qnbc-10k_20201231.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
Commission file number 0-17706
QNB Corp.
(Exact Name of Registrant as Specified in Its Charter)
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (215) 538-5600
Securities registered pursuant to Section 12(b) of the Act: None.
Title of each class Trading Symbol Name of each exchange on which registered
Common Stock QNBC N/A
Securities registered pursuant to Section 12(g) of the Act:
Common Stock
Title of class
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act. Yes ☐No☒
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐No☒
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes☒ No ☐
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐ Accelerated filer ☐
Non-accelerated filer ☒ Smaller reporting company ☒
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☐
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
As of February 26, 2021, 3,554,550 shares of common stock of the registrant were outstanding. As of June 30, 2020, the aggregate market value of the common stock of the registrant held by non-affiliates was approximately $91,885,103 based upon the average bid and asked prices of the common stock as reported on the OTC BB.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of registrant’s Proxy Statement for the annual meeting of its shareholders to be held May 25, 2021 are incorporated by reference in Part III of this report.
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FORM 10-K INDEX
PART I PAGE
Item 1 Business 3
Item 1A Risk Factors 12
Item 1B Unresolved Staff Comments 16
Item 2 Properties 17
Item 3 Legal Proceedings 17
Item 4 Mine Safety Disclosures 17
PART II
Item 6 Selected Financial Data 20
Item 7A Quantitative and Qualitative Disclosures about Market Risk 51
Item 8 Financial Statements and Supplementary Data 52
Item 9A Controls and Procedures 100
Item 9B Other Information 100
PART III
Item 10 Directors, Executive Officers and Corporate Governance 101
Item 11 Executive Compensation 101
Item 14 Principal Accounting Fees and Services 102
PART IV
Item 15 Exhibits, Financial Statement Schedules 103
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PART I
FORWARD-LOOKING STATEMENTS
In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides a safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.
Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, could affect the future financial results of QNB Corp. and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited to, the following:
• Volatility in interest rates and shape of the yield curve;
• Credit risk;
• Liquidity risk;
• Operating, legal and regulatory risks;
• Economic, political and competitive forces affecting QNB Corp.’s business;
QNB Corp. (herein referred to as “QNB” or the “Company”) cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this Annual Report on Form 10-K, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
ITEM 1. BUSINESS
Overview
QNB was incorporated under the laws of the Commonwealth of Pennsylvania on June 4, 1984. QNB is registered with the Board of Governors of the Federal Reserve System as a bank holding company under the Bank Holding Company Act of 1956 and conducts its business through its wholly-owned subsidiary, QNB Bank (the “Bank”).
Prior to December 28, 2007, the Bank was a national banking association organized in 1877 as The Quakertown National Bank, was chartered under the National Banking Act and was subject to Federal and state laws applicable to national banks. Effective December 28, 2007, the Bank became a Pennsylvania chartered commercial bank and changed its name to QNB Bank. The Bank, whose principal office is located in Quakertown, Bucks County, Pennsylvania, operated twelve full-service community banking offices in Bucks, Montgomery and Lehigh counties in southeastern Pennsylvania as of December 31, 2020.
The Bank is engaged in the general commercial banking business and provides a full range of banking services to its customers. These banking services consist of, among other things, attracting deposits and using these funds in making commercial loans, residential mortgage loans, consumer loans, and purchasing investment securities. These deposits are in the form of time, demand and savings accounts. Time deposits include certificates of deposit and individual retirement accounts. The Bank’s demand and savings accounts include money market accounts, interest-bearing demand accounts (including a higher yielding checking account), club accounts, traditional statement savings accounts, and a higher yielding online savings account.
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At December 31, 2020, QNB had total assets of $1,440,229,000, total loans receivable of $920,042,000, total deposits of $1,228,067,000 and total shareholders’ equity of $134,445,000. For the year ended December 31, 2020, QNB reported net income of $12,083,000 compared to net income for the year ended December 31, 2019 of $12,357,000 and December 31, 2018 of $11,335,000.
At February 18, 2021, the Bank had 192 full-time employees and eight part-time employees. The Bank’s employees have a customer-oriented philosophy emphasizing personal service and flexible solutions which together make achieving our customers’ goals possible. They maintain close contact with both the residents and local business people in the communities in which they serve, responding to changes in market conditions and customer requests in a timely manner.
Competition and Market Area
The banking business is highly competitive, and the profitability of QNB depends principally upon the Bank’s ability to compete in its market area. QNB faces intense competition within its market, both in making loans and attracting deposits. Bucks, Lehigh, and Montgomery counties have a high concentration of financial institutions, including large national and regional banks, community banks, savings institutions and credit unions. Some of QNB’s competitors offer products and services that QNB currently does not offer, such as traditional trust services and full-service insurance.
In addition, as a result of consolidation in the banking industry, some of QNB’s competitors may enjoy advantages such as greater financial resources, a wider geographic presence, more favorable pricing alternatives and lower origination and operating costs. However, QNB has been able to compete effectively with other financial institutions by emphasizing the establishment of long-term relationships and customer loyalty. A strong focus on small-business solutions, providing fast local decision-making on loans, exceptional personal customer service and technology solutions, including internet- and mobile-banking, electronic bill pay and remote deposit capture, also enable QNB to compete successfully.
Competition for loans and deposits comes principally from commercial banks, savings institutions, credit unions and non-bank financial service providers. Factors in successfully competing for deposits include providing excellent customer service, convenient locations and hours of operation, attractive rates, low fees, and alternative delivery systems. One such delivery system is remote deposit capture for those commercial customers that are not conveniently located near one of our branches, or mobile banking for retail customers. Successful loan origination tends to depend not only on interest rate and terms of the loan but also on being responsive and flexible to the customers’ needs. While many competitors within the Bank’s primary market have substantially higher legal lending limits, QNB often has the ability, through loan participations, to meet the larger lending needs of its customers.
QNB’s success is dependent to a significant degree on economic conditions in southeastern Pennsylvania, especially Bucks, Lehigh and Montgomery counties, which it defines as its primary market. The banking industry is affected by general economic conditions, including the effects of recession, unemployment, declining real estate values, inflation, trends in the national and global economies, and other factors beyond QNB’s control.
Monetary Policy and Economic Conditions
The business of financial institutions is affected not only by general economic conditions, but also by the policies of various governmental regulatory agencies, including the Board of Governors of the Federal Reserve (the “Federal Reserve”). The Federal Reserve regulates money, credit conditions and interest rates to influence general economic conditions primarily through open market operations in U.S. government securities, changes in the discount rate on bank borrowings and changes in the reserve requirements against depository institutions’ deposits. These policies and regulations significantly affect the overall growth and distribution of loans, investments and deposits, as well as the interest rates charged on loans and the interest rates paid on deposits.
The monetary policies of the Federal Reserve have had a significant effect on the operating results of financial institutions in the past and are expected to continue to have significant effects in the future. In view of the changing conditions in the economy and the financial markets in addition to the activities of monetary and fiscal authorities, the prediction of future changes in interest rates, credit availability or deposit levels is very challenging.
Supervision and Regulation
Banks and bank holding companies operate in a highly-regulated environment and are regularly examined by Federal and state regulatory authorities. Federal statutes that apply to QNB and its subsidiary include the Bank Holding Company Act of 1956 (“BHCA”), the Federal Reserve Act and the Federal Deposit Insurance Act (“FDIA”), as those statutes have been significantly amended by recent laws such as the Dodd-Frank Wall Street Reform and Consumer Protection Act the “Dodd-Frank Act”), the Gramm-Leach-Bliley Act (“GLBA”), and others. In general, these statutes regulate the corporate governance of the Bank and eligible business activities of QNB and impose certain restrictions and limitations on such important matters as mergers and acquisitions, intercompany transactions, loans and dividends, and capital adequacy, among others. Other corporate governance requirements are imposed on QNB by Federal securities and other laws, including the Sarbanes-Oxley Act, described later.
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The Company is under the jurisdiction of the Securities and Exchange Commission and of state securities commissions for matters relating to the offering and sale of its securities. In addition, the Company is subject to the Securities and Exchange Commission’s rules and regulations relating to periodic reporting, proxy solicitation and insider trading.
Set forth below is a brief summary of some of the significant regulatory concepts and laws that affect QNB and the Bank. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by references to the particular statutory or regulatory provisions themselves. Proposals to change banking laws and regulations are frequently introduced in Congress, the state legislatures, and before the various bank regulatory agencies. QNB cannot determine the likelihood of passage or timing of any such proposals or legislation or the impact they may have on QNB and its subsidiary. A change in law, regulations or regulatory policy may have a material effect on QNB and its subsidiary.
Bank Holding Company Regulation
QNB is registered as a bank holding company and is subject to the regulations of the Federal Reserve under the BHCA. In addition, QNB Corp., as a Pennsylvania business corporation, is subject to the Pennsylvania Business Corporation Law of 1988 (the “BCL”), as amended, and to certain provisions of the Pennsylvania Banking Code of 1965, as amended (the “Banking Code”).
Bank holding companies are required to file periodic reports with, and are subject to examination by, the Federal Reserve. The Federal Reserve’s regulations require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve, pursuant to its “source of strength” regulations, may require QNB to commit its resources to provide adequate capital funds to the Bank during periods of financial distress or adversity.
Federal Reserve approval may be required before QNB may begin to engage in any non-banking activity and before any non-banking business may be acquired by QNB.
Regulatory Restrictions on Dividends
Dividend payments made by the Bank to the Company are subject to the Pennsylvania Banking Code, the FDIA, and the regulations of the Federal Deposit Insurance Corporation (“FDIC”). Under the Banking Code, no dividends may be paid except from “accumulated net earnings” (generally retained earnings). The Federal Reserve and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions. Under the FDIA, the Bank is prohibited from paying any dividends, making other distributions or paying any management fees if, after such payment, it would fail to satisfy its minimum capital requirements. See also “Supervision and Regulation – Bank Regulation”.
In addition to the dividend restrictions described above, the banking regulators have the authority to prohibit or to limit the payment of dividends by the Bank if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the Bank.
Under Pennsylvania law, QNB may not pay a dividend, if, after giving effect thereto, it would be unable to pay its debts as they become due in the usual course of business and, after giving effect to the dividend, the total assets of QNB would be less than the sum of its total liabilities plus the amount that would be needed, if QNB were to be dissolved at the time of distribution, to satisfy the preferential rights upon dissolution of shareholders whose rights are superior to those receiving the dividend.
It is also the policy of the Federal Reserve that a bank holding company generally only pay dividends out of net income over the past year and only if the prospective rate of earnings retention appears consistent with a bank holding company’s capital needs, asset quality, and overall financial condition. In the current financial and economic environment, the Federal Reserve has indicated that bank holding companies should carefully review their dividend policy and has discouraged dividend pay-out ratios at the 100% level unless both asset quality and capital are very strong. A bank holding company also should not maintain a dividend level that places undue pressure on the capital of such institution’s subsidiaries, or that may undermine the bank holding company’s ability to serve as a source of strength for such subsidiaries.
The minimum capital requirements implemented by Basel III, and described below under “Capital Adequacy,” also introduced a capital conservation buffer, comprised of common equity Tier 1 capital, above a banking institution’s minimum risk-based capital requirements in an amount greater than 2.5% of total risk-weighted assets in order to avoid limitations on certain distributions, including dividend payments.
The approval of the Federal Reserve is required for a state bank member in the Federal Reserve system to pay dividends if the total of all dividends declared in any calendar year exceeds the Bank’s net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years. Under this formula, the Bank can declare dividends in 2021 without approval of the Federal Reserve of approximately $21,883,000 plus an additional amount equal to the Bank’s net profits for 2020 up to the date of any such dividend declaration. Under the restrictions applicable to the Bank, to remain “well capitalized,” the Bank had approximately $30,379,000 available for payment of dividends to the Company at December 31, 2020.
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Capital Adequacy
In July 2013, the Federal bank regulatory agencies adopted revisions to the agencies’ capital adequacy guidelines and prompt corrective action rules, which were designed to enhance such requirements and implement the revised standards of the Basel Committee on Banking Supervision, commonly referred to as Basel III. The rules generally implemented higher minimum capital requirements, added a new common equity Tier 1 capital requirement, and established criteria that instruments must meet to be considered common equity Tier 1 capital, additional Tier 1 capital or Tier 2 capital. Tier 1 capital consists principally of common shareholders’ equity, plus retained earnings, less certain intangible assets. Tier 2 capital includes the allowance for loan and lease losses (up to 1.25 percent of risk-weighted assets), qualifying preferred stock, subordinated debt, and qualifying Tier 2 minority interests. The current minimum capital requirements are a common equity Tier 1 capital ratio of 4.5%, a Tier 1 capital ratio of 6.0%, and a total capital ratio of 8.0%. In addition, in order to avoid limitations on certain capital distributions (including dividend payments and certain discretionary bonus payments to executive officers), as of January 1, 2019, a banking organization must hold a capital conservation buffer comprised of common equity Tier 1 capital above its minimum risk-based capital requirements in an amount greater than 2.5% of total risk-weighted assets. At December 31, 2020, QNB’s Tier 1 capital, total capital (Tier 1 and Tier 2 combined) and common equity Tier 1 equity ratios were 12.86%, 13.95%, and 12.86%, respectively.
