ITEM 1A – RISK FACTORS
An investment in our common stock is subject to risks inherent in our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, our business, financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of our common stock could decline significantly, and you could lose all or part of your investment.
Risks Related to Credit
If our allowance for loan losses is not sufficient to cover actual losses, our earnings would decrease.
There is no precise method of predicting loan losses. The required level of reserves, and the related provision for loan losses, can fluctuate from year to year, based on charge-offs and/or recoveries, loan volume, credit administration practices, and local and national economic conditions, among other factors. The ALL, which is a reserve established through a provision for loan losses charged to expense, represents management’s best estimate of probable incurred losses within the existing portfolio of loans. The level of the allowance reflects management’s evaluation of, among other factors, the status of specific impaired loans, historical loss experience, delinquency, credit concentrations and economic conditions within our market area. The determination of the appropriate level of the ALL inherently involves a high degree of subjectivity and judgment and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require us to increase our ALL.
In addition, bank regulatory agencies periodically review our ALL and may require us to increase the provision for loan losses or to recognize further loan charge-offs, based on judgments that differ from those of, or information not available to, management. If loan charge-offs in future periods exceed the ALL, there would be a need to record additional provisions to increase our ALL. Furthermore, growth in the loan portfolio would generally lead to an increase in the provision for loan losses. Generally, increases in our ALL will result in a decrease in net income and stockholders’ equity, and may have a material adverse effect on our financial condition and results of operations.
The deterioration of one or more of our significant lending relationships could result in a significant increase in the nonperforming loans and the provisions for loan losses, which would negatively impact our results of operations. A significant portion of our loan customers have been negatively impacted by protocols either required or recommended due to COVID-19. Some industries or sectors have been impacted more than others. In many cases, the projects supporting these loans are not generating adequate cash flow to service the debt. If conditions do not improve or more government assistance is not provided, we may have to look to secondary sources of repayment, including liquidation of collateral or collection from guarantors. Going to secondary sources of repayment typically increases our risk of loss. Some of the industries most impacted and our related loan volume to such industries are in the hospitality sector and commercial real estate.
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Further, we have elected to delay implementation of ASU 2016-13, Measurement of Credit Losses on Financial Instruments, under the three-year delay permitted by the FASB in 2019. For a more complete description of the potential impact ASU 2016-13 may have on our financial statements and ALL, please refer to the "Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition" risk factor below and Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data" appearing elsewhere in this Form 10-K.
Commercial real estate lending may expose us to a greater risk of loss and impact our earnings and profitability.
Our business strategy includes making loans secured by commercial real estate. These types of loans generally have higher risk-adjusted returns and shorter maturities than other loans. Loans secured by commercial real estate properties are generally for larger amounts and may involve a greater degree of risk than other loans. Payments on loans secured by these properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties. Accordingly, repayment of these loans is subject to conditions in the real estate market or the local economy. In challenging economic conditions, these loans represent higher risk and could result in an increase in our total net charge-offs, requiring us to increase our ALL, which could have a material adverse effect on our financial condition or results of operations. While we seek to minimize these risks in a variety of ways, there can be no assurance that these measures will protect against credit-related losses.
The credit risk related to commercial and industrial loans is greater than the risk related to residential loans.
Commercial and industrial loans generally carry larger loan balances and involve a greater degree of risk of nonpayment or late payment than home equity loans or residential mortgage loans.
Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans are more susceptible to risk of loss during a downturn in the economy, as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. We attempt to mitigate this risk through our underwriting standards, including evaluating the creditworthiness of the borrower and, to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are typical. However, these procedures cannot entirely eliminate the risk of loss associated with commercial and industrial lending.
As a participating lender in the SBA Paycheck Protection Program (“PPP”), we are subject to additional risks of litigation from our clients or other parties regarding our processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.
On March 27, 2020, President Trump signed the CARES Act, which included a $349 billion loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. We are a participating as a lender in the PPP. The PPP opened on April 3, 2020; however, because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there is some ambiguity in the laws, rules and guidance regarding the operation of the PPP, which exposes the Company to risks relating to noncompliance with the PPP. On or about April 16, 2020, the SBA notified lenders that the $349 billion earmarked for the PPP was exhausted. Congress has approved additional funding for the PPP and President Trump signed the new legislation on April 24, 2020. Since the opening of the PPP, several larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. We may be exposed to the risk of litigation, from both clients and non-clients that approached us regarding PPP loans, regarding our process and procedures used in processing applications for the PPP. If any such litigation is filed against us and is not resolved in a manner favorable to us, it may result in significant financial liability or adversely affect our reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.
We also have credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by us, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by us, the SBA may deny its liability under the guaranty,
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reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from us.
Risks Related to Interest Rates and Investments
Changes in interest rates could adversely impact the Company’s financial condition and results of operations.
Our operations are subject to risks and uncertainties surrounding our exposure to changes in the interest rate environment. Operating income, net income and liquidity depend to a great extent on our net interest margin, i.e., the difference between the interest yields we receive on interest-earning assets, such as loans and securities, and the interest rates we pay on interest-bearing liabilities, such as deposits and borrowings. These rates are highly sensitive to many factors beyond our control, including competition, general economic conditions, and monetary and fiscal policies of various governmental and regulatory authorities, including the FRB. If the rate of interest we pay on our interest-bearing liabilities increases more than the rate of interest we receive on our interest-earning assets, our net interest income, and therefore our earnings and liquidity, could be materially adversely affected. Our earnings and liquidity could also be materially adversely affected if the rates on interest-earning assets fall more quickly than those on our interest-bearing liabilities.
Changes in interest rates also can affect our ability to originate loans; the ability of borrowers to repay adjustable or variable rate loans; our ability to obtain and retain deposits in competition with other available investment alternatives; and the value of interest-earning assets, which would negatively impact stockholders’ equity, and the ability to realize gains from the sale of such assets. Based on our interest rate sensitivity analyses, an increase in the general level of interest rates will negatively affect the market value of the investment portfolio because of the relatively higher duration of certain securities included in the investment portfolio.
Our subordinated notes, issued in December 2018, have a 6.0% fixed interest rate through December 2023, after which the interest rate will convert to a variable rate of the London Interbank Offered Rate (“LIBOR”) plus 3.16% through maturity in December 2028. Depending on our financial condition at the time of the rate changing from fixed to variable, an increase in the interest rate on our subordinated debt could have a material adverse effect on our liquidity and results of operations.
The expected discontinuance of LIBOR presents risks to the financial instruments originated, issued or held by us that use LIBOR as a reference rate.
LIBOR is used as a reference rate for many of our transactions, which means it is the base on which relevant interest rates are determined. Transactions include those in which we lend and borrow money and issue, purchase and sell securities. LIBOR is the subject of recent national and international regulatory guidance and proposals for reform. The United Kingdom Financial Conduct Authority, which regulates the process for setting LIBOR, announced in July 2017 that it intends to stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. In November 2020, the FRB announced that LIBOR will be phased out and eventually replaced by June 2023. Banks were instructed to stop writing contracts using LIBOR by the end of 2021.
LIBOR is expected to be replaced by the Secured Overnight Financing Rate, or SOFR, which is a median of rates that market participants pay to borrow cash on an overnight basis, using US Treasury Securities as collateral.
If SOFR does not achieve wide acceptance as the alternative to LIBOR, there likely will be disruption to all of the markets relying on the availability of a broadly accepted reference rate. Should SOFR ultimately replace LIBOR, risks will remain for us with respect to outstanding loans or other instruments using LIBOR. Those risks arise in connection with transitioning those instruments to a new reference rate and the corresponding value transfer that may occur in connection with that transition. Risks related to transitioning instruments to SOFR or to how LIBOR is calculated and its availability include impacts on the yield on loans or securities held by us and amounts paid on securities we have issued. The value of loans, securities, or borrowings tied to LIBOR and the trading market for LIBOR-based securities could also be negatively impacted upon its discontinuance or phase out.
Further, it is possible that LIBOR quotes will become unavailable prior to 2022 if a sufficient number of banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition from LIBOR would be accelerated and magnified. These risks may also be increased due to the shorter time frame for preparing for the transition.
Risks Related to Competition and to Our Business Strategy
Difficult economic and market conditions can adversely affect the financial services industry and may materially and adversely affect the Company.
Our operations are sensitive to general business and economic conditions in the U.S. If the growth of the U.S. economy slows, or if the economy worsens or enters into a recession, our growth and profitability could be constrained. In addition,
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economic conditions in foreign countries can affect the stability of global financial markets, which could impact the U.S. economy and financial markets. Weak economic conditions are characterized by deflation, fluctuations in debt and equity capital markets, including a lack of liquidity and/or depressed prices in the secondary market for mortgage loans, increased delinquencies on mortgage, consumer and commercial loans, residential and commercial real estate price declines and lower home sales and commercial activity. All of these factors are detrimental to our business. Our business is significantly affected by monetary and related policies of the U.S. federal government, its agencies and government-sponsored entities. Changes in any of these policies could have a material adverse effect on our business, financial position, results of operations and cash flows.
In particular, we may face the following risks in connection with volatility in the economic environment:
•Loan delinquencies could increase;
•Problem assets and foreclosures could increase;
•Demand for our products and services could decline; and
•Collateral for loans made by us, especially real estate, could decline in value, reducing client borrowing power, and reducing the value of the assets and collateral associated with our loans.
Because our business is concentrated in south central Pennsylvania, the greater Baltimore region, and Washington County, Maryland, our financial performance could be materially adversely affected by economic conditions and real estate values in these market areas.
Our operations and the properties securing our loans are primarily located in south central Pennsylvania, the greater Baltimore region, and Washington County, Maryland. Our operating results depend largely on economic conditions and real estate valuations in these and surrounding areas. A deterioration in the economic conditions in these market areas could materially adversely affect our operations and increase loan delinquencies, increase problem assets and foreclosures, increase claims and lawsuits, decrease the demand for our products and services and decrease the value of collateral securing loans, especially real estate, in turn reducing clients’ borrowing power, the value of assets associated with nonperforming loans and collateral coverage.
Competition from other banks and financial institutions in originating loans, attracting deposits and providing other financial services may adversely affect our profitability and liquidity.
We experience substantial competition in originating both commercial and consumer loans in our market area. This competition comes principally from other banks, savings institutions, credit unions, mortgage banking companies and other lenders. Some of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income and liquidity by decreasing the number and size of loans that we originate and the interest rates we are able to charge on these loans.
As we expand our online lending capabilities, we will face competition, particularly in residential mortgage lending, from non-bank lenders (financial institutions that only make loans and do not offer deposit accounts such as a savings account or checking account) and financial technology companies that use new technology and innovation with available resources in order to compete in the marketplace of traditional financial institutions and intermediaries in the delivery of financial services. This competition could similarly reduce our net income and liquidity.
In attracting business and consumer deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Some of our competitors enjoy advantages, including more expansive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could materially adversely affect our ability to generate the funds necessary for lending operations. As a result, we may need to seek other sources of funds that may be more expensive to obtain and could increase our cost of funds.
The Company’s business strategy includes the continuation of moderate growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.
Over the long term, we expect to continue to experience organic growth in loans and total assets, the level of our deposits and the scale of our operations. Achieving our growth targets requires us to successfully execute our business strategies, which includes continuing to grow our loan portfolio. Our ability to successfully grow will also depend on the continued availability of loan opportunities that meet underwriting standards. In addition, we may consider the acquisition of other financial
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institutions and branches within or outside of our market area to the extent permitted by our regulators. The success of any such acquisition will depend on a number of factors, including our ability to integrate the acquired institutions or branches into the current operations of the Company; our ability to limit the outflow of deposits held by clients of the acquired institution or branch locations; our ability to control the incremental increase in noninterest expense arising from any acquisition; and our ability to retain and integrate the appropriate personnel of the acquired institution or branches. We believe we have the resources and internal systems in place to successfully achieve and manage our future growth. If we do not manage our growth effectively, we may not be able to achieve our business plan goals and our business and prospects could be harmed.
The Company may be adversely affected by technological advances.
Technological advances impact our business. The banking industry undergoes constant technological change with frequent introductions of new technology-driven products and services. In addition to improving client services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success may depend, in part, on our ability to address the needs of our current and prospective clients by using technology to provide products and services that will satisfy demands for convenience, as well as to create additional efficiencies in operations.
We face security risks, including denial of service attacks, hacking, social engineering attacks targeting our colleagues and clients, malware intrusion or data corruption attempts, and identity theft that could result in the disclosure of confidential information, adversely affect our business or reputation, and create significant legal and financial exposure.
