Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of Virginia National Bankshares Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data.
Merger with Fauquier
On April 1, 2021, the Company merged with Fauquier, pursuant to the Agreement and Plan of Reorganization dated October 1, 2020, including a related Plan of Merger. Pursuant to the Merger Agreement, Fauquier shareholders received 0.675 shares of Company stock for each share of Fauquier common stock, with cash paid in lieu of fractional shares, resulting in the Company issuing 2,571,213 shares of common stock. In connection with the transaction, TFB, Fauquier's wholly-owned bank subsidiary, was merged with and into the Bank.
Impact of COVID-19
The COVID-19 pandemic has caused, and will likely continue to cause, economic and social disruption, significantly affecting many industries, including many of our clients. Significant uncertainty exists regarding the magnitude of the impact and duration of this pandemic. Following are brief descriptions of areas within the Company that have been negatively impacted.
Allowance for loan losses -The Company’s consolidated financial statements include estimates and assumptions made by management which affect the reported amounts of assets and liabilities, including the level of the ALLL that is established. The ALLL calculation and resulting provision for loan losses are impacted by changes in economic conditions. During the first and second quarters of 2020, the Company downgraded the economic qualitative factors within its ALLL model in light of the effects of the COVID-19 pandemic on the economy. No additional downgrades of such factors were taken during the third and fourth quarters of 2020,or the first quarter of 2021. During the second quarter of 2021, the Company upgraded the economic qualitative factors, resulting in a release of a portion of the reserves for loan losses related to the pandemic, as credit deterioration since the onset of COVID-19 had not been experienced to the extent anticipated. No additional changes were made to the economic qualitative factors during the third or fourth quarters of 2021. If economic conditions improve or worsen, the Company could experience changes in the required ALLL. It is possible that asset quality metrics could decline in the future if the effects of the COVID-19 pandemic are sustained.
Potential credit exposures -While most industries have been adversely impacted by the COVID-19 pandemic, the Company has exposures on its balance sheet as of December 31, 2021 in the following categories of loans that are considered to have higher risk of significant impact:
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Travel accommodations (hotels/motels/B&B) - $29.0 million, or 2.8% of loans,
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Restaurants - $19.8 million, or 1.9% of loans,
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Retail trade - $13.3 million, or 1.3% of loans,
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Arts, entertainment and recreation - $13.0 million, or 1.3% of loans, and
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Wholesale trade - $9.5 million, or 0.9% of loans.
Note that the loan balances and percentages above do not include PPP loans made to entities within such categories.
Loan deferrals - In accordance with guidance from regulators and the CARES Act, the Bank worked with borrowers who have been adversely affected by COVID-19 to defer principal only, or principal and interest payments for a 90- to 180-day period. While interest will continue to accrue to income, in accordance with GAAP, if the Company ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively affected. Loan deferrals as of December 31, 2021 amount to $1.2 million and consist of only two loans. Both loans are 100% government-guaranteed for which the deferrals were approved by the United States Department of Agriculture. In accordance with interagency guidance issued in March 2020 and the CARES Act, these short-term deferrals are not considered TDRs.
PPP Loans - Primarily within the second quarter of 2020 and the first quarter of 2021, the Company devoted significant resources to accept PPP applications, a program designed to provide a direct incentive for small businesses to keep employees on their payroll. In total, the Company, including the Bank and TFB, funded
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$207.5 million in PPP loans, with average origination fees of 3.9%, assisting many nonprofits and local businesses through this program. As of December 31, 2021, 89.9% of the total dollars of PPP loans had been forgiven by the SBA, with $20.7 million outstanding. Loans funded through the PPP are fully guaranteed by the U.S. government. The Company believes that it performed the required due diligence pursuant to the established SBA criteria; nonetheless, if a determination is made that certain loans did not meet the criteria established for the program, the Company may be required to establish additional ALLL through provision for loan loss expense, which will negatively impact net income.
Credit quality standards - Throughout the onset of this pandemic, the Company has maintained its high standards of credit quality on organic loan funding to limit credit risk exposure.
Capital and Liquidity
As of December 31, 2021, capital ratios of the Company were in excess of regulatory requirements. While currently included in the category of “well capitalized” by bank regulators, a prolonged economic recession could adversely impact reported and regulatory capital ratios.
The Company maintains access to multiple sources of liquidity. Management has also enhanced its capital, liquidity, loan and deposit stress tests, as well as capital and liquidity contingency plans to validate how the Company can react effectively to the economic downturn caused by this pandemic and other potential impacts on the economy.
Goodwill
As of December 31, 2021, the goodwill on the Company's balance sheet was not deemed to be impaired. However, management may determine that goodwill is required to be evaluated for impairment in the future due to the presence of a triggering event, which may have a negative impact on the Company’s results of operations.
Operations, Processes, Controls and Business Continuity Plan
The Company reacted quickly to the COVID-19 pandemic and began internal social distancing in mid-March 2020, as well as distancing from the public by keeping drive-thru services available, and encouraging customers to conduct transactions at ATMs, through online banking and the mobile app. The Company also increased consumer and business mobile deposit limits to encourage customers to make deposits remotely from the safety of their home or business. The Company implemented a schedule whereby most staff members worked remotely, allowing the remaining essential staff to create more distance between each other within the offices. The Company temporarily increased the number of staff in the client service center to assist more customers by telephone and encourage them to utilize online and mobile banking. The client service center was also temporarily moved to a larger location to allow for appropriate social distancing. In addition, the Company enhanced disinfecting procedures to include hospital-grade cleaning solution and foggers, increased the frequency of cleaning and issued personal protective equipment, including N-95 and disposable face masks, face shields, sneeze guards, gloves and thermometers, to employees, along with specific instructions for use, to enhance their safety. The Company also installed disinfecting protective strips to high touch areas, placed free-standing air filter machines throughout our facilities, purchased COVID-19 instant test kits for on-site testing and provided antibody testing options to all employees. Management provides frequent email communications and social media updates regarding COVID-19, helpful tips and status of Company initiatives, as well as warning customers of potential scams during this pandemic.
The Company’s preparedness resulted in minimal impact to the Company’s operations as a result of the COVID-19 pandemic. Effective and thorough business continuity planning allowed for successful deployment of most employees to work in a remote environment. No material operational or internal control risks have been identified to date, and the Company has enhanced fraud-related controls.
Application of Critical Accounting Policies and Critical Accounting Critical Estimates
The accounting and reporting policies followed by the Company conform, in all material respects, to GAAP and to general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Company bases estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates.
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The Company considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s financial statements.The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations.
Following are the accounting policies and estimates that the Company considers as critical:
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Loans acquired in a business combination: Acquired Loans are classified as either (i) purchased credit-impaired loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition. PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.
On a semi-annual basis, the Company evaluates the estimate of cash flows expected to be collected on PCI loans. Estimates of cash flows for PCI loans require significant judgment. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses resulting in an increase to the allowance for loan losses. Subsequent significant increases in cash flows may result in a reversal of post-acquisition provision for loan losses or a transfer from nonaccretable difference to accretable yield that increases interest income over the remaining life of the loan or pool(s) of loans. Disposals of loans, which may include sale of loans to third parties, receipt of payments in full or in part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.
PCI loans are not classified as nonperforming loans by the Company at the time they are acquired, regardless of whether they had been classified as nonperforming by the previous holder of such loans, and they will not be classified as nonperforming so long as, at semi-annual re-estimation periods, we believe we will fully collect the new carrying value of the pools of loans.
The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the Acquired Loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing loans. A provision for loan losses may be required for any deterioration in these loans in future periods.
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Allowance for loan lossesis a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that are inherent in the loan portfolio. Accounting policies related to the allowance for loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” The level of the allowance reflects management’s continuing evaluation of: industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion and Note 4 – Loans and Note 5 – Allowance for Loan Losses in the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data, elsewhere in this report for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
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Impaired loansare loans so designated when, based on current information and events, it is probable the Company will be unable to collect all amounts when due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net of the impairment, using either the present value of estimated future cash flows at the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. Additional information on impaired loans, which includes both TDRs and
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non-accrual loans, is included in Note 4 – Loans and Note 5 – Allowance for Loan Losses, in the Notes to Consolidated Financial Statements.
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Fair value measurementsare used by the Company to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realized value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Additional discussion of valuation methodologies is presented in Note 17 – Fair Value Measurements, in the Notes to Consolidated Financial Statements.
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Other-than-temporary impairment of securities accounting policies require a periodic review by management to determine if the decline in the fair value of any security appears to be other-than-temporary. Factors considered in determining whether the decline is other-than-temporary include, but are not limited to: the length of time and the extent to which fair value has been below cost; the financial condition and near-term prospects of the issuer; and the Company’s intent to sell. See Note 1 – Summary of Significant Accounting Policies and Note 3 – Securities, in the Notes to Consolidated Financial Statements, for further details on the accounting policies for other-than-temporary impairment of securities and the methodology used by management to make this evaluation.
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Intangible assetaccounting policies require that goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually, or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. Intangible assets with definite useful lives are amortized over their estimated useful lives, which range from 3 to 10 years, to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the Company’s Consolidated Balance Sheets. Additional discussion of the accounting policies and composition of goodwill and other intangibles assets is presented in Note 1 – Summary of Significant Accounting Policies, Note 2 - Business Combinations and Note 8 – Goodwill and Other Intangible Assets, in the Notes to Consolidated Financial Statements.