In addition to the risk-based capital guidelines, the Federal Reserve requires a bank holding company to maintain a minimum leverage ratio. This requires a minimum level of Tier 1 capital (as determined under the risk-based capital rules) to average total consolidated assets of 4% for those bank holding companies that have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion. The Federal Reserve expects all other bank holding companies to maintain a ratio of at least 1% to 2% above the stated minimum. At December 31, 2020, QNB’s leverage ratio was 9.07%.
Pursuant to the prompt corrective action provisions of the FDIA, the Federal banking agencies have specified, by regulation, the levels at which an insured institution is considered well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized. Under these regulations, an institution is considered well capitalized if it satisfies each of the following requirements:
• Total risk-based capital ratio of 10% or more.
• Tier 1 risk-based capital ratio of 8% or more.
• Common equity tier 1 risk-based capital ratio of 6.5% or more.
• Leverage ratio of 5% or more, and
At December 31, 2020 and 2019, the Bank qualified as well capitalized under these regulatory standards. See Note 20 of the Notes to Consolidated Financial Statements included at Item 8 of this Report for additional information.
Bank Regulation
As a Pennsylvania-chartered insured commercial bank, the Bank is subject to extensive regulation and examination by the Pennsylvania Department of Banking and Securities (the “Department”) and by the FDIC, which insures its deposits to the maximum extent permitted by law.
The Federal and state laws and regulations applicable to banks regulate, among other things, the scope of their business, their investments, the reserves required to be kept against deposits, the timing of the availability of deposited funds, the nature and amount of collateral for certain loans, the activities of a bank with respect to mergers and consolidations, and the establishment of branches. The laws and regulations governing the Bank generally have been promulgated to protect depositors and not for the purpose of protecting QNB’s shareholders. This regulatory structure also gives the Federal and state banking agencies extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulation, whether by the Department, the FDIC or the United States Congress, could have a material impact on the Company, the Bank and their operations.
As a subsidiary bank of a bank holding company, the Bank is subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to QNB, on investments in the stock or other securities of QNB, and on taking such stock or securities as collateral for loans.
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FDIC Insurance Assessments
The Bank’s deposits are insured to the applicable limits as determined by the FDIC, which is currently $250,000 per depositor. Under the FDIC's risk-based assessment system, insured institutions were previously assigned one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution's assessment rate depended largely on the category to which it was assigned, with institutions deemed less risky paying lower FDIC deposit insurance premiums. The Dodd-Frank Act required the FDIC to revise its procedures to base deposit insurance assessments on each insured institution's total assets less tangible equity instead of deposits and also mandated that the Deposit Insurance Fund achieve a reserve ratio of 1.35% of insured deposits by September 2020. Assessments for most banks are based on certain financial measures and supervisory ratings derived from statistical modeling estimating the probability of failure over three years, and also set maximum rates for institutions with composite CAMELS ratings of 1 or 2 and minimum rates for other institutions, The total base assessment range (after possible adjustments) for most banks is 1.5 basis points to 30 basis points. As of the September 2019 assessment date, when the Deposit Insurance Fund reserve ratio reached or exceeded 1.38%, banks with less than $10 billion of total consolidated assets began receiving certain "small bank assessment credits" for the portion of their assessments that contributed to the growth in the FDIC's fund reserve ratio from 1.15% to 1.35%; credits were to be applied so long as the Deposit Insurance Fund reserve ratio is at or above 1.35%. All then remaining small bank credits were refunded during 2020, ending the application of small bank credits.
At June 30, 2019 and September 30, 2019 the Reserve Ratio was greater than 1.38% and the Bank received Small Institution Credits totaling $273,000. For the years ended December 31, 2020, 2019 and 2018, the Bank recorded $569,000, $266,000 (net of Small Institution Credits of $273,000), and $592,000, respectively, in FDIC deposit insurance premium expense.
All insured institutions of the FDIC were required to pay assessments to fund interest payments on Financing Corporation (FICO) bonds. The Financing Corporation was created by Congress to issue bonds to finance the resolution of failed thrift institutions. The FDIC had the authority to set the Financing Corporation assessment rate every quarter. These assessments continued until the Financing Corporation bonds matured in 2019. The expense for 2019 and 2018 recorded by QNB was $3,000 and $32,000, respectively. There was no expense recorded in 2020.
Federal Home Loan Bank System
The Bank is a member of the Federal Home Loan Bank of Pittsburgh (“FHLB”), which is one of 11 regional Federal Home Loan Banks. Each Federal Home Loan Bank serves as a reserve or central bank for members within its assigned region. It is funded primarily from funds deposited by member institutions and proceeds from the sale of consolidated obligations of the Federal Home Loan Bank System. It makes loans to members (i.e. advances) in accordance with policies and procedures established by the board of directors of the Federal Home Loan Bank. At December 31, 2020, the Bank had $0 of overnight FHLB advances outstanding and $10,000,000 in long-term debt.
The Bank is required to purchase and maintain stock in the FHLB as a condition of membership in an amount equal to 0.10% of its assets. In addition, each member is required to purchase and maintain activity-based stock of 4% of outstanding advances from the FHLB. At December 31, 2020, the Bank had $1,029,000 in stock of the FHLB.
Community Reinvestment Act
Under the Community Reinvestment Act, (“CRA”) as amended the FDIC is required to assess all financial institutions that it regulates to determine whether these institutions are meeting the credit needs of the communities that they serve. The CRA focuses specifically on low- and moderate-income neighborhoods.
An institution’s record is considered during the evaluation of any application made by such institutions for, among other things:
• Approval of a branch or other deposit facility;
• An office relocation or a merger; and
• Any acquisition of bank shares.
The CRA also requires that the regulatory agency make publicly available the evaluation of the Bank’s record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods. This evaluation includes a descriptive rating of either outstanding, satisfactory, needs to improve, or substantial noncompliance, and a statement describing the basis for the rating. The Bank’s most recent CRA rating was “Satisfactory”.
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USA Patriot Act
The USA Patriot Act strengthens the anti-money laundering provisions of the Bank Secrecy Act. The Act requires financial institutions to establish certain procedures to be able to identify and verify the identity of its customers. Specifically, the Bank must have procedures in place to:
• Verify the identity of persons applying to open an account;
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act is intended to bolster public confidence in the nation’s capital markets by imposing new duties and penalties for non-compliance on public companies and their executives, directors, auditors, attorneys and securities analysts. Some of the more significant aspects of the Act as it relates to QNB include:
The Act also imposes requirements for corporate governance, auditor independence, accounting standards, audit committee member independence and increased authority, executive compensation, insider loans and whistleblower protection. As a result of the Act, QNB adopted a Code of Business Conduct and Ethics applicable to its CEO, CFO and Controller, which meets the requirements of the Act, to supplement its long-standing Code of Ethics, which applies to all directors and employees.
QNB’s Code of Business Conduct and Ethics can be found on the Bank’s website at www.qnbbank.com.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”)
The Dodd-Frank Act was enacted on July 21, 2010. This law made significant changes to the bank regulatory structure and affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies.
The Dodd-Frank Act created a new Consumer Financial Protection Bureau (“CFPB”) with broad powers to supervise and enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The CFPB has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Banks and savings institutions with $10 billion or less in assets such as the Bank will continue to be examined for compliance with the consumer laws by their primary bank regulators. The Dodd-Frank Act also weakened the Federal preemption rules that had been applicable for national banks and Federal savings associations and gave state attorneys general the ability to enforce Federal consumer protection laws.
Many of the provisions of the Dodd-Frank Act do not apply to the Bank, as it does not engage in many of the specific activities sought to be regulated by the Dodd-Frank Act. Many of the provisions, however, such as increased capital requirements and changes to FDIC insurance premiums already implemented, affected all banking entities. In addition, the financial crisis of 2008 and the enactment of the Dodd-Frank Act in response to that crisis has resulted in an era of increased regulatory oversight over all financial entities. The ultimate changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.
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Economic Growth, Regulatory Relief, and Consumer Protection Act
On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “EGRC Act”), which was designed to ease certain restrictions imposed by the Dodd-Frank Act, was enacted into law. Most of the changes made by the EGRC Act can be grouped into five general areas: mortgage lending; certain regulatory relief for “community” banks; enhanced consumer protections in specific areas, including subjecting credit reporting agencies to additional requirements; certain regulatory relief for large financial institutions, including increasing the threshold at which institutions are classified a systemically important financial institutions (from $50 billion to $250 billion) and therefore subject to stricter oversight, and revising the rules for larger institution stress testing; and certain changes to Federal securities regulations designed to promote capital formation. Some of the key provisions of the EGRC Act as it relates to community banks and bank holding companies include, but are not limited to: (i) designating mortgages held in portfolio as “qualified mortgages” for banks with less than $10 billion in assets, subject to certain documentation and product limitations; (ii) exempting banks with less than $10 billion in assets (and total trading assets and trading liabilities of 5% or less of total assets) from Volcker Rule requirements relating to proprietary trading; (iii) simplifying capital calculations for banks with less than $10 billion in assets by requiring Federal banking agencies to establish a community bank leverage ratio of Tier 1 capital to average consolidated assets of not less than 8% or more than 10%, and provide that banks that maintain Tier 1 capital in excess of such ratio will be deemed to be in compliance with risk-based capital and leverage requirements; (iv) assisting smaller banks with obtaining stable funding by providing an exception for reciprocal deposits from FDIC restrictions on acceptance of brokered deposits; (v) raising the eligibility for use of short-form Call Reports from $1 billion to $5 billion in assets; (vi) clarifying definitions pertaining to high volatility commercial real estate loans (HVCRE), which require higher capital allocations, so that only loans with increased risk are subject to higher risk weightings; and (vii) changing the eligibility for use of the small bank holding company policy statement from institutions with under $1 billion in assets to institutions with under $3 billion in assets. As noted, the ECRC Act as implemented by the Federal Reserve Board effective August 30, 2018, raised the threshold of the Federal Reserve Board's "Small Bank Holding Company" exception to the application of consolidated capital requirements from $1 billion to $3 billion of consolidated assets. Consequently, bank holding companies having less than $3 billion of consolidated assets are not subject to the consolidated capital requirements unless otherwise directed by the Federal Reserve Board.
Section 201 of the EGRC Act directed the federal banking agencies to develop a community bank leverage ratio (“CBLR”) of not less than 8% and not more than 10% for qualifying community banks and bank holding companies with total consolidated assets of less than $10 billion. Qualifying community banking organizations that exceed the CBLR level established by the agencies, and that elect to be covered by the CBLR framework, will be considered to have met: (i) the generally applicable leverage and risk-based capital requirements under the banking agencies’ capital rules; (ii) the capital ratio requirements necessary to be considered “well capitalized” under the banking agencies’ prompt corrective action framework in the case of insured depository institutions; and (iii) any other applicable capital or leverage requirements.
On November 13, 2019, the Federal banking agencies published a final rule that provides for a simple measure of capital adequacy for certain community banking organizations, consistent with Section 201 of the EGRC Act. The final rule is effective on January 1, 2020. Under the EGRC Act, depository institutions and depository institution holding companies that have less than $10 billion in total consolidated assets and meet other qualifying criteria, including a leverage ratio (equal to tier 1 capital divided by average total consolidated assets) of greater than 9%, will be eligible to opt into the community bank leverage ratio framework (qualifying community banking organizations). Qualifying community banking organizations that elect to use the community bank leverage ratio framework and that maintain a leverage ratio of greater than 9% will be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the agencies’ generally applicable capital rules and, if applicable, will be considered to have met the well-capitalized ratio requirements for purposes of prompt corrective action framework under Section 38 of the FDIA. The final rule includes a two-quarter grace period during which a qualifying community banking organization that temporarily fails to meet any of the qualifying criteria, including the greater than 9% leverage ratio requirement, generally would still be deemed well-capitalized so long as the banking organization maintains a leverage ratio greater than 8%. At the end of the grace period, the banking organization must meet all qualifying criteria to remain in the community bank leverage ratio framework or otherwise must comply with and report under the generally applicable rule. Similarly, a banking organization that fails to maintain a leverage ratio greater than 8% would not be permitted to use the grace period and must comply with the capital rule’s generally applicable requirements and file the appropriate regulatory reports. As a result of the Coronavirus Aid, Relief, and Economic Security Act enacted during 2020, the CBLR was reduced to 8.0% for the remainder of 2020 and set at 8.5% for 2021.
QNB does not currently meet all the requirements under the EGRC Act, including the CBLR framework, to be considered a qualifying community banking organization. QNB does not believe, however, that the changes resulting from the EGRC Act will materially impact QNB’s business, operations, or financial results going forward.
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Coronavirus Aid, Relief, and Economic Security Act
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was signed into law. As permitted under Section 4013 of the CARES Act, QNB continues to provide customers experiencing financial hardship caused by the COVID-19 Pandemic, solutions to help them through this difficult period. Upon requests from customers, QNB: has provided an interest only payment option, granted in 90 days increments; has provided payment deferment for commercial, mortgage and consumer loans with no late fee during the deferment period; has granted foreclosure and motor vehicle repossession reprieve; and will not adversely impact credit reporting for customers who were granted relief on mortgage or consumer loans. None of these modifications are considered troubled-debt restructurings as the customers were not experiencing financial difficulty prior to the COVID-19 Pandemic. Interest continues to be accrued on all COVID-19 modifications during the deferment period. QNB had modified a total 305 commercial loans or $160,676,000 and 61 retail loans or $8,808,000 during the year due to COVID-19. As of December 31, 2020, QNB had modifications on approximately 4.0% of the December 31, 2020 commercial portfolio, consisting of 16 loans with an outstanding balance of $31,147,000, of which 13 loans totaling $30,613,000 had extended the initial modification period, and had modifications to approximately 1.8% of the December 31, 2020 retail portfolio, consisting of 13 loans with an outstanding balance of $2,723,000, of which 11 loans totaling $2,428,000 had extended the initial deferment period, related to the COVID-19 Pandemic. QNB will continue work with our borrowers during this difficult time.
