, debt-to-income (“DTI”) ratios, liquidity and net worth. Income and financial information is obtained from personal tax returns, personal financial statements and employment documentation. A maximum LTV ratio of 80% is generally required. The DTI ratio is limited to 43% of gross income.
Consumer real estate mortgages may have fixed interest rates for the entire term of the loan or variable interest rates subject to change after the first, third, or fifth year. Variable rates are based on the weekly average yield of United States Treasury Securities and are underwritten at fully-indexed rates.
Home equity loans are secured primarily by second mortgages on residential property. The underwriting policy for home equity loans generally permits aggregate (the total of all liens secured by the collateral property) borrowing availability up to 80% of the appraised value of the collateral. We offer both fixed rate and variable rate home equity loans, with variable rate loans underwritten at fully-indexed rates. Decisions are primarily based on LTV ratios, DTI ratios, liquidity and credit history. We do not offer home equity loan products with reduced documentation.
We do not offer certain high risk loan products such as interest-only consumer mortgage loans, hybrid loans, payment option adjustable rate mortgages (“ARMs”), reverse mortgage loans, loans with initial teaser rates or any product with negative amortization. A hybrid loan begins as a fixed rate mortgage and after a set number of years, automatically adjusts to an ARM. Payment option ARMs usually have adjustable rates, for which borrowers choose their monthly payment of either a full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan in accordance with the originally underwritten amortization.
Commercial Real Estate Loans. Commercial real estate loans generally are secured by first mortgages on real estate, including multifamily residential real estate, commercial real estate occupied by the owner/borrower, and commercial real estate leased to non-owners. Properties financed include retail centers, office space, hotels and motels, apartments, and industrial properties. Loans in the commercial real estate segment are impacted by economic risks from changing commercial real estate markets, rental markets for multi-family housing and commercial buildings, and economic factors that would impact the businesses housed by the commercial real estate. Underwriting decisions are based upon an analysis of the economic viability of the collateral and creditworthiness of the borrower. The Bank obtains appraisals from qualified certified independent appraisers to establish the value of collateral properties. The loan amount is generally limited to 80% of the lower of cost or appraised value and is individually determined based on the property type, quality, location and financial strength of any guarantors. The property’s projected net cash flows compared to the debt service (often referred to as the “debt service coverage ratio”) is required to be 115% or greater and is computed after deduction for a vacancy factor and property expenses, as appropriate. Borrower cash flow may be supplemented by a personal guarantee from the principal(s) of the borrower and guarantees from other parties. The Bank may employ stress testing techniques on higher balance loans to determine repayment ability in a changing rate environment before granting loan approval. The Bank requires title insurance, fire, extended coverage casualty insurance and flood insurance, if appropriate, in order to protect the security interest in the underlying property.
Commercial Non Real Estate Loans. Commercial non real estate loans are secured by collateral other than real estate, or are unsecured. Credit risk for commercial non real estate loans is subject to economic conditions, borrower repayment ability and collateral value (if secured). Commercial and agricultural loans primarily finance equipment acquisition, expansion, working capital, and other general business purposes. Because these loans have a higher degree of risk, the Bank generally obtains collateral such as inventory, accounts receivables or equipment and personal guarantees from the borrowing entity’s principal owners. The Bank’s policy limits lending up to 60% of the appraised value for inventory, up to 90% of the lower of cost of market value of equipment and up to 70% for accounts receivables less than 90 days old. Credit decisions are based upon an assessment of the financial capacity of the applicant, including the primary borrower’s ability to repay within proposed terms, a risk assessment, financial strength of guarantors and adequacy of collateral. Credit agency reports of individual owners’ credit history supplement the analysis.
Public Sector and IDA Loans. Public sector and IDA loans are extended to municipalities and related entities within the Bank’s geographical footprint. Borrowers include general taxing authorities such as a city or county, industrial/economic development authorities or utility authorities. Credit risk stems from the entity’s ability to repay through either a direct obligation or assignment of specific revenues from an enterprise or other economic activity. Repayment sources are derived from taxation, such as property taxes and sales taxes, or revenue from the project financed with the loan. The Company’s underwriting considers economic and population trends of the municipality and the municipality’s reserves, pension liabilities and other liabilities.