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Income taxaccounting policies have the objective to recognize the amount of taxes payable or refundable for the current year and the deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact the Company’s consolidated financial condition or results of operations.
See Note 1 – Summary of Significant Accounting Policies and Note 11 – Income Taxes, in the Notes to Consolidated Financial Statements, for further detail on the accounting policies for income taxes and for components of the deferred tax assets and liabilities.
Non-GAAP Presentations
The accounting and reporting policies of the Company conform to GAAP and prevailing practices in the banking industry. However, certain non-GAAP measures are used by management to supplement the evaluation of the Company’s performance. These include adjusted ROAA, adjusted ROAE, adjusted net income, adjusted earnings per share, adjusted ALLL to total loans, tangible book value per share and the following fully-taxable equivalent measures: net interest income-FTE, efficiency ratio-FTE and net interest margin-FTE. Interest on tax-exempt loans and securities is presented on a taxable-equivalent basis (which converts the income on loans and investments for which no income taxes are paid to the equivalent yield as if income taxes were paid) using the federal corporate income tax rate of 21 percent that was applicable for all periods presented.
Management believes that the use of these non-GAAP measures provides meaningful information about operating performance by enhancing comparability with other financial periods, other financial institutions, and between different sources of interest income. The non-GAAP measures used by management enhance comparability by excluding the effects of (1) items that do not reflect ongoing operating performance, such as merger and merger-related expenses, (2) items that do not reflect the implicit percentage of the ALLL to total loans, such as the impact of fair value adjustment and PPP loans, (3) balances of intangible assets, including goodwill, that vary significantly between institutions, and (4) tax benefits that are not consistent across different opportunities for investment. These non-GAAP financial measures should not be considered an alternative to GAAP-basis financial statements, and other banks and bank holding companies may define or calculate these or similar measures differently. Net income is discussed in Management’s Discussion and Analysis on a GAAP basis unless noted as “non-GAAP.”
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A reconcilement of the non-GAAP financial measures used by the Company to evaluate and measure the Company's performance to the most directly comparable GAAP financial measures is presented below:
(Dollars in thousands, except per share data)
Reconcilement of Non-GAAP Measures: Year Ended December 31
Performance measures
Return on average assets 0.61 % 1.00 %
Impact of merger expenses 1 0.33 % 0.09 %
Operating return on average assets 1 (non-GAAP) 0.94 % 1.09 %
Return on average equity 7.17 % 10.01 %
Impact of merger expenses 1 3.91 % 0.88 %
Operating return on average equity 1 (non-GAAP) 11.08 % 10.89 %
Net income, excluding merger expenses 1 (non-GAAP) $ 15,566 $ 8,682
Net income per share, diluted $ 2.14 $ 2.95
Impact of merger expenses 1 1.17 0.26
Net income per share, excluding merger expenses 1 (non-GAAP) $ 3.32 $ 3.21
Fully taxable-equivalent measures
Fully taxable-equivalent adjustment 271 126
Impact of FTE adjustment -0.4 % -0.3 %
Efficiency ratio (FTE) 4 76.3 % 61.4 %
Net interest margin 2.92 % 3.16 %
Fully tax-equivalent adjustment 0.02 % 0.01 %
Net interest margin (FTE) 2 2.94 % 3.17 %
Other financial measures
ALLL to total loans 0.56 % 0.90 %
Impact of acquired loans and fair value mark 0.39 % 0.00 %
ALLL to total loans 0.56 % 0.90 %
Impact of PPP loans 0.02 % 0.08 %
ALLL to total loans, excluding PPP loans (non-GAAP) 0.58 % 0.98 %
Impact of intangible assets (3.14 ) (0.26 )
Tangible book value per share (non-GAAP) $ 27.36 $ 30.17
1 References to merger expenses include merger and merger-related expenses and are net of tax.
2 FTE calculations use a Federal income tax rate of 21%.
3 The efficiency ratio, GAAP basis, is computed by dividing noninterest expense by the sum of net interest income and noninterest income.
4 The efficiency ratio, FTE, is computed by dividing noninterest expense by the sum of net interest income (FTE) and noninterest income.
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Results of Operations
Consolidated Return on Assets and Equity and Other Key Ratios
The ratio of net income to average total assets and average shareholders' equity and certain other ratios for the years indicated are as follows:
Return on average assets 0.61 % 1.00 %
Operating return on average assets (non-GAAP) 0.94 % 1.09 %
Return on average equity 7.17 % 10.01 %
Operating return on average equity (non-GAAP) 11.08 % 10.89 %
Average equity to average assets 8.52 % 10.00 %
Cash dividend payout ratio 55.95 % 40.82 %
Net income for the year ended December 31, 2021 was $10.1 million, or $2.14 per diluted share, a 26.2% increase compared to $8.0 million, or $2.95 per diluted share for the year ended December 31, 2020. This $2.1 million increase was primarily the result of a $21.1 million increase in net interest income, a $3.9 million increase in noninterest income, and a $608 thousand reduction in provision for loan losses. Negatively affecting net income for 2021 compared to 2020 was a $23.7 million increase in noninterest expense. Each component of such year-over-year changes are described in more detail below.
The efficiency ratio (FTE) was 76.3% for the year ended December 31, 2021, compared to 61.4% for the same period of 2020, increasing due primarily to the one-time impact of merger and merger-related expenses.
The Company has four reportable segments: the Bank, VNB Trust and Estate Services, Sturman Wealth and Masonry Capital.
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Bank - The Bank’s commercial banking activities involve making loans, taking deposits and offering related services to individuals, businesses and charitable organizations. Loan fee income, service charges from deposit accounts, and other non-interest-related revenue, such as fees for debit cards and ATM usage and fees for treasury management services, generate additional income for this segment.
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Sturman Wealth Advisors – This segment offers wealth and investment advisory services. Revenue for this segment is generated primarily from investment advisory and financial planning fees, with a small and decreasing portion attributable to brokerage commissions. During February 2016, the Company purchased the book of business, including interest in the client relationships, (“Purchased Relationships”), from a current officer (the “Seller”) of the Company pursuant to an employment and asset purchase agreement (the “Purchase Agreement”). Prior to becoming an employee of the Company and until the effective date of the sale, the Seller provided services to the Purchased Relationships as a sole proprietor. Under the terms of the Purchase Agreement, the Company will receive all future revenue for investment management, advisory, brokerage, insurance, consulting, and related services performed for the Purchased Relationships. More information on this purchase can be found under Goodwill and Other Intangible Assets in Note 8 of the Notes to Consolidated Financial Statements, which is found in Item 8. Financial Statements and Supplementary Data.
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VNB Trust and Estate Services - This segment offers corporate trustee services, trust and estate administration, IRA administration and custody services and offers in-house investment management services. Revenue for this segment is generated from administration, service and custody fees, as well as management fees which are derived from Assets Under Management. Investment management services currently are offered through affiliated and third-party managers.
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Masonry Capital - Masonry Capital offers investment management services for separately managed accounts and a private investment fund employing a value-based, catalyst-driven investment strategy. Revenue for this segment is generated from management fees which are derived from Assets Under Management and incentive income which is based on the investment returns generated on performance-based Assets Under Management.
The Bank segment earned net income of $9.0 million in 2021, a $708 thousand increase over the $8.3 million netted in 2020. Sturman Wealth earned $384 thousand in 2021 compared to $48 thousand in the prior year. VNB Trust and Estate Services realized net income of $162 thousand in 2021, compared to a net loss of $52 thousand in 2020. Masonry Capital realized net income of $561 thousand in 2021, compared to a net loss of $274 thousand in 2020.
Details of the changes in the various components of net income are further discussed below.
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Net Interest Income
Net interest income is computed as the difference between the interest income on earning assets and the interest expense on deposits and other interest bearing liabilities. Net interest income represents the principal source of revenue for the Company and accounted for 81.1% of the total revenue in 2021. Net interest margin (FTE) is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income (FTE) and net interest margin (FTE).
The following table details the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest bearing liabilities, for the years ended December 31, 2021, 2020, and 2019.
Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE)
Interest Average Interest Average Interest Average
ASSETS
Interest earning assets:
Securities
Loans:
Other interest-bearing deposits 160,960 233 0.14 % - - - - - -
LIABILITIES AND SHAREHOLDERS' EQUITY
Interest bearing liabilities:
Interest bearing deposits:
Junior subordinated debt 2,565 148 5.77 % - - - - - -
Non-Interest-Bearing Liabilities:
Interest expense as a percentage of average earning assets 0.21 % 0.44 % 0.69 %
(1)
Tax-exempt income for investment securities has been adjusted to a fully tax-equivalent basis (FTE), using a Federal income tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations earlier in this section.
(2)
Interest rate spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities.
(3)
Net interest margin (FTE) is net interest income (FTE) expressed as a percentage of average earning assets.
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The purpose of the volume and rate analysis below is to describe the impact on the net interest income (FTE) of the Company resulting from changes in average balances and average interest rates for the periods indicated. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Interest income is reported on a tax-equivalent basis.