As provided under the CARES Act, the U.S. Small Business Administration (“SBA”) and Treasury have implemented the Paycheck Protection Program (“PPP”) which is designed to assist small businesses and their employees during this crisis. This program provides small businesses with payroll assistance in the form of a 100% guaranteed loan from SBA. Eligible borrowers can receive up to 2.5 times their monthly average payroll expenses for the prior year. Congress originally approved $349 billion for this program as part of the CARES Act. The first round of funding was quickly exhausted by April 16, 2020 and Congress worked to provide an additional $310 billion in funding which was approved on April 23, 2020. The SBA reopened its portal to begin accepting PPP loans for approval on Monday, April 27, 2020. As of August 13, 2020, QNB closed 660 loans totaling $82,475,000; of which $72,821,000 were outstanding at December 31, 2020. QNB received origination fees from the SBA ranging from one to five basis points which are recognized in interest income as a yield adjustment over the term of the loan. Net unearned fees and costs on PPP loans was $1,909,000 at December 31, 2020. Funds are primarily being transferred into the borrowers’ deposit accounts, and disbursement on these PPP loan proceeds are being funded by cash held at the Federal Reserve and proceeds from calls and payments of investment securities. QNB has ample resources to cover future disbursements through short-term Federal Home Loan Bank (“FHLB”) advances and participation in the Federal Reserve’s Paycheck Protection Program Liquidity Facility (“PPPLF”), if necessary. On June 5, 2020, the Paycheck Protection Program Flexibility Act of 2020 was signed into law and amends the CARES Act. The amended act eases rules on how and when small businesses can use the proceeds from PPP loans and still be eligible for loan forgiveness. The amended act made the following changes: (1) extended the maximum covered period for loan forgiveness purposes to 24 weeks or December 31, 2020; (2) lowered the amount required to be spent on payroll costs from 75% to 60%; (3) extended the loan maturity period from two to five years; and (4) revised the loan deferral period, among other changes.
On December 27, 2020, the Consolidated Appropriations Act was signed into law, which both funds the federal government until September 30, 2021 and broadly addresses additional COVID-19 responses and relief. Included among those relief provisions are certain extensions to elements of the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) that address the application of U.S. GAAP by financial institutions.
Section 540 (Extensions of Temporary Relief and Emergency Authorities) amended Section 4014 of the CARES Act and further delays the required adoption of the FASB’s ASU 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 326), including the current expected credit loss (CECL) model, by insured depository institutions, credit unions and bank holding companies. Those entities that have not previously adopted and were preparing to adopt on December 31, 2020, now have until the earlier of a) the first day of the financial institution’s fiscal year that begins after the date on which the national COVID-19 emergency terminates or b) January 1, 2022 to adopt ASU 2016-13. The required adoption date for QNB and other small reporting companies has not changed and remains at January 31, 2023.
Section 541 (Extension of Temporary Relief from Troubled Debt Restructurings and Insurer Clarification) also extends the period established by Section 4013 of the CARES Act under which consideration of troubled debt restructuring identification and accounting triggered by effects of the COVID-19 epidemic are suspended. That period is extended to the earlier of a) January 1, 2022, or b) the date that is 60 days after the date on which the national COVID-19 emergency terminates. In addition, Section 541 amended the relief to expand beyond financial institutions to include insurance companies. The requirement that the subject specific loans not be more that 30 days past due as of December 31, 2019 was not changed.
On December 27, 2020, the Economic Aid to Hard-Hit Small Businesses, Nonprofits and Venues Act (“Economic Aid Act”) was signed into law. The Economic Aid Act reopens and expands the PPP. Eligible businesses that previously did not obtain a First Draw Loan may now apply for a PPP loan through March 31, 2021, or until the appropriations are exhausted. Second Draw Loans are available to those who previously received a First Draw Loan. Under these new PPP loans, a borrower may select a covered period anywhere between eight weeks and 24 weeks after the loan is first advanced.
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The full impact of the COVID-19 Pandemic is unknown and rapidly evolving. Uncertainties exist related to the duration of the COVID-19 Pandemic and its potential effects on QNB’s customers and prospects, including impacts on national and local economies, unemployment, maintaining a competent workforce, and disruptions in the supply chain. There are no assurances as to how the COVID-19 Pandemic might affect QNB’s loan, investment and deposit portfolios.
Possible Future Legislation
Congress is often considering some financial industry legislation, and the Federal banking agencies routinely propose new regulations. The Company cannot predict the future effect any new legislation, or new rules adopted by Federal or state banking agencies, will have on the business of the Company and its subsidiaries. Given that the financial industry remains under scrutiny, the Company expects that there will be legislative and regulatory actions that may materially affect the banking industry in the foreseeable future.
Additional Information
QNB’s principal executive offices are located at 320 West Broad Street, Quakertown, Pennsylvania. Its telephone number is (215) 538-5600.
QNB also makes its periodic and current reports available, including this annual report for Form 10-K, free of charge, on its website, www.qnbbank.com, as soon as reasonably practicable after such material is electronically filed with the SEC. Information available on the website is not a part of, and should not be incorporated into, this annual report on Form 10-K. In addition, the SEC maintains a website that contains reports, proxy and information statements and other information regarding registrants, including QNB, that file electronically with the SEC which can be accessed at www.sec.gov.
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ITEM 1A. RISK FACTORS
The following discusses risks that management believes are specific to our business and could have a negative impact on QNB’s financial performance. When analyzing an investment in QNB, the risks and uncertainties described below, together with all of the other information included or incorporated by reference in this report, should be carefully considered. This list should not be viewed as comprehensive and may not include all risks that may affect the financial performance of QNB.
Our net interest income, net income and results of operations are sensitive to fluctuations in interest rates.
QNB’s profitability is largely a function of the spread between the interest rates earned on earning assets and the interest rates paid on deposits and other interest-bearing liabilities. Like most financial institutions, QNB’s net interest income and margin will be affected by general economic conditions and other factors, including fiscal and monetary policies of the Federal government, that influence market interest rates and QNB’s ability to respond to changes in such rates. At any given time, QNB’s assets and liabilities may be such that they are affected differently by a change in interest rates. As a result, an increase or decrease in rates, the length of loan terms or the mix of adjustable- and fixed-rate loans or investment securities in QNB’s portfolio could have a positive or negative effect on its net income, capital and liquidity. Although management believes it has implemented strategies and guidelines to reduce the potential effects of adverse changes in interest rates on results of operations, any substantial and prolonged change in market interest rates could affect operating results negatively.
We are subject to credit risk in connection with our lending activities, and our financial condition and results of operations may be negatively affected by economic conditions and other factors that could adversely affect our customers.
As a lender, QNB is exposed to the risk that its borrowers may be unable to repay their loans and that the current market value of any collateral securing the payment of their loans may not be sufficient to assure repayment in full. Credit losses are inherent in the lending business and could have a material adverse effect on the operating results of QNB. Adverse changes in the economy or business conditions, either nationally or in QNB’s market areas, could increase credit-related losses and expenses and/or limit growth. Substantially all of QNB’s loans are to businesses and individuals in its limited geographic area and any economic decline in this market could impact QNB adversely. QNB makes various assumptions and judgments about the collectability of its loan portfolio and provides an allowance for loan losses based on a number of factors. If these assumptions are incorrect, the allowance for loan losses may not be sufficient to cover losses and may cause QNB to increase the allowance in the future by increasing the provision for loan losses, thereby having an adverse effect on operating results. QNB has adopted underwriting and credit monitoring procedures and credit policies that management believes are appropriate to control these risks; however, such policies and procedures may not prevent unexpected losses that could have a material adverse effect on QNB’s financial condition or results of operations.
A deterioration in regional or national economic conditions may adversely affect our financial condition and results of operations.
QNB primarily provides banking services to customers located in the Bucks, Lehigh and Montgomery Counties in Pennsylvania. Adverse effects of a regional economic downturn could affect QNB’s ability to attract deposits and qualified loans. Economic factors impacting the local economy with this region, such as a decline in real estate values, unemployment, and natural disasters, may have a negative impact on credit-worthiness of customers, the value of collateral, and customers’ ability to repay loans, which would result in write-downs, increases in non-performing loans, and a decline in QNB’s financial performance measurements. Unlike larger banks that are more geographically diversified, we provide banking and financial services locally and therefore are more affected by adverse local economic conditions.
Similarly, potential adverse effects of any national economic downturn or concerns with the stability of the financial markets could lead to lack of consumer confidence, increased market volatility, and a general reduction in business activity. Such events may result in increased regulation of the financial services industry and increased compliance costs; greater difficulty in assessing the creditworthiness of customers and increased credit risk; greater difficulty in originating loans that meet our underwriting criteria; liquidity issues to the extent that it becomes more difficult to borrow from third parties, including other financial institutions; and limitations on growth.
We face significant competition from other banks and financial institutions in our market area, many of which are larger in terms of asset size and market capitalization.
The financial services industry is highly competitive, with competition for attracting and retaining deposits and making loans coming from other banks and savings institutions, credit unions, mutual fund companies, insurance companies and other non-bank businesses. Many of QNB’s competitors are much larger in terms of total assets and market capitalization, have a higher lending limit, have greater access to capital and funding, and offer a broader array of financial products and services. In light of this, QNB’s ability to continue to compete effectively is dependent upon its ability to maintain and build relationships by delivering top quality service. Competition within the financial services industry also impacts QNB’s ability to attract and retain low-cost deposits which could impact QNB’s liquidity. Lowering loan rates and increasing deposit rates compresses the interest rate margin and profitability.
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At December 31, 2020, our lending limit per borrower was approximately $19,003,000. Accordingly, the size of loans that we may offer to potential borrowers (without participation by other lenders) is less than the size of loans that many of our competitors with larger capitalization are able to offer. Our legal lending limit also impacts the efficiency of our lending operation because it tends to lower our average loan size, which means we have to generate a higher number of transactions to achieve the same portfolio volume. We may engage in loan participations with other banks for loans in excess of our legal lending limit. However, there can be no assurance that such participations will be available or on terms which are favorable to us and our customers.
Our results of operations may be adversely affected by other-than-temporary impairment charges relating to our debt securities.
QNB purchases U.S. Government and U.S. Government agency debt securities, U.S. Government agency issued mortgage-backed securities or collateralized mortgage obligation securities, obligations of states and municipalities and corporate debt securities. QNB is exposed to the risk that the issuers of these debt securities may experience significant deterioration in credit quality which could impact the market value of such issuer’s securities. QNB periodically evaluates its debt securities to determine if market value declines are other-than-temporary. Once a decline is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized for the credit related portion of the impairment.
Our results of operations may be adversely affected by fair value declines in our investments in equity securities.
The Company’s investment in marketable equity securities primarily consists of investments in large cap stock companies. Changes in fair value are recorded in unrealized gain/(losses) in non-interest income These equity securities are carried at fair value and are no longer analyzed for impairment on an ongoing basis beginning in 2018. QNB had 16 equity securities with unrealized losses of approximately $1,122,000 at December 31, 2020. The severity and duration of the fair value declines are consistent with current stock market developments.
At December 31, 2020, the Bank had $1,029,000 in capital stock of the FHLB and $12,000 in capital stock of ACBB. These equity securities are restricted in that they can only be sold back to the respective institutions or another member institution at par. Therefore, they are less liquid than other tradable equity securities, their fair value is equal to amortized cost, and no impairment write-downs have been recorded on these securities.
Our assets at December 31, 2020 included a deferred tax asset and we may not be able to realize the full benefit of that asset.
As of December 31, 2020, QNB had a net deferred tax asset of $66,000. Our ability to realize these tax benefits ultimately depends on the existence of sufficient taxable income of the appropriate character (ordinary income or capital gains) within the applicable carryback and carryforward periods provided under the tax law. Estimating whether the deferred tax asset will be realized requires us to exercise significant judgment and is inherently uncertain because it requires the prediction of future occurrences. The deferred tax asset may be reduced in the future if estimates of future income, our tax planning strategies, or tax rate changes resulting from Federal tax reform do not support the amount of the deferred tax asset. If it is determined in the future that a valuation allowance of the deferred tax asset is necessary, we may incur a charge to earnings resulting and a reduction to regulatory capital for the amount included in any such allowance.
A disruption in components of our business infrastructure resulting from financial or technological difficulties of our third- party vendors on which we rely could adversely affect our business.
Third parties provide key components of our business infrastructure, such as Internet connections, software platforms and network access. Any disruption in Internet, network access or other voice or data communication services provided by these third parties or any failure of these third parties to handle current or higher volumes of use could adversely affect the ability to deliver products and services to clients and otherwise to conduct business. Disruptions or failures in the business infrastructure or operating systems that support our business and customers, or cyber-attacks or security breaches of the networks, systems, or devices that our customers use to access our products and services, could damage our reputation, cause us to incur additional expenses, result in losses, or subject us to regulatory sanctions or additional regulatory scrutiny, any of which could adversely affect our results of operations or financial condition.