Our computer systems and network infrastructure and those of third parties, on which we are highly dependent, are subject to security risks and could be susceptible to cyber attacks, such as denial of service attacks, hacking, terrorist activities, or identity theft. Our business relies on the secure processing, transmission, storage, and retrieval of confidential, proprietary, and other information in our computer and data management systems and networks, and in the computer and data management systems and networks of third parties. In addition, in order to access our network, products, and services, our clients and other third parties may use personal mobile devices or computing devices that are outside of our network environment and are subject to their own cybersecurity risks.
We, our clients, regulators, and other third parties, including other financial services institutions and companies engaged in data processing, have been subject to, and are likely to continue to be the target of, cyber attacks. These cyber attacks include computer viruses, malicious or destructive code, phishing attacks, denial of service or information, ransomware, improper access by employees or vendors, attacks on personal email of employees, ransom demands to not expose security vulnerabilities in our systems or the systems of third parties or other security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of confidential, proprietary, and other information of ours, our employees, our clients, or of third parties, damage our systems or otherwise materially disrupt our or our clients’ or other third parties’ network access or business operations. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities or incidents. Despite efforts to ensure the integrity of our systems and implement controls, processes, policies, and other protective measures, we may not be able to anticipate all security breaches, nor may we be able to implement sufficient preventive measures against such security breaches, which may result in material losses or consequences for us.
Cybersecurity risks for banking organizations have significantly increased in recent years in part because of the proliferation of new technologies, and the use of the internet and telecommunications technologies to conduct financial transactions. For example, cybersecurity risks may increase in the future as we continue to increase our mobile-payment and other internet-based product offerings to meet client demand and expand our internal usage of web-based products and applications. In addition, cybersecurity risks have significantly increased in recent years, in part due to the increased sophistication and activities of organized crime affiliates, terrorist organizations, hostile foreign governments, disgruntled employees or vendors, activists, and other external parties, including those involved in corporate espionage. Even the most advanced internal control environment may be vulnerable to compromise. Due to increasing geopolitical tensions, nation state cyber attacks and ransomware are both increasing in sophistication and prevalence. Targeted social engineering and email attacks (i.e. “spear phishing” attacks) are becoming more sophisticated and are extremely difficult to prevent. In such an attack, an attacker will attempt to fraudulently induce colleagues, clients, or other users of our systems to disclose sensitive information in order to gain access to its data or that of its clients. Persistent attackers may succeed in penetrating defenses given enough resources, time, and motive. The techniques used by cyber criminals change frequently, may not be recognized until launched, and may not be recognized until well after a breach has occurred. The speed at which new vulnerabilities are discovered and exploited often before security patches are published continues to rise. The risk of a security breach caused by a cyber attack at a vendor or by unauthorized vendor access has also increased in recent years. Additionally, the existence of cyber attacks or security breaches at third-party vendors with access to our data may not be disclosed to us in a timely manner.
We also face indirect technology, cybersecurity, and operational risks relating to the clients and other third parties with whom we do business or upon whom we rely to facilitate or enable our business activities, including, for example, financial
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counterparties, regulators, and providers of critical infrastructure such as internet access and electrical power. As a result of increasing consolidation, interdependence, and complexity of financial entities and technology systems, a technology failure, cyber attack, or other information or security breach that significantly degrades, deletes, or compromises the systems or data of one or more financial entities could have a material impact on counterparties or other market participants, including us. This consolidation, interconnectivity, and complexity increases the risk of operational failure, on both individual and industry-wide bases, as disparate systems need to be integrated, often on an accelerated basis. Any third-party technology failure, cyber attack, or other information or security breach, termination, or constraint could, among other things, adversely affect our ability to effect transactions, service our clients, manage our exposure to risk, or expand our business.
Cyber attacks or other information or security breaches, whether directed at us or third parties, may result in a material loss or have material consequences. Furthermore, the public perception that a cyber attack on our systems has been successful, whether or not this perception is correct, may damage our reputation with clients and third parties with whom we do business. Hacking of personal information and identity theft risks, in particular, could cause serious reputational harm. A successful penetration or circumvention of system security could cause us serious negative consequences, including our loss of clients and business opportunities, costs associated with maintaining business relationships after an attack or breach; significant business disruption to our operations and business, misappropriation, exposure, or destruction of our confidential information, intellectual property, funds, and/or those of our clients; or damage to our or our clients’ and/or third parties’ computers or systems, and could result in a violation of applicable privacy laws and other laws, litigation exposure, regulatory fines, penalties or intervention, loss of confidence in our security measures, reputational damage, reimbursement or other compensatory costs, additional compliance costs, and could adversely impact our results of operations, liquidity and financial condition. In addition, we may not have adequate insurance coverage to compensate for losses from a cybersecurity event.
Cybersecurity and data privacy are areas of heightened legislative and regulatory focus.
As cybersecurity and data privacy risks for banking organizations and the broader financial system have significantly increased in recent years, cybersecurity and data privacy issues have become the subject of increasing legislative and regulatory focus. The federal bank regulatory agencies have proposed regulations that would enhance cyber risk management standards, which would apply to a wide range of large financial institutions and their third-party service providers and would focus on cyber risk governance and management, management of internal and external dependencies, and incident response, cyber resilience, and situational awareness. Several states have also proposed or adopted cybersecurity legislation and regulations, which require, among other things, notification to affected individuals when there has been a security breach of their personal data.
We receive, maintain, and store non-public personal information of our clients and counterparties, including, but not limited to, personally identifiable information and personal financial information. The sharing, use, disclosure, and protection of these types of information are governed by federal and state law. Both personally identifiable information and personal financial information are increasingly subject to legislation and regulation, the intent of which is to protect the privacy of personal information and personal financial information that is collected and handled.
We may become subject to new legislation or regulation concerning cybersecurity or the privacy of personally identifiable information and personal financial information or of any other information we may store or maintain. We could be adversely affected if new legislation or regulations are adopted or if existing legislation or regulations are modified such that we are required to alter our systems or require changes to our business practices or privacy policies. If cybersecurity, data privacy, data protection, data transfer, or data retention laws are implemented, interpreted, or applied in a manner inconsistent with our current practices, we may be subject to fines, litigation, or regulatory enforcement actions or ordered to change our business practices, policies, or systems in a manner that adversely impacts our operating results.
We may become subject to claims and litigation pertaining to fiduciary responsibility.
We provide fiduciary services through OFA. From time to time, clients may make claims and take legal action with regard to the performance of our fiduciary responsibilities. Whether such claims and legal actions are founded or unfounded, if such claims or legal actions are not resolved in a manner favorable to us, the claims or related actions may result in significant financial expense and liability to us and/or adversely affect our reputation in the marketplace, as well as adversely impact client demand for our products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Interest rate volatility stemming from COVID-19 could negatively affect our net interest income, lending activities, deposits and profitability.
Our net interest income, lending activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19. In March 2020, the FRB lowered the target range for the federal funds rate to a range from 0 to 0.25 percent, citing concerns about the impact of COVID-19 on markets and stress in the energy
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sector. A prolonged period of extremely volatile and unstable market conditions would likely increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in current fair market values of our assets. Fluctuations in interest rates will impact both the level of income and expense recorded on most of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.
Risks Related to Mergers and Acquisitions
On October 1, 2018, we completed the acquisition of Mercersburg, and on May 1, 2019, we completed the acquisition of Hamilton Bancorp, Inc.
Growing by acquisition involves risks.
We intend to pursue a growth plan consistent with our business strategy, including growth by acquisition, as well as leveraging our existing branch network and adding new branch locations in current and future markets we choose to serve.
Our ability to manage growth successfully will depend on our ability to attract qualified personnel and maintain cost controls and asset quality while attracting additional loans and deposits on favorable terms, as well as on factors beyond our control, such as economic conditions and competition. If we grow too quickly and are not able to attract qualified personnel, control costs and maintain asset quality, this continued rapid growth could materially adversely affect our financial performance.
Goodwill incurred in acquisitions may negatively affect our financial condition.
To the extent that merger consideration, consisting of cash and shares of our common stock, exceeds the fair value of the net assets acquired, including identifiable intangibles, that amount will be reported as goodwill by us. In accordance with current accounting guidance, goodwill will not be amortized but will be evaluated for impairment annually or more frequently if events or circumstances warrant. A failure to realize expected benefits of the mergers could adversely impact the carrying value of the goodwill recognized in the mergers and, in turn, negatively affect our financial results.
We may be unable to successfully integrate the operations of acquired entities over time.
Acquisitions involve the integration with Orrstown of companies that previously operated independently. The difficulties of combining the operations of the acquired companies with Orrstown include:
•integrating personnel with diverse business backgrounds;
•integrating departments, systems, operating procedures and information technologies;
•combining different corporate cultures;
•retaining existing clients and attracting new clients; and
•retaining key employees.
The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of the combined company and the loss of key personnel. The diversion of management’s attention and any delays or difficulties encountered in connection with the merger and the integration process could have a material adverse effect on the business and results of operations of the combined company.
The success of acquisitions depends, in part, on our ability to realize the anticipated benefits and cost savings from combining the businesses acquired with Orrstown. If we are unable to successfully execute on integration, the anticipated earnings and cost savings to be derived from acquisitions may not be realized fully or may take longer to realize than expected. In addition, as with regard to any acquisition, a significant change in interest rates or economic conditions or decline in asset valuations may also cause us not to realize expected benefits and result in the acquisitions not meeting expectations.
The market price of our common stock after acquisitions may be affected by factors different from those affecting our shares currently.
The businesses of the Company and acquired entities may differ and, accordingly, the results of operations of the combined company and the market price of the shares of common stock of the combined company may be affected by factors different from those currently affecting the independent results of operations and market prices of common stock of each separate entity. The market value of our common stock fluctuates based upon various factors, including changes in our business, operations or prospects, market assessments of the merger, regulatory considerations, market and economic
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considerations, and other factors. Further, the market price of our common stock after an acquisition may be affected by factors different from those currently affecting our common stock.
Additionally, future business acquisitions may result in the issuance and payment of additional shares of stock, which would dilute current shareholders’ ownership interests, and may involve the payment of a premium over book and market values. Therefore, dilution of our tangible book value and net income per common share could occur in connection with any future transaction.
Risks Related to Regulatory Compliance and Legal Matters
Governmental regulation and regulatory actions against us may impair our operations or restrict our growth.
The Company is subject to regulation and supervision under federal and state laws and regulations. The requirements and limitations imposed by such laws and regulations limit the manner in which we conduct our business, undertake new investments and activities and obtain financing. These regulations are designed primarily for the promotion of the safety and soundness of financial institutions and the protection of the deposit insurance funds and consumers, and not to benefit our shareholders.
Applicable laws and regulations impose capital adequacy requirements and restrict our ability to repurchase stock or to receive dividends from our subsidiaries. Our ability to service our obligations and pay dividends to shareholders is largely dependent on the receipt of dividends from our subsidiaries, primarily the Bank. The FRB requires a BHC to act as a source of financial and managerial strength for its subsidiary banks. The FRB could require us to commit resources to the Bank when doing so is not otherwise in the interests of our shareholders or creditors.
We are subject to supervision and examination by numerous governmental bodies. The results of these supervisory or examination activities could result in limitations on our ability to engage in new activities or expand geographically. These activities also could result in significant fines, penalties, or required corrective actions, some of which could be expensive and difficult to implement. As we expand our product and service offerings into additional states, there could be an increase in state regulation affecting our operations. Different approaches to regulation by different jurisdictions could increase our compliance costs or risks of non-compliance.
Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is within our control. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied or enforced. The Company cannot predict the substance or impact of pending or future legislation, regulation or the application thereof.
Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business processes, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner. Bank regulations can hinder our ability to compete with financial services companies that are not regulated in the same manner or are subject to less regulation. A failure to comply, or to have adequate policies and procedures designed to comply, with regulatory requirements and expectations could expose us to damages, fines and regulatory penalties and other regulatory or enforcement actions or consequences, such as limitations on activities otherwise permissible for us or additional requirements for engaging in new activities, and could also injure our reputation with clients and others with whom we do business.
Increases in FDIC insurance premiums may have a material adverse effect on our results of operations.
We are generally unable to control the amount of premiums that are required to be paid for FDIC insurance. If there are bank or financial institution failures, the Company may be required to pay significantly higher premiums than the levels currently imposed or additional special assessments or taxes that could adversely affect earnings. Any future increases or required prepayments in FDIC insurance premiums may materially adversely affect our results of operations.