Volume and Rate Analysis
2021 compared to 2020
Change due to: Increase/
(Dollars in thousands) Volume Rate (Decrease)
Assets:
Loans:
Other interest-bearing deposits 233 - 233
Liabilities and Shareholders' equity:
Interest-bearing deposits:
Junior subordinated debt 148 - 148
Total interest-bearing liabilities 2,129 (2,196 ) (67 )
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2020 compared to 2019
Change due to: Increase/
(Dollars in thousands) Volume Rate (Decrease)
Assets:
Loans:
Liabilities and Shareholders' equity:
Interest-bearing deposits:
Interest checking $ 43 (133 ) $ (90 )
Total interest-bearing deposits 386 (1,293 ) (907 )
Total interest-bearing liabilities 490 (1,412 ) (922 )
For 2021, net interest income (FTE) of $45.3 million was recognized, an increase of $21.3 million over 2020. Net interest income (FTE) for 2020 totaled $24.0 million and was $2.0 million increase over the 2019 total of $22.0 million. Average earning assets increased $783.1 million or 103.5% in 2021 compared to 2020 and increased $140.6 million or 22.8% in 2020 compared to 2019. The increases in volume of real estate and commercial loans from 2020 to 2021 were the primary contributing factors of the increase in net interest income. The declines in rates paid on deposits over the same period also positively impacted net interest income. The average balance for loans as a percentage of earnings assets for 2021 was 66.1%, compared to 79.4% and 85.1% in 2020 and 2019, respectively.
The 2021 net interest margin (FTE) declined 23 bps to 2.94% from 3.17% in 2020. The 2020 net interest margin (FTE) declined 40 bps from 3.57% in 2019. The tax-equivalent yield on average earning assets for 2021 of 3.15% was 47 bps lower than the 2020 yield of 3.62%. The 2019 tax-equivalent yield on average earning assets of 4.27% was 65 bps higher than the comparable 2020 yield. Loan yields for 2021 were 4.32%, improving 17 bps from the loan yield of 4.15% for 2020. Average loans for 2021 of $1.0 billion were $416.4 million higher than the 2020 average of $600.9 million, due to the Merger. 2020’s average loan balances were $77.1 million higher than the 2019 average of $523.8 million due to the origination of PPP loans during 2020.
Interest expense as a percentage of average earning assets declined to 21 bps for 2021, compared to 44 and 69 bps for 2020 and 2019, respectively. Net interest margin will be impacted by future changes in short-term and long-term interest rate levels on deposits, as well as the impact from the competitive environment. A continuing primary driver of the Company’s low cost of funds is the Company’s level of non-interest bearing demand deposits and low-cost deposit accounts. Following is a table illustrating the average balances of deposit accounts as a percentage of total deposit account balances.
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Provision for Loan Losses
The level of the allowance reflects changes in the size of the portfolio or in any of its components, as well as management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, and economic, political and regulatory conditions. Additional information concerning management’s methodology in determining the adequacy of the allowance for loan losses is contained later in this section under Allowance for Loan Losses, in addition to Note 1 and Note 5 of the Notes to Consolidated Financial Statements, found in Item 8. Financial Statements and Supplementary Data.
Based on management’s continuing evaluation of the loan portfolio in 2021, the Company recorded a provision for loan losses of $1.0 million, compared to a provision of $1.6 million in 2020 and $1.4 million in 2019. The decrease in 2021 is the result of the Company releasing of a portion of the reserves that were added during 2020 since the credit deterioration was not experienced to the extent previously anticipated. The increase in the 2020 provision for loan losses was largely the result of worsening economic qualitative factors associated with COVID-19.
The allowance for loan losses as a percentage of total loans was 0.56% at December 31, 2021 compared to 0.90% at December 31, 2020.
The following is a summary of the changes in the allowance for loan losses for the years ended December 31, 2021, 2020, and 2019:
Noninterest Income
The major components of noninterest income are detailed below. Year-to-year variances are shown for each noninterest income category.
(Dollars in thousands) For the year ended December 31 Variance
Noninterest income:
Earnings/increase in value of bank owned life insurance 708 437 271 62.0 %
Gains on sales and calls of securities - 743 (743 ) -100.0 %
Noninterest income of $10.5 million for the year ended December 31, 2021 experienced a net increase over the prior year of $3.9 million, as a result of the following variances:
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Debit/credit card and ATM fees, Trust and estate services fees, deposit accounts fees, advisory and brokerage income and investment management income increased $1.5 million, $1.2 million, $808 thousand, $454 thousand and $379 thousand, respectively, due primarily to the Merger and the addition of Fauquier's customers in each of the respective areas;
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Performance fees on assets under management increased $789 thousand due to improved market conditions period over period;
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Earnings from bank owned life insurance increased $271 thousand primarily as a result of the addition of the Fauquier policies;
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The above increases were offset by:
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Loan swap fee income decreased $1.2 million, as a result of decreased demand of such product due to the interest rate environment, and
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Gains on sales and calls of securities decreased $743 thousand, as no securities were sold in 2021.
Noninterest Expense
Noninterest expense of $42.5 million reported for 2021 increased $23.7 million or 126.4% from the $18.8 million for 2020. The major components of noninterest expense are detailed below. Year-over-year variances are shown for each noninterest expense category.
(Dollars in thousands) December 31, December 31, Variance
Noninterest expense:
Core deposit intangible amortization 1,389 - 1,389 --
Salaries and employee benefits accounted for the largest increase, increasing 70.4% from $9.5 million in 2020 to $16.1 million in 2021. This increase was due to the Merger and the addition of Fauquier's employees effective April 1, 2021, offset by a reduction in salaries for redundant positions, occurring through the year. At December 31, 2021, the Company had 173 full-time equivalent employees compared to 86 at year-end 2020.
Merger expenses accounted for the next largest increase, amounting to $7.4 million in 2021, compared to $988 thousand in 2020. These expenses included investment banker fees, expenses related to the integration of systems and operations, change of control payments, severance and stay-put bonuses, and legal and consulting expenses, which have been expensed as incurred.
Core deposit intangible amortization expense is a result of the Merger and amounted to $1.4 million in 2021.
Provision for Income Taxes
The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and the income tax bases of assets and liabilities using the applicable enacted marginal tax rate.
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For 2021, the Company provided $1.8 million for Federal income taxes, resulting in an effective income tax rate of 15.5%. In 2020, the Company provided $2.1 million for Federal income taxes, resulting in an effective income tax rate of 20.6%. The effective tax rate is lower in 2021 due to the impact of low-income housing tax credits acquired during the Merger, offset by the non-deductibility of certain merger-related expenses for tax purposes. Additionally, the effective income tax rates for 2021 and 2020 were lower than the U.S. statutory rate of 21% due to the effect of tax-exempt income from municipal bonds and bank owned life insurance policies.
More information on income taxes, including net deferred taxes can be found in Note 11 – Income Taxes of the Notes to Consolidated Financial Statements which is found in Item 8. Financial Statements and Supplementary Data.
BALANCE SHEET ANALYSIS
Securities
The investment securities portfolio has a primary role in the management of the Company’s liquidity requirements and interest rate sensitivity, as well as generating significant interest income. Investment securities also play a key role in diversifying the Company’s balance sheet. In addition, a portion of the investment securities portfolio is pledged as collateral for public fund deposits. Changes in deposit and other funding balances and in loan production will impact the overall level of the investment portfolio.
As of December 31, 2021, the Company’s investment portfolio totaled $308.8 million, with obligations of U.S. government corporations and government-sponsored enterprises amounting to $202.5 million, or approximately 66% of the total. The Company’s investment portfolio totaled $177.1 million as of December 31, 2020.
During the year ended December 31, 2021, there were no sales of securities. For the year ended December 31, 2020, proceeds from the sales of securities amounted to $69.5 million, and gross realized gains on these securities were $742 thousand. An additional $1 thousand gain was realized from a call of a security during 2020. Management proactively manages the mix of earning assets and cost of funds to maximize the earning capacity of the Company.
In accordance with ASC 320, “Investments - Debt and Equity Securities,” the Company has categorized its unrestricted securities portfolio as Available for Sale. Securities classified as AFS may be sold in the future, prior to maturity. Any decision to sell a security classified as AFS would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. AFS securities are carried at fair value. Net aggregate unrealized gains or losses on these securities are included, net of taxes, as a component of shareholders’ equity. All of the Company’s unrestricted securities were investment grade or better as of December 31, 2021. Given the generally high credit quality of the Company’s AFS investment portfolio, management expects to realize all of its investment upon market recovery or the maturity of such instruments and thus believes that any impairment in value is interest-rate-related and therefore temporary. AFS securities included gross unrealized gains of $1.4 million and gross unrealized losses of $4.2 million as of December 31, 2021.
Amount Percent Amount Percent
All mortgage-backed securities included in the above tables were issued by U.S. government agencies and corporations. At December 31, 2021, the securities issued by political subdivisions or agencies were highly rated with 100% of the municipal bonds having AA or higher ratings. Approximately 65% of the municipal bonds are general obligation bonds, and issuers are geographically diverse. The Company held no issues that exceeded 10% of the Company’s shareholders' equity at December 31, 2021.