Our failure to properly or timely utilize effective technologies to deliver our products and services, or a systems failure or breach of network security with respect to our information systems could adversely affect our business.
The market for financial services is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and mobile banking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able to properly or timely anticipate or implement such technologies or properly train our staff to use such technologies. Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results.
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In addition, we rely heavily on our information systems to conduct business. Maintaining and protecting those systems is difficult and expensive, as is dealing with any failure, interruption or breach in security of these systems, whether due to acts or omissions by us or by a third party and whether intentional or not. Any such failure, interruption or breach could result in failures or disruptions in our customer relationship management or our information systems. The policies, procedures and technical safeguards we have in place to prevent or limit the effect of any failure, interruption or security breach of our information systems may be insufficient to prevent or remedy the effects of any such event. Moreover, as cyber threats continue to evolve, we may be required to expend significant additional resources to modify or enhance our protective measures relating to information security. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, cause us to incur additional expenses, result in losses, or subject us to regulatory sanctions or additional regulatory scrutiny, any of which could adversely affect our business, financial condition or operating results.
Changes in accounting standards applicable to us could materially impact how we report our financial condition and results of operations.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the FASB changes the financial accounting and reporting standards that govern the preparation of our financial statements.
These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements. Management believes the current financial statements are prepared in accordance with U.S. generally accepted accounting principles.
A new accounting standard, which requires us to measure certain financial assets (including loans) using current expected credit losses (“CECL”) beginning in calendar year 2023, will likely result in material changes to our allowance for loan losses.
Current U.S. GAAP requires an incurred loss methodology for recognizing credit losses that delays recognition until it is probable that a loss has been incurred as of the balance sheet date. The Financial Accounting Standards Board has adopted a new accounting standard, effective for QNB beginning January 1, 2023, referred to as CECL. The new accounting standard replaces the current loss methodology with a methodology that reflects current expected credit losses and requires consideration of a broader range of reasonableness and reportable information to determine credit loss estimates. QNB is in the process of evaluating the impact of the adoption of the new accounting standard on QNB’s financial statements; however, it is expected that the allowance for loan losses will materially change upon the adoption of CECL. Any increase in our allowance for loan losses may have a material adverse effect on our financial condition and results of operations.
We operate in a highly regulated environment and are subject to examination and supervision by bank regulatory agencies, which could have an adverse impact on our operations or increase the cost of our operations.
We operate in a highly regulated environment and are subject to extensive examination by the Board of Governors of the Federal Reserve System, the FDIC, and the Pennsylvania Department of Banking and Securities. The bank regulatory agencies exercise broad discretion in connection with their supervisory and enforcement activities. Federal and state banking laws and regulations are designed primarily to protect depositors, the deposit funds, and consumers, and not necessarily shareholders of a financial institution. Banking regulations or the activities of bank regulatory agencies may, for example, limit a financial institution’s growth and potential shareholder returns by restricting certain activities such as the payment of dividends, expansion of branch offices, and acquisition activities.
The significant laws and regulations that govern our activities are described under “Item 1 - Description of Business” in this Form 10-K. These laws and regulations, along with existing tax, accounting, securities, and monetary laws, regulations, standards, policies, and interpretations control the manner in which financial institutions conduct business. Such laws, regulations, standards, policies, and interpretations are constantly evolving and may change significantly over time. The potential exists for additional federal or state laws or regulations, or new policies or interpretations by regulatory agencies having jurisdiction over our activities, to affect many aspects of our operations, including capital requirements, lending and funding practices, and liquidity standards. Additional laws, regulations or other regulatory requirements, or any substantial change in regulation and oversight, may have a material impact on our operations by increasing our cost of regulatory compliance and of doing business and otherwise affecting our operations, and may significantly affect the markets in which we do business, the markets for and value of our investments, the fees we charge and our ongoing operations, costs and profitability.
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If we lose the availability of wholesale funding we may be unable to support interest-earning asset growth, which could adversely impact our operating results and liquidity.
Management periodically uses wholesale funding sources to support loan demand and deposit withdrawals and to provide sufficient liquidity. Wholesale funding primarily is made up of borrowings from the FHLB but may also include unsecured Federal funds from correspondent banks, Federal advances and wholesale certificates of deposit.
If wholesale funding becomes unavailable, QNB may need to reduce interest-earning asset growth through production reduction, sale of assets, or participating out future and current loans; this could adversely impact future net income. A termination or change in borrowings from the FHLB, the Federal Reserve or correspondent banks may have an adverse effect on our liquidity and operating results.
Our disclosure controls and procedures and our internal control over financial reporting may not achieve their intended objectives.
Management diligently reviews and updates its internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by QNB in reports filed or submitted under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Management believes that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Any undetected circumvention of these controls could have a material adverse impact on QNB’s financial condition and results of operations.
These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.
We may not be able to attract and retain highly qualified personnel to execute our business strategy.
Our success depends upon the ability to attract and retain highly motivated, well-qualified personnel. We face significant competition in the recruitment of qualified employees. Our ability to execute our business strategy and provide high-quality service may suffer if we are unable to recruit or retain a sufficient number of qualified employees or if the costs of employee compensation or benefits increase substantially. QNB currently has employment agreements and change of control agreements with five of its senior officers.
Uncertainty relating to the expected phase-out of the London Interbank Offered Rate (“LIBOR”) in 2021 may adversely affect us.
LIBOR has been used extensively in the United States as a reference rate for various financial contracts, including adjustable-rate loans, asset-backed securities, and interest rate swaps. In 2017, the Chief Executive of the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that the FCA will not compel panel banks to submit rates for the calculation of LIBOR after 2021. The announcement means that the continuation of LIBOR on the current basis cannot be guaranteed after 2021. At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR, and it is impossible to predict the effect of any such alternatives on the value of LIBOR-based variable rate loans and other securities or financial arrangements, given LIBOR's current role in determining market interest rates globally. The uncertainty as to the nature and effect of such reforms and actions relating to the discontinuance of LIBOR may adversely affect the value of and return on certain of our financial assets and liabilities that are based on or are linked to LIBOR, which may adversely affect the Company's results of operations or financial condition. In addition, LIBOR-related reforms may also require changes to the agreements that govern these LIBOR-based products, as well as our internal systems and processes.
Acts of terrorism and other external events, including natural disasters and epidemics, could impact our ability to conduct business.
Financial institutions have been, and continue to be, targets of terrorist threats aimed at compromising operating and communication systems. Other external events, including natural disasters and epidemics could impact our business continuity. Such events could cause significant damage, impact the stability of our facilities and result in additional expenses, impair the ability of our borrowers to repay their loans, and result in the loss of revenue. While we have established and regularly test disaster recovery procedures, the occurrence of any such event could have a material adverse effect on our business, operations and financial condition.
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The continuing COVID-19 pandemic may adversely impact our business and financial results, and the ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
Since the beginning of January 2020, the coronavirus outbreak has disrupted global supply chains, lowered equity market valuations, created significant volatility and disruption in financial markets, increased unemployment levels, and decreased consumer confidence. Additionally, the COVID-19 pandemic has resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities, including in our primary market areas. As a result, the demand for our products and services may be significantly impacted, which could adversely affect our revenue. This may result in a significant decrease in business and/or cause QNB’s customers to be unable to meet existing payment or other obligations to QNB, particularly in in QNB’s market area. The continuing COVID-19 pandemic could result in the recognition of credit losses in our loan portfolios and increases in our allowance for credit losses, particularly if businesses remain closed, the impact on the global economy worsens, or more customers draw on their lines of credit or seek additional loans to help finance their businesses. Similarly, because of changing economic and market conditions affecting bond issuers, we may be required to recognize impairments on the securities we hold as well as reductions in other comprehensive income. Although the Company maintains contingency plans for pandemic outbreaks, a spread of COVID-19, or an outbreak of another contagious disease, could also negatively impact the availability of key personnel of QNB necessary to conduct the business of QNB. Our business operations may be further disrupted if significant portions of our workforce are unable to work effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. Such a spread or outbreak could also negatively impact the business and operations of third-party service providers who perform critical services for QNB’s business. Moreover, the pandemic has created additional operational and compliance risks, including the need to quickly implement and execute new programs and procedures for the products and services we offer our customers, provide enhanced safety measures for our employees and customers, comply with rapidly changing regulatory requirements, address any increased risk of fraudulent activity, and protect the integrity and functionality of our systems and networks as a larger number of our employees work remotely. The extent to which the COVID-19 pandemic impacts our business, results of operations, and financial condition, as well as our regulatory capital and liquidity ratios and our cost of capital, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
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ITEM 2. PROPERTIES
The principal office of both QNB Bank and QNB Corp. is located at 15 North Third Street, Quakertown, Pennsylvania. QNB Bank conducts business from its principal office and eleven other branch offices located in Bucks, Lehigh, and Montgomery Counties in Pennsylvania. QNB Bank owns its principal office, three branch locations, its administrative and operations facility and a computer facility. QNB Bank leases its remaining eight branch properties. The leases on the properties generally contain renewal options. In management’s opinion, these properties are in good condition and are currently adequate for QNB’s purposes.
The following table details QNB Bank’s properties:
Location
• Quakertown, PA – Towne Bank Center - 320-322 West Broad Street Owned
• Quakertown, PA – Computer Center - 121 West Broad Street Owned
• Quakertown, PA – Country Square Branch - 240 South West End Boulevard Leased
• Dublin, PA – Dublin Branch - 161 North Main Street Leased
• Pennsburg, PA – Upper Perkiomen Valley Branch - 410 Pottstown Avenue Leased
• Coopersburg, PA – Coopersburg Branch - 51 South Third Street Owned
• Perkasie, PA – Perkasie Branch - 607 Chestnut Street Owned
• Souderton, PA – Souderton Branch - 750 Route 113 Leased
• Wescosville, PA – Wescosville Branch - 950 Mill Creek Road Leased
• Colmar, PA – Colmar Branch - 127 Bethlehem Pike Owned
• Warminster, PA – Warminster Branch - 1402 West Street Road Owned
• Allentown, PA – Allentown Branch - 535 N. 19th Street Leased
ITEM 3. LEGAL PROCEEDINGS
Although there are currently no material proceedings to which QNB is the subject, future litigation that arises during the normal course of QNB’s business could be material and have a negative impact on QNB’s earnings. Future litigation also could adversely impact the reputation of QNB in the communities that it serves.
ITEM 4. MINE SAFETY DISCLOSURES
None.
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PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Stock Information
QNB common stock is quoted on the over-the-counter bulletin board (“OTCBB”). QNB had approximately 649 shareholders of record as of February 26, 2021.
The following table sets forth the high and low bid and ask stock prices for QNB common stock on a quarterly basis during 2020 and 2019. These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
Cash
High Low dividend
Bid Ask Bid Ask per share
QNB has traditionally paid quarterly cash dividends on the last Friday of each quarter. The Company expects to continue the practice of paying quarterly cash dividends to its shareholders; however, future dividends are dependent upon future earnings, financial condition, appropriate legal restrictions, and other factors relevant at the time the board of directors considers declaring a dividend. Certain laws restrict the amount of dividends that may be paid to shareholders in any given year. See “Shareholders’ Equity - Capital Adequacy” included in Item 7 of this Form 10-K filing and Note 20 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K filing, for additional information that discusses and quantifies this regulatory restriction.
The following table provides information on repurchases by QNB of its common stock in each month of the quarter ended December 31, 2020.
(1) Transactions are reported as of settlement dates.
(4) QNB’s current stock repurchase plan has no expiration date.
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Stock Performance Graph
Set forth below is a performance graph comparing the yearly cumulative total shareholder return on QNB’s common stock with:
All of these cumulative total returns are computed assuming the reinvestment of dividends at the frequency with which dividends were paid during the applicable years.
Period Ending
Source: S&P Global Markets Intelligence © 2020
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ITEM 6. SELECTED FINANCIAL DATA (in thousands, except share and per share data)
Income and expense
Share and Per Share Data
Balance Sheet at Year-end
Investment securities
Trading $ — $ — $ — $ — $ 3,596
Selected Financial Ratios
Net income as a percentage of:
Average shareholders' equity to average total assets 9.21 9.63 9.20 9.09 9.16
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations – Overview
QNB Corp. (“QNB” or the “Company”) earns its net income primarily through its subsidiary, QNB Bank (the “Bank”). Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. QNB seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors. Due to its limited geographic area, comprised principally of Bucks, Lehigh and Montgomery counties, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact.
Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.
Net income for the year ended December 31, 2020 was $12,083,000, or $3.42 per share on a diluted basis. This compares to 2019 net income of $12,357,000, or $3.53 per share on a diluted basis and 2018 net income of $11,335,000, or $3.25 per share on a diluted basis. Two important measures of profitability in the banking industry are an institution’s return on average assets and return on average shareholders’ equity. Return on average assets was 0.90%, 1.02% and 0.96% in 2020, 2019, and 2018, respectively, and return on average shareholders’ equity was 9.76%, 10.58% and 10.47%, respectively, during those same periods.