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Consumer Non-Real Estate Loans. Consumer non-real estate includes credit cards, automobile and other consumer loans. Credit cards and certain other consumer loans are unsecured, while collateral is obtained for automobile loans and other consumer loans. Credit risk stems primarily from the borrower’s ability to repay. Our procedures for underwriting consumer loans include an assessment of an applicant’s overall financial capacity, including credit history and the ability to meet existing obligations and payments on the proposed loan. If the loan is secured by an automobile or other collateral, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount. We require borrowers to maintain collision insurance on loans secured by automobiles.
TDRs
Loan modifications are reviewed at the time of modification to determine whether the loan should be designated as TDR. When the Company grants a concession to a borrower for economic or legal reasons related to a borrower’s financial condition, the loan is classified as a TDR. When the Company grants a subsequent modification to a loan that had previously been modified but not designated as a TDR, it considers whether the totality of the accommodations amount to a concession that, along with the evaluation of borrower financial difficulty, indicate TDR status. Concessions may include reduction of the interest rate, extension of the maturity date at an interest rate lower than the current market rate for a new loan with similar risk, forgiveness of principal or accrued interest or other actions intended to minimize the economic loss. TDRs may be removed from TDR status if the restructuring agreement specifies a contractual interest rate that is a market interest rate at the time of restructuring and the loan is in compliance with its modified terms one year after the restructure was completed.
Past due status and nonaccrual designation
A loan is considered past due when a payment of principal and/or interest is due but not paid. Credit card payments not received within 30 days after the statement date, real estate loan payments not received within the payment cycle and all other non-real estate secured loans for which payment is not made within the required payment cycle are considered 30 days past due. Management closely monitors loans past due 30-89 days and loans past due 90 or more days.
The Company considers multiple factors when determining whether to discontinue accrual of interest on individual loans. Generally loans are placed in nonaccrual status when collection of interest and/or full principal is considered doubtful. Interest accrual is discontinued at the time a commercial real estate loan or commercial non real estate loan is 90 days delinquent unless the credit is well secured and in the process of collection. Loans modified to provide relief from payments of interest or principle for more than 90 days are designated nonaccrual. Accrued interest is reversed against income when a loan is placed in nonaccrual status. Any interest payments received during a loan’s nonaccrual period are credited to the principal balance of the loan.
Loans in nonaccrual are reviewed on an individual loan basis to determine whether they may return to accrual status. To return to accrual status, the Company’s evaluation must determine that the underlying cause of the original delinquency or weakness has been resolved, such as receipt of new guarantees and/or increased cash flows that cover the debt service, and that future payments are reasonably assured. Nonaccrual loans that are not TDR are returned to accrual status when all the principal and interest amounts contractually due are current and future payments are reasonably assured. Nonaccrual TDR loans may return to accrual status after six months of timely repayment performance.
Charge-off policy
The Company’s charge-off policy meets or is more stringent than the minimum standards required by regulators. When available information confirms that a specific loan or a portion thereof, within any loan class, is uncollectible the amount is charged off against the allowance for loan losses. Additionally, losses on consumer real estate and consumer non-real estate loans are typically charged off no later than when the loans are 120-180 days past due, and losses on loans secured by residential real estate or by commercial real estate are charged off by the time the loans reach 180 days past due, in compliance with regulatory guidelines. Accordingly, secured loans may be charged down to the estimated value of the collateral, with previously accrued unpaid interest reversed. Subsequent charge-offs may be required as a result of changes in the market value of collateral or other repayment prospects.
Allowance for Loan Losses
The allowance for loan losses is an estimate of probable losses inherent in the loan portfolio. The allowance is funded by the provision for loan losses, reduced by charge-offs of loans and increased by recoveries of previously charged-off loans. The determination of the allowance is based on two accounting principles, Accounting Standards Codification (“ASC”) Topic 450-20 (Contingencies) which requires that losses be accrued when occurrence is probable and the amount of the loss is reasonably estimable, and ASC Topic 310-10 (Receivables) which requires accrual of losses on impaired loans if the recorded investment exceeds fair value.
The Company evaluates the allowance each quarter through a methodology that estimates losses on individual impaired loans and evaluates the effect of numerous factors on the credit risk of groups of homogeneous loans ("collectively evaluated loans").