The Company’s holdings of restricted securities totaled $5.0 million and $3.0 million at December 31, 2021 and December 31, 2020, respectively, and consisted of stock in the Federal Reserve Bank, stock in the FHLB, and stock in CBB Financial Corporation, the holding company for Community Bankers’ Bank, and an investment in an SBA loan fund. The Bank is required to hold stock in the Federal Reserve Bank and the FHLB as a condition of membership with each of these correspondent banks. The amount of stock required to be held by the Bank is periodically assessed by each bank, and the Bank may be subject to purchase or surrender stock held in these banks, as determined by their respective calculations. The amount of FHLB stock held decreased $2.0 million from December 31, 2020 to December 31, 2021, as stock was relinquished due to the paydown of advances during the period. Stock ownership in the bank holding company for Community Bankers’ Bank provides the Bank with several benefits that are not available to non-shareholder correspondent banks. None of these stock issues are traded on the open market and can only be redeemed by the respective issuer. Restricted stock holdings are recorded at cost.
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The table shown below details the amortized cost and fair value of AFS securities at December 31, 2021 based upon contractual maturities, by major investment categories. Expected maturities may differ from contractual maturities because issuers have the right to call or prepay obligations. The tax-equivalent yield is based upon a federal tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations section earlier in Item 7.
Maturity Distribution and Average Yields
Contractual Maturities of Debt Securities at December 31, 2021
U.S. Government-Sponsored Agencies:
Mortgage-backed securities/CMOs
Municipal bonds
Weighted average yield is calculated based on the relative amortized cost of the securities. Yields on tax-exempt securities have been computed on a tax-equivalent basis using the federal corporate income tax rate of 21 percent.
As stated, the preceding table reflects the distribution of the contractual maturities of the investment portfolio at December 31, 2021. Management’s investment portfolio strategy is to structure the portfolio so that it is a constant source of liquidity for the balance sheet. In order to achieve greater liquidity in the portfolio, securities that have a monthly flow of principal repayments become a key component. To illustrate the difference between contractual maturity and average life, consider the difference for the fixed rate mortgage-backed securities (MBS) component of this portfolio. At December 31, 2021, the weighted average maturity of the fixed rate MBS sector was 18.75 years, and the projected average life for this group of securities is 5.0 years.
Another indication of the investment portfolio’s liquidity potential is shown by the projected annual principal cash flow from maturities, callable bonds, and monthly principal repayments. For the next three years, the principal cash flows are estimated to be $27.9 million for 2022, $29.2 million for 2023, and $26.9 million for 202, based upon rates remaining at current levels. This represents approximately 28% of the investment portfolio’s AFS balance at December 31, 2021 that will be available to support the future liquidity needs of the Company. Cash flow projections are subject to change based upon changes to market interest rates.
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Loan Portfolio
The Company’s loan portfolio totaled $1.1 billion as of December 31, 2021 or 53.8% of total assets. Loan balances increased $451.8 million, or 74.1%, from the balance of $609.4 million as of December 31, 2020. Note that all loan balances are presented net of credit and other fair value discounts, when applicable. The table below shows the composition of the loan portfolio:
(Dollars in thousands) As of December 31,
Real estate mortgage:
Less: Allowance for loan losses (5,984 ) (5,455 )
During 2020 and 2021, the Company assisted nonprofit organizations and local businesses by funding $207.5 million of PPP loans, which were designed to provide economic relief to small businesses adversely impacted by the COVID-19 pandemic. These loans carry a 1% annual interest rate; however, in addition, the Company recognized $2.3 million and $2.1 million in PPP loan origination fees in 2021 and 2020, respectively. As of December 31, 2021, 89% of the total dollars of PPP loans had been forgiven by the SBA, with $20.7 million outstanding.
The addition of purchased loans in connection with the Merger with Fauquier accounted for the bulk of the $451.8 million increase from December 31, 2020 to December 31, 2021.
At December 31, 2021, the loan-to-deposit ratio stood at 59.1%, compared to 83.4% at December 31, 2020.
The Company’s objective is to maintain the historically strong credit quality of the loan portfolio by maintaining rigorous underwriting standards. These standards coupled with regular evaluation of the creditworthiness of, and the designation of lending limits for, each borrower has helped the Company achieve this objective. The primary portfolio strategy includes seeking industry and loan size diversification in order to minimize credit exposure and originating loans in markets with which the Company is familiar. The predominant market area for loans includes Charlottesville, Albemarle County, Fauquier County, Prince William County, Winchester, Frederick County, Manassas, Richmond and areas in the Commonwealth of Virginia that are within a 75 mile radius of any Virginia National Bank location.
Based on underwriting standards, loans may be secured in whole or in part by collateral such as liquid assets, accounts receivable, equipment, inventory and real property. The collateral securing any loan may depend on the type of loan and may vary in value based on market conditions.
The Company’s real estate loan portfolio increased by $478.5 million to a balance of $911.1 million at December 31, 2021 from $432.6 million at December 31, 2020. This category comprised 85.9% of all loans, and these loans are secured by mortgages on real property located principally in Virginia. Of this amount, approximately $358.2 million represented loans on residential properties. Commercial real estate loans totaled $473.6 million as of December 31, 2021. Sources of repayment are from the borrower’s operating profits, cash flows and liquidation of pledged collateral. The remaining real estate loans were comprised of construction and land development loans which totaled $79.3 million as of December 31, 2021, an increase of $56.8 million compared to the December 31, 2020 balance of $22.5 million as a result of the addition of Fauquier loans as part of the Merger.
As of December 31, 2021, the Company’s commercial and industrial loan portfolio totaled $96.7 million, a $22.0 million decline from the $118.7 million balance at year-end 2020. This category, representing approximately 9.1% of all loans, includes loans made to individuals and small to medium-sized businesses, as well as loans purchased on the syndicated and government guaranteed markets. As discussed previously, the Company participated in the PPP loan initiative during 2020 and 2021 with balances of $54.2 million and $20.7 million as of December 31, 2020 and December 31, 2021, respectively. Forgiveness of a significant amount of loans during 2021 caused the overall decline.
Consumer loans, comprised of student loans purchased, revolving credit, and other fixed payment loans, totaled $53.4 million as of December 31, 2021 or 5.0% of all loans. Consumer loans ended 2021 with balances $4.7 million lower than the prior year-end, primarily due to normal amortization within the student loan portfolio.
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The following table presents the maturity/repricing distribution of the Company’s loans at December 31, 2021. The table also presents the portion of loans that have fixed interest rates or variable/floating interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the Wall Street Journal prime rate, LIBOR rates, or U.S. Treasury bond indices.
Maturities and Sensitivities of Loans to Changes in Interest Rates
(Dollars in thousands) As of December 31, 2021
One Year or Less After 1 to 5 Years After Five to 15 Years After 15 Years Total
Fixed Rate:
Variable Rate:
Total loans at December 31, 2021 included loans purchased in connection with the Merger. These loans were recorded at estimated fair value on the date of acquisition without the carryover of the related ALLL. The following table presents the outstanding principal balance and the carrying amount of purchased loans:
(Dollars in thousands) December 31, 2021
Carrying amount:
For a description of the Company's accounting for purchased performing and PCI loans, see "Critical Accounting Estimates" earlier in Item 7.
Loan Asset Quality
Intrinsic to the lending process is the possibility of loss. While management endeavors to minimize this risk, it recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio, which in turn depend on current and future economic conditions, the financial condition of borrowers, the realization of collateral, and the credit management process.
Generally, loans are placed on non-accrual status when management believes, after considering economic and business conditions and collections efforts, that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement, or when the loan is past due for 90 days or more, unless the debt is both well-secured and in the process of collection.
At December 31, 2021 and 2020, the Company had loans classified as non-accrual with balances of $495 thousand and $8 thousand, respectively. The non-accrual balance as of December 31, 2021 consists of only one loan. Acquired Loans which otherwise would be in non-accrual status are not included in this figure, as they earn interest through the yield accretion.
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Loans 90 days or more past due and still accruing interest amounted to $801 thousand as of December 31, 2021, compared to $137 thousand as of December 31, 2020. The 2021 balance includes a government-guaranteed loan in the amount of $548 thousand and $115 thousand of defaulted PPP loans for which claims have been filed with the SBA. The portfolio only includes eight non-insured student loans that are 90 days or more past due and still accruing interest, amounting to $83 thousand. Loans acquired during the Merger which are greater than 90 days past due and still accruing interest are included in this figure, net of their fair value mark.
TDRs occur when the Company agrees to modify the original terms of a loan by granting a concession that it would not otherwise consider due to the deterioration in the financial condition of the borrower. These concessions are done in an attempt to improve the paying capacity of the borrower, and in some cases to avoid foreclosure, and are made with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs that are considered to be performing continue to accrue interest under the terms of the restructuring agreement. TDRs that have been placed in non-accrual status are considered to be nonperforming.
Total performing TDR balances declined to $1.0 million as of December 31, 2021 compared to $1.3 million as of December 31, 2020. Based on regulatory guidance issued in 2016 on Student Lending, the Company classified 58 of its student loans purchased as TDRs for a total of $935 thousand as of December 31, 2021 and 75 of its student loans purchased as TDRs for a total of $1.2 million as of December 31, 2020. Nonperforming TDR balances increased to $495 thousand as of December 31, 2021 compared to $8 thousand as of December 31, 2020.