The Bank contributed $11,753,000 to net income for the year ended December 31, 2020 compared to $10,648,000 for the same period in 2019; whereas the holding company contributed $330,000 to net income for the year ended December 31, 2020 compared to $1,709,000 for the same period in 2019. The decrease at the holding company resulted primarily from a decrease in gains on sales of equity securities and a decrease in the fair value of the equity portfolio during 2020.
2020 versus 2019
The results for 2020 include the following significant components:
• Provision for income taxes decreased $288,000.
2019 versus 2018
The results for 2019 include the following significant components:
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These items, as well as others, will be explained more thoroughly in the next sections.
Net Interest Income
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the years ended December 31, 2020, 2019, and 2018.
Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities and interest-bearing balances at the Federal Reserve Bank (Fed). Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest-bearing deposits.
For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the table that appears above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.
2020 versus 2019
On a tax-equivalent basis, net interest income for 2020 increased $865,000, or 2.3%, to $37,939,000. The net interest margin, which decreased 24 basis points to 2.92% was unfavorably impacted by decreased rates on loans. The average rate earned on earning assets decreased 60 basis points from 4.02% for 2019 to 3.42% for 2020 with the yield on loans decreasing 53 basis points, favorably impacted by a $48,161,000 increase in average commercial and industrial loans partially offset by an 123 basis point decrease in the related yield and a $9,475,000 increase in average residential real estate loans partially offset by a 19 basis point decrease in yield, and unfavorably impacted by a 36 basis point decrease in the yield partially offset by a $21,719,000 increase in average commercial real estate loans. The yield on investment securities declined 45 basis points to 1.92%. In comparison, the interest rate paid on total average interest-bearing liabilities decreased 44 basis points from 1.07% for 2019 to 0.63% for 2020 with the average rate paid on interest-bearing deposits increasing from 1.06% to 0.63% for the same time periods, respectively, partially offset by a $75,213,000 increase in average interest-bearing deposits.
Market disruption caused by local bank consolidation positively impacted both loan and deposit growth which was partially offset by the competitive local interest rate market for quality loans and deposits. Net interest spread decreased 16 basis points to 2.79% for 2020 compared to 2.95% for 2019. Average earning assets increased by $122,532,000, or 10.4%, to $1,297,151,000 for 2020, with average loans increasing $60,465,000, or 7.5%, to $871,991,000. The growth in loans and investment securities was funded by a $120,038,000, or 11.6%, increase in average total deposits.
2019 versus 2018
On a tax-equivalent basis, net interest income for 2019 increased $1,241,000, or 3.5%, to $37,074,000. The net interest margin, which increased three basis points to 3.16% was favorably impacted by increased rates on loans. The average rate earned on earning assets increased 17 basis points from 3.85% for 2018 to 4.02% for 2019 with the yield on loans increasing 16 basis points, favorably impacted by a $32,443,000 increase in average commercial real estate loans and an 16 basis point increase in the related yield, a $5,290,000 increase in average residential real estate loans and a 12 basis point increase in yield, and a $2,447,000 increase in average commercial and industrial loans and a 15 basis point increase in the related yield. The yield on investment securities increased to 2.37%. In comparison, the interest rate paid on total average interest-bearing liabilities increased 19 basis points from 0.88% for 2018 to 1.07% for 2019 with the average rate paid on interest-bearing deposits increasing from 0.86% to 1.06% for the same time periods, respectively, and a $15,780,000 increase in average interest-bearing deposits.
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Average Balances, Rates, and Interest Income and Expense Summary (Tax-Equivalent Basis)
Average Average Average Average Average Average
balance rate Interest balance rate Interest balance rate Interest
Assets
Investment securities (AFS & Equities):
Loans:
Liabilities and Shareholders' Equity
Interest-bearing deposits:
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21 percent. Non-accrual loans and investment securities are included in earning assets.
* Includes loans held-for-sale
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Rate-Volume Analysis of Changes in Net Interest Income (1) (2) (3)
Due to change in: Total Due to change in: Total
Volume Rate Change Volume Rate Change
Interest income:
Investment securities (AFS & Equities):
U.S. Treasury $ (46 ) $ — $ (46 ) $ 1 $ 45 $ 46
Pooled trust preferred — (1 ) (1 ) (2 ) — (2 )
Loans:
Interest expense:
The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis decreased $2,814,000 to $44,384,000 for 2020, while total interest expense decreased $3,679,000 to $6,445,000. Volume growth in earning assets contributed an additional $5,293,000 of interest income and interest rate decreases contributed to a reduction in interest income of $8,107,000. Rate-related interest expense decreased $3,921,000, while volume-related interest expense increased $242,000.
Investments
2020 versus 2019
Interest income on available-for-sale and equity investment securities decreased $1,043,000 when comparing the two years. The increase in average balances contributed an additional $878,000 to interest income but was offset by $1,921,000 due to the 45-basis point decrease in rates. The average yield on the available-for-sale and equity investment portfolio decreased to 1.92% for 2020 compared to 2.37% for 2019.
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Income on U.S. Government agency securities decreased $370,000, due to a decrease in average balances totaling $5,225,000 and a 43-basis point decrease in the yield from 1.81% for 2019 to 1.38% for 2020. Most of the bonds in the agency portfolio have call features ranging from three months to three years, many of which were exercised during 2020 as a result of the declining rates during the year.
Interest income on tax-exempt municipal securities increased $91,000. Average balances, which increased $11,192,000, contributed $396,000 to interest income. The decrease in yield of 46 basis points from 3.54% in 2019 to 3.08% in 2020 partially offset the increase in interest income by $305,000. Many of these bonds have either reached maturity or their call dates and are being replaced with municipal bonds with less favorable tax-equivalent yields. Typically, QNB purchased municipal bonds with 10- to 15-year maturities with call dates between 2 and 5 years. Future demand for tax-exempt municipal securities is uncertain, as the tax-equivalent yield could be less favorable compared to other securities with similar risk-based capital asset-weighting characteristics.
All the mortgage-backed and collateralized mortgage obligations (“CMO”) securities owned by QNB are issued by U.S. Government agencies and sponsored enterprises (“GSE”) and carry the implicit backing of the U.S. Government, but they are not direct obligations of the U.S. Government. Interest income on mortgage-backed securities and CMOs decreased $807,000 due to 57-basis point decrease in rate from 2.18% for 2019 to 1.61% for 2020 partially offset by an increase of $25,401,000, or 11.7%, in average balances. This portfolio generally provides higher yields relative to agency bonds and provides monthly cash flow which can be used for liquidity purposes or can be reinvested as interest rates increase.
Income on corporate debt securities decreased $28,000 due to a decrease in average balances of $653,000 and a decrease in yield from 3.74% for 2019 to 3.69% for 2020.
Dividend income on equities increased $118,000 due to an increase in average balances of $2,790,000 and an increase in yield of 23 basis points.
2019 versus 2018
Interest income on available-for-sale and equity investment securities decreased $115,000 when comparing the two years. The decrease in average balances contributed to $519,000 of the decrease, partially offset by $404,000 due to the increase in rates. The average yield on the available-for-sale and equity investment portfolio increased slightly to 2.37% for 2019 compared to 2.32% for 2018. The decrease in the investment portfolio is due to funding needs to support loan growth.
Income on U.S. Government agency securities decreased $34,000, due to a decrease in average balances totaling $2,513,000, which was partially offset by an increase in the yield on the portfolio of two basis points from 1.79% for 2018 to 1.81% for 2019. Most of the bonds in the agency portfolio have call features ranging from three months to three years, many of which were not exercised during 2019 as a result of the rising rates during the year.
Interest income on tax-exempt municipal securities decreased $399,000. Average balances, which decreased $16,416,000, contributed $539,000 to the interest income decline. The increase in yield of 25 basis points from 3.29% in 2018 to 3.54% in 2019 partially offset the decrease in interest income by $140,000.
Interest income on mortgage-backed securities and CMOs increased $150,000 due to both an increase of $3,282,000, or 1.5%, in average balances and an increase in yield of four basis points from 2.14% for 2018 to 2.18% for 2019.
Income on corporate debt securities increased $150,000 due to an increase in average balances of $1,760,000 and an increase in yield from 2.39% for 2018 to 3.74% for 2019.
Loans
2020 versus 2019
The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, hotels, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner or investment properties. The category also includes construction and land development loans. Income on commercial real estate loans decreased $731,000. The increase in average balances of $21,719,000, or 4.7%, contributed an increase in interest income of $1,047,000; this was offset by the 36-basis point decrease in yield, from 4.82% in 2019 to 4.46% in 2020 resulted in a decrease of interest income of $1,778,000.
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Income on commercial and industrial loans, the second largest category, increased $4,000 with the positive impact from an increase in average balances. Average commercial and industrial loans increased $48,161,000, or 30.6%, to $205,566,000 for 2020, resulting in a $2,531,000 increase in interest income. Average yield on these loans decreased 123 basis points to 4.02% causing a decrease of $2,527,000 in interest income. Many of the loans in this category are indexed to the prime interest rate, which decreased 25 basis points in August 2019 with an additional decrease of 25 basis points in September 2019, 25 basis points in October and a total of 150 basis points in March 2020. Included in this category are the PPP loans which contributed $53,374,000 of the net volume increase. The PPP loans yield one percent to the customer, however QNB received origination fees from the SBA ranging from one to five basis points, resulting in a yield of approximately 3.36% for 2020. The PPP loans contributed 24 basis points to the decline in the average yield.
Tax-exempt loan income decreased $335,000 from $1,609,000 in 2019. When comparing the same periods, average balances decreased $11,904,000 to $35,665,000, which contributed a $402,000 decrease in interest income. The average yield on the tax-exempt loan portfolio increased from 3.38% for 2019 to 3.57% for 2020, resulting in an increase in interest income of $67,000. The decrease in volume during 2020 was a result of municipal loans being refinanced as bonds.
QNB strives to become the “local consumer lender of choice”, and to affect this goal, QNB has refocused its retail lending efforts by strengthening the management of the area, adding new product offerings and by increasing marketing and promotion. The positive impact of this renewed focus has been year-over-year growth in balances in residential mortgages. Overall, interest income for retail lending decreased $691,000 in 2020 compared with 2019, driven by the 62-basis point decrease in yield.
Given the low yields on alternative investment securities, QNB retained certain fixed rate and hybrid adjustable rate mortgages to borrowers with high credit scores and low loan-to-value ratios. As a result, average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $9,475,000, or 14.0%, to $77,077,000 for 2020. The average yield on the residential real estate portfolio decreased 19 basis points to 3.79% for 2020 compared to 3.98% for 2019. Overall, interest income for this segment grew $234,000 in 2020.
Income on home equity loans decreased by $830,000 when comparing 2020 and 2019. During 2020 and 2019, QNB offered attractive rates on both variable rate and fixed rate home equity loans. Mortgage rates dropped during 2020 resulting in the refinancing home-equity lines into longer-term mortgages, this contributed to the decrease in average balances of $6,145,000, or 9.1%, to $61,493,000 when comparing 2020 and 2019. The yield on the home equity portfolio decreased 88 basis points to 3.79% when comparing the two years. The home values have recovered; therefore, we expect that the demand for home equity loans will continue.
Interest income on consumer loans decreased $95,000. Consumer loans at QNB experienced a decline in average balances in 2020, which decreased $841,000, or12.4%, led by a decline in student loans. Student loan balances are no longer insured, and QNB ceased funding originations through its third-party provider during the second half of 2018; average balances decreased $544,000 and interest income decreased $69,000 when comparing 2020 and 2019.
2019 versus 2018
Income on commercial real estate loans increased $2,258,000. The increase in average balances of $32,443,000, or 7.5%, contributed an increase in interest income of $1,512,000. The 16-basis point increase in yield, from 4.66% in 2018 to 4.82% in 2019 resulted in an increase of interest income of $746,000.
Income on commercial and industrial loans increased $368,000 with the positive impact from an increase in yield and average balances. Average commercial and industrial loans increased $2,447,000, or 1.6%, to $157,405,000 for 2019, resulting in a $124,000 increase in interest income. Average yield on these loans increased 15 basis points to 5.25% providing an additional $244,000 in interest income.
Tax-exempt loan income increased $225,000 from 2018. When comparing the same periods, average balances increased $4,557,000 to $47,569,000, which contributed a $147,000 increase in interest income. The average yield on the tax-exempt loan portfolio increased from 3.22% for 2018 to 3.38% for 2019, resulting in an increase in interest income of $78,000.
Interest income for retail lending interest income for retail lending increased $444,000 in 2019 compared with 2018, driven by the increase in average balances and average rate increases on residential and home equity loans.
Average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $5,290,000, or 8.5%, to $67,602,000 for 2019. The average yield on the residential real estate portfolio increased 12 basis points to 3.98% for 2019 compared to 3.86% for 2018. Overall, interest income for this segment grew $286,000 in 2019.
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Income on home equity loans increased by $169,000 when comparing 2019 and 2018.Average balances increased $262,000, or 0.4%, to $67,638,000 when comparing 2019 and 2018. The yield on the home equity portfolio increased 23 basis points to 4.67% when comparing the two years.
Interest income on consumer loans decreased $11,000. Average balances in this segment decreased $217,000, or 3.1%, led by a decline in student loans. Student loan average balances decreased $362,000 and interest income decreased $17,000 when comparing 2019 and 2018. This decrease was partially offset by an increase in consumer installment loans.