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Impaired loans
Impaired loans are larger non-homogeneous loans for which there is a probability that collection of principal or interest will not occur according to the contractual terms of the loan agreement, as well as loans whose terms have been modified in a TDR. The Company performs ongoing analysis of the loan portfolio to determine credit quality on an individual loan basis and to identify impaired loans. Generally, impaired loans have risk ratings that indicate higher risk, such as “classified” or “special mention.” Nonaccrual loan relationships that meet the Company’s balance threshold of $250 are designated impaired. Other loan relationships that meet the Company’s balance threshold of $250 and for which a credit review identified a weakness that indicates principal and interest will not be collected according to the loan terms. All TDRs, regardless of size or past due status are designated impaired.
Impaired loan measurement methods
Impaired loans are individually evaluated to determine appropriate reserves and are measured at the lower of the invested amount or the fair value. Fair value of impaired loans is estimated by either the present value of the loan’s expected future cash flows (“cash flow method”) or the estimated fair value, less selling costs, of the underlying collateral (“collateral method”).
Cash flow method:
The cash flow method is applied to loans that are not collateral dependent and for which cash flows may be estimated. The cash flow method measures fair value using assumptions specific to each loan, including expected amount and timing of cash flows and discount rate. For TDR loans, the discount rate is the rate immediately prior to the modification that resulted in a TDR. If an impaired loan evaluated under the cash flow method becomes 90 days or more past due, it is examined to determine whether the late payment indicates collateral dependency or cash flows below those that were used in the fair value measurement.
Collateral method:
The collateral method is applied to impaired loans that are collateral-dependent, for which foreclosure is imminent or for which non-collateral repayment sources are determined not to be available or reliable. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Fair value is based upon the “as-is” value of independent appraisals or evaluations.
Impaired loans secured by residential 1-4 family properties with outstanding principal balances greater than $250 are valued using an appraisal. Appraisals are also used to value impaired loans secured by commercial real estate with outstanding principal balances greater than $500. Impaired loans secured by residential 1-4 family property with outstanding principal balances of $250 or less, or secured by commercial real estate with outstanding principal balances of $500 or less, are valued using a real estate evaluation prepared by a third party.
Appraisals must conform to the Uniform Standards of Professional Appraisal Practice and are prepared by an independent third-party appraiser who is certified and licensed and who is approved by the Company. Appraisals may incorporate market analysis, comparable sales analysis, cash flow analysis and market data pertinent to the property to determine market value.
Evaluations are prepared by third party providers and reviewed by employees of the Company who are independent of the loan origination, operation, management and collection functions. Evaluations provide a property’s market value based on the property’s current physical condition and characteristics and the economic market conditions that affect the collateral’s market value. Multiple sources of data contribute to the estimate of market value, including physical inspection, independent third-party automated tools, comparable sales analysis and local market information.
Updated appraisals or evaluations are ordered when a loan becomes impaired if the appraisal or evaluation on file is more than 24 months old. Appraisals and evaluations are reviewed for propriety and reasonableness and may be discounted if the Company determines that the value exceeds reasonable levels. If an updated appraisal or evaluation has been ordered but has not been received by a reporting date, the fair value may be based on the most recent available appraisal or evaluation, discounted for age. The appraisal or evaluation value is reduced by selling costs if recovery is expected solely from the sale of collateral.
Results of fair value measurement
The estimated fair value is compared with the loan’s recorded investment (unpaid principal net of any interest payments made during the nonaccrual period and net of any partial charge-offs, accrued interest and deferred fees and costs). Any amount of recorded investment that exceeds estimated fair value on collateral-dependent loans, as well as any other impairment loss considered uncollectible, is charged against the allowance for loan losses. Fair value shortfalls that are not considered uncollectible for loans that are not collateral-dependent are accrued in the allowance as specific reserves. Impaired loans for which collection of interest or principal is in doubt are placed in nonaccrual status. If fair value of an impaired loan is higher than the book value, no specific reserve is recorded, and the loan remains impaired as long as analysis indicates that collection of the loan will not occur according to the contractual terms of the loan agreement.
Nonaccrual status of impaired loans
Nonaccrual status is applied to impaired loans that are not TDRs and for which fair value measurement indicates an impairment loss. Nonaccrual status is applied to TDRs that allow the borrower to discontinue payments of principal or interest for more than 90 days, unless the modification provides reasonable assurance of repayment performance and collateral value supports regular underwriting requirements. TDRs that maintain current status for at least a six-month period, including history prior to restructuring, may accrue interest. Impaired loans with partial charge-offs are maintained as impaired until the remaining balance is satisfied.
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Collectively evaluated loans