The table below summarizes the Company's credit ratios as of December 31, 2021 and 2021:
Nonaccrual loans $ 495 $ 8
Allowance for loan losses $ 5,984 $ 5,455
Nonaccrual loans to total loans 0.05 % 0.00 %
ALLL to total loans 0.56 % 0.90 %
In accordance with 2020 regulatory guidance and the CARES Act, the Bank has approved for certain customers who have been adversely affected by the COVID-19 pandemic to defer principal-only, or principal and interest, payments for a 90- to 180-day period. Such short-term modifications, which were made on a good faith basis in response to the COVID-19 pandemic to borrowers who were current prior to any relief, are not to be considered TDRs. While interest will continue to accrue to income, in accordance with GAAP, if the Bank ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively impacted. A total of $59.0 million in loan deferments have been approved since the beginning of the pandemic. As of December 31, 2021, $57.8 million, or 98.0%, of the total loan deferments approved have returned to normal payment schedules and are now current.
See Note 4 – Loans and Note 5 – Allowance for Loan Losses in the accompanying Notes to Consolidated Financial Statements included in Item 8. Financial Statements and Supplementary Data for further details regarding the Company’s loan asset quality measurements.
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Allowance for Loan Losses
In general, the Company determines the adequacy of its allowance for loan losses by considering the risk classification and delinquency status of loans and other factors. Management may also establish specific allowances for loans which management believes require allowances greater than those allocated according to their risk classification. The purpose of the allowance is toprovide for losses inherent in the loan portfolio. Since risks to the loan portfolio include general economic trends as well as conditions affecting individual borrowers, the allowance is an estimate. The Company is committed to determining, on an ongoing basis, the adequacy of its allowance for loan losses.
The Company applies historical loss rates to various pools of loans based on risk rating classifications. In addition, the adequacy of the allowance is further evaluated by applying estimates of loss that could be attributable to any one of the following eight qualitative factors:
1)
Changes in national and local economic conditions, including the condition of various market segments;
2)
Changes in the value of underlying collateral;
3)
Changes in volume of classified assets, measured as a percentage of capital;
4)
Changes in volume of delinquent loans;
5)
The existence and effect of any concentrations of credit and changes in the level of such concentrations;
6)
Changes in lending policies and procedures, including underwriting standards;
7)
Changes in the experience, ability and depth of lending management and staff; and
8)
Changes in the level of policy exceptions.
Management utilizes a loss migration model for determining the quantitative risk assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, and increase efficiencies related to performing the calculations by further segmenting the loan classes. The quantitative risk factor for each loan class primarily utilizes a migration analysis loss method based on loss history for the prior twelve quarters.
See Note 4 – Loans and Note 5 – Allowance for Loan Losses in the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data, for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
Activity for the allowance for loan losses is provided in the following table:
As of and for the year ended December 31, 2021
Allowance for Loan Losses:
As of and for the year ended December 31, 2020
Allowance for Loan Losses:
Charge-offs - - - (805 ) (805 )
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As of December 31, 2021, the ALLL was $6.0 million, a net increase of $529 thousand from $5.5 million at December 31, 2020. Management’s estimates for the ALLL resulted in the Company’s allowance to total loans outstanding ratio of 0.56% at December 31, 2021, compared to 0.90% at December 31, 2020 and 0.78% at December 31, 2019. The primary reason that the ALLL as a percentage of loans decreased from December 31, 2020 to December 31, 2021 was due to the addition of TFB loans effective with the Merger, which do not require an ALLL based on the fair value mark. Note that without the impact of acquired loans and the fair value mark, the ALLL to total loans outstanding would have been 0.95% as of December 31, 2021 (for reconcilement of this non-GAAP measure, see the “Non-GAAP Presentation” section earlier in Item 7).
During 2021, there were $835 thousand in loan balances charged off, with a total of $350 thousand in recoveries of previously charged-off balances, resulting in net charge-offs of $485 thousand. During 2020, there were $805 thousand in loan balances charged off, with a total of $429 thousand in recoveries of previously charged-off balances, resulting in net charge-offs of $376 thousand. The ratio of net charge-offs to average loans was 0.05% and 0.06% for 2021 and 2020, respectively.
The table below provides an allocation of year-end allowance for loan losses by loan type; however, allocation of a portion of the allowance to one loan category does not preclude its availability to absorb losses in other categories.
Allocation of the Allowance for Loan Losses
Real estate construction and land 399 7.48 %
Real estate construction 160 3.69 %
Deposits
Depository accounts represent the Company’s primary source of funding and are comprised of demand deposits, interest-bearing checking accounts, money market deposit accounts and time deposits. These deposits have been provided predominantly by individuals, businesses and charitable organizations in the Charlottesville/Albemarle County, Fauquier County, Manassas, Prince William County, Richmond and Winchester areas.
Depository accounts held by the Company as of December 31, 2021, totaled $1.8 billion, an increase of $1.0 billion or 145.8% compared to the December 31, 2020 total of $730.8 million.
At December 31, 2021, the balances of non-interest bearing demand deposits were $522.3 million or 29.1% of total deposits, a 149.0% increase from $209.8 million at December 31, 2020. Interest-bearing transaction and money market accounts totaled $1.1 billion at December 31, 2021, an increase of $690.0 million compared to $421.9 million at December 31, 2020. The Company offers ICS®, which allows customers access to multi-million-dollar FDIC insurance on funds placed into demand deposit and/or money market deposit accounts. As of December 31, 2021, the reciprocal ICS® balances included in demand deposit and money market accounts were $39.2 million and $225.9 million, respectively. The Company’s low-cost deposit accounts, which include both non-interest and interest bearing checking accounts as well as money market accounts, represented 91.0% of total deposit account balances at December 31, 2021 and compared favorably to the 86.4% of total deposit account balances at December 31, 2020.
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Certificates of deposit and other time deposit balances increased $62.9 million to $162.0 million at December 31, 2021 from the balance of $99.1 million at December 31, 2020. Included in this deposit total were reciprocal relationships under CDARSTM, whereby depositors can obtain FDIC insurance on deposits up to $50 million. These reciprocal CDARSTM deposits totaled $6.1 million and $8.5 million at December 31, 2021 and 2020, respectively.
Average Balances and Rates Paid
(Dollars in thousands) Years Ended December 31
Average Average Average Average
Balance Rate Balance Rate
Interest-bearing deposits:
As of December 31, 2021 and 2020, the estimated amounts of total uninsured deposits were $585.6 million and $276.4 million, respectively.
Maturities of time deposits in excess of FDIC insurance limits as of December 31, 2021 were as follows:
(Dollars in thousands)
Amount Percentage
Over three months to six months 5,607 12.38 %
Over six months to one year 6,963 15.37 %
Borrowings
Borrowings, consisting primarily of FHLB advances and federal funds purchased, are additional sources of funds for the Company. The level of these borrowings is determined by various factors, including customer demand and the Company's ability to earn a favorable spread on the funds obtained.
The Company has a collateral dependent line of credit with the FHLB. During the third quarter of 2021, the Company prepaid 100% of its outstanding FHLB advances, which positively impacted interest expense by $416 thousand as a result of accelerating the accretion of the fair value purchase mark on such acquired Fauquier debt. A prepayment penalty in the amount of $243 thousand was incurred and is reported in noninterest expense, netting to an overall gain on the transaction of $173 thousand. Due to this repayment, at December 31, 2021, the Company had no outstanding borrowings from the FHLB. As of December 31, 2020, the Company had outstanding balances of $30.0 million from three FHLB advances with $10 million maturing in each of the years 2021, 2023, and 2025. The Company had no outstanding borrowings as of December 31, 2019.
As of December 31, 2021, the Company had a letter of credit for $60.0 million issued in favor of the Commonwealth of Virginia Department of the Treasury to secure public fund depository accounts and collateralized against these pledged commercial mortgages.
Additional borrowing arrangements maintained by the Bank include formal federal funds lines with five correspondent banks. The Company had no outstanding balances in federal funds purchased as of December 31, 2021, 2020, or 2019.
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Total borrowings consist of the following as of December 31, 2021, 2020, and 2019:
FHLB advances $ - $ 30,000 $ -
Total borrowings $ - $ 30,000 $ -
Annual average interest rate paid 0.82 % 0.47 % 2.58 %
Annual interest rate at end of period - 0.48 % -
Details on available borrowing lines can be found later under Liquidity in the Asset/Liability Management section.
Junior Subordinated Debt
In 2006, a subsidiary of Fauquier, Fauquier Statutory Trust II, privately issued $4.0 million face amount of the trust’s Floating Rate Capital Securities in a pooled capital securities offering. Simultaneously, the trust used the proceeds of that sale to purchase $4.0 million principal amount of the Fauquier’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. As of December 31, 2021, total capital securities were $3.4 million, as adjusted to fair value as of the date of the Merger. The interest rate on the capital security resets every three months at 1.70% above the then current three-month LIBOR and is paid quarterly. Management is in communication with the issuer regarding the alternative reference rate that will apply after the discontinuance of LIBOR.