Deposits and Borrowings
2020 versus 2019
Earning assets are funded primarily by deposits, which increased on average by $120,038,000, or 11.6%, to $1,150,411,000, when comparing 2020 and 2019. Total interest expense for 2020 was $6,455,000 compared with $10,124,000 for 2019, a decrease of $3,679,000. Interest expense on total deposits decreased $3,362,000 and interest expense on borrowed funds decreased $317,000 when comparing the two years. The rate paid on interest-bearing deposits decreased 43 basis points; the rate paid on borrowings decreased 59 basis points, when comparing the two periods. Deposit and borrowing costs are expected to increase as the competition for deposits increases when rates rise
Consistent with the past several years, the growth in deposits during 2020 was centered in accounts with greater liquidity. Average non-interest-bearing demand accounts increased $44,825,000, or 31.6%, to $186,897,000 for 2020; QNB has been successful in increasing both personal and business checking accounts. Average interest-bearing demand accounts increased $39,635,000, or 18.7%, to $252,050,000 for 2020 compared with 2019, with interest expense on interest-bearing demand accounts decreasing $322,000 to $668,000 for 2020. The average rate paid decreased 21 basis points to 0.26% for 2020 compared to 0.47% for 2019. Interest-bearing business checking account average balances increased by $10,689,000, or 24.3%, and related interest expense decreased $265,000, or 72 basis points in yield, when comparing the two years. This was primarily due to initial proceeds from PPP loans being held by customers at the Bank. Also included in this category is QNB-Rewards checking, a tiered-rate checking account product. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 debit card purchase transactions post and clear per statement cycle. If these qualifications are not met, the rate paid for 2020 was 0.20%. For 2020, the average balance in this product was $74,447,000 and the related interest expense was $325,000 for an average cost of funds of 0.44%. In comparison, the average balance in this product was $59,490,000 and the related interest expense was $392,000 for an average cost of funds of 0.66%. The rates paid on the QNB-Rewards product, assuming qualifications are met, is attractive relative to competitors’ offerings as well as other QNB products. This product also generates fee income through the use of the debit card. The average balance of other interest-bearing demand accounts included in this category increased from $108,872,000 for 2019 to $122,861,000 for 2020. The average rate paid on these balances was 0.05% for both years.
Average money market accounts increased $839,000, or 0.9%, to $90,989,000 for 2020 compared with 2019. Interest expense on money market accounts decreased $410,000 to $405,000 for 2020 compared with 2019. The average interest rate paid on money market accounts was 0.45% for 2020, a decrease of 45 basis points compared with 2019. The balances in this category primarily comprise Select money market accounts, a product that pays a tiered rate based on account balances. The balances remaining in these accounts for 2020 were primarily at higher-yielding tiers.
Interest expense on municipal interest-bearing demand accounts decreased $1,344,000 to $679,000 for 2020. The average balance of municipal interest-bearing demand accounts increased $7,134,000, or 6.3%, to $119,673,000 and the average interest rate paid on these accounts decreased 123 basis points to 0.57% for 2020 from 1.80% for 2019. Most of these accounts are indexed to the Federal funds rate with negotiated rate floors between 0.25% and 0.50%. Many of these deposits are seasonal in nature and are received during the third quarter as tax receipts are collected and are withdrawn over the course of the next year.
QNB’s online e-Savings product is the largest category of savings deposits and was created to compete with other online savings accounts. Average balances increased $35,050,000, or 20.4%, to $207,177,000 in 2020 compared with $172,127,000 in 2019. The average cost of funds on these accounts was 0.50% for 2020 and 0.86% for 2019. The yield on this account may rise along with market rates and as competition for savings balances increases. Traditional statement savings accounts and club accounts are also included in the savings category and increased on average by $10,376,000, or 14.7%, to $81,108,000. The average rate paid on total savings accounts was 0.40% for 2020, a 26-basis point decrease from 0.66% for 2019 and interest expense decreased $450,000, to $1,155,000 from $1,605,000 over the same period.
Interest expense on time deposits decreased $836,000, to $3,155,000 in 2020, due to a 25-basis point decrease in yield, from 1.73% in 2019 to 1.48% in 2020. The decrease in average balances was $17,821,000 in 2020, to $212,517,000. Similar to fixed-rate loans and investment securities, time deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment. However, the maturity and repricing characteristics of time deposits tend to be shorter.
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Approximately $131,190,000, or 66.6%, in time deposits will reprice or mature over the next 12 months compared with 59.8% of the portfolio at December 31, 2019. The average rate paid on these time deposits is approximately 1.16%.
Short-term borrowings are comprised of sweep accounts structured as repurchase agreements with our commercial customers and overnight borrowings from correspondent banks with average balances in 2020 of $50,007,000 and $1,738,000, respectively. Interest expense on short-term borrowings decreased by $453,000 to $247,000 when comparing the two years. During this period average balances of repurchase agreements increased $9,788,000 with a 28-basis point decrease in average rate paid, resulting in a decrease of cost of funds of $69,000. The average balances of borrowings from correspondent banks declined $15,023,000 and the average rate paid decreased 59 basis points, resulting in a decrease in cost of funds of $384,000.
Average long-term debt was $8,566,000 with an average yield of 1.57%, 33 basis points lower than the yield on short-term FHLB borrowings. The yield on interest-bearing liabilities decreased 44 basis points to 0.63% for 2020.
2019 versus 2018
Total interest expense for 2019 was $10,124,000 compared with $8,185,000 for 2018, an increase of $1,939,000. Interest expense on total deposits increased $1,911,000 and interest expense on borrowed funds increased $28,000 when comparing the two years. The rate paid on interest-bearing deposits increased 20 basis points; the rate paid on borrowings increased 13 basis points, when comparing the two periods.
Average non-interest-bearing demand accounts increased $11,439,000, or 8.8%, to $142,072,000 for 2019; QNB has been successful in increasing both personal and business checking accounts. Average interest-bearing demand accounts increased $18,043,000, or 9.3%, to $212,415,000 for 2019 compared with 2018, with interest expense on interest-bearing demand accounts increasing $301,000 to $990,000 for 2019. The average rate paid increased 12 basis points to 0.47% for 2019 compared to 0.35% for 2018. Interest-bearing business checking account average balances increased by $10,206,000, or 30.2%, and related interest expense increased $245,000, or 35 basis points in yield, when comparing the two years. This was primarily due to one large commercial customer consolidating both existing and external accounts. For 2019, the average balance QNB-Rewards checking was $59,490,000 and the related interest expense was $392,000 for an average cost of funds of 0.66%. In comparison, the average balance of the QNB-Rewards accounts for 2018 was $54,188,000, yielding 0.62%. The average balance of other interest-bearing demand accounts included in this category increased from $106,337,000 for 2018 to $108,872,000 for 2019. The average rate paid on these balances was 0.05% for both years
Average money market accounts increased $12,437,000, or 16.0%, to $90,150,000 for 2019 compared with 2018. The increase in money market balances is a result of a shift in balances to from less liquid and lower yielding savings accounts. Interest expense on money market accounts increased $486,000 to $815,000 for 2019 compared with 2018. The average interest rate paid on money market accounts was 0.90% for 2019, an increase of 48 basis points compared with 2018.
Interest expense on municipal interest-bearing demand accounts increased $486,000 to $2,023,000 for 2019. The average balance of municipal interest-bearing demand accounts increased $6,128,000, or 5.8%, to $112,539,000 and the average interest rate paid on these accounts increased 36 basis points to 1.80% for 2019 from 1.44% for 2018.
Online eSavings average balances declined $23,131,000, or 11.8%, to $172,127,000 in 2019 compared with 195,258,000 in 2018, resulting from a shift to more liquid deposit accounts. . The average cost of funds on these accounts was 0.86% for 2019 and 0.79% for 2018. Traditional statement savings accounts and club accounts are also included in the savings category and decreased on average by $956,000, or 1.3%, to $70,732,000. The average rate paid on total savings accounts was 0.66% for 2019, a four-basis point increase from 2018 while interest expense decreased $52,000, to $1,605,000 from $1,657,000 over the same period.
Interest expense on time deposits increased $690,000, to $3,991,000 in 2019, due to a 28-basis point increase in yield, from 1.45% in 2018 to 1.73% in 2019. The increase in average balances was $3,259,000 in 2019, to $230,338,000.
Short-term borrowings are comprised of sweep accounts structured as repurchase agreements with our commercial customers and overnight borrowings from correspondent banks with average balances in 2019 of $40,219,000 and $16,761,000, respectively. Interest expense on short-term borrowings increased by $28,000 to $700,000 when comparing the two years. During this period average balances of repurchase agreements increased $2,047,000 with a 15-basis point increase in average rate paid, resulting in an increase of cost of funds of $73,000. This was partly offset by a decrease in average balances of borrowings from correspondent banks of $6,006,000 while the average rate paid increased 46 basis points, resulting in a net decrease in cost of funds of $45,000.
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Provision for Loan Losses
The provision for loan losses represents management’s determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. QNB recorded a provision for loan losses of $1,250,000, $1,300,000 and $1,130,000 for the twelve-month periods ended December 31, 2020, 2019 and 2018, respectively. Net loan charge-offs were $311,000, or 0.04% of total average loans for 2020 compared with $247,000, or 0.03% of total average loans in 2019 and $137,000, or 0.02% of total average loans in 2018. The majority of the commercial loans charged off during 2020 and 2019 had specific reserves established during the allowance for loan loss calculation process prior to the decision to charge-off the loans. Deterioration in credit quality or significant growth in the loan portfolio may result in a higher provision for loan losses in 2021.
Non-Interest Income
Non-interest income comparison
Change from prior year
$ Change % Change
N/M - Not Meaningful
2020 versus 2019
QNB, through its core banking business, generates various fees and service charges. Total non-interest income includes service charges on deposit accounts, ATM and debit card income, retail brokerage and advisory income, income on bank-owned life insurance, merchant income and gains and losses on investment securities and residential mortgage loans. Total non-interest income was $8,317,000 in 2019 compared with $7,602,000 in 2020, a decline of $715,000.
Fees for services to customers are primarily comprised of service charges on deposit accounts. These fees were $1,315,000 for 2020, a decrease of $376,000, or 22.2%, from 2019. Overdraft income, which represented approximately 71% and 77% of total fees for services to customers in 2020 and 2019, respectively, decreased by $376,000, or 28.8%, when comparing 2020 to 2019. The decreasein overdraft income primarily reflects a decrease in the number of overdraft occurrences.
ATM and debit card income is primarily comprised of transaction income on debit cards and ATM cards and ATM surcharge income for the use of QNB’s ATM machines by non-QNB customers. ATM and debit card income was $2,195,000 in 2020, an increase of $125,000, or 6.0%, from the amount recorded in 2019. Debit card interchange income increased $117,000, or 5.8%, to $2,131,000 in 2020, while ATM surcharge income and monthly card fees income increased $8,000 to $64,000. The growth in checking accounts and card usage contributed to the increase in debit card income, including the QNB Rewards checking product, a tiered-rate checking account which requires, among other terms, the posting of a minimum of twelve debit card purchase transactions per statement cycle to receive the high interest rate.
QNB provides securities and advisory services under the name QNB Financial Services through an independent third-party registered Broker/Dealer and Registered Investment Advisor. QNB terminated its contract with its third-party broker-dealer effective August 1, 2018 and entered into a similar arrangement with another third-party provider. QNB Financial Services finalized the transferring of accounts to the new provider’s platform during 2019. QNB receives a percentage of the revenue generated but is responsible for salaries and expenses of advisors who are QNB employees. Retail brokerage and advisory revenue was $581,000 for 2020 compared with $560,000 in 2019, an increase of $21,000, or 3.8%. In 2018 and throughout 2019, there was a transition to move toward advanced advisory fees based on assets under management in lieu of fees per transaction; advisory fees increased $24,000 comparing 2020 to 2019. Sales in front-loaded products, such as annuities and alternative investments (which include private equity, hedge funds, managed futures, real estate “REITs”, commodities and derivatives contracts) and trailing income related to these decreased
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$3,000 in 2020 over 2019. In 2020, the net income provided by QNB Financial Services was $197,000, compared with $82,000 in net income for 2019.
Income on bank-owned life insurance (“BOLI”) represents the earnings and death benefits on life insurance policies in which the Bank is the beneficiary. The insurance carriers reset the rates on these policies annually taking into consideration the interest rate environment as well as mortality costs. The existing policies have rate floors which limit how low the earnings rate can go. Some of these policies are currently at their floor. Income on these policies during 2020 was $294,000 compared to $292,000 for 2019.
Merchant income represents fees charged to merchants for the Bank’s handling of credit card or charge sales. Merchant income was $417,000 for 2020, an increase of $69,000, or 19.8%, from the amount reported in 2019. The increase in merchant income is primarily a result of increased usage.
The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed-income portfolio to take advantage of changes in the shape of the yield curve, changes in spread relationships in different sectors, and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio. In addition, the Corporation owns a small portfolio of equity securities for the purpose of generating both dividend income and capital appreciation.
Net gains on investment securities decreased $1,146,000 to a net gain of $609,000 for the year ended December 31, 2020, compared with a net gain of $1,755,000 for the year ended December 31, 2019, primarily due to market conditions which resulted in greater opportunities for profitable sales in 2019 compared with 2020. Gains from equity securities were $1,781,000 in 2019 compared to gains of $585,000 in 2020. Net gains on the sale of fixed income securities were $24,000 for 2020 compared to net losses of $26,000 for 2019. Unrealized losses on equity securities of $47,000 were recorded during 2020 compared to unrealized gains $770,000 during 2019.
The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination. The net gain on the sale of residential mortgage loans was $1,724,000 and $195,000 for 2020 and 2019, respectively. Mortgage financing activity increased in 2020, as an improvement in rates prompted borrowers to purchase. Proceeds from the sale of residential mortgages were $35,605,000 and $7,324,000 for the years ended December 31, 2020 and 2019, respectively. Included in the gains on the sale of residential mortgages in 2020 and 2019 are $249,000 and $54,000, respectively, related to the recognition of mortgage servicing assets.
QNB retains servicing rights for residential mortgages sold in the secondary market. A servicing fee is retained on all mortgage loans sold and serviced. QNB recognizes its obligation to service financial assets that are retained in a transfer of assets in the form of a servicing asset. The servicing asset is amortized in proportion to, and over, the period of net servicing income or loss. On a quarterly basis, servicing assets are assessed for impairment based on their fair value. Mortgage servicing income of $41,000 for 2020 and $117,000 for 2019 is included in other non-interest income.
Other non-interest income, excluding mortgage servicing income, was $473,000 for 2020, a decline of $46,000 from the amount recorded in 2019. Other non-interest income included broker-dealer conversion costs reimbursements of $66,000 and $83,000 for 2020 and 2019, respectively. Other non-interest income included a $58,000 deferred gain on the sale of a bank-financed other real estate owned property in 2019. Title company income increased $31,000 when comparing 2020 to 2019.
2019 versus 2018
Total non-interest income was $8,317,000 in 2019 compared with $4,892,000 in 2018, an increase of $3,425,000.
Fees for services to customers were $1,691,000 for 2019, a decrease of $8,000, or 0.5%, from 2018. ATM and debit card income was $2,070,000 in 2019, an increase of $175,000, or 9.2%, from the amount recorded in 2018. Debit card interchange income increased $173,000, or 9.4%, to $2,014,000 in 2019, while ATM surcharge income and monthly card fees income increased $2,000 to $56,000.
Retail brokerage and advisory revenue was $560,000 for 2019 compared with $370,000 in 2018, an increase of $190,000, or 51.4%. In 2018 and throughout 2019, there was a transition to move toward advanced advisory fees based on assets under management in lieu of fees per transaction; advisory fees increased $175,000 comparing 2019 to 2018. There was also growth in sales in front-loaded products in 2019 than in 2018, resulting in increased revenues of $15,000.
Income on BOLI policies during 2019 was $292,000 compared to $291,000 for 2018.
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Merchant income was $348,000 for 2019, an increase of $22,000, or 6.7%, from the amount reported in 2018. The increase in merchant income is primarily a result of increased usage.
Net gains on investment securities increased $1,831,000 to a net gain of $1,755,000 for the year ended December 31, 2019, compared with a net loss of $76,000 for the year ended December 31, 2018, primarily due to market conditions which resulted in greater opportunities for profitable sales in 2019 compared with 2018. Gains from equity securities were $1,781,000 in 2019 compared to losses of $79,000 in 2018. Strong performance in the U.S. equity markets during 2019, enabled QNB to sell some equity holdings and recognize gains. Net losses on the sale of fixed income securities were $26,000 for 2019 compared to net gains of $3,000 for 2018. The adoption of Accounting Standard Update 2016-01 (ASU 2016-01) effective January 1, 2018 requires the Company to record unrealized gains or losses on equity securities through earnings, rather than in other comprehensive income (loss), a component of shareholders’ equity. Unrealized gains on equity securities of $770,000 were recorded during 2019 compared to unrealized losses $336,000 during 2018.
The net gain on the sale of residential mortgage loans was $195,000 and $105,000 for 2019 and 2018, respectively. Mortgage financing activity increased in 2019, as an improvement in rates prompted borrowers to purchase. Proceeds from the sale of residential mortgages were $7,324,000 and $4,478,000 for the years ended December 31, 2019 and 2018, respectively. Included in the gains on the sale of residential mortgages in 2019 and 2018 are $54,000 and $33,000, respectively, related to the recognition of mortgage servicing assets.
Other non-interest income, excluding mortgage servicing income, was $519,000 for 2019, an increase of $27,000 from the amount recorded in 2018. Other non-interest income included broker-dealer conversion costs reimbursements of $83,000 and $48,000 for 2019 and 2018, respectively. Other non-interest income included a $58,000 deferred gain on the sale of a bank-financed other real estate owned property in 2019 and 2018 included a $57,000 sales tax refund. Decreased revenues from letters of credit fees of $22,000 were partially offset by increased revenue in credit cards and title company income of $8,000 and $12,000, respectively, when comparing 2019 to 2018.
Non-Interest Expense
Non-interest expense comparison
Change from prior year
$ Change % Change
2020 versus 2019
Non-interest expense is comprised of costs related to salaries and employee benefits, net occupancy, furniture and equipment, marketing, third party services, FDIC insurance premiums, regulatory assessments and taxes and various other operating expenses. Total non-interest expense was $28,955,000 in 2020, an increase of $851,000, or 3.0%, from the $28,104,000 in 2019. QNB’s overhead efficiency ratio, which represents the percentage of each dollar of revenue that is used for non-interest expense, is calculated by taking non-interest expense divided by net operating revenue (tax-equivalent net interest income plus non-interest income). QNB’s efficiency ratios for 2020, 2019 and 2018 were 63.6%, 61.9%, and 63.6%, respectively. The increase in the 2020 efficiency ratio is primarily due to non-interest expense in 2020 being higher by $851,000 over 2019 versus tax-equivalent income increasing $148,000.
Salaries and benefits expense is the largest component of non-interest expense. QNB monitors, using various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense for 2020 was $16,541,000, an increase of $455,000 compared with $16,086,000 reported in 2019. Salary expense and related payroll taxes for 2020 was $13,762,000, an increase of $88,000 compared with $13,674,000 reported in 2019. Included in salary expense in 2020 was incentive compensation plus related payroll taxes of $731,000, a $309,000 decrease over incentive compensation in 2019. Benefit expense for 2020 was $2,779,000, an increase of $367,000, or 15.2%, from the amount recorded in 2019. Medical premiums
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increased $330,000. Retirement plan matching and safe harbor increased $92,000 compared to 2019. QNB utilized unvested forfeited 401(k) contributions to offset retirement plan matching in 2020 and 2019.
Net occupancy and furniture and equipment expense increased $378,000, to $4,914,000 when comparing 2020 to 2019, due primarily to increased software, additional 2020 building and equipment maintenance resulting from the COVID-19 Pandemic, branch rent related to a 2020 renewed lease and higher depreciation in 2020 resulting from renovations, one new branch and a branch relocation in 2019.
Marketing expense was $876,000 for 2020, a $166,000 decrease from the expense recorded in 2019. Advertising and sales promotions expense declined $87,000 and marketing expenses related to public relations declined $82,000, respectively, for the year ended December 31, 2020 compared with 2019. QNB’s contributions and sponsorships for not-for-profit organizations, events and clubs in the communities it serves are included in public relations expense; many of these events were cancelled or postponed due to the COVID-19 Pandemic.
Third party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, statement printing and mailing, investment security safekeeping and supply management services. Third party services increased $70,000.
Telephone, postage and supplies expense increased $16,000 to $736,000 in 2020, compared with 2019, primarily due to an increase in supplies of $16,000 related to the COVID-19 Pandemic.
FDIC insurance premium expense increased $300,000 in 2020. The premium assessment formula for small institutions was changed by the FDIC and implemented in late 2016 and is based on asset growth and related risk assumptions determined by the FDIC as well as capital. Small institutions, for FDIC premium assessments purposes, are defined as those with total consolidated assets less than $10 billion. On September 30, 2018, the Deposit Insurance Fund Reserve Ratio reached 1.36%. Because the reserve ratio has exceeded 1.35%, a change impacting QNB’s deposit insurance assessment occurred under the FDIC regulations: Small institutions were awarded assessment credits for the portion of their assessments that contributed to the growth in the reserve ratio from 1.15% to 1.35%, to be applied when the reserve ratio is at least 1.38%. QNB received $273,000 in assessment credits during 2019.
State tax expense represents the payment of the Pennsylvania Shares Tax and Pennsylvania sales and use tax. State tax expense was $887,000 and $760,000 for the years 2020 and 2019, respectively. The Pennsylvania Shares Tax is based primarily on the equity of the Bank. The increase in Pennsylvania Shares Tax is a result of growth of the Bank’s capital.
Other operating expenses for the twelve months ended December 31, 2020 decreased $329,000, or 11.6%. In 2019 there was a write-off of a receivable of $103,000 and foreclosure expenses of $42,000. The remaining decreases were primarily due to reduced business development, travel, seminar and meeting expenses related to cancellations of events due to the COVID-19 Pandemic.
2019 versus 2018
Total non-interest expense was $28,104,000 in 2019, an increase of $2,219,000, or 8.6%, from the $25,885,000 recorded in 2018. Salaries and benefits expense for 2019 was $16,086,000, an increase of $1,675,000 compared with $14,411,000 reported in 2018. Salary expense and related payroll taxes for 2019 was $13,674,000, an increase of $1,411,000 compared with $12,263,000 reported in 2018. Included in salary expense in 2019 was incentive compensation plus related payroll taxes of $1,040,000, a $130,000 increase over incentive compensation in 2018. Benefit expense for 2019 was $2,412,000, an increase of $264,000, or 12.3%, from the amount recorded in 2018. Medical premiums increased $129,000. Retirement plan matching and safe harbor increased $71,000 compared to 2018. QNB utilized unvested forfeited 401(k) contributions to offset retirement plan matching in 2019 and 2018.
Net occupancy and furniture and equipment expense increased $499,000, to $4,536,000 when comparing 2019 to 2018, due primarily to increased software, higher depreciation resulting from 2019 renovations, one new branch and a branch relocation, building and equipment maintenance and branch rent.
Marketing expense was $1,042,000 for 2019, a $115,000 increase from the expense recorded in 2018. Advertising and sales promotions expense increased $83,000 and marketing expenses related to public relations increased $32,000, respectively, for the year ended December 31, 2019 compared with 2018.
Third party services decreased $36,000 when comparing the two periods, primarily due to tax preparation fees in 2018 of $36,000 related to method changes implemented for the 2017 returns.
Telephone, postage and supplies expense increased $35,000 to $720,000 in 2019, compared with 2018, primarily due to an increase in postage expense of $31,000.
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FDIC insurance premium expense decreased $355,000, or 56.9%, in 2019. QNB received $273,000 in assessment credits during 2019.
State tax expense represents the payment of the Pennsylvania Shares Tax and Pennsylvania sales and use tax. State tax expense was $760,000 and $727,000 for the years 2019 and 2018, respectively.
Other operating expenses for the twelve months ended December 31, 2019 increased $253,000, or 9.8%. In 2019 there was a write-off of a receivable of $103,000, the remaining increases were primarily due to debit card expense, business development costs and foreclosure expenses.
Income Taxes
Applicable income tax expense and effective tax rates were $2,562,000, or 17.5% for 2020, $2,850,000, or 18.7%, for 2019 compared with $1,557,000, or 12.1%, for 2018. The primary reason for the decreased effective tax rate for 2020 over 2019 was due to the state taxes on the realized gains on securities in 2019. In 2018, QNB elected to change its tax methods for bad debt conformity and for loan origination costs effective with the filing of the 2017 tax return which resulted in a tax benefit of $415,000. These discrete tax items were recorded in 2018.
Summary Impact of 2018 Discrete Tax Items
Tax provision, discrete items and revaluation of net deferred tax asset 415
Reported Net Income (GAAP) $ 11,335
Effect of discrete items and tax legislation on diluted earnings per share 0.11
Reported Diluted Earnings per Share (GAAP) $ 3.25
Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, our reported results prepared in accordance with GAAP. In the event of disclosure or release of non-GAAP financial measures, the SEC Regulation G requires: (i) the presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP and (ii) a reconciliation of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure calculated and presented in accordance with GAAP.
For the year ended December 31, 2018, the effective tax rate excluding the discrete items was 15.3%; the primary reason for the increase effective tax rate for 2019 over 2018 was due to the state taxes on the realized gains on securities. QNB expects the effective tax rate in 2021 to be similar to the 17.5%, less than the 21% corporate rate, due to its holdings of tax-free assets, including municipal bonds, municipal loans, and life insurance contracts. For a more comprehensive analysis of income tax expense and deferred taxes, refer to Note 11 in the Notes to Consolidated Financial Statements.
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Financial Condition
ASSETS
The following table presents total assets at the dates indicated:
Change from prior year
Cash and interest-earning deposits
Total cash and cash equivalents increased $21,723,000 from $17,608,000 at December 31, 2019 to $39,331,000 at December 31, 2020. QNB had interest-bearing balances at the Federal Reserve Bank of $25,581,000 compared with $1,584,000 and interest-bearing balances in a brokerage account of $242,000 compared with $3,616,000 at December 31, 2020 and December 31, 2019, respectively. Net cash was provided by operating activities. The maturity, prepayment and sales of investment securities and proceeds received from deposit growth more than offset loan growth and the purchases of investment securities.
Investment Securities and Other Short-Term Investments
At December 31, 2020 and 2019, QNB had no Federal funds sold. With the Federal funds rate between 0% and 0.25%, excess funds for liquidity purposes are kept at the Federal Reserve. These funds carry a 0% risk weighting for risk-based capital calculation purposes.
QNB accounts for its investments by classifying securities into four categories. Debt securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Debt securities that QNB has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. Debt securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses, net of tax, excluded from earnings and reported as a separate component of shareholders’ equity. Equity investments with readily determinable fair values are measured at fair value with changes in fair value recognized in net income. Management determines the appropriate classification of securities at the time of purchase.
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Investment Portfolio History
Investment Securities Available-for-Sale
U.S. Government agencies and sponsored enterprises (GSEs):
Equity Investments
Investment Securities - Trading
QNB did not hold any trading security during 2020 or 2019.
Investments Held-To-Maturity Debt Securities
QNB did not hold any held-to-maturity security during 2020 or 2019.
Investments Available-For-Sale Debt Securities
Available-for-sale investment securities include securities that management intends to use as part of its liquidity and asset/liability management strategy. These securities may be sold in response to changes in market interest rates, changes in the securities prepayment or credit risk, the need for liquidity, or growth in loan demand. At December 31, 2020, the fair value of investment debt securities available-for-sale was $435,646,000, or $7,151,000 above the amortized cost of $428,495,000. This compares to a fair value of $349,710,000, or $325,000 above the amortized cost of $349,385,000, at December 31, 2019. The available-for-sale portfolio, excluding the pooled trust preferred securities, had a weighted average maturity of approximately 5.2 years at December 31, 2020 and 4.6 years at December 31, 2019. The weighted average tax-equivalent yield, excluding the pooled trust preferred securities, was 1.57% and 2.36% at December 31, 2020 and 2019, respectively.
At December 31, 2020, approximately 78% of QNB’s investment securities available-for-sale were either U.S. Government agency debt securities, U.S. Government agency issued mortgage-backed securities or CMOs. As of December 31, 2020, QNB held no securities of any one issue or any one issuer (excluding the U.S. Government and its agencies) that were in excess of 10% of shareholders’ equity.
The QNB investment portfolio represents a significant portion of earning assets and interest income. QNB actively manages the investment portfolio in an attempt to maximize earnings, while considering liquidity needs, interest rate risk and credit risk. The increase of the investment portfolio as a percent of total assets in 2020 is due to deposit growth and the investment of excess funds. Proceeds from the sale of investment securities available-for-sale were $6,930,000 during 2020 compared with $47,851,000 during 2019. In addition to the proceeds from the sale of investment securities available-for-sale, proceeds from maturities, calls and prepayments were $207,245,000 in 2020 compared with $68,174,000 in 2019. During 2020, $295,734,000 of investment securities available-for-sale were purchased compared with $113,688,000 during 2019.
The balance of U.S. Government agency securities increased $478,000 to $69,776,000 at December 31, 2020 and represents 16.0% of the available-for-sale investment portfolio, compared with 19.8% at December 31, 2019. U.S. Government agency issued CMO and MBS balances increased $49,356,000 to $270,795,000 and represents 62.2% of the available-for-sale portfolio compared with 63.4% at December 31, 2019. These bonds provide monthly cash flow to be reinvested in either loans or other securities, potentially at higher yields as rates increase.
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The balance of municipal securities increased $37,031,000 to $87,812,000 at December 31, 2020, representing 20.2% of the available-for-sale portfolio compared with 14.5% at December 31, 2019. QNB focuses on the financial performance of the underlying issuer for municipal bond purchases in addition to the bond rating of the issuer or the rating of bond insurer, if present. Ninety-four bonds were purchased with a book value of $51,787,000 and thirty-five bonds with a book value of $15,045,000 were called or matured in 2020.
QNB owns one collateralized debt obligations (“CDO”) in the form of a pooled trust preferred security. The security is comprised of securities issued by banks or bank holding companies. QNB owns the mezzanine tranche of this security. The security is structured so that the senior and mezzanine tranches are protected from defaults by over-collateralization and cash flow default protection provided by subordinated tranches. The trust preferred security the Bank continues to hold has a carrying balance of $70,000 at December 31, 2020 and represents the senior-most obligation of the trust. There was no credit-related other-than-temporary impairment charge during 2020, 2019 or 2018. Future estimates of fair value of the remaining security could require recording additional OTTI charges through earnings. For additional detail on these securities see Notes 4 and 17 of the Notes to Consolidated Financial Statements.
The weighted average maturity is based on the stated contractual maturity or likely call date of all securities except for MBS and CMOs, which are based on estimated average life. The maturity of the portfolio could become shorter if interest rates declined and prepayments on MBS and CMOs increased or securities are called. However, the estimated average life could lengthen if interest rates were to increase and principal payments on MBS and CMOs slowed or securities anticipated to be called extend past their call date.
Investment Portfolio Maturities and Weighted Average Yields
Investment Securities Available-for-Sale
U.S. Government agency:
State and municipal:
Mortgage-backed:
Collateralized mortgage obligations (CMOs):
Pooled trust preferred:
Fair value — — — 70 70
Weighted average yield — — — 2.64 % 2.64 %
Corporate debt:
Securities are assigned to categories based on stated contractual maturity except for mortgage-backed securities and CMOs which are based on anticipated payment periods and state and municipal securities which are based on pre-refunded date, if applicable. Tax-exempt securities were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21% and a Tax Equity and Financial Responsibility Act (“TEFRA”) adjustment for the cost of funds. Weighted average yields on investment securities available-for-sale are based on amortized cost.
Investments in Equity Securities
Equity securities increased $3,685,000 to $12,849,000 at December 31, 2020 from $9,164,000 at December 31, 2019. QNB sold $4,767,000 in equity securities for a net gain of $585,000 and purchased $7,914,000 in equities during 2020.
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QNB adopted ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, effective January 1, 2018. This ASU was issued by the Financial Accounting Standards Board (FASB) on January 5, 2016 to enhance the reporting model for financial instruments to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The FASB issued ASU 2018-03 in February 2018 which provides technical corrections and improvements to ASU 2016-01. QNB used the modified retrospective method for transition in which the cumulative effect will be recognized at the date of adoption with no restatement of comparative periods presented. QNB reclassified a loss, net of taxes, of $254,000 from accumulated other comprehensive loss to retained earnings on January 1, 2018. Increases and decreases in the fair value were recognized in net income during 2020, 2019 and 2018. At December 31, 2020, the fair value of the equity securities was $12,849,000, or $65,000 above the cost of $12,784,000 compared to $$9,164,000, or $111,000 above the cost of $9,053,000 at December 31, 2019.
The equities portfolio comprises blue-chip large-capitalized stocks, providing a taxable equivalent dividend yield of 3.54%. The estimated cumulative contribution (realized and unrealized net gains (losses), plus dividends) of the equity portfolio to earnings per share from January 1, 2008 through December 31, 2020 is $1.79 per diluted share. Details of the equity portfolio’s contribution to net income is detailed in the following table.
Net Income (Expense) on Equity Securities For the Year Ended December 31,
Equity Securities:
Unrealized (loss) gain N/A N/A N/A (336 ) 770 (47 )
Loans
QNB’s primary business is to accept deposits and to make loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets, and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices.
QNB has comprehensive policies and procedures that define and govern commercial and retail loan originations and the management of risk. All loans are underwritten in a manner that emphasizes the borrowers’ capacity to pay. The measurement of capacity to pay delineates the potential risk of non-payment or default. The higher potential for default determines the need for and amount of collateral required. QNB makes unsecured commercial loans when the capacity to pay is considered substantial. As capacity lessens, collateral is required to provide a secondary source of repayment and to mitigate the risk of loss. Various policies and procedures provide guidance to the lenders on such factors as amount, terms, price, maturity and appropriate collateral levels. Each risk factor is considered critical to ensuring that QNB receives an adequate return for the risk undertaken, and that the risk of loss is minimized.
QNB manages the risk associated with commercial loans by having lenders work in tandem with credit analysts while maintaining independence between personnel. In addition, a Bank loan committee and a committee of the Board of Directors review and approve certain loan requests on a weekly basis. Other than disclosed in the forthcoming Loan Portfolio Table, at December 31, 2020, there was a concentration of loans to lessors of residential buildings and dwellings of 14.9% of total loans and to lessors of nonresidential buildings of 19.6% of total loans, compared with 16.6% and 18.3% of total loans, respectively, at December 31, 2019. These concentrations were primarily within the commercial real estate categories.
QNB moved from an eight-grade risk rating system to a ten-grade system in 2018, further disaggregating the credit quality of the loan portfolio to enhance credit risk strategies.
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QNB’s commercial lending activity is focused on small businesses within the local community. Commercial purpose loans are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or group of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these types of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Commercial and industrial loans represent commercial purpose loans that are either secured by collateral other than real estate or unsecured.
Commercial loans secured by commercial real estate include commercial purpose loans collateralized at least in part by commercial real estate. Some of these loans may not be for the express purpose of conducting commercial real estate transactions. Commercial loans secured by residential real estate are commercial purpose loans generally secured by the business owner’s residence or residential investment properties owned by the borrower and rented to tenants. Commercial loans secured by either commercial real estate or residential real estate are originated primarily within the Eastern Pennsylvania market area, are within the Bank’s underwriting criteria, and generally include the guarantee of the borrowers. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale of or lease of the subject property. Commercial real estate and commercial construction loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties.
Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.
The Company originates fixed rate and adjustable-rate residential real estate loans that are secured by the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. To reduce interest rate risk, qualifying originations of fixed-rate loans to individuals for 1-4 family residential mortgages with maturities of 15 years or greater are generally sold in the secondary market. Mortgage loan origination activity increased in 2020 with $39,474,000 in residential mortgages originated for sale during 2020, compared with $8,106,000 for 2019. There were $6,570,000 in residential mortgage loans held-for-sale at December 31, 2020 and $977,000 at December 31, 2019. These loans are carried at the lower of aggregate cost or market.
The home equity portfolio consists of fixed-rate home equity loans and variable rate home equity lines of credit. These loans are often in a junior lien position and therefore carry a higher risk than first lien 1-4 family residential loans. Risks associated with loans secured by residential properties, either first lien residential mortgages or home equity loans and lines, are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.
The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than loans secured by residential real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess or more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower, and, if secured, the value of the collateral.
Under the CARES Act, enacted on March 27, 2020, QNB continues to provide customers experiencing financial hardship caused by the COVID-19 Pandemic, solutions to help them through this difficult period. As of December 31, 2020, QNB had modifications to approximately 4.0% of the commercial portfolio, with an outstanding balance of $31,148,000, and modifications to approximately 1.8% of the retail portfolio, with an outstanding balance of $2,722,000, related to the COVID-19 Pandemic. During 2020, the Bank originated $82,475,000 in PPP loans, enabling 660 businesses to maintain their payrolls and stay in operation. At December 31, 2020, QNB had 556 PPP loans totaling $72,821,000 reported in commercial and industrial loans. PPP loan origination fees net of costs amounted to $1,909,000 at December 31, 2020 and are recognized in interest income as a yield adjustment over the term of the loans. The PPP loans are 100% guaranteed by the SBA. Excluding PPP loans net of deferred fees at December 31, 2020, loans receivable would have increased $28,514,000, or 3.5% since year-end 2019.
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Total loan receivables at December 31, 2020 were $920,042,000, an increase of $99,426,000, or 12.1%, from December 31, 2019. This follows a 4.5% increase in outstanding loans in 2019. A key financial ratio, loans to deposits was 74.9% at December 31, 2020, compared with 79.1% at December 31, 2019. QNB continues to be committed to make loans available to credit worthy consumers and businesses.
Loan Portfolio
Commercial:
Retail:
Loan Maturities and Interest Sensitivity
Commercial:
Retail:
Demand loans and loans with no stated maturity are included in one year or less. Table details final maturity.
The following shows the amount of loans due after one year that have fixed interest rates and variable or adjustable interest rates at December 31, 2020:
Loans with fixed predetermined interest rates: $195,877,000
Loans with variable or adjustable interest rates: $593,220,000
The Allowance for Loan Losses Allocation table on Page 43 shows the percentage composition of the loan portfolio over the past five years. There was very little change in the composition of the portfolio between the periods ended December 31, 2019 and 2020. Loans secured by commercial real estate represent the largest sector of the portfolio, remaining 41.0% of the portfolio at both December 31, 2020 and December 31, 2019, as the balances in this sector grew by $41,536000, or 12.4%, from $336,050,000 at December 31, 2019 to $377,586,000 at December 31, 2020. While loans secured by commercial real estate represent a significant portion of the total portfolio, the collateral is diversified, including investment properties, manufacturing facilities, office buildings, hospitality properties, hospitals, retirement and nursing home facilities, warehouses and owner-occupied facilities. Commercial real estate loans have drawn the attention of the regulators in recent years as a potential source of risk. QNB monitors these types of loans closely, obtaining updated appraisals on loans classified substandard or worse. As detailed in the Allowance for Loan Losses table, QNB had no charge-offs in this category in 2020, 2019 or 2018.