FRANKLIN FINANCIAL SERVICES CORP /PA/ Management’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-K)
Summary of selected financial data from and for the year ended
2021 2020 2019 2018 2017 (Dollars in thousands, except per share) Balance Sheet Highlights Total assets
$ 1,773,806 $ 1,535,038 $ 1,269,157 $ 1,209,587 $ 1,179,813Investment and equity securities 530,292 397,331 187,873 131,846 127,336 Loans, net 983,746 992,915 922,609 960,960 931,908 Deposits 1,584,359 1,354,573 1,125,392 1,082,629 1,047,181
Shareholders' equity 157,065 145,176 127,528 118,396 115,144 Summary of Operations Interest income $ 47,573
$ 45,939 $ 49,235 $ 44,868 $ 39,885Interest expense 2,902 3,978 7,113 4,214 2,491 Net interest income 44,671 41,961 42,122 40,654 37,394 Provision for loan losses (2,100) 4,625 237 9,954 670 Net interest income after provision for loan losses 46,771 37,336 41,885 30,700 36,724 Noninterest income 19,488 15,084 15,424 12,629 12,189 Noninterest expense 43,245 39,362 38,314 37,369 43,172 Income before income taxes 23,014 13,058 18,995 5,960 5,741 Federal income tax expense (benefit) 3,398 258 2,880 (165) 3,565 Net income $ 19,616 $ 12,800 $ 16,115 $ 6,125 $ 2,176Performance Measurements Return on average assets 1.17% 0.91% 1.29% 0.52% 0.19% Return on average equity 13.20% 9.56% 13.17% 5.34% 1.80% Return on average tangible equity (1) 14.05% 10.24% 14.22% 5.80% 1.94% Efficiency ratio (1) 66.12% 67.32% 65.36% 68.27% 82.59% Net interest margin, fully tax equivalent 2.88% 3.21% 3.68% 3.78% 3.72% Shareholders' Value (per common share) Diluted earnings per share $ 4.42 $ 2.93 $ 3.67 $ 1.39 $ 0.50Basic earnings per share 4.44 2.94 3.68 1.40 0.50 Regular cash dividends paid 1.25 1.2 1.17 1.05 0.93 Book value 35.36 33.07 29.30 26.85 26.44 Tangible book value (1) 33.34 31.02 27.23 24.81 24.37 Market value** 33.10 27.03 38.69 31.50 37.36 Market value/book value ratio 93.61% 81.74% 132.05% 117.32% 141.30% Market value/tangible book value ratio 99.29% 87.13% 142.11% 126.97% 153.30% Price/earnings multiple year-to-date 7.49 9.23 10.54 22.66 74.72 Current quarter dividend yield* 3.87% 4.44% 3.10% 3.43% 2.49% Dividend payout ratio 28.16% 40.83% 31.74% 75.07% 185.25% Safety and Soundness Average equity/average assets 8.89% 9.48% 9.78% 9.73% 10.62% Risk-based capital ratio (Total) 18.41% 17.69% 16.08% 15.21% 15.31% Leverage ratio (Tier 1) 8.52% 8.69% 9.72% 9.78% 9.73% Common equity ratio (Tier 1) 15.20% 14.32% 14.82% 13.96% 14.06% Nonperforming loans/gross loans 0.74% 0.87% 0.42% 0.27% 0.28% Nonperforming assets/total assets 0.42% 0.57% 0.31% 0.44% 0.45% Allowance for loan loss/loans 1.51% 1.66% 1.28% 1.28% 1.25% Net loan recoveries (charge-offs)/average loans 0.02% 0.02% -0.07% -0.97% 0.01% Assets under Management Trust and Investment Services (fair value) $ 946,964 $ 836,381 $ 790,949 $ 684,825 $ 686,941Held at third-party brokers (fair value) 58,052 112,624
127,976 122,213 158,145
** Based on the closing price of FRAF as quoted on the Nasdaq Capital Market for 2021, 2020 and 2019 and the OTCQX for all prior periods (1) See the section titled "GAAP versus Non-GAAP Presentation" that follows. 18
Application of critical accounting policies:
Disclosure of the Corporation's significant accounting policies is included in Note 1 to the consolidated financial statements. These policies are particularly sensitive requiring significant judgments, estimates and assumptions to be made by Management. Senior management has discussed the development of such estimates, and related Management Discussion and Analysis disclosure, with the Audit Committee of the Board of Directors. The following accounting policy is identified by management to be critical to the results of operations: Allowance for Loan Losses and the Annual Goodwill Impairment Evaluation. GAAP versus non-GAAP Presentations - The Corporation supplements its traditional GAAP measurements with certain non-GAAP measurements to evaluate its performance and to eliminate the effect of intangible assets. By eliminating intangible assets, the Corporation believes it presents a measurement that is comparable to companies that have no intangible assets or to companies that have eliminated intangible assets in similar calculations. However, not all companies may use the same calculation method for each measurement. The Efficiency Ratio measures the cost to generate