The Trust II issuance of capital securities and the respective subordinated debentures are callable at any time. The subordinated debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The capital securities are guaranteed by the Company on a subordinated basis.
ASSET/LIABILITY MANAGEMENT
The Company’s primary earnings source is its net interest income; therefore, the Company devotes significant time and resources to assist in the management of interest rate risk and asset quality. The Company’s net interest income is affected by changes in market interest rates and by the level and composition of interest-earning assets and interest-bearing liabilities. The Company’s objectives in its asset/liability management are to utilize its capital effectively, to provide adequate liquidity and to enhance net interest income, without taking undue risks or subjecting the Company unduly to interest rate fluctuations. The Company takes a coordinated approach to the management of its liquidity, capital and interest rate risk. This risk management process is governed by policies and limits established by the Bank’s Asset/Liability Committee, which are reviewed and approved by the Bank’s Board of Directors. This committee, which is comprised of directors and members of management, meets to review, among other things, economic conditions, interest rates, yield curves, cash flow projections, expected customer actions, liquidity levels, capital ratios and repricing characteristics of assets, liabilities and financial instruments.
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market indices such as interest rates. The Company’s principal market risk exposure is interest rate risk. Interest rate risk is the exposure to changes in market interest rates. Interest rate sensitivity is the relationship between market interest rates and net interest income due to the repricing characteristics of assets and liabilities. The Company monitors the interest rate sensitivity of its balance sheet positions by examining its near-term sensitivity and its longer-term gap position. In its management of interest rate risk, the Company utilizes several financial and statistical tools including traditional gap analysis and sophisticated income simulation models.
A traditional gap analysis is prepared based on the maturity and repricing characteristics of interest-earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on the net interest margin. The Company’s balance sheet structure is primarily short-term in nature with a substantial portion
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of rate-sensitive assets and rate-sensitive liabilities repricing or maturing within one year, as shown in the Gap Interest Sensitivity Analysis table below.
Gap Interest Sensitivity Analysis
As of December 31, 2021
Within 90 to 365 1 to 4 Over Non Rate
90 days days years 4 years Sensitive Total
Assets
Interest-bearing deposits in other banks 336,032 - - - - 336,032
Liabilities and Shareholders' Equity
Junior subordinated debt - 3,367 - - - 3,367
The Company utilizes the gap analysis to complement its income simulations modeling. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes in interest rates and other factors that could have an impact on interest rate sensitivity or net interest income.
ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon. It also utilizes additional tools to monitor potential longer-term interest rate risk. The income simulation models measure the Company’s net interest income volatility or sensitivity to interest rate changes utilizing statistical techniques that allow the Company to consider various factors which impact net interest income. These factors include actual maturities, estimated cash flows, repricing characteristics, deposit growth/retention and, most importantly, the relative sensitivity of the Company’s assets and liabilities to changes in market interest rates. This relative sensitivity is important to consider as the Company’s core deposit base has not been subject to the same degree of interest rate sensitivity as its assets. The core deposit costs are internally managed and tend to exhibit less sensitivity to changes in interest rates than the Company’s adjustable rate assets whose yields are based on external indices and generally change in concert with market interest rates. The Company’s interest rate sensitivity is determined by identifying the probable impact of changes in market interest rates on the yields on the Company’s assets and the rates that would be paid on its liabilities. This modeling technique involves a degree of estimation based on certain assumptions that management believes to be reasonable. Utilizing this process, management projects the impact of changes in interest rates on net interest margin. The Company has established certain policy limits for the potential volatility of its net interest margin assuming certain levels of changes in market interest rates with the objective of maintaining a stable net interest margin under various probable rate scenarios. Management generally has maintained a risk position well within the policy limits.
As market conditions vary from those assumed in the income simulation models, actual results will also differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other variables. Furthermore, this sensitivity analysis does not reflect actions that the ALCO might take in responding to or anticipating changes in interest rates.
In simulating the effects of upward and downward changes in market rates to net interest income over a rolling two-year horizon, the model utilizes a “static” balance sheet approach where balance sheet composition or mix as of the measurement date is maintained over the two-year horizon. Similarly, the base case simulation performed assumes interest rates on the measurement date are unchanged for the next 24 months. Then the simulation assumes all rate indices are instantaneously shocked upward and downward by 100 bps to 400 basis points, in 100 basis point increments. Due to the low level of
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interest rates, the shock down analysis where the rates fall 300 basis points or more are not considered meaningful and are therefore not shown in the results below as ofDecember 31, 2021.
(Dollars in thousands) Change in Net Interest Income
Change in Yield Curve Percentage Amount
Base case 0.00 % -
In addition to monitoring the effects to interest income, the model computes the effects to the economic value of equity using the same “static” balance sheet with immediate and parallel rate changes for the same rate change horizons. The Asset/Liability Committee monitors the results compared to policy limits that have been established.
As individual rate indices have not historically moved to the same degree, non-parallel rate shocks are also performed to add a degree of sophistication over the parallel rate shocks. In these analyses, the effects to net interest income and market value of equity are computed using eight different scenarios. Changing slopes and twists of the yield curve are achieved by incorporating both likely and unlikely change across different tenors. Since Federal funds rates may not change to the same degree or direction that longer term Treasury bonds may move, the different scenarios are analyzed so that management and the Asset/Liability Committee can monitor risks as they more severely stress the Company’s balance sheet.
The shape of the yield curve can cause downward pressure on net interest income. In general, if and to the extent that the yield curve is flatter (i.e., the differences between interest rates for different maturities are relatively smaller) than previously anticipated, then the yield on the Company’s interest earning assets and its cash flows will tend to be lower. Management believes that a relatively flat yield curve could continue to affect adversely the Company’s net interest income in 2022.
Liquidity
Liquidity represents the Company’s ability to provide funds to meet customer demand for loan and deposit withdrawals without impairing profitability. Effective management of balance sheet liquidity is necessary to fund growth in earning assets and to pay liability maturities and depository customers’ withdrawal requirements. The Company maintains a Liquidity Management Policy that is approved by the Board of Directors. The policy sets limits in a number of areas, including limits on the amount of non-core liabilities, and funding long-term assets with non-core liabilities.
The Bank’s customer base has provided a stable source of funds and liquidity. Limits contained within the Bank’s Investment Policy also provides for appropriate levels of liquidity through maturities and cash flows within the securities portfolio. Other sources of balance sheet liquidity are obtained from the repayment of loan proceeds and overnight investments. The Bank has numerous secondary sources of liquidity including access to borrowing arrangements from a number of correspondent banks. Available borrowing arrangements maintained by the Bank include formal federal funds lines with five major regional correspondent banks, access to advances from the Federal Home Loan Bank and access to the discount window at the Federal Reserve Bank.
Borrowing Lines
As of December 31, 2021
Correspondent Banks $ 95,000
Federal Home Loan Bank of Atlanta 14,200
As of December 31, 2021, the Company had no outstanding advances with the FHLB.
Any excess funds are sold on a daily basis in the federal funds market or maintained on account at the Federal Reserve. The Company maintained an average of $109.1 million outstanding in federal funds sold, an average of $161.0 million at the Federal Reserve and an average of less than $1 thousand in federal funds purchased during 2021 due to annual testing of the federal funds lines. On December 31, 2021 the Company had no balance outstanding in federal funds purchased. The Company intends to maintain sufficient liquidity at all times to meet its funding commitments.
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Capital
The Basel III Capital Rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).
The Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios of the Bank were 14.15%, 14.15%, 14.72% and 7.69%, respectively, as of December 31, 2021, exceeding the minimum requirements.
With respect to the Bank, to be “well capitalized” under the PCA regulations, a bank must have the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%. The Bank exceeds the thresholds to be considered well capitalized as of December 31, 2021.
On September 17, 2019 the FDIC finalized a rule that introduced an optional simplified measure of capital adequacy for qualifying community banking organizations, referred to as, the community bank leverage ratio framework, as required by the EGRRCPA. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
In order to qualify for the CBLR framework, a community banking organization must have a Tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the PCA regulations and will not be required to report or calculate risk-based capital.
The CBLR framework was made available for community banking organizations to use in their March 31, 2020 Call Report. The Company has not opted into the CBLR framework.
The Basel III capital regulations and CBLR framework are discussed in greater detail under the caption “Supervision and Regulation,” found earlier in this report under “Item 1. Business.” In addition, information regarding the Company’s risk-based capital at December 31, 2021 and December 31, 2020 is presented in Note 15 – Capital Requirements of the Notes to Consolidated Financial Statements, contained in Item 8. Financial Statements and Supplementary Data. Using the most recent capital requirements, the Bank’s capital ratios remain above the levels designated by bank regulators as "well capitalized" at December 31, 2021.
Impact of Inflation and Changing Prices
The Company’s financial statements included herein have been prepared in accordance with GAAP, which requires the financial position and operating results to be measured principally in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. Inflation affects the Company’s results of operations mainly through increased operating costs, but since nearly all of the Company’s assets and liabilities are monetary in nature, changes in interest rates affect the financial condition of the Company to a greater degree than changes in the rate of inflation. Although interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. The Company’s management reviews pricing of its products and services, in light of current and expected costs due to inflation, to mitigate the inflationary impact on financial performance.
Off-Balance Sheet Arrangements
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Additional information concerning the Company’s off-balance sheet arrangements is contained in Note 13 of the Notes to Consolidated Financial Statements, found in Item 8. Financial Statements and Supplementary Data.
Related Party Transactions
The Company and its subsidiaries have business dealings with companies owned by directors and beneficial shareholders of the Company. In 2021 and 2020, leasing/rental expenditures of $520 thousand and $511 thousand respectively, (including reimbursements for taxes, insurance, and other expenses) were paid to an entity indirectly owned by a director of the Company.
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Contractual Commitments
In the normal course of business, the Company and its subsidiaries enter into contractual obligations, including obligations on lease arrangements, contractual commitments for capital expenditures, and service contracts. The significant contractual obligations include the leasing of certain of its banking and operations offices under operating lease agreements on terms ranging from 1 to 10 years, most with renewal options.
Following is a schedule of future minimum rental payments under non-cancelable operating leases that have initial or remaining terms in excess of one year as of December 31, 2021:
(Dollars in thousands) 1 year or less 1-3 years 3-5 years After 5 years Total
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not required for smaller reporting company.
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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors
Virginia National Bankshares Corporation
Charlottesville, Virginia
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Virginia National Bankshares Corporation and Subsidiaries (the Corporation) as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for the years then ended, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Corporation as of December 31, 2021 and 2020, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on the Corporation’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Corporation in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Corporation is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Corporation’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
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Allowance for Loan Losses – Qualitative Factors
As described in Note 1 – Summary of Significant Accounting Policies and Note 5 – Allowance for Loan Losses to the consolidated financial statements, the Corporation maintains an allowance for loan losses that represents management’s best estimate of probable losses inherent in the loan portfolio. For loans that are not specifically identified for impairment, management determines the allowance for loan losses based on historical loss experience adjusted for qualitative factors. Qualitative adjustments to the historical loss experience are established by applying a loss percentage to the loan segments established by management based on their assessment of shared risk characteristics within groups of similar loans.
Qualitative factors are determined based on management’s continuing evaluation of inputs and assumptions underlying the quality of the loan portfolio. Management evaluates qualitative factors by loan segment, primarily considering changes in current economic conditions, collateral values, classified asset and delinquency trends, the existence and effect of concentrations, lending policies and procedures, the experience and depth of the lending team, and policy exception levels. Qualitative factors contribute significantly to the allowance for loan losses. Management exercised significant judgment when assessing the qualitative factors in estimating the allowance for loan losses. We identified the assessment of the qualitative factors as a critical audit matter as auditing the qualitative factors involved especially complex and subjective auditor judgment in evaluating management’s assessment of the inherently subjective estimates.
The primary audit procedures we performed to address this critical audit matter included:
•
Evaluating the completeness and accuracy of data inputs used as a basis for the qualitative factors.
•
Evaluating the reasonableness of management’s judgments related to the determination of qualitative factors.
•
Evaluating the qualitative factors for directional consistency and for reasonableness.
•
Testing the mathematical accuracy of the allowance calculation, including the application of the qualitative factors.
Business Combinations – Fair Value of Acquired Loans
As described in Note 1 – Summary of Significant Accounting Policies and Note 2 – Business Combinations to the consolidated financial statements, the Corporation completed its acquisition of Fauquier Bankshares, Inc. on April 1, 2021. The transaction was accounted for as a business combination using the acquisition method of accounting. Accordingly, assets acquired and liabilities assumed were recorded at fair value on the acquisition date, including acquired loans. Determining the acquired fair values, particularly in relation to the loan portfolio, is inherently subjective and involves significant judgment regarding the methods and assumptions used to estimate fair value. In determining the fair value of loans acquired, management must determine whether or not acquired loans have evidence of credit deterioration at acquisition, the amount and timing of cash flows expected to be collected, and market discount rates, among other assumptions. Changes in these assumptions could have a significant impact on the fair value of the loans acquired and the amount of goodwill recorded.
We identified the acquisition date fair value of acquired loans as a critical audit matter as auditing this estimate is especially complex and requires subjective auditor judgment. Auditing this estimate required a high level of judgment in evaluating management’s identification of loans with evidence of credit deterioration, the need for specialized skill in development and application of subjective assumptions in estimated cash flows, and the size of the acquired loan portfolio.
The primary audit procedures we performed to address this critical audit matter included the following:
•
Substantively testing management’s process, including the use of our own valuation specialist to assess the Corporation’s methods and significant assumptions utilized in determining the fair value of the acquired loan portfolio and evaluating whether the assumptions used were reasonable with respect to market participant views and other factors.
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•
Testing the completeness and accuracy of loans determined to have credit deterioration at acquisition and evaluating the reasonableness of the criteria utilized by management in making the determination.
•
Testing the accuracy of the data utilized in the development of acquisition date fair values by confirming, on a sample basis, select data.
/s/ Yount, Hyde & Barbour, P.C.
We have served as the Corporation’s auditor since 1998.
Richmond, Virginia
March 25, 2022
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VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except shares and per share data)
ASSETS
Interest-bearing deposits in other banks 336,032 -
Securities:
Restricted securities, at cost 4,950 3,010
Allowance for loan losses (5,984 ) (5,455 )
Core deposit intangible, net 8,271 -
Other intangible assets, net 274 341
Other real estate owned, net 611 -
Accrued interest receivable and other assets 18,144 6,341
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Demand deposits:
Certificates of deposit and other time deposits 162,045 99,102
Advances from the FHLB - 30,000
Junior subordinated debt 3,367 -
Accrued interest payable and other liabilities 3,552 1,459
Commitments and contingent liabilities
Shareholders' equity:
Preferred stock, $2.50 par value - -
Accumulated other comprehensive income (loss) (2,211 ) 1,460
Preferred shares outstanding - -
See Notes to Consolidated Financial Statements
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VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(dollars in thousands, except per share data)
For the years ended December 31,
Interest and dividend income:
Other interest-bearing deposits 233 -
Investment securities:
Interest expense:
Certificates and other time deposits 1,108 1,454
Net interest income after provision for loan losses 43,974 22,257
Noninterest income:
Advisory and brokerage income 1,154 700
Debit/credit card and ATM fees 2,070 612
Bank owned life insurance income 708 437
Gains on sales of securities - 743
Noninterest expense:
FDIC deposit insurance assessment 858 187
Marketing, advertising and promotion 922 409
Merger and merger-related expenses 7,423 988
Core deposit intangible amortization 1,389 -
Net income per common share, basic $ 2.16 $ 2.95
Net income per common share, diluted $ 2.14 $ 2.95
See Notes to the Consolidated Financial Statements
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VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in thousands)
For the years endedDecember 31,
Other comprehensive income (loss)
Total other comprehensive income (loss) (3,671 ) 1,503
Total comprehensive income $ 6,400 $ 9,481
See Notes to Consolidated Financial Statements
62
VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(dollars in thousands, except per share data)
Accumulated
Other
Common Capital Retained Comprehensive
Stock Surplus Earnings Income (Loss) Total
Stock option expense - 124 - - 124
Restricted stock grant expense - 140 - - 140
Vested stock grants 2 (2 ) - - -
Cash dividends declared ($1.20 per share) - - (3,254 ) - (3,254 )
Other comprehensive income - - - 1,503 1,503
Cash in lieu of fractional shares (4 ) (4 )
Exercise of stock options 3 27 - - 30
Stock option expense - 145 - - 145
Restricted stock grant expense - 376 - - 376
Vested stock grants 25 (25 ) - - -
Cash dividends declared ($1.20 per share) - - (5,594 ) - (5,594 )
Other comprehensive loss - - - (3,671 ) (3,671 )
See Notes to Consolidated Financial Statements
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VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
For the years ended December 31,
CASH FLOWS FROM OPERATING ACTIVITIES:
Net accretion of certain acquisition-related adjustments (3,381 ) -
Amortization of intangible assets 1,456 90
Net amortization and accretion of securities 1,542 724
Net gains on sales and calls of securities - (743 )
Net gains on sales of other assets (65 ) -
Bank owned life insurance income (708 ) (437 )
Depreciation and other amortization 2,944 1,866
Deferred tax expense (benefit) 702 (214 )
Net change in:
Accrued interest receivable and other assets (2,605 ) (946 )
Accrued interest payable and other liabilities 1,574 (951 )
Net cash provided by operating activities 13,065 9,253
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of Fauquier Bankshares 153,278 -
Purchases of available for sale securities (74,427 ) (167,357 )
Net increase in restricted investments (320 ) (1,327 )
Proceeds from sale of available for sale securities - 69,494
Proceeds from sale of loans 6,251 -
Proceeds from sale of premises and equipment 34 -
Cash payment for wealth management book of business - (50 )
Purchase of bank premises and equipment, net (1,293 ) (199 )
Net cash provided by (used in) investing activities 262,188 (129,948 )
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in other borrowings (42,582 ) 30,000
Proceeds from stock options exercised 30 -
NET INCREASE IN CASH AND CASH EQUIVALENTS $ 474,145 $ 15,610
CASH AND CASH EQUIVALENTS:
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Unrealized (losses) gains on available for sale securities $ (4,566 ) $ 1,902
Unrealized (losses) gains on interest rate swaps $ (81 ) $ -
Assets acquired in business combination $ 910,494 $ -
Liabilities assumed in business combination $ 840,226 $ -
Change in goodwill $ 7,768 $ -
See Notes to Consolidated Financial Statements
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 – Summary of Significant Accounting Policies
The Company - Headquartered in Charlottesville, Virginia, Virginia National Bankshares Corporation (the Company) (NASDAQ: VABK) is a bank holding company incorporated under the laws of the Commonwealth of Virginia. The Company is authorized to issue (a) 10,000,000 shares of common stock with a par value of $2.50 per share and (b) 2,000,000 shares of preferred stock at a par value $2.50 per share. There is currently no preferred stock outstanding. The Company is regulated under the Bank Holding Company Act of 1956, as amended and is subject to inspection, examination, and supervision by the Federal Reserve Board.
Virginia National Bank (the Bank) is a wholly-owned subsidiary of the Company and was organized in 1998 under federal law as a national banking association to engage in a general commercial and retail banking business. The Bank is also headquartered in Charlottesville, Virginia and primarily serves the Virginia communities in and around the cities of Charlottesville, Winchester, Manassas and Richmond, and the counties of Albemarle, Fauquier, Frederick and Prince William. As a national bank, the Bank is subject to the supervision, examination and regulation of the OCC.
The Bank offers a full range of banking and related financial services to meet the needs of individuals, businesses and charitable organizations, including the fiduciary services of VNB Trust and Estate Services. The Bank also offers, through its networking agreements with third parties, investment advisory and other investment services under Sturman Wealth Advisors. Investment management services are offered through Masonry Capital Management, LLC, a registered investment adviser and wholly-owned subsidiary of the Company.
The Bank, through its financial subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company, and Bankers Title Shenandoah, LLC, a title insurance company, both of which are owned by a consortium of Virginia community banks.
The Bank has another subsidiary, Special Properties Acquisition - VA, LLC, which was originally formed by Fauquier to hold other real estate owned; however, there are no assets currently held by this subsidiary.
In addition, the Company owns Fauquier Statutory Trust II (“Trust II”), which is an unconsolidated subsidiary. The subordinated debt owed to Trust II is reported as a liability of the Company.
On April 1, 2021, the Company completed the Merger with Fauquier with and into the Company for total consideration paid of $78.0 million. In connection with the transaction, TFB, Fauquier's wholly-owned bank subsidiary, was merged with and into the Bank. Additional information about this transaction is presented in Note 2 – Business Combinations.
Basis of Financial Information - The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to the reporting guidelines prescribed by regulatory authorities. The following is a description of the more significant of those policies and practices.
Principles of consolidation –The consolidated financial statements include the accounts of the Company, and its wholly-owned subsidiaries, the Bank and Masonry Capital. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of estimates –The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses (including impaired loans), acquisition accounting, other-than-temporary impairment of securities, intangible assets, income taxes, and fair value measurements.
Cash flow reporting –For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash and cash equivalents consist of cash on hand, funds due from banks, interest bearing deposits in other banks and federal funds sold.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Securities – Unrestricted investments are classified in two categories as described below.
•
Securities held to maturity – Securities classified as held to maturity are those debt securities the Company has both the positive intent and ability to hold to maturity regardless of changes in market conditions, liquidity needs or changes in general economic conditions. Currently the Company has no securities classified as held to maturity because of Management’s desire to have more flexibility in managing the investment portfolio.
•
Securities available for sale – Securities classified as AFS are those debt securities that the Company intends to hold for an indefinite period of time but not necessarily to maturity. Any decision to sell a security classified as AFS would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. AFS securities are carried at fair value. Unrealized gains or losses are reported as a separate component of other comprehensive income. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings.
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities or to “call” dates, whichever occurs first. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (1) the Company intends to sell the security or (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-than-likely that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income.
Restricted securities – As members of the FRB and the FHLB, the Company is required to maintain certain minimum investments in the common stock of the FRB and FHLB. Required levels of investments are based upon the Bank’s capital and a percentage of qualifying assets. Additionally, the Company has purchased common stock in CBB Financial Corp. (“CBBFC”), the holding company for Community Bankers’ Bank and an investment in an SBA loan fund. These restricted securities are carried at cost.
Loans –Loans are reported at the principal balance outstanding net of unearned discounts and of the allowance for loan losses. Interest income on loans is reported on the level-yield method and includes amortization of deferred loan fees and costs over the loan term. Acquired Loans were recorded at fair value at the Merger date without carryover of Fauquier's allowance for loan losses or net deferred fee/costs. The fair value of the Acquired Loans was determined using market participant assumptions in estimating the amount and timing of both principal and interest cash flows expected to be collected on the loans and then discounting those cash flows based on a discount rate that would be required by a market participant. Acquired Loans are classified as either (i) purchased credit-impaired loans or (ii) purchased performing loans. PCI loans are not classified as nonperforming loans by the Company at the time they are acquired, regardless of whether they had been classified as nonperforming by the previous holder of such loans, and they will not be classified as nonperforming so long as, at semi-annual re-estimation periods, we believe we will full collect the new carrying value of the pools of loans. Purchased performing loans are accounted for using the contractual cash flows method of recognizing discount accretion based on the Acquired Loans' contractual cash flows. Further information regarding the Company’s accounting policies related to past due loans, non-accrual loans, impaired loans and troubled-debt restructurings is presented in Note 4 - Loans.
Allowance for loan losses – The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses inherent in the loan portfolio. The allowance for loan losses includes allowance allocations calculated in accordance with FASB ASC Topic 310, “Receivables” and allowance allocations calculated in accordance
66
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
with ASC Topic 450, “Contingencies.” Further information regarding the Company’s policies and methodology used to estimate the allowance for loan losses is presented in Note 5 – Allowance for Loan Losses.
Transfers of financial assets – Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company or its subsidiaries – put presumptively beyond reach of the transferor and its creditors, even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company or its subsidiaries does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Premises and equipment –Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method based on the estimated useful lives of assets, which range from 3 to 40 years. Expenditures for repairs and maintenance are charged to expense as incurred. The costs of major renewals and betterments are capitalized and depreciated over their estimated useful lives. Upon disposition, the asset and related accumulated depreciation are removed from the books and any resulting gain or loss is charged to income. More information regarding premises and equipment is presented in Note 6 – Premises and Equipment.
Leases -The Company recognizes a lease liability and a right-of-use asset in connection with leases in which it is a lessee, except for leases with a term of twelve months or less. A lease liability represents the Company’s obligation to make future payments under lease contracts, and a right-of-use asset represents the Company’s right to control the use of the underlying property during the lease term. Lease liabilities and right-of-use assets are recognized upon commencement of a lease and measured as the present value of lease payments over the lease term, discounted at the incremental borrowing rate of the lessee. Further information regarding leases is presented in Note 7 – Leases.
Intangible assets –Goodwill is determined as the excess of the fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and other intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually, or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. The Company performs the test as of December 31 of each year whereby the estimated fair value is compared to the carrying value. Intangible assets with definite useful lives are amortized over their estimated useful lives, which range from 3 to 10 years, to their estimated residual values. Goodwill is the only intangible asset with an indefinite life included on the Company’s Consolidated Balance Sheets. Management has concluded that no impairment of these assets existed as of the balance sheet date. More information regarding intangible assets is presented in Note 8 – Goodwill and Other Intangible Assets.
BOLI –The Company has purchased life insurance on certain key employees and acquired BOLI policies as part of the Merger. These policies are recorded at their cash surrender value on the Consolidated Balance Sheets. Income generated from polices is recorded as noninterest income.
Other Real Estate Owned - Assets acquired through or in lieu of loan foreclosures are held for sale and are initially recorded at fair value less selling costs at the date of foreclosure, establishing a new cost basis. When the carrying amount exceeds the acquisition date fair value less selling costs, the excess is charged off against the ALLL. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell, and any valuation adjustments occurring from post-acquisition reviews are charged to expense as incurred. Revenue and expenses from operations and changes in the valuation allowance are included in other expenses on the Company’s Consolidated Statements of Income.
Fair value measurements – ASC Topic 820, “Fair Value Measurements and Disclosures,” defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and requires certain disclosures about fair value measurements. In general, fair values of financial instruments are based upon internally developed models that primarily use, as inputs, observable market-based
67
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
parameters. Any such valuation adjustments are applied consistently over time. Additional information on fair value measurements is presented in Note 17 – Fair Value Measurements.
Stock-based compensation –The Company accounts for all plans under recognition and measurement accounting principles which require that the compensation cost relating to stock-based payment transactions be recognized in the financial statements. Stock-based compensation arrangements include stock options and unrestricted or restricted stock grants. For stock options, compensation is estimated at the date of grant, using the Black-Scholes option valuation model for determining fair value. The model employs the following assumptions:
•
Dividend yield - calculated as the ratio of historical cash dividends paid per share of common stock to the stock price on the date of grant;
•
Expected life (term of the option) - based on the average of the contractual life and vesting schedule for the respective option;
•
Expected volatility - based on the monthly historical volatility of the Company’s stock price over the expected life of the options;