Legislative, regulatory and legal developments involving income and other taxes could materially adversely affect the Company’s results of operations and cash flows.
The Company is subject to U.S. federal and U.S. state income, payroll, property, sales and use, and other types of taxes, including the Pennsylvania Bank Shares Tax. Significant judgment is required in determining the Company's provisions for income taxes. Changes in tax rates, enactments of new tax laws, revisions of tax regulations, and claims or litigation with taxing authorities could result in substantially higher taxes, and therefore, could have a significant adverse effect on the Company's results of operations, financial condition and liquidity. Increases in the assessment rate for the Pennsylvania Bank Shares Tax, which is calculated on the outstanding equity of the Bank, may also materially adversely affect results of operations.
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The Company is required to use judgment in applying accounting policies and different estimates and assumptions in the application of these policies could result in a decrease in capital and/or other material changes to the reports of financial condition and results of operations.
Material estimates that are particularly susceptible to significant change relate to the determination of the ALL, the fair value of certain financial instruments, particularly securities, and goodwill and purchase accounting associated with acquisitions. While we have identified those accounting policies that we consider critical and have procedures in place to facilitate the associated judgments, different assumptions in the application of these policies could have a material adverse effect on our financial condition and results of operations.
Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.
From time to time, the FASB, SEC and other regulatory bodies change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes can be operationally complex to implement and can materially impact how we record and report our financial condition and results of operations.
For example, in June 2016, the FASB issued Accounting Standards Update 2016-13, Measurement of Credit Losses on Financial Instruments, that will, upon adoption, substantially change the accounting for credit losses on loans and other financial assets held by banks, financial institutions and other organizations. The update replaces existing incurred loss impairment guidance and establishes a single allowance framework for financial assets carried at amortized cost. Upon adoption of ASU 2016-13, companies must recognize credit losses on these assets equal to management’s estimate of credit losses over the full remaining expected life. Companies must consider all relevant information when estimating expected credit losses, including details about past events, current conditions, and reasonable and supportable forecasts.
The changes were effective for most publicly-held companies on January 1, 2020. However, in July 2019, the FASB approved permitting “smaller reporting companies”, such as Orrstown, up to an additional 3 years to adopt ASU 2016-13. We elected not to adopt ASU 2016-13 on January 1, 2020, and have not yet determined if we will adopt its provisions prior to the extended implementation date of January 1, 2023.
In December 2018, the FRB, OCC and FDIC released a final rule to revise their regulatory capital rules, in part to address the upcoming change to the treatment of credit expense and allowances under ASC 2016-13. The final rule provides an optional three year phase-in period for the day-one adverse regulatory capital effects upon adopting the standard. The impact of this final rule on the Company will depend on whether we elect to phase in the impact of ASU 2016-13 over a three year period. The standard is likely to have a negative impact, potentially materially, to the ALL and our capital position at adoption. When we adopt ASU 2016-13, we will also determine whether we will elect the phase-in provisions for regulatory capital. It is possible that our ongoing reported earnings and lending activity will be negatively impacted in periods following adoption of ASU 2016-13.
The short-term and long-term impact of changing regulatory capital requirements and new capital rules is uncertain.
The Basel III Capital Rules have targeted higher levels of base capital, certain capital buffers, and a migration toward common equity as the key source of regulatory capital, as domestic and international bank regulatory agencies have sought to require financial institutions, including depository institutions, to maintain generally higher levels of capital. The application of more stringent capital requirements to the Company and the Bank could, among other things, result in lower returns on invested capital, result in the need for additional capital, and result in regulatory actions if we were to be unable to comply with such requirements, including limitations on our ability to make distributions, including paying out dividends or buying back shares. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term of our funding, restructure our business models, and/or increase our holdings of liquid assets.
Noncompliance with the Bank Secrecy Act and other anti-money laundering statutes and regulations could cause us material financial loss.
The Bank Secrecy Act and the PATRIOT Act contain anti-money laundering and financial transparency provisions intended to detect and prevent the use of the U.S. financial system for money laundering and terrorist financing activities. The Bank Secrecy Act, as amended by the PATRIOT Act, requires depository institutions and their holding companies to undertake activities including maintaining an anti-money laundering program, verifying the identity of clients, monitoring for and reporting suspicious transactions, reporting on cash transactions exceeding specified thresholds, and responding to requests for information by regulatory authorities and law enforcement agencies. FinCEN, a unit of the Treasury Department that administers the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the federal bank regulatory agencies, as well as the U.S. Department of Justice, Drug Enforcement Administration, and IRS.
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There is also increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control. If our policies, procedures, and systems are deemed deficient or the policies, procedures, and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain planned business activities, including acquisition plans, which would negatively impact our business, financial condition, and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
Pending litigation and legal proceedings and the impact of any finding of liability or damages could adversely impact the Company and its financial condition and results of operations.
As more fully described in Note 23, Contingencies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statement and Supplementary Data," of this Annual Report on Form 10-K, the Company believes that the allegations of the Southeastern Pennsylvania Transportation Authority's third amended complaint are without merit and it intends to vigorously defend itself against those claims. It is not possible at this time to estimate reasonably possible losses, or even a range of reasonably possible losses, in connection with the litigation. There can be no assurances, however, that the Company will not incur any losses associated with this litigation or that any losses that are incurred will not be material.
Indemnification costs associated with litigation and legal proceedings could adversely impact the Company and its financial condition and results of operations.
We are generally required, to the extent permitted by Pennsylvania law, to indemnify our current and former directors and officers who are named as defendants in lawsuits. We also have certain contractual indemnification obligations to third parties regarding litigation. Generally, insurance coverage is not available for such indemnification costs we could incur to third parties. Current or future litigation could result in indemnification expenses that could have a materially adverse impact on our financial condition and results of operations.
Risks Related to Liquidity
The Parent Company is a holding company dependent for liquidity on payments from its bank subsidiary, which is subject to restrictions.
The Parent Company is a holding company and depends on dividends, distributions and other payments from the Bank to fund dividend payments and stock repurchases, if permitted, and to fund all payments on obligations. The Bank is subject to laws that restrict dividend payments or authorize regulatory bodies to prohibit or reduce the flow of funds from it to us. In addition, our right to participate in a distribution of assets upon the Bank’s liquidation or reorganization is subject to the prior claims of the Bank’s creditors, including its depositors.
The soundness of other financial institutions could adversely affect the Company.
Our ability to engage in routine funding and other transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have historically led to market-wide liquidity problems, losses of depositor, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions. We could experience increases in deposits and assets as a result of other banks’ difficulties or failure, which would increase the capital we are required to maintain to support such growth.
Risks Related to Owning our Stock
If the Company wants, or is compelled, to raise additional capital in the future, that capital may not be available when it is needed or on terms favorable to current shareholders.
Federal banking regulators require us and our banking subsidiary to maintain adequate levels of capital to support our operations. These capital levels are determined and dictated by law, regulation and banking regulatory agencies. In addition, capital levels are also determined by our management and board of directors based on capital levels that they believe are necessary to support our business operations. At December 31, 2020, all four capital ratios for us and our banking subsidiary were above regulatory minimum levels to be deemed “well capitalized” under current bank regulatory guidelines. To be “well capitalized,” banks generally must maintain a tier 1 leverage ratio of at least 5.0%, CET1 capital ratio of 6.5%, Tier 1 risk-based capital ratio of at least 8.0%, and a total risk-based capital ratio of at least 10.0%.
The Company’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we cannot provide assurance of our ability to raise
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additional capital on terms and time frames acceptable to us or to raise additional capital at all. Additionally, the inability to raise capital in sufficient amounts may adversely affect our operations, financial condition and results of operations. Our ability to borrow could also be impaired by factors that are nonspecific to us, such as severe disruption of the financial markets or negative news and expectations about the prospects for the financial services industry as a whole. If we raise capital through the issuance of additional shares of our common stock or other securities, we would likely dilute the ownership interests of current investors by diluting earnings per share of our common stock and potentially dilute book value per share, depending on the issuance price. The price at which we issue additional shares of stock could be less than the current market price of our common stock. Furthermore, a capital raise through the issuance of additional shares may have an adverse impact on our stock price.
The market price of our common stock is subject to volatility.
The market price of the Company’s common stock has been subject to fluctuations in response to numerous factors, many of which are beyond our control. These factors include actual or anticipated variations in our operational results and cash flows, changes in financial estimates by securities analysts, trading volume, large purchases or sales of our common stock, market conditions within the banking industry, the general state of the securities markets and the market for stocks of financial institutions, as well as general economic conditions.
A reduction in our credit rating could adversely affect our access to capital and could increase our cost of funds.
A credit rating agency regularly evaluates Orrstown and the Bank, and credit ratings are based on a number of factors, including our financial strength and ability to generate earnings, as well as factors not entirely within our control, including conditions affecting the financial services industry, the economy, and changes in rating methodologies. There can be no assurance that we will maintain our current credit ratings. A downgrade of the credit ratings of Orrstown or the Bank could adversely affect our access to liquidity and capital, and could significantly increase our cost of funds, trigger additional collateral or funding requirements, and decrease the number of investors and counterparties willing to lend to us or purchase our securities. This could affect our growth, profitability, and financial condition, including liquidity.
The Parent Company's primary source of income is dividends received from its bank subsidiary.
The Parent Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company also has repurchased shares of its common stock. The Company’s primary source of income is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid from the Bank to the Company without prior approval of regulatory agencies. Restrictions on the Bank’s ability to dividend funds to the Company are included in Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
General Risk Factors
The COVID-19 pandemic has caused a significant global and national economic downturn and unprecedented levels of unemployment, which may adversely affect our business and results of operations, and the future impact of the COVID-19 pandemic on the global, national and local economies and our business, results of operations and financial condition remain uncertain.
The COVID-19 pandemic has caused a significant global and national economic downturn and unprecedented levels of unemployment, which has adversely affected, and is expected to continue to adversely affect, the Company’s business and results of operations, and the future impact of the COVID-19 pandemic on the global, national and local economies and the Company’s business, results of operations and financial condition remain uncertain.
The COVID-19 pandemic has resulted in authorities implementing numerous measures attempting to contain the spread and impact of COVID-19, such as travel bans and restrictions, quarantines, shelter in place orders, and limitations on business activity, including closures. These measures are, among other things, severely restricting global and national economic activity, which is disrupting supply chains, lowering asset valuations, significantly increasing unemployment and underemployment levels, decreasing liquidity in markets for certain securities and causing significant volatility and disruptions in the financial markets. These measures have negatively impacted, and could continue to negatively impact, businesses, market participants, our counterparties and clients, and the global, national and local economies for a prolonged period of time. Should current economic conditions persist or continue to deteriorate, this economic environment could have a continued adverse effect on our business and operations, including, but not limited to: decreased demand for our products and services; protracted periods of lower interest rates; lower asset management fees; and increased credit losses due to deterioration in the financial condition of our consumer and commercial borrowers, including declining asset and collateral values, which may result in an increase in our provision for credit losses and net charge-offs. Additionally, our liquidity and regulatory capital could be adversely impacted by customer withdrawal of deposits, volatility and disruptions in the capital and credit markets, and customer draws on lines of
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credit. To the extent the COVID-19 pandemic continues to adversely affect the economy, and/or adversely affects our business, results of operations or financial condition, it may also have the effect of increasing the likelihood and/or magnitude of other risks including those risks related to market, credit, and business operations, or risks described herein.
In response to the economic and market conditions resulting from the COVID-19 pandemic, governments and regulatory authorities, including central banks, have acted to provide fiscal and monetary stimulus to support the global and national economy. However, there can be no assurance that these measures will stimulate the global and national economy or avert recessionary conditions in markets in which we conduct operations.
We continue to closely monitor the COVID-19 pandemic and related risks as they evolve. The magnitude, duration and likelihood of the current outbreak of COVID-19, further outbreaks of COVID-19, future actions taken by governmental authorities and/or other third parties in response to the COVID-19 pandemic, and its future direct and indirect effects on the global, national and local economies and our business and results of operation are highly uncertain. The COVID-19 pandemic may cause prolonged global, national or local recessionary economic conditions or longer lasting effects on economic conditions than currently exist, which could have a material adverse effect on our business, results of operations and financial condition.
The Company may not be able to attract and retain skilled people.
Competition for the best people in most activities engaged in by us can be intense, and we may not be able to attract and hire sufficiently skilled people to fill open and newly created positions or to retain current or future employees. An inability to attract and retain individuals with the necessary skills to fill open positions, or the unexpected loss of services of one or more of our key personnel, could have a material adverse impact on our business due to the loss of their skills, knowledge of our markets, years of industry experience or the difficulty of promptly finding qualified replacement personnel.
We believe that our continued growth and future success will depend in large part on the skills of our management team and our ability to motivate and retain these individuals and other key personnel. The loss of service of one or more of our executive officers or key personnel could reduce our ability to successfully implement our long-term business strategy, our business could suffer, and the value of our stock could be materially adversely affected. Leadership changes will occur from time to time, and we cannot predict whether significant resignations will occur or whether we will be able to recruit additional qualified personnel. We believe our management team possesses valuable knowledge about the banking industry and that their knowledge and relationships could be very difficult to replicate. Our success also depends on the experience of our branch managers and lending officers and on their relationships with the clients and communities they serve. The loss of these key personnel could negatively impact our banking operations. The loss of key personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our business, financial condition, or operating results.
We could be adversely affected by a failure in our internal controls.
We rely on our employees to design, manage, and operate our systems and controls to assure that we properly enter into, record and manage processes, transactions and other relationships with clients, suppliers and other parties with whom we do business. In some cases, we rely on employees of third parties to perform these tasks. We also depend on employees and the systems and controls for which they are responsible to assure that we identify and mitigate the risks that are inherent in our relationships and activities. These concerns are increased when we change processes or procedures, introduce new products or services, or implement new technologies, as we may fail to adequately identify or manage operational risks resulting from such changes.
As a result of our necessary reliance on employees, whether ours or those of third parties, to perform these tasks and manage resulting risks, we are subject to human vulnerabilities. These range from innocent human error to misconduct or malfeasance, potentially leading to operational breakdowns or other failures. Our controls may not be adequate to prevent problems resulting from human involvement in our business, including risks associated with the design, operation and monitoring of automated systems.
Errors by our employees or others responsible for systems and controls on which we depend and any resulting failures of those systems and controls could result in significant harm to us. This could include client remediation costs, regulatory fines or penalties, litigation or enforcement actions, or limitations on our business activities. We could also suffer damage to our reputation, impacting our ability to attract and retain clients and employees.
We continue to devote a significant amount of effort and resources to constantly strengthening our controls and ensuring compliance with complex accounting standards and regulations. However, these efforts may not be effective in preventing a breach in, or failure of, our controls.
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Negative public opinion could damage our reputation and adversely affect our earnings.
Reputational risk, or the risk to the Company's earnings and capital from negative public opinion, is inherent in our business. Negative public opinion can result from the actual or perceived manner in which we conduct our business activities, including banking operations and trust and investment operations, our management of actual or potential conflicts of interest and ethical issues, and our protection of confidential client information. Negative public opinion can adversely affect the Company's ability to keep and attract clients and can expose the Company to litigation and regulatory action. Although we take steps to minimize reputation risk in the way we conduct our business activities and deal with our clients, communities and vendors, these steps may not be effective.
Acts of terrorism, natural disasters, global climate change, pandemics and global conflicts may have a negative impact on our business and operations.
Acts of terrorism, natural disasters, global climate change, pandemics, global conflicts or other similar events could have a negative impact on our business and operations. While we have in place business continuity plans, such events could still damage our facilities, disrupt or delay the normal operations of our business (including communications and technology), result in harm to, or cause travel limitations on, our employees, and have a similar impact on our clients, suppliers, third-party vendors and counterparties. These events also could impact us negatively to the extent that they result in reduced capital markets activity, lower asset price levels, or disruptions in general economic activity in the U.S. or abroad, or in financial market settlement functions. In addition, these or similar events may impact economic growth negatively, which could have an adverse effect on our business and operations, and may have other adverse effects on us in ways that we are unable to predict.
ITEM 1B – UNRESOLVED STAFF COMMENTS
None.
ITEM 2 – PROPERTIES
Our principal executive offices are located at 77 East King Street, Shippensburg, Pennsylvania, with additional executive and administrative offices at 4750 Lindle Road, Harrisburg, Pennsylvania. These facilities are owned by the Bank, which also maintains its principal and additional executive and administrative offices at those locations.
We own or lease other premises for use in conducting our business activities, including bank branches, an operations center, and offices in Berks, Cumberland, Dauphin, Franklin, Lancaster, Perry, and York Counties, Pennsylvania and Anne Arundel, Baltimore, Howard, and Washington Counties, Maryland, as well as Baltimore City, Maryland. We believe that the properties currently owned and leased are adequate for present levels of operation. We are constantly evaluating the best and most efficient mix of branch locations to service our clients due to evolving trends in our industry and increased client engagement through digital channels.
In October 2019, Orrstown announced the consolidation of five Pennsylvania branches in Franklin and Perry Counties that averaged less than $20.0 million in deposits per location into other, larger Orrstown Bank branches, as well as the sale of an operation's center facility. Orrstown expects that these efforts will improve the profitability of the remaining branch locations and eliminate close to 50,000 square feet of excess back office space. The branch consolidations were completed in January 2020, and the sale of the operations center facility was completed in the second quarter of 2020. In October 2020, the Company announced the consolidation of an additional six branch locations, the discontinuance of three loan production offices, and a reduction in back-office real estate. These facilities were closed in the first quarter of 2021.
ITEM 3 – LEGAL PROCEEDINGS
Information regarding legal proceedings is included in Note 23, Contingencies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statement and Supplementary Data."
ITEM 4 – MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is traded on the NASDAQ Capital Market under the symbol “ORRF.” At the close of business on March 11, 2021, there were 0 shareholders of record.
The Board declared cash dividends of $0.68 and $0.60 per common share in 2020 and 2019, respectively. Our Board is currently committed to continuing to pay regular cash dividends; however, there can be no assurance as to future dividends because they are dependent on our future earnings, capital requirements and financial condition. Restrictions on the payment of dividends are discussed in Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." On January 20, 2021, the Board declared a cash dividend of $0.18 per common share, which was paid on February 8, 2021, to shareholders of record as of February 1, 2021.
Securities Authorized for Issuance under Equity Compensation Plans
Information regarding the Company's equity compensation plans is included in Part III, Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Issuer Purchases of Equity Securities
In September 2015, the Board of Directors of the Company authorized a share repurchase program under which the Company may repurchase up to 5% of the Company's outstanding shares of common stock, or approximately 416,000 shares, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Securities Exchange Act of 1934, as amended. When and if appropriate, repurchases may be made in open market or privately negotiated transactions, depending on market conditions, regulatory requirements and other corporate considerations, as determined by management. Share repurchases may not occur and the share repurchase program may be discontinued at any time.
No shares were repurchased from October 1, 2020 to December 31, 2020. As of December 31, 2020, 154,680 shares had been repurchased under the program at a total cost of $2.6 million, or $16.88 per share and the maximum number of shares that may yet be purchased under the plan is 261,320 shares.
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PERFORMANCE GRAPH
The performance graph below compares the cumulative total shareholder return on our common stock with other indexes: the SNL index of banks with assets between $1.0 billion and $5.0 billion, the S&P 500 Index, and the NASDAQ Composite index. The graph assumes an investment of $100 on December 31, 2015 and reinvestment of dividends on the date of payment without commissions. Shareholder returns on our common stock are based on trades on the NASDAQ Stock Market. The performance graph represents past performance and should not be considered to be an indication of future performance.
Period Ending
Source: S&P Global Market Intelligence © 2021
In accordance with the rules of the SEC, this section captioned “Performance Graph” shall not be incorporated by reference into any of our future filings made under the Exchange Act or the Securities Act. The Performance Graph and its accompanying table are not deemed to be soliciting material or to be considered filed under the Exchange Act or the Securities Act.
Recent Sales of Unregistered Securities
The Company has not sold any equity securities within the past three years which were not registered under the Securities Act.
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ITEM 6 – SELECTED FINANCIAL DATA
At or For The Year Ended December 31,
Summary of Operations
Per Share Information
Stock Price Statistics
Year-End Information
Financial Ratios
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ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is intended to assist readers in understanding the consolidated financial condition and results of operations of Orrstown and should be read in conjunction with our Consolidated Financial Statements and notes thereto included in this Annual Report on Form 10-K. Certain prior period amounts presented in this discussion and analysis have been reclassified to conform to current period classifications.
Overview
The results of our operations are highly dependent on economic conditions and market interest rates. Our profitability for the years ended December 31, 2020, 2019 and 2018 was influenced by our continued organic growth and ongoing expansion into targeted markets, the acquisitions of Mercersburg and Hamilton, and a continued focus on maintaining strong asset quality. These and other matters are discussed more fully below.
During the year ended December 31, 2020, the Company recognized charges associated with the consolidation of six branch locations, the discontinuance of three loan production offices, a reduction in back-office real estate and staffing reductions. These actions were initiated due to evolving client preferences for the digital delivery of products and services. In addition, the anticipated future cost reductions resulting from these actions will prepare the Company for a challenging operating environment in 2021. A charge of $1.6 million was recorded in the year ended December 31, 2020, which included $1.3 million related to branch consolidations.
Critical Accounting Estimates
The Company's consolidated financial statements are prepared in accordance with GAAP, and follow general practices within the financial services industry. The most significant accounting policies followed by the Company are presented in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." In applying those accounting policies, the Company's management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. Certain of the critical accounting estimates are more dependent on such judgment and, in some cases, may contribute to volatility in our reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. Some of the more significant areas in which the Company's management applies critical assumptions and estimates include the following.
Accounting for loan losses — The loan portfolio is the largest asset on the Company's consolidated balance sheets. The allowance for loan losses represents the amount that, in management’s judgment, appropriately reflects credit losses inherent in the loan portfolio at the balance sheet date. A provision for credit losses is recorded to adjust the level of the ALL as deemed necessary by management. In estimating losses inherent in the loan portfolio, assumptions and judgment are applied to measure amounts and timing of expected future cash flows, collateral values and other factors used to determine the borrowers’ abilities to repay obligations. Historical loss trends are also considered, as are economic conditions, industry trends, portfolio trends and borrower-specific financial data. Loans acquired at a discount, that is, in part, attributable to credit quality, are initially recorded at fair value with no carry-over of an acquired entity’s previously established ALL. Cash flows expected at acquisition, in excess of estimated fair value, are recognized as interest income over the remaining lives of the loans. Subsequent decreases in the expected principal cash flows require the Company to evaluate the need for additions to the ALL. Subsequent improvements in expected cash flows result, first, in the recovery of any applicable ALL and, then, in the recognition of additional interest income over the remaining lives of the loans. Changes in the circumstances considered when determining management’s estimates and assumptions, could result in changes to those estimates and assumptions, and also in adjustment of the ALL, or, in the case of loans acquired at a discount, increases in interest income in future periods. The Company has delayed the implementation of ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The implementation deadline of ASU 2016-13 was extended for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022.
Valuation methodologies — Management applies various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include derivatives and mortgage servicing assets. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, costs of servicing and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on our results of operations, financial condition or disclosures of fair value information. In addition to valuation, the Company must assess whether there are any declines in value
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below the carrying value of certain assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statements of income. Examples include investment securities, mortgage servicing rights, goodwill and core deposit intangible assets, among others.
Readers of the Company's consolidated financial statements should be aware that the estimates and assumptions used may need to be updated in future financial presentations for changes in circumstances, business or economic conditions, in order to fairly represent the condition of the Company at that time.
Economic Climate, Inflation and Interest Rates
Preliminary real GDP for the fourth quarter of 2020 resulted in an annualized increase of 4.0%. This is a substantial decrease from an increase of 38.3% for the third quarter of 2020, which reflected the impact of government stimulus and the gradual re-opening of the economy from COVID-19 related shutdowns as multiple vaccines have been approved. Overall, real GDP decreased by 3.5 % for 2020 as compared to an increase of 2.2% in 2019.The increase in fourth quarter of 2020 reflected both the continued economic recovery from the sharp declines earlier in the year and the ongoing impact of the COVID-19 pandemic, including new restrictions and closures that took effect in some parts of the country. The full economic effects of the COVID-19 pandemic cannot be quantified in the GDP estimate for the fourth quarter of 2020 because the impacts are generally embedded in source data and cannot be separately identified. As restrictions continue to be lifted and the world population gets vaccinated, there is hope that the leisure, travel and entertainment industries will recover. Weekly jobless claims remain high but the Labor Department announced a decline to 730,000 on February 25, 2021, a decline of 110,000 claims from the previous report. Also, the prospects for a new government stimulus packages have recently been renewed, but remain uncertain.
The pace of U.S. economic growth weakened substantially late in the first quarter of 2020 and into the second quarter of 2020 as over 30 million people in the U.S filed for unemployment since mid-March 2020. Early in 2020, a novel coronavirus (“COVID-19”) emerged and spread, first in China and then around the globe. The fast spread of the virus and the fear that resulted combined to create a high level of uncertainty about the near and intermediate future economic outlook. Because of this uncertainty, markets were pricing in a wide range of potential outcomes by buying sovereign government bonds, especially U.S. Treasuries, and selling stocks and bonds not issued by sovereign governments. The COVID-19 pandemic has adversely affected, and is likely to continue to adversely affect, economic activity globally, nationally and locally. Actions taken around the world to help mitigate the spread of COVID-19 include restrictions on travel, quarantines in certain areas, and forced closures for certain types of public places and businesses, as well as shelter-in-place orders by many states. These restrictions have slowly been lifted as multiple vaccines have been rolled out late in the fourth quarter of 2020.
The decline in second quarter GDP reflected the response to COVID-19, as shelter-in-place orders issued in March and April were partially lifted in some areas of the country in May and June, and government pandemic assistance payments were distributed to households and businesses. This led to shifts in economic activity, as businesses remained closed or operated remotely and consumers and businesses significantly reduced or redirected their spending. Actions taken to mitigate the spread of COVID-19 have had, and are expected to continue to have, an adverse impact on the economies and financial markets of many countries, including the geographical area in which the Company operates.
Due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling for the first time below 1.00% on March 3, 2020; it was at 0.69% on September 30, 2020. On March 3, 2020, in reaction to the increase in uncertainty, the Federal Reserve cut the Fed Funds rates by 50 basis points between regularly scheduled meetings to a target range of 1.00% to 1.25%. On March 11, 2020, the World Health Organization declared COVID-19 a global pandemic. On March 13, 2020, a national emergency was declared by President Trump under the National Emergencies Act. On March 15, 2020, the Federal Reserve responded by again reducing the Fed Funds rate, this time by 100 basis points, to 0% to 0.25%. The Fed Funds rate was left unchanged in future meetings with rates expected to remain at this level for an extended period of time. These reductions in interest rates and other effects of the COVID-19 pandemic may adversely affect the Company's financial condition and results of operations in future periods. It is unknown how long the adverse conditions associated with the COVID-19 pandemic will last and what the complete financial effect will be to the Company. It is reasonably foreseeable that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.
The majority of the assets and liabilities of a financial institution are monetary in nature, and therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the growth of total assets and on noninterest expenses, which tend to rise during periods of general inflation. Inflationary pressures remain modest and there is great uncertainty about when, or if, inflation will increase and pressure interest rates to move higher.
As the Company’s balance sheet consists primarily of financial instruments, interest income and interest expense are greatly influenced by the level of interest rates and the slope of the yield curve as well as the mix of assets and funding. The Company has been able to grow its net interest income by $14.3 million from 2019 to 2020, through a combination of organic
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commercial loan growth and the recognition of SBA PPP processing fee income. Competition for quality lending opportunities and deposits remains intense, which, together with a flattening yield curve, will continue to challenge our ability to grow our net interest margin and to leverage our overhead expenses.
Results of Operations
Summary
Earnings in 2020 reflected continuing increased interest income from expanding loan and investment portfolios, partially offset by the impact of decreasing interest rates and an overall increase in interest expense. In addition, the comparability of operating results for 2020 with 2019 has been impacted by the Hamilton acquisition, which was completed on May 1, 2019. Hamilton added loans and deposits totaling $347.1 million and $388.2 million, respectively.
The Company recorded net income of $26.5 million, $16.9 million and $12.8 million for 2020, 2019 and 2018, respectively. Diluted earnings per share totaled $2.40, $1.61 and $1.50 for 2020, 2019 and 2018, respectively.
Net interest income totaled $83.6 million, $69.3 million and $52.2 million for 2020, 2019 and 2018, respectively, principally reflecting our expanded geographic footprint, organic growth in commercial loans from an expanded sales force as we continued to take advantage of market opportunities, and SBA PPP processing fee income. As previously noted, interest rates increased throughout 2018 and 2019 and decreased throughout 2020, contributing to fluctuations in yields on loans and investments, and, to a lesser extent, costs of interest-bearing liabilities.
Asset quality trends continue to exhibit low levels of charge-offs and non-performing loans. The provision for loan losses totaled $5.3 million, $900 thousand and $800 thousand in 2020, 2019 and 2018, respectively. The increase in provision for loan losses in 2020 was primarily a result of increased uncertainty related to the COVID-19 pandemic.
Noninterest expenses totaled $74.1 million, $77.3 million and $57.9 million for 2020, 2019 and 2018, respectively. The changes in certain components of noninterest expenses between years reflect the Hamilton acquisition, and the Company's continued focus on aligning its talent and locations with its business model. Salaries and employee benefits expense increased $7.0 million from 2018 to 2019 and by $3.9 million from 2019 to 2020. Occupancy and furniture and fixture costs increased $1.9 million from 2018 to 2019 and $0.5 million from 2019 to 2020 as new and acquired branch locations were brought on line. In 2020, the Company incurred $1.3 million in pretax branch consolidation expenses, with $9.0 million incurred in 2019 for pretax merger related and branch consolidation expenses. During 2020, the Company recorded a loss of $736 thousand associated with the sale of an operations facility.
Income tax expense totaled $6.0 million, $2.7 million and $1.6 million for 2020, 2019 and 2018, or an effective tax rate of 18.6%, 13.8% and 11.4% respectively. The Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The difference in the effective tax rate in 2020 from prior years was primarily due to an increase in estimated earnings before income taxes.
Net Interest Income
Net interest income is the primary component of Orrstown's revenue. Interest-earning assets include loans, securities and federal funds sold. Interest-bearing liabilities include deposits and borrowed funds.
Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities, and the composition of those assets and liabilities. “Net interest spread” and “net interest margin” are two common statistics related to changes in net interest income. Net interest spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. Net interest margin is the ratio of net interest income to average earning asset balances. Through the use of noninterest-bearing demand deposits and shareholders' equity, the net interest margin exceeds the net interest spread, as these funding sources are noninterest-bearing.
The FRB influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the prime interest rate. In 2018, the prime rate rose with 25 basis point increases in each of March, June, September and December, ending the year at 5.50%. In 2019, 25 basis point reductions occurred in August, September and October and the prime rate ended the year at 4.75%. In March 2020, the prime rate was reduced by 150 basis points and ended the year at 3.25%.
Core deposits are deposits that are stable, lower cost and generally reprice more slowly than other deposits when interest rates change. Core deposits, which exclude certificates of deposit, are typically funds of local clients who also have a borrowing or other relationship with the Bank. We are primarily funded by core deposits, with noninterest-bearing demand deposits
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historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on our net interest income and net interest margin in a rising interest rate environment.
Net interest income totaled $83.6 million, $69.3 million and $52.2 million in 2020, 2019 and 2018, respectively. The following table presents net interest income, net interest spread and net interest margin on a taxable-equivalent basis for 2020, 2019 and 2018. Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 21% federal corporate tax rate for 2020, 2019 and 2018, reflecting our statutory tax rates for those years.
Assets
Liabilities and Shareholders’ Equity
Taxable-equivalent net interest margin 3.44 % 3.43 % 3.36 %
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NOTES TO ANALYSIS OF NET INTEREST INCOME:
(2) Average balances include nonaccrual loans.
(3) Interest income on loans includes prepayment and late fees.
The following table presents changes in net interest income on a taxable-equivalent basis for 2020, 2019 and 2018 by rate and volume components.
AverageVolume AverageRate Total AverageVolume AverageRate Total
Interest Income
Interest Expense
Securities sold under agreements to repurchase 118 (145) (27) (7) 41 33
average rate and the remainder is attributable to rate.
2020 versus 2019
In 2020, net interest income increased $14.3 million, or 20.7%, compared with 2019. Net interest income for 2020 on a taxable-equivalent basis increased $14.1 million, or 20.0%, compared with 2019. The Company’s net interest spread increased five basis points to 3.29% for 2020 compared with 2019. Taxable-equivalent yields on interest-earning assets and costs of interest-bearing liabilities both increased from 2019 to 2020, reflecting increased average balances from SBA PPP loans, organic growth and acquisitions, partially offset by changes in the interest rate environment between years. Other factors impacting the comparison of taxable-equivalent yields between 2019 and 2020 include the effect of purchase accounting related to the Hamilton acquisition and the timing of our adjustments to rates paid on interest-bearing deposits in response to market demand.
Interest income on a taxable-equivalent basis on loans increased $12.3 million, or 16.3%, from 2019 to 2020. The increase resulted from SBA PPP loans originated in 2020, which drove an increase in average loan volume and a decrease in yield, with average loans increasing $435.7 million, or 29.2%, and yield decreasing 50 basis points from 5.06% in 2019 to 4.56% in 2020. For the year ended December 31, 2020, SBA PPP loans had an average balance of $318.4 million and an average yield of 3.5%. Accretion of purchase accounting adjustments in connection with acquisitions increased interest income by $2.3 million, $3.8 million and $335 thousand in 2020, 2019 and 2018, respectively.
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Interest income earned on a taxable-equivalent basis on securities decreased by $4.7 million, or 27.4%, from 2019 to 2020, with both average volume and yield decreasing. Average securities decreased by $5.2 million, or 1.0%, and the taxable-equivalent yield decreased from 3.43% in 2019 to 2.52% in 2020. Contributing to the overall decrease in interest income on securities was a decrease in average securities balances of $5.2 million from 2019 to 2020. This was partially offset by declines in the yield on floating rate securities, which fell as the FRB reduced short-term rates by 75 basis points in the second half of 2019 and an additional 150 basis points in the first half of 2020.
Interest expense on deposits and borrowings decreased by $7.7 million from 2019 to 2020, despite an increase in the average balance of interest-bearing liabilities of $247.9 million, or 14.1%. The cost of interest-bearing liabilities declined by 55 basis points from 1.35% in 2019 to 0.80% in 2020 due to a decline in market interest rates. In addition, there was an increase in non-interest bearing liabilities of $147.5 million, or 62.9% from 2019 to 2020 due primarily to the funding of SBA PPP loans in 2020.
The Company's ability to attract new deposits in all categories, but in particular interest-bearing demand deposits, resulted in an increase in average interest-bearing deposits totaling $236.3 million, or 25.7%, in 2020. Interest expense for these deposits decreased by $3.5 million, with the cost of funds decreasing from 0.90% in 2019 to 0.41% in 2020. The decrease was driven by the decreasing market rates from 2019 through 2020 due to the rate decreases commenced by the FRB.
The Company also increased its average FHLB advances in 2020. Borrowings generally have higher interest rates associated with them than interest-bearing deposits. Interest expense on all borrowings decreased $374 thousand in 2020, with average balances decreasing $9.2 million for short-term borrowings while FHLB advances increased $75.7 million. The average rate paid on short-term borrowings decreased from 1.28% in 2019 to 0.48% in 2020 and the average rate paid on FHLB advances decreased from 2.21% in 2019 to 1.07% in 2020.
2019 versus 2018
In 2019, net interest income increased $17.1 million, or 32.9%, compared with 2018. Net interest income for 2019 on a taxable-equivalent basis increased $16.8 million, or 31.3%, compared with 2018. The Company’s net interest spread increased three basis points to 3.24% for 2019 compared with 2018. Taxable-equivalent yields on interest-earning assets and costs of interest-bearing liabilities both increased from 2018 to 2019, reflecting increased average balances from organic growth and acquisitions, partially offset by changes in the interest rate environment between years. Other factors impacting the comparison of taxable-equivalent yields between 2018 and 2019 include the effect of purchase accounting related to the Mercersburg and Hamilton acquisitions and the timing of our adjustments to rates paid on interest-bearing deposits in response to market demand.
Interest income on a taxable-equivalent basis on loans increased $24.5 million, or 48.1%, from 2018 to 2019. The increase resulted from an increase in both average loan volume and yield, with average loans increasing $392.2 million, or 35.6%, and interest income on loans increasing 42 basis points from 4.64% in 2018 to 5.06% in 2019. The Company's geographic expansion and sales efforts with additional loan officers continued to drive loan growth in 2019 across most loan classes. Increases in prime lending rates in 2018 contributed to an increased yield in the first half of 2019, but were partially offset by rate decreases in the second half. In addition, the middle of the yield curve inverted for much of 2019, which lowered the rate on new loans more than the rate on new deposits, which pressured net interest margin. Accretion of purchase accounting adjustments in connection with the acquisitions increased 2019 interest income by $3.8 million compared with $335 thousand in 2018.
Interest income earned on a taxable-equivalent basis on securities increased $1.4 million, or 8.9%, from 2018 to 2019, with both average volume and yield increasing. Average securities increased $19.8 million, or 4.1%, and the taxable-equivalent yield increased from 3.28% in 2018 to 3.43% in 2019. Contributing to the overall increase in interest income on securities was the purchase of higher yielding, longer maturity, tax-free state and political subdivisions investments in the third quarter of 2018, that were subsequently sold in the third quarter of 2019. This was partially offset by declines in the yield of floating rate securities, which fell as the FRB reduced short-term rates by 75 basis points in the second half of 2019.
Interest expense on deposits and borrowings increased $10.2 million from 2018 to 2019, as the average balance of interest-bearing liabilities increased $393.1 million, or 28.9%. Interest expense on interest-bearing deposits declined less than the decline in market rates due to competitive factors in the marketplace.
Our ability to attract new deposits in all categories, but in particular interest-bearing demand deposits, resulted in an increase in average interest-bearing deposits totaling $152.2 million, or 19.8% in 2019, of which approximately $51.0 million was acquired in the Hamilton acquisition. Interest expense for these deposits increased $3.3 million, with the cost of funds increasing from 0.65% in 2018 to 0.90% in 2019. The increase was driven by increasing market rates throughout 2018, followed by falling short-term rates once the FRB began to decrease rates in the second half of 2019. As noted, yields on
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interest-bearing deposits did not fall as much as market rates due to competitive factors. As a result, interest was paid at higher rates on interest-bearing deposits in 2019 than in 2018.
We also decreased our average short-term borrowings in 2019 in favor of brokered deposits at more attractive rates in early 2019. In late 2018, we issued $32.5 million in aggregate principal amount of subordinated notes, the proceeds of which were designated for the cash portion of merger and acquisition activity and for general corporate purposes. Borrowings generally have higher interest rates associated with them than interest-bearing deposits. Interest expense on all borrowings increased $1.1 million in 2019, with average balances decreasing $49.2 million for short-term borrowings while long-term borrowings also decreased $3.0 million. The average rate paid on short-term borrowings increased from 1.94% in 2018 to 1.95% in 2019 and the average rate paid on long-term borrowings increased from 1.95% in 2018 to 2.21% in 2019.
Provision for Loan Losses
The Company recorded a provision for loan losses of $5.3 million, $900 thousand and $800 thousand in 2020, 2019, and 2018, respectively. In calculating the provision for loan losses, both quantitative and qualitative factors, including the Company's favorable historical charge-off data and stable economic and market conditions, were considered in the determination of the adequacy of the ALL. Net charge-offs and loan growth resulted in the determination that a provision expense was required in 2020, 2019 and 2018. The increase in provision from 2019 to 2020 was due primarily to the impact of COVID-19 on the Company's loan portfolio as a new qualitative factor was created to address the associated risk.
See further discussion in the “Asset Quality” and “Credit Risk Management” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Noninterest Income
The following table compares noninterest income for 2020, 2019 and 2018.
Gain on sale of commercial loans 2,803 — — 2,803 — — % — %
2020 versus 2019
Noninterest income decreased by $230 thousand from 2019 to 2020. The Company continues to focus on growth in relationship fee-based revenue for commercial and retail clients. The following were significant factors in that net decrease.
•A decline of $530 thousand in service charges on deposit accounts reflects the impact of COVID-19, as the Company waived certain fees for a period of time and experienced an overall decline in account usage.
•Interchange income reflected an overall increase in our clients' activity and card usage due to COVID-19.
•Mortgage banking income increased by $2.7 million due to an increase in loans sold to $205.2 million in 2020 from $106.7 million in 2019 as interest rate declines led to significant refinancing activity.
•Swap fee income declined by $350 thousand from 2019 to 2020. In 2020, Orrstown began entering into interest rate swap agreements directly with its commercial customers. This offering replaced the third party swap transactions
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initiated in the prior year. This fee revenue will fluctuate from quarter to quarter, but client demand to fix loan interest rates declined slightly in the current rate environment.
•Trust and brokerage income reflected increased revenue from strong stock market performance.
•Income from life insurance included death benefit proceeds of $58 thousand in 2020 and $255 thousand in 2019.
•There was a decline of $4.8 million in investment gains from 2019 to 2020 due to prior year asset/liability management strategies which resulted in net gains of $4.8 million on sales of securities, as market conditions presented opportunities to improve responsiveness of the portfolio to interest rate conditions.
2019 versus 2018
Noninterest income increased $7.5 million from 2018 to 2019. We continue to focus on growth in relationship fee-based revenue for commercial and retail clients. In addition to the impact of the Mercersburg and Hamilton acquisitions, the following were significant factors in that net increase.
•Service charges on deposit accounts and interchange on debit card income reflected an overall increase in the Company's clients' activity and card usage from our organic growth as well as the expanded client base from the acquisitions. These stable sources of fee revenue should grow over time as we add retail and commercial clients.
•Gains on SBA loan sales, which are included in other service charges, commissions and fees, decreased approximately $300 thousand from 2018 to 2019.
•The Company began offering interest rate hedging products through a third party in the second half of 2019, whereby its receives a fee at loan closing.
•Trust and brokerage income reflected increased revenue from generally improved market conditions, additional advisors and increased estate fees in 2019. We continue to look to build this business over the coming years and have recently begun efforts to offer wealth management products in our acquired Baltimore market area.
•The increase in mortgage banking activities reflects the increase in loans sold from $93.1 million in 2018 to $106.7 million in 2019. With interest rates currently at low levels and recent market expansion efforts, we see opportunities to increase our market share with existing clients by increasing our focus on branch referrals and local market outreach efforts.
•Income from life insurance included death benefit proceeds in both 2019 and 2018, with the increase between years principally attributable to life insurance assets obtained through acquisitions.
•In both 2019 and 2018, asset/liability management strategies resulted in net gains on sales of securities, as market conditions presented opportunities to improve responsiveness of the portfolio to interest rate conditions, while also considering funding requirements of anticipated lending activity.
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Noninterest Expenses
The following table compares noninterest expenses for 2020, 2019 and 2018.
$ Change % Change
2020 versus 2019
Noninterest expenses decreased by $3.2 million from 2019 to 2020. The following were significant factors in that net decrease.
•The salaries and employee benefit increase includes the impact in 2020 of additional employees, including new client-facing employees in new branches in targeted expansion markets and others that were hired throughout 2019, as well as additional new relationship managers. Higher costs in 2020 also include annual merit and incentive compensation increases in 2020, increased stock compensation expense from additional share-based awards granted in 2020, and higher medical costs for claims activity and the expanded workforce.
•Occupancy expense in 2020 reflects a full period of expense for our expanded presence in Lancaster County, Pennsylvania, with two branch banking locations added in the first quarter of 2019. In addition, lease termination costs of $588 thousand were recognized in 2020 as a part of the Company's restructuring plan.
•Advertising and bank promotions expense declined from 2019 to 2020 due to additional costs incurred in 2019 for the celebration of the Bank's 100th anniversary year, as well as marketing associated with the acquisitions.
•FDIC insurance expense reflects credits received in the second half of 2019 under the FDIC's regulations to provide credits, when the reserve ratio reaches 1.38%, to banks with consolidated assets below $10 billion. FDIC insurance expense increased in 2020 after the remaining credits were used to partially offset first quarter 2020 expense.
•In 2020, branch consolidation costs totaled $1.3 million and there were no merger related costs. These costs primarily represented lease termination costs. Merger related costs incurred in 2019 totaled $8.0 million. In the fourth quarter of 2019, the Company recorded $1.0 million in expenses associated with the announced consolidation of five branches into other, larger Bank branches, which was completed in January 2020. The expenses principally represented owned real estate write downs, lease termination costs, severance benefits for impacted employees and other branch exit related expenses.
•The insurance claim receivable (recovery) write off relates to an expense recorded in 2019 to write off an insurance claim receivable from a 2018 cyber security incident. In 2019, the Company received reimbursement totaling $59 thousand for the write off. In February 2020, the Company received an additional $486 thousand reimbursement in a final settlement of the matter.
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•Other line items within noninterest expenses are generally attributable to normal fluctuations in the ordinary course of business.
2019 versus 2018
Noninterest expenses increased $19.4 million from 2018 to 2019. In addition to the impact of the Mercersburg and Hamilton acquisitions, the following were significant factors in that net increase.
•The salaries and employee benefits increase includes the impact in 2019 of additional employees, including new client-facing employees in new branches in targeted expansion markets and others that were hired throughout 2018 and 2019, as well as additional new relationship managers. Higher costs in 2019 also include annual merit and incentive compensation increases in 2019, increased stock compensation expense from additional share-based awards granted in 2019, and higher medical costs for claims activity and the expanded workforce.
•Occupancy and furniture and equipment expenses in 2019 reflect a full period of expense for our expanded presence in Lancaster County, Pennsylvania, with two branch banking locations added in the third and fourth quarters of 2018 and two in the first quarter of 2019.
•Increases in data processing reflect volume increases and physical growth and costs associated with more sophisticated product and service offerings.
•Advertising and bank promotions expense includes additional costs incurred in 2019 for the celebration of the Bank's 100th anniversary year, as well as marketing associated with the acquisitions.
•FDIC insurance expense reflects credits received in the second half of 2019 under the FDIC's regulations to provide credits, when the reserve ratio reaches 1.38%, to banks with consolidated assets below $10 billion.
•Intangible asset amortization increased due to the core deposit intangibles recorded in the Mercersburg and Hamilton acquisitions.
•Merger related costs incurred in 2019 totaled $8.0 million and represented principally data processing contract termination costs, employee contract termination costs and legal and consulting fees for the Hamilton acquisition and system conversion expenses for both the Mercersburg and Hamilton acquisitions. In the fourth quarter of 2019, the Company recorded $988 thousand in expenses associated with the announced consolidation of five branches into other, larger Bank branches, which was completed in January 2020. The expenses principally represented owned real estate write downs, lease termination costs, severance benefits for impacted employees and other branch exit related expenses.
•The insurance claim receivable write off relates to an expense recorded in 2019 to write off an insurance claim receivable from a 2018 cyber security incident. In 2019, the Company received reimbursement totaling $59 thousand for the write off. In February 2020, the Company received an additional $486 thousand reimbursement in a final settlement of the matter.
•Other line items within noninterest expenses are generally attributable to normal fluctuations in the ordinary course of business.
Income Taxes
Income tax expense totaled $6.0 million, $2.7 million and $1.6 million for 2020, 2019 and 2018, respectively. The effective tax rate for 2020 was 18.6% compared with 13.8% for 2019 and 11.4% for 2018. Generally, the Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The difference in the effective tax rate in 2020 from prior years was primarily due to an increase in estimated earnings before income taxes. In 2019, the Company's effective tax rate increased principally due to increased profitability, offset partially by benefits realized from a $185 thousand expense reduction related to a favorable tax law clarification on the treatment of life insurance assets of an acquired entity, as well as a $334 thousand expense reduction related to an increase in deferred state income taxes due to a state tax rate change resulting from the Hamilton acquisition.
Note 8, Income Taxes, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," includes a reconciliation of our federal statutory tax rate to the Company's effective tax rate, which is a meaningful comparison between years and measures income tax expense as a percentage of pretax income.
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Financial Condition
Management devotes substantial time to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and management of the risks associated with these investments.
Securities Available for Sale
The Company utilizes securities available for sale to manage interest rate risk, to enhance income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings.
The Company has established investment policies and an asset management policy to assist in administering our investment portfolio. Decisions to purchase or sell these securities are based on economic conditions and management’s strategy to respond to changes in interest rates, liquidity, pledges to secure deposits and repurchase agreements and other factors while trying to maximize return on the investments. We may segregate our investment portfolio into three categories: “securities held to maturity,” “trading securities” and “securities available for sale.” At December 31, 2020, management has classified the entire securities portfolio as available for sale, which is accounted for at current market value with unrealized gains and losses excluded from earnings and reported in OCI, net of income taxes.
Our securities available for sale portfolio includes debt investments that are subject to varying degrees of credit and market risks, which arise from general market conditions, and factors impacting specific industries, as well as news that may impact specific issues. Management monitors its debt securities, using various indicators in determining whether a debt security is other-than-temporarily impaired, including the amount of time the security has been in an unrealized loss position, and the extent of the unrealized loss. In addition, management assesses whether it is likely we will have to sell the security prior to recovery, or if we are able to hold the security until the price recovers. For those debt securities in which management concludes the security is other-than-temporarily impaired, it recognizes the credit component of an OTTI impairment in earnings and the remaining portion in OCI. Management considers the asset quality of our debt security portfolio to be strong; therefore, the Company did not record any OTTI expense in 2020, 2019 or 2018.
The following table summarizes the fair value of securities available for sale at December 31, 2020, 2019 and 2018.
GSE residential mortgage-backed securities 4,293 — —
Private label residential CMOs — — 143
The Company decreased its investment portfolio in 2020, with the average balance of securities decreasing from $499.6 million for the year ended December 31, 2019 to $494.4 million for the year ended December 31, 2020.
In late 2018, the Company increased its holdings of longer maturity state and political subdivisions in anticipation of falling interest rates. In 2019, interest rates fell and the attractiveness of tax-free state and political subdivisions declined. In response, we reduced our holdings of longer maturity tax-free state and political subdivisions at a gain. These securities were replaced with additional asset-backed and private label commercial CMOs that were either floating rate or had shorter average lives than the state and political subdivision investments.
Asset-backed securities and CMOs provide monthly cash flows that may be used, in part, to meet anticipated loan demand in 2020, as management anticipates the loan portfolio will continue to grow.
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The following table shows the maturities of investment securities at book value at December 31, 2020, and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 21% federal income tax rate.
States and political subdivisions
Average maturity (years) — — 7.6 16.9 14.4
GSE residential mortgage-backed securities
Yield — % — % — % 1.84 % 1.84 %
Average maturity (years) — — — 0.3 0.3
GSE residential CMOs
Yield — % — % — % 2.16 % 2.16 %
Average maturity (years) — — — 23.1 23.1
Non-agency CMOs
Yield — % — % — % 1.09 % 1.09 %
Average maturity (years) — — — 4.5 4.5
Private label commercial CMOs
Asset-backed
Other
Yield — % 2.45 % — % — % 1.64 %
Average maturity (years) — 2.4 — — 1.6
Total
The average maturity is based on the contractual terms of the debt or mortgage-backed securities, and does not factor in required repayments or anticipated prepayments. At December 31, 2020, the weighted average estimated life is 20 years for mortgage-backed and CMO securities, and 21 years for asset-backed securities, based on current interest rates and anticipated prepayment speeds.
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The following table summarizes the credit ratings and collateral associated with the Company's investment portfolio, excluding equity securities, at December 31, 2020:
PACE Loan ABS 1 % $ 5,147 $ 5,243 5 % 100 % — % — % — % — % PACE Loans
Bank CDs — % $ 249 $ 249 — % — % — % — % 100 % FDIC Insured CD
(1) Minimum of 97% guaranteed by U.S. government
(3) 100% guaranteed by U.S. government agencies
Loan Portfolio
The Company offers a variety of products to meet the credit needs of its borrowers, principally commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.
Generally, we are permitted under applicable law to make loans to single borrowers (including certain related persons and entities) in aggregate amounts of up to 15% of the sum of total capital and the ALL. The Company’s legal lending limit to one borrower was $34.7 million at December 31, 2020. No borrower had an outstanding exposure exceeding the limit at year-end.
The risks associated with lending activities differ among loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans and general economic conditions. Any of these factors may adversely impact a borrower’s ability to repay loans, and also impact the associated collateral. A further discussion on the classes of loans the Company makes and related risks is included in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
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The following table presents the loan portfolio, excluding residential LHFS, by segments and classes at December 31.
Commercial real estate:
Acquisition and development:
Residential mortgage:
(1) Includes $403.3 million and $0 of SBA PPP loans, net of deferred fees and costs, as of December 31, 2020 and 2019, respectively.
The loan portfolio at December 31, 2020 increased by $335.4 million, or 20.4%, from December 31, 2019 due primarily to the origination of SBA PPP loans in 2020, which was partially offset by a reduction in mortgage loans resulting from significant refinancing activity in the low interest rate environment. The increase in the loan portfolio from 2018 to 2019 was approximately 75% attributable to loans acquired in the Hamilton transaction. The Mercersburg acquisition in 2018 and Hamilton acquisition in 2019 increased the loan portfolio, principally in the residential mortgage - first lien and commercial real estate - owner and non-owner occupied classes. The Company's organic growth has occurred in both core and newer markets, such as Lancaster County, Pennsylvania, principally in commercial real estate, and in commercial and industrial loans and installment and other loans as we focused on increasing diversification in the portfolio. The growth in installment and other loans in 2018 through 2020 was principally attributable to purchased automobile financing loans at higher returns than comparable cash flows in the investment portfolio.
Competition for new business opportunities remains strong, which may temper loan growth in future quarters.
In addition to monitoring our loan portfolio by loan class as noted above, we also monitor concentrations by segment. The Bank’s lending policy reports segment concentrations that exceeds 20% of the Bank’s total risk-based capital ("RBC"). The following segments met this criterion at December 31, 2020.
Balance % of Total Loans % of Total RBC
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The following table presents expected maturities of certain loan classes by fixed rate or adjustable rate categories at December 31, 2020.
Due In
One Yearor Less OneYear ThroughFive Years After FiveYears Total
Acquisition and development:
1-4 family residential construction
Commercial and land development
Commercial and industrial
The final maturity is used in the determination of maturity of acquisition and development loans that convert from construction to permanent status. Variable rate loans shown above include semi-fixed loans that contractually will adjust with prime or LIBOR after the interest lock period, which may be up to 10 years. At December 31, 2020, these semi-fixed loans totaled $29.8 million.
Asset Quality
Risk Elements
The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is managed through our underwriting standards, on-going credit reviews, and monitoring of asset quality measures. Additionally, loan portfolio diversification, which limits exposure to a single industry or borrower, and collateral requirements also mitigate our risk of credit loss.
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The following table presents the Company’s risk elements and relevant asset quality ratios at December 31.
Loans past due 90 days or more and still accruing (1) 554 2,232 57 — —
Asset quality ratios:
Total nonperforming assets to total assets 0.37 % 0.46 % 0.27 % 0.69 % 0.52 %
Total risk assets to total loans and OREO 0.60 % 0.86 % 0.52 % 1.19 % 0.94 %
(1) Includes $456 thousand and $2.0 million, respectively, of purchased credit impaired loans at December 31, 2020 and 2019.
The following table provides detail of impaired loans at December 31, 2020 and 2019.
Commercial real estate:
Acquisition and development
Commercial and land development 814 — 814 — — —
Residential mortgage:
Installment and other loans 17 — 17 85 — 85
Nonperforming assets include nonaccrual loans and foreclosed real estate. Risk assets, which include nonperforming assets and restructured and loans past due 90 days or more and still accruing, totaled $11.8 million at December 31, 2020, an increase of $2.3 million or 16.1%, from $14.1 million at December 31, 2019. Nonaccrual loans totaled $10.3 million at December 31, 2020, a decrease of $347 thousand from December 31, 2019. The change in nonaccrual loan amounts also impacted other asset quality ratios detailed above.
The ALL totaled $20.2 million at December 31, 2020, a $5.5 million increase from $14.7 million at December 31, 2019, resulting from net recoveries of $171 thousand and a provision for loan losses of $5.3 million for 2020. The ALL is higher as a percentage of the total loan portfolio at December 31, 2020 than in prior years, reflecting the increased ALL balance. An
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increase in special mention loans and loan modifications due to COVID-19 led to the inclusion of $2.8 million in qualitative reserves associated with COVID-19 in the ALL at December 31, 2020. Management believes its coverage ratios are adequate for the risk profile of the loan portfolio given ongoing monitoring of the portfolio and its quantitative and qualitative analysis performed at December 31, 2020. As new information is learned about borrowers or updated appraisals on real estate with lower fair values are obtained, the Company may experience an increase in impaired loans.
For the years ended December 31, 2020, 2019, and 2018, recoveries of $1.2 million, $606 thousand and $882 thousand, respectively, were credited to the ALL. These recoveries on previously charged-off relationships are the result of successful loan monitoring and workout solutions. Recoveries are difficult to predict, and any additional recoveries that the Company receives will be used to replenish the ALL. Recoveries favorably impact historical charge-off factors, and contribute to changes in the quantitative and qualitative factors used in our allowance adequacy analysis. However, as the loan portfolio continues to grow, future provisions for loan losses may result.
The Company takes partial charge-offs on collateral-dependent loans when carrying value exceeds estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Impairment reserves remain in place if updated appraisals are pending, and represent management’s estimate of potential loss.
The following table presents exposure to relationships with an impaired loan balance, partial charge-offs taken to date and specific reserves established on the relationships at December 31, 2020 and 2019.
# ofRelationships RecordedInvestment PartialCharge-offsto Date SpecificReserves
Relationships greater than $1 million 2 $ 5,639 $ — $ —
Relationships greater than $500 thousand but less than $1 million 2 1,211 17 —
Relationships greater than $250 thousand but less than $500 thousand 2 637 — —
Relationships greater than $1 million 2 $ 5,218 $ — $ —
Relationships greater than $250 thousand but less than $500 thousand 3 980 — —
Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $1.0 million, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed and corresponding risk ratings are reaffirmed by the Bank's Problem Loan Committee, with subsequent reporting to the Management ERM Committee.
In its individual loan impairment analysis, the Company determines the extent of any full or partial charge-offs that may be required, or any reserves that may be needed. The determination of the Company’s charge-offs or impairment reserve include an evaluation of the outstanding loan balance and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships at December 31, 2020. However, over time, additional information may result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed.
The Company’s foreclosed real estate balance at December 31, 2020 was zero for both residential and commercial properties. During 2020, no expense was recorded for the write-down of other real estate owned properties.
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In an effort to assist clients which were negatively impacted by the COVID-19 pandemic, the Bank offered various mitigation options, including a loan payment deferral program. Under this program, most commercial deferrals were for a 90-day period, while most consumer deferrals were for a 180-day period. As of December 31, 2020, the Company had loan deferrals under this program for commercial and consumer clients with a total loan balance of $15.7 million and $2.5 million, respectively. In accordance with the revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on April 7, 2020, these deferrals are exempt from TDR status as they meet the specified requirements. Below is a summary of select loan concentrations and the deferrals within those categories at December 31, 2020.
The following table summarizes COVID-19 related modifications, including deferrals and forbearances:
Loan Type Amount of Loans Percent of Non-PPP Loans
The following table summarizes COVID-19 related deferral balances within certain industry segments at December 31, 2020:
Strip Center/Retail — — 61,268 —
Senior Housing — — 43,814 —
Credit Risk Management
Allowance for Loan Losses
The Company maintains the ALL at a level deemed adequate by management for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses which is charged to earnings. On a quarterly basis, management assesses the adequacy of the ALL utilizing a defined methodology which considers specific credit evaluation of impaired loans, historical loss experience and qualitative factors. Management addresses the requirements for loans individually identified as impaired, loans collectively evaluated for impairment, and other bank regulatory guidance in its assessment.
The ALL is evaluated based on review of the collectability of loans in light of historical experience; the nature and volume of the loan portfolio; adverse situations that may affect a borrower’s ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A description of the methodology for establishing the allowance and provision for loan losses and related procedures in establishing the appropriate level of reserve is included in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
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The following table summarizes the Company’s internal risk ratings at December 31, 2020 and 2019.
Commercial real estate:
Acquisition and development:
Residential mortgage:
Commercial real estate:
Acquisition and development:
Residential mortgage:
Non-Impaired Substandard loans are performing loans which have characteristics that cause management concern over the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as
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nonperforming, or impaired, loans in the future. Generally, management feels that substandard loans that are currently performing and not considered impaired result in some doubt as to the borrower’s ability to continue to perform under the terms of the loan, and represent potential problem loans. Non-impaired Substandard loans totaled $16.7 million at December 31, 2020.
Additionally, the Special Mention classification is intended to be a temporary classification reflective of loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Company’s position at some future date. Special mention loans represent an elevated risk, but their weakness does not yet justify a more severe, or classified, rating. These loans require inquiry by lenders on the cause of the potential weakness and, once analyzed, the loan classification may be downgraded to Substandard or, alternatively, could be upgraded to Pass. Special mention loans increased by $74.8 million from December 31, 2019 to December 31, 2020 due primarily to the economic weakness created by COVID-19 as well as related loan modifications completed in 2020. Any loans with second modifications that are COVID-19 related are classified as special mention.
The following tables summarize the average recorded investment in impaired loans and interest income recognized, on a cash basis, and interest income earned but not recognized for years ended December 31, 2020, 2019, 2018, 2017 and 2016.
AverageImpairedBalance InterestIncomeRecognized InterestEarnedBut NotRecognized
Commercial real estate:
Non-owner occupied 83 — —
Multi-family 205 — —
Non-owner occupied residential 388 — 21
Acquisition and development:
Commercial and land development 641 — 23
Commercial and industrial 1,196 — 20
Residential mortgage:
Home equity – term 11 — 1
Home equity – lines of credit 692 1 36
Installment and other loans 25 — 1
Commercial real estate:
Non-owner occupied 46 — —
Non-owner occupied residential 217 — 21
Acquisition and development:
1-4 family residential construction — — —
Commercial and land development 21 — —
Commercial and industrial 683 — 130
Residential mortgage:
Home equity – term 13 — 1
Home equity – lines of credit 750 2 64
Installment and other loans 13 — 2
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AverageImpairedBalance InterestIncomeRecognized InterestEarnedBut NotRecognized
Commercial real estate:
Non-owner occupied residential 346 — 36
Acquisition and development:
1-4 family residential construction 181 — —
Commercial and land development 1 — 1
Commercial and industrial 322 — 29
Residential mortgage:
Home equity – term 19 — 2
Home equity – lines of credit 657 2 52
Installment and other loans 4 — 5
Commercial real estate:
Non-owner occupied 392 — 10
Non-owner occupied residential 418 — 35
Acquisition and development:
1-4 family residential construction 154 — 7
Commercial and industrial 413 — 25
Residential mortgage:
Home equity – term 61 — 1
Home equity – lines of credit 488 2 26
Installment and other loans 10 — 3
Commercial real estate:
Non-owner occupied residential 645 — 35
Acquisition and development:
Commercial and land development 3 — 1
Commercial and industrial 575 — 25
Residential mortgage:
Home equity – term 98 — 6
Home equity – lines of credit 455 — 19
Installment and other loans 12 — 3
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The following table summarizes activity in the ALL for years ended December 31, 2020, 2019, 2018, 2017 and 2016.
Commercial Consumer
The following table summarizes asset quality ratios for years ended December 31, 2020, 2019, 2018, 2017 and 2016.
The Company recorded a provision for loan losses expense of $5.3 million, $900 thousand, $800 thousand, $1.0 million and $250 thousand for 2020, 2019, 2018, 2017 and 2016, respectively. In addition, in certain cases, loans were successfully
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worked out with smaller charge-offs than the reserve established on them. From 2016 to 2019, the Company has benefited from organic loan portfolio growth and favorable historical charge-off data combined with relatively stable economic conditions over the periods presented above. This was a principal factor in management's determination that a negative or modest provision could be recorded despite net charge-offs recorded in 2016. In 2017, management determined that a provision expense that offset net charge-offs for the year would maintain an adequate ALL, principally due to a charge-off in connection with one commercial credit downgraded to nonaccrual status during the year. In 2018 and 2019, our continued organic loan portfolio growth was a key factor in the quantitative and qualitative considerations used by management in the determination of the provision expense required to maintain an adequate allowance for loan losses. In 2020, the severe economic impact of COVID-19 on the loan portfolio drove an increase in qualitative assumptions. These variations in net charge-offs (recoveries) and provision expense (recovery) resulted in the fluctuations in the ratios presented in the tables above.
See further discussion in the “Provision for Loan Losses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Also, see Note 4, Loans and Allowance for Loan Losses, in the Notes to Consolidated Financial Statements for additional information on the COVID-19 qualitative assumptions.
The following table shows the allocation of the ALL by loan class, as well as the percent of each loan class in relation to the total loan balance at December 31, 2020, 2019, 2018, 2017 and 2016.
Commercial real estate:
Acquisition and development:
Residential mortgage:
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The following table summarizes the ending loan balance individually or collectively evaluated for impairment by loan class and the ALL allocation for each at December 31, 2020 and 2019.
Commercial Consumer
Loans allocated by:
Allowance for loan losses allocated by:
Individually evaluated for impairment $ — $ — $ 1 $ — $ 1 $ 33 $ — $ 33 $ — $ 34
Loans allocated by:
Allowance for loan losses allocated by:
Individually evaluated for impairment $ — $ — $ — $ — $ — $ 36 $ — $ 36 $ — $ 36
In addition to the reserve allocations on impaired loans noted above, 11 loans, with aggregate outstanding principal balances of $1.2 million, have had cumulative partial charge-offs to the ALL totaling $562 thousand at December 31, 2020. As updated appraisals were received on collateral-dependent loans, partial charge-offs were taken to the extent the loans’ principal balance exceeded their fair value.
Management believes the allocation of the ALL between the various loan classes adequately reflects the probable incurred credit losses in each portfolio and is based on the methodology outlined in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." Management re-evaluates and makes certain enhancements to its methodology used to establish a reserve to better reflect the risks inherent in the different segments of the portfolio, particularly in light of increased charge-offs, with noticeable differences between the different loan classes. Management believes these enhancements to the ALL methodology improve the accuracy of quantifying probable incurred credit losses inherent in the portfolio. Management charges actual loan losses to the reserve and bases the provision for loan losses on its overall analysis.
The largest component of the ALL for the years presented has been allocated to the commercial real estate segment, particularly the non-owner occupied loan classes. The higher allocations in these classes as compared with the other classes is consistent with the inherent risk associated with these loans, as well as generally higher levels of impaired and criticized loans for the periods presented. There has generally been a decrease in the ALL allocated to the commercial real estate portfolio, as the level of classified assets has declined, and historical loss rates have improved as a result of improving economic and market conditions.
The unallocated portion of the ALL reflects estimated inherent losses within the portfolio that have not been detected, as well as the risk of error in the specific and general reserve allocation, other potential exposure in the loan portfolio, variances in management’s assessment of national and local economic conditions and other factors management believes appropriate at the time. The unallocated portion of the allowance increased from $140 thousand at December 31, 2019 to $218 thousand at December 31, 2020 and represents 1.1% of the ALL at December 31, 2020, compared with 1.0% at December 31, 2019. Changes in qualitative factors of certain loan categories were made during 2019 to reflect limited credit losses in recent history.
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The Company monitors the unallocated portion of the ALL, and by policy, has determined it should not exceed 3% of the total reserve. Future negative provisions for loan losses may result if the unallocated portion was to increase, and management determined the reserves were not required for the anticipated risk in the portfolio.
Management believes the Company’s ALL is adequate based on information currently available. Future adjustments to the ALL and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management’s assumptions as to future delinquencies or loss rates.
Deposits
Total deposits grew $481.4 million, or 25.7%, from $1.9 billion at December 31, 2019 to $2.4 billion at December 31, 2020. This increase was primarily due to deposits generated through the SBA PPP during 2020. In 2019, the Company acquired $388.2 million in deposits from Hamilton. At December 31, 2019, those acquired accounts totaled approximately $332.0 million. During 2019, brokered deposits were reduced by $110.6 million and subscription service CDs declined by $21.9 million. Organic growth totaled approximately $147.7 million in 2019.
The following table presents average deposits for years ended December 31, 2020, 2019, and 2018.
Average total deposits increased $310.5 million, or 16.8%, from 2019 to 2020. SBA PPP loan funding was the principal driver of this increase. Average time deposits less than $250 thousand grew from $287.9 million in 2018 to $483.9 million in 2019 and average time deposits in excess of $250 thousand increased from $36.3 million in 2018 to $66.0 million in 2019.
In addition to deposits from acquisitions, the Bank has been able to garner organic growth in both interest-bearing and noninterest-bearing deposit relationships from enhanced cash management offerings as we continued to develop commercial relationships. We also continued to grow core funding deposits through marketing campaigns and improvement in our product delivery with investments in technology and increased sales efforts. We have also been able to increase interest-free funds as we expanded our commercial and industrial loan portfolio.
In 2020, the Bank reduced its brokered deposit balances to zero at December 31, 2020 compared with $16.1 million at December 31, 2019, and averaged $3.2 million for 2020 compared with $100.8 million for 2019. Given interest rate conditions and asset/liability strategies, the Bank borrowed additional funds from FHLB of Pittsburgh to replace called brokered deposits from the second half of 2019 through 2020.
Management evaluates its utilization of brokered deposits, taking into consideration the interest rate curve and regulatory views on non-core funding sources, and balances this funding source with its funding needs based on growth initiatives. The Company anticipates that as loan growth increases, it will be able to generate core deposit funding by offering competitive rates.
The following table presents maturities of time deposits of $250,000 or more at December 31, 2020.
Total
Three months or less $ 25,828
Over three months through six months 15,734
Over six months through one year 12,057
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Borrowings
In addition to deposit products, the Company uses short-term borrowing sources to meet liquidity needs and for temporary funding. Sources of short-term borrowings include the FHLB of Pittsburgh, federal funds purchased, and to a lesser extent, the FRB discount window. Short-term borrowings also include securities sold under agreements to repurchase with deposit clients, in which a client sweeps a portion of a deposit balance into a repurchase agreement, which is a secured borrowing with a pool of securities pledged against the balance.
The Company also utilizes long-term debt, consisting principally of FHLB fixed and amortizing advances to fund its balance sheet with original maturities greater than one year. The Company evaluates its funding needs, interest rate movements, the cost of options, and the availability of attractive structures when considering the timing and extent of when it enters into long-term borrowings.
In December 2018, we issued unsecured subordinated notes payable totaling $32.5 million, the proceeds of which were designated for general corporate use, including funding of cash consideration for mergers and acquisitions.
For additional information about borrowings, refer to Note 13, Short-Term Borrowings, Note 14, Long-Term Debt, and Note 15, Subordinated Notes, to the Consolidated Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data."
Shareholders' Equity
In 2020, total shareholders’ equity increased $23.0 million, or 10.3%. Net income increased equity by $26.5 million. AOCI increased by $3.8 million due to an increase of $4.8 million in unrealized gains on securities partially offset by $1.0 million in unrealized losses on derivatives during 2020. Dividends paid to shareholders decreased equity by $7.6 million.
In September, 2015, the Board of Directors authorized a stock repurchase program which is more fully described in Item 5 under Issuer Purchases of Equity Securities. The maximum number of shares that may yet be purchased under the plan is 261,320 shares at December 31, 2020.
The following table includes additional information for shareholders’ equity for years ended December 31, 2020, 2019, and 2018.
Average equity to average assets ratio 8.58 % 9.26 % 8.75 %
Capital Adequacy and Regulatory Matters
Capital management in a regulated financial services industry must properly balance return on equity to its shareholders while maintaining sufficient levels of capital and related risk-based regulatory capital ratios to satisfy statutory regulatory requirements. The Company’s capital management strategies have been developed to provide attractive rates of returns to its shareholders, while maintaining a “well capitalized” position of regulatory strength.
Effective with the third quarter of 2018, the FRB raised the consolidated asset limit on small bank holding companies from $1 billion to $3 billion, and a company with assets under the revised limits is not subject to the FRB consolidated capital rules. A company with consolidated assets under the revised limit may continue to file reports that include capital amounts and ratios. The Company has elected to continue to file those reports.
Management believes the Company and the Bank met all capital adequacy requirements to which they are subject at December 31, 2020 and December 31, 2019. At December 31, 2020, the Bank was considered well capitalized under applicable banking regulations.
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Tables presenting the Company’s and the Bank’s capital amounts and ratios at December 31, 2020 and 2019 are included in Note 17 Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data."
The Company routinely evaluates its capital levels in light of its risk profile to assess its capital needs. In addition to the minimum capital ratio requirement and minimum capital ratio to be well capitalized presented in the tables in Note 17, we must maintain a capital conservation buffer as noted in Item 1 - Business under the topic Basel III Capital Rules. At December 31, 2020, the Company's and the Bank's capital conservation buffer, based on the most restrictive capital ratio, was 6.5% and 6.7%, which is above the regulatory requirement of 2.50% at December 31, 2020.
Liquidity and Rate Sensitivity
Liquidity. The primary function of asset/liability management is to ensure adequate liquidity and manage the Company’s sensitivity to changing interest rates. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The Company's primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities, the sale of mortgage loans and borrowings from the FHLB of Pittsburgh. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company's maximum borrowing capacity from the FHLB is $830.3 million at December 31, 2020.
The Company regularly adjusts its investments in liquid assets based upon its assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities and the objectives of its asset/liability management policy.