one dollarof revenue. The non-GAAP measurements are not intended to be used as a substitute for the related GAAP measurements. The following table shows the calculation of the non-GAAP measurements. (Dollars in thousands, except per share) For the Year Ended December 31 2021 2020 2019 2018 2017 Return on Average Tangible Equity (non-GAAP) Net income $ 19,616 $ 12,800 $ 16,115 $ 6,125 $ 2,176Average shareholders' equity 148,637 133,958 122,377 114,625 120,993 Less average intangible assets (9,016) (9,016) (9,016) (9,016) (9,016) Average shareholders' equity (non-GAAP) 139,621 124,942 113,361 105,609 111,977 Return on average tangible equity (non-GAAP) 14.05% 10.24% 14.22% 5.80% 1.94% Tangible Book Value (per share) (non-GAAP) Shareholders' equity $ 157,065 $ 145,176 $ 127,528 $ 118,396 $ 115,144Less intangible assets (9,016) (9,016) (9,016) (9,016) (9,016) Shareholders' equity (non-GAAP) 148,049 136,160 118,512 109,380 106,128 Shares outstanding (in thousands) 4,441 4,389 4,353 4,409 4,355 Tangible book value (non-GAAP) 33.34 31.02 27.23 24.81 24.37 Efficiency Ratio (non-GAAP) Noninterest expense $ 43,245 $ 39,362 $ 38,314 $ 37,369 $ 43,172Net interest income 44,671 41,961 42,122 40,654 37,394 Plus tax equivalent adjustment to net interest income 1,466 1,407 1,393 1,522 2,690 Plus noninterest income, net of securities transactions 19,271 15,104 15,102 12,564 12,186 Total revenue 65,408 58,472 58,617
Efficiency ratio (non-GAAP) 66.12% 67.32% 65.36% 68.27% 82.59%
Results of Operations: Management's Overview The following discussion and analysis is intended to assist the reader in reviewing the financial information presented and should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein. Summary
?Year-to-date, net interest income was
$44.7 million(including $3.3 millionof PPP interest and fees), an increase of 6.5% compared to $42.0 millionfor the same period in 2020 (including $2.9 millionof PPP interest and fees). On a year-over-year comparison, the net interest margin was 2.88% for 2021 compared to 3.21% in 2020. The decrease in the 2021 net interest margin was due primarily to a 0.45% decline in the yield on earning assets from 3.51% in 2020 to 19
3.06% in 2021 as all asset classes had lower yields in 2021. This decrease was partially offset by a reduction in the cost of interest-bearing liabilities from 0.39% for 2020 to 0.24% for 2021. Likewise, the cost of all deposits decreased from 0.28% in 2020 to 0.12% in 2021. ? ?Average earning assets for 2021 were
$1.7 billioncompared to $1.4 billionin 2020, an increase of 18.8%. In 2021, the average balance of interest-bearing cash balances increased $34.2 million(45.6%), the average balance of the investment portfolio increased $203.5 million(71.9%) and the average balance of the loan portfolio increased $16.1 million(1.6%), over the prior year averages. Within the loan portfolio, average commercial loan balances increased $5.8 millionduring the year. The average balance of PPP loans included in the commercial loan portfolio for 2021 was $41.4 million. Total deposits averaged $1.5 billionfor 2021, an increase of $232 million(18.5%) over the average balance for 2020. All deposit categories reported a year-over-year increase in average balances, except for time deposits. ? ?The provision for loan loss expense was a reversal of $2.1 millioncompared to a $4.6 millionprovision expense for the same period in 2020. The 2020 provision expense was the result of an increase in several qualitative factors in the allowance for loan loss calculation due to the projected economic effects and impact of the COVID-19 pandemic. During 2021, several qualitative factors were reduced, reflecting a lower risk of loss in the loan portfolio, and the twenty-quarter historical average charge-off rate used in the calculation decreased, thereby resulting in a reversal of the provision for loan loss expense. The allowance for loan loss ratio was 1.51% of gross loans as of December 31, 2021, compared to 1.66% at December 31, 2020. ? ?Noninterest income was $19.5 millioncompared to $15.1 millionin 2020. Significant year-to-date variances include the gain on sale of $1.8 millionon the sale of the Bank's headquarters building, increases in Investment and Trust Servicesfees ( $1.1 million), gains on the sale of mortgages (up $894 thousand) and debit card income (up $326 thousand). These increases were partially offset by a decrease of $545 thousandfrom gains on bank owned life insurance. ? ?Noninterest expense was $43.2 millionin 2021 compared to $39.4 millionin 2020. The following categories contributed to the year-over-year increase: salaries and benefits increased $2.4 million(primarily incentive compensation and health insurance), FDICinsurance increased $278 thousand, data processing expense increased $607 thousand, and a nonservice pension settlement expense of $425 thousand. Other expenses decreased $293 thousanddue primarily to a $636 thousandexpense reversal relating to the reversal of a previously established off-balance sheet liability reserve. ? ?The effective tax rate was 14.8% for 2021. Total assets at December 31, 2021were $1.774 billioncompared $1.535 billionat December 31, 2020, an increase of 15.6%. Significant balance sheet changes since December 31, 2020, include: ?Short-term interest-bearing deposits in other banks increased $124.6 million(310.8%) and the investment portfolio increased $132.9 million(33.5%). ? ?The net loan portfolio decreased $9.2 millionover the year-end 2020 balance. Commercial loans were down $13.9 millionfrom year-end 2020 as new production was completely offset by a $44.5 millionreduction in PPP loans. The Bank held $7.8 millionin PPP loans at December 31, 2021, and $370 thousandof deferred PPP fees remaining to be recognized. ? ?As of December 31, 2021, the Bank had no loans under a COVID modified payment schedule and all loans previously on modified payment have returned to contractual payment schedules. ? ?Deposits increased $230 million(17.0%) over year-end 2020, with all deposit products showing an increase except time deposits. Money management accounts and interest-bearing checking products showed the largest increases over the prior year-end. ? ?Shareholders' equity increased $11.9 millionfrom December 31, 2020, due primarily to an increase of $14.1 millionin retained earnings during 2021 partially offset by a decrease of $3.7 millionin accumulated other comprehensive income (AOCI) as the fair value of the investment portfolio declined during the year. At December 31, 2021, the book value of the Corporation's common stock was $35.36per share and tangible book value was $33.34per share. In December 2021, an open market repurchase plan was approved to repurchase 150,000 shares over a one-year period.
Other key performance measures are presented in section 6 of this report.
A more detailed discussion of the areas that had the greatest effect on the reported results follows.
Table of Contents Net Interest Income The most important source of the Corporation's earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation's 21% Federal statutory rate. The components of net interest income are detailed in Tables 1, 2 and 3. Table 1 show the change in tax-equivalent net interest income year over year. Changes in interest income and expense are driven by changes in balance (volume) and changes in the average rate on interest-earning assets and interest-bearing liabilities. The changes attributable to rate or volume are shown in Table 2. The yield on earning assets (Table 3) declined from 3.51% for 2020 to 3.06% for 2021. The benefit provided by tax-exempt income was
$1.5 millionin 2021. Table 1. Net Interest Income Change (Dollars in thousands) 2021 2020 $ % Interest income $ 47,573 $ 45,939 $ 1,6343.6 Interest expense 2,902 3,978 (1,076) (27.0) Net interest income 44,671 41,961 2,710 6.5 Tax equivalent adjustment 1,466 1,407 59 4.2
Tax-equivalent net interest income
Table 2 identifies increases and decreases in tax equivalent net interest income due to either changes in average volume or to changes in average rates for interest-earning assets and interest-bearing liabilities. Numerous and simultaneous balance and rate changes occur during the year. The amount of change that is not due solely to volume or rate is allocated proportionally to both. Table 2. Rate-Volume Analysis of Tax Equivalent Net Interest Income
2021 Compared to 2020 2020 Compared to 2019 Increase (Decrease) due to: Increase (Decrease) due to: Increase (Decrease) due to: (Dollars in thousands) Volume Rate Net Volume Rate Net Interest earned on: Interest-bearing obligations in other banks
$ 159 $ (386) $ (227) $ (11) $ (1,111) $ (1,122)Investment securities: Taxable 3,262 (771) 2,491 2,555 (580) 1,975 Nontaxable 877 (168) 709 826 (135) 691 Loans: Commercial, industrial and agriculture 237 (924) (687) 882 (4,599) (3,717) Residential mortgage (89) (271) (360) 46 (324) (278) Home equity loans and lines 397 (849) (452) 291 (1,002) (711) Consumer 10 209 219 39 (159) (120) Loans 555 (1,835) (1,280) 1,258 (6,084) (4,826) Total net change in interest income 4,853 (3,160) 1,693 4,628 (7,910) (3,282) Interest expense on: Interest-bearing checking 164 (439) (275) 188 (671) (483) Money management 230 (988) (758) 347 (2,908) (2,561) Savings 18 (59) (41) 44 (318) (274) Time deposits (110) (514) (624) (56) (152) (208) Other borrowings - - - (18) (18) (36) Subordinate Notes 619 3 622 213 214 427 Total net change in interest expense 921 (1,997) (1,076) 718 (3,853) (3,135)
Change in tax equivalent net interest income
$ 3,932 $ (1,163) $ 2,769 $ 3,910 $ (4,057) $ (147)21
The following table shows average balances, tax equivalent (T/E) interest income and expense, and returns earned or rates paid on assets or liabilities. Unexpected loans are included in average loan balances.
Table 3. Analysis of Net Interest Income 2021 2020 Average Income or Average Average Income or Average (Dollars in thousands) balance expense yield/rate balance expense yield/rate
obligations of other banks
$ 109,263 $ 2490.23% $ 75,063 $ 4760.63% Investment securities: Taxable 392,789 7,216 1.84% 219,815 4,725 2.15% Tax Exempt 93,764 2,661 2.84% 63,246 1,952 3.09% Investments 486,553 9,877 2.03% 283,061 6,677 2.36% Loans: Commercial, industrial and agricultural 849,201 33,982 4.00% 843,412 34,669 4.11% Residential mortgage 68,581 2,382 3.47% 70,932 2,742 3.87% Home equity loans and lines 83,465 2,103 2.52% 71,042 2,555 3.60% Consumer 6,855 446 6.51% 6,581 227 3.45% Loans 1,008,102 38,913 3.86% 991,967 40,193 4.05% Total interest-earning assets 1,603,918 $ 49,0393.06% 1,350,091 $ 47,3463.51% Other assets 67,381 63,507 Total assets $ 1,671,299 $ 1,413,598Interest-bearing liabilities: Deposits: Interest-bearing checking $ 472,596 $ 5210.11% $ 379,564 $ 7960.21% Money Management 537,010 830 0.15% 460,447 1,588 0.34% Savings 112,506 64 0.06% 93,645 105 0.11% Time 72,525 438 0.60% 81,847 1,062 1.30% Total interest-bearing deposits 1,194,637 1,853 0.16% 1,015,503 3,551 0.35% Other borrowings - - - - - - Subordinate notes 19,571 1,049 5.36% 8,022 427 5.32% Total interest-bearing liabilities 1,214,208 2,902 0.24% 1,023,525 3,978 0.39% Noninterest-bearing deposits 293,027 240,042 Other liabilities 15,427 16,073 Shareholders' equity 148,637 133,958 Total liabilities and shareholders' equity $ 1,671,299 $ 1,413,598T/E net interest income/Net interest margin 46,137 2.88% 43,368 3.21% Tax equivalent adjustment (1,466) (1,407) Net interest income $ 44,671 $ 41,961Net Interest Spread 2.82% 3.12% Cost of Funds 0.19% 0.31% Cost of Deposits 0.12% 0.28% Provision for Loan Losses In 2021, the Bank recorded gross loan charge-offs of $330 thousand, which were more than offset by $707 thousandof recoveries, resulting in net loan recovery of $377 thousand. For 2021, the Corporation reversed $2.1 millionthrough the provision for loan loss expense. The allowance for loan losses was $15.1 millionat year-end 2021 (1.51% of total loans), compared to $16.8 millionat year-end 2020 (1.66% of total loans). Management closely monitors the credit quality of the portfolio in order to ensure that an appropriate ALL is maintained. As part of this process, Management performs a comprehensive analysis of the loan portfolio considering delinquencies trends and events, current economic conditions, and other relevant factors to determine the adequacy of the allowance for loan losses and the provision for loan losses. For more information, refer to the Loan Quality discussion and Table 10. 22
Table of Contents Noninterest Income
The following table presents a comparison of non-interest income for the years ended
Table 4. Noninterest Income Change (Dollars in thousands) 2021 2020 Amount % Noninterest Income Investment and trust services fees
$ 7,111 $ 6,040 $ 1,07117.7 Loan service charges 904 853 51 6.0 Gain on sale of loans 2,430 1,536 894 58.2 Deposit service charges and fees 2,258 1,977 281 14.2 Other service charges and fees 1,650 1,446 204 14.1 Debit card income 2,170 1,844 326 17.7 Increase in cash surrender value of life insurance 446 457 (11) (2.4) Bank owned life insurance gain 295 840 (545) (64.9) Net gain on sales of debt securities 127 29 98 337.9 Change in fair value of equity securities 90 (49) 139 (283.7) Gain on sale of bank premises 1,776 - 1,776 N/A Other 231 111 120 108.1 Total $ 19,488 $ 15,084 $ 4,40429.2
The most significant changes in non-interest income are discussed below:
Investment and Trust Service fees: These fees are comprised of asset management fees, estate administration and settlement fees, employee benefit plans, and commissions from the sale of insurance and investment products. Asset management fees are recurring in nature and are affected by the fair value of assets under management at the time the fees are recognized. Asset management fees totaled
$6.5 millionfor 2021, an increase of $865 thousandover 2020. The fair value of trust assets under management was $947.0 millionat year-end, compared to $836.4 millionat the end of 2020. By the nature of an estate settlement, these fees are considered nonrecurring. Estate fees increased by $260 thousand, to $454 thousandin 2021. Commissions from the sale of insurance and investment products decreased by $48 thousandcompared to 2020.
Loan servicing fees: This category primarily includes commercial letter of credit fees, commercial loan prepayment penalties, mortgage servicing fees and consumer debt protection fees.
Gain on Sale of Loans: This category includes the cost of selling mortgages in the secondary market.
Deposit fees: This category is comprised primarily of fees from overdrafts, an overdraft protection program, service charges, and account analysis fees. The increase of
$281 thousandin this category was due to the addition of new deposit products. Other service charges and fees: The most significant items in this category include fees from the Bank's merchant card program and ATM fees. Merchant card fees increased $45 thousandwhile ATM fees increased $25 thousand, due to higher usage. Debit card income: Debit card fees are comprised of both a retail and business card program. Retail fees increased by $268 thousand, 19% increase over the prior year, while business card fees increased $113 thousand, a 25% increase over the prior year. The business debit card offers a cash back rewards program based on usage, while the retail debit card offers reward points based on usage. Debit card income is reported net of reward program expense.
Gain on bank-owned life insurance: The Bank received larger death benefits from bank-owned life insurance policies in 2020 than in 2021.
Capital gain on sale of bank premises: The Bank sold its current head office to
Table of Contents Noninterest Expense
The following table presents a comparison of non-interest expenses for the years ended
Table 5. Noninterest Expense
(Dollars in thousands) Change Noninterest Expense 2021 2020 Amount % Salaries and benefits
$ 24,780 $ 22,392 $ 2,38810.7 Net occupancy 3,580 3,350 230 6.9 Marketing and advertising 1,533 1,757 (224) (12.7) Legal and professional 2,013 1,802 211 11.7 Data processing 4,026 3,419 607 17.8 Pennsylvania bank shares tax 1,017 965 52 5.4 FDIC insurance 735 457 278 60.8 ATM/debit card processing 1,305 1,088 217 19.9 Telecommunications 407 458 (51) (11.1) Nonservice pension 819 351 468 133.3 Other 3,030 3,323 (293) (8.8) Total $ 43,245 $ 39,362 $ 3,8839.9
The most significant changes in non-interest expenses are described below:
Salaries and benefits: This category is the largest noninterest expense category and includes expenses for salaries, health benefits, insurance, pension service, taxes and other employee benefit programs. This category increased by
$2.4 millioncompared to the prior year from salary increases of $877 thousanddue to higher expense for incentive compensation plans, $710 thousandincrease in health insurance expense as the Bank's self-funded plan generated less surplus in 2021 compared to 2020, and $365 thousanddue to merit increases. See Note 17 of the accompanying consolidated financial statements for additional information on benefit plans. Net Occupancy: This category includes all of the expense associated with the properties and facilities used for bank operations such as depreciation, leases, maintenance, utilities and real estate taxes. Equipment maintenance contracts and depreciation increased during 2021 but were offset by a decrease in depreciation expense as the Bank sold its headquarters building at 20 South Main Street, Chambersburg, PA.Legal and professional fees: This category consists of fees paid to outside legal counsel, consultants, and audit fees. Legal fees increased $67 thousanddue to services provided in the normal course of business. Internal and external audit fees increased by $21 thousand. Data processing: The largest cost in this category is the expense associated with the Bank's core processing system and related services and accounted for $2.3 millionof the total data processing costs compared to $1.8 millionin 2020. The increase was due to increased transaction volume and the introduction of new products. An increase in software expense contributed $347 thousandto the total increase in this category. FDICinsurance: This category consists of the total fees paid to the Federal Deposit Insurance Corporation(FDIC). The expense for 2021 increased compared to prior year due to growth of the Bank's balance sheet. Nonservice pension: The increase in the nonservice pension expense was due to $425 thousandof pension settlement costs related to lump-sum pension payouts during the year. Provision for Income Taxes The Corporation recorded a Federal income tax expense of $3.4 millioncompared to $258 thousandin 2020. The effective tax rate for 2021 and 2020 was 14.8% and 2.0%, respectively. In 2020, Corporation recorded an income tax benefit of $1.1 milliondue to the passage of the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) in March 2020. The CARES Act allowed for net operating losses (NOL) incurred in 2018, 2019 and 2020 to be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The Corporation incurred an NOL in 2018 that it was able to carryback to prior periods when the statutory rate for the Corporation was 34% as compared to the current rate of 21%. Without the benefit of the NOL carryback, the effective tax rate for 2020 would have been 10.5%. The Corporation's 2021 effective tax rate was lower than its statutory rate due to the effect of tax-exempt income from certain investment securities, loans, and bank owned life insurance. The Corporation's 2021 effective tax rate was higher than the comparable rate in 2020 (adjusted of the NOL) due to higher pre-tax, taxable 24
Income. For a more complete analysis of the federal income tax expense, refer to note 14 of the accompanying consolidated financial statements.
One method of evaluating the Corporation's condition is in terms of its sources and uses of funds. Assets represent uses of funds while liabilities represent sources of funds. At
December 31, 2021, total assets increased 15.6% over the prior year to $1.77 billionfrom $1.54 billionat the end of 2020.
Interest-bearing deposits at other banks:
This asset increased to
$175.2 millionat December 31, 2021compared to $52.8 millionat December 31, 2020, as the Bank had excess cash from growth in deposits that outpaced the growth of earning assets. The average balance for 2021 increased to $109.3 millioncompared to $75.1 millionin 2020. At year-end, $10.5 millionwas in the form of long-term certificates of deposit and $163.3 millionwas held in an interest-bearing account at the Federal Reserve.
The investment portfolio serves as a mechanism to invest funds if funding sources out pace lending activity, to provide liquidity for lending and operations, and provide collateral for deposits and borrowings. The mix of securities and investing decisions are made as a component of balance sheet management. Debt securities include
U.S.Government Agencies, U.S. Government Agencymortgage-backed securities, non-agency mortgage-backed securities, state and municipal government bonds, and corporate debt in the form of bank-issued subordinated debt. The average life of the portfolio is 6.9 years and $160.3 million(fair value) is pledged as collateral for deposits. The Bank has no investments in a single issuer that exceeds 10% of shareholders equity. All securities are classified as available for sale and all investment balances refer to fair value, unless noted otherwise. The following table presents the amortized cost and estimated fair value of investment securities by type at December 31for the past two years: Table 6. Investment Securitiesat Amortized Cost and Estimated Fair Value 2021 2020 Amortized Fair Amortized Fair (Dollars in thousands) Cost value Cost value
12,574 Municipal securities 206,501 212,227 236,253 247,054 Corporate securities 24,794 24,939 20,421 20,288
Agency mortgage-backed securities 123,686 122,669 70,443
Non-agency mortgage-backed securities 30,904 30,666 8,412
8,453 Asset-backed securities 45,472 45,550 36,246 36,330 Total
$ 525,717 $ 529,811 $ 384,369 $ 396,94025
The following table presents investment securities at
December 31, 2021by maturity, and the weighted average yield for each maturity presented. The yields presented in this table are calculated using tax-equivalent interest and the amortized cost. Table 7. Maturity Distribution of Investment Portfolio After one year After five years After ten One year or less through five years through ten years years Total Fair Fair Fair Fair Fair (Dollars in thousands) Value Yield Value Yield Value Yield Value Yield Value Yield Available for Sale U.S. Government and Agency securities $ - - $ 1,0160.94% $ 91,5101.28% $ 1,2341.01% $ 93,7601.27% Municipal securities 1,862 2.98% 5,171 2.74% 39,635 2.51% 165,559 2.61% 212,227 2.60% Corporate securities - - - - 23,688 4.38% 1,251 4.28% 24,939 4.37% Agency mortgage-backed securities 1,044 1.76% 1,846 2.86% 33,934 1.69% 85,845 0.89% 122,669 1.14% Non-Agency mortgage-backed securities 504 3.83% 7,931 3.77% 5,414 1.78% 16,817 1.82% 30,666 2.34% Asset-backed securities 20 2.27% 536 2.37% 481 0.80% 44,513 0.88% 45,550 0.90% Total $ 3,4302.73% $ 16,5003.13% $
Table 3 shows the two-year trend of average balances and yields on the investment portfolio. The tax-equivalent yield on the portfolio decreased from 2.36% in 2020 to 2.03% in 2021.
U.S. Agencymortgage-backed securities and municipal bonds continue to comprise the largest sectors by fair value of the portfolio, approximately 23% and 40% respectively. The Bank expects that the portfolio will continue to remain concentrated in these investment sectors. The portfolio produced $71.3 millionin cash flows in 2021 while $215.67 millionwas invested into the portfolio during the year. Municipal Bonds: This sector holds $212.2 millionor 40% of the total portfolio and the amortized cost decreased by $30.0 millionyear over year. The Bank's municipal bond portfolio is well diversified geographically and is comprised of both tax-exempt (46% of the portfolio) and taxable (54% of the portfolio) municipal bonds. Sixty-five percent of the portfolio are general obligation bonds and thirty-five percent are revenue bonds. The portfolio holds bonds from 221 issuers within 34 states. The largest dollar exposure is in the states of Texas(14%) and Californiaand Pennsylvania(11% each). When purchasing municipal bonds, the Bank looks primarily to the underlying credit of the issuer as a sign of credit quality and then to any credit enhancement. The entire portfolio is rated "A" or higher by a nationally recognized rating agency.
Corporate bonds: This sector mainly includes
Mortgage-backed Securities(MBS): This sector holds $153.3 millionor 29% of the total portfolio. The majority of this sector ( $122.7 million) is comprised of bonds issued and guaranteed by the U.S. Governmentor a government sponsored entity. The non-agency MBS portfolio is comprised of senior private label first-lien commercial and residential mortgages. As senior position bonds, they benefit from credit support in the form of junior tranches and reserve funds that absorb loss prior to the senior bonds. Asset-backed Securities (ABS): This sector holds $45.6 million, or 9%, of the total portfolio. FFELP (Federal Family Education Loan Program) bonds make up the maturity of this sector and have a 97% guarantee from the US Department of Education. The FFELP bonds are all rated AAA. Impairment: For securities with an unrealized loss, Management applies a systematic methodology in order to perform an assessment of the potential for other-than-temporary impairment. In the case of debt securities, investments considered for other-than-temporary impairment: (1) had a specified maturity or repricing date, (2) were generally expected to be redeemed at par, and (3) were expected to achieve a recovery in market value within a reasonable period of time. In addition, the Bank considers whether it intends to sell these securities or whether it will be forced to sell these securities before the earlier of amortized cost recovery or maturity. The impairment identified on debt securities and subject to assessment at December 31, 2021, was deemed to be temporary and required no further adjustments to the financial statements, unless otherwise noted. The Bank recorded no impairment charges in 2021.
Equity securities at fair value
The Company holds an equity investment whose fair value is readily determinable. AT
Table of Contents Restricted Stock at Cost The Bank held
$495 thousandof restricted stock at the end of 2021 of which $465 thousandis stock in the Federal Home Loan Bank of Pittsburgh(FHLB). FHLB stock is carried at a cost of $100per share. FHLB stock is evaluated for impairment primarily based on an assessment of the ultimate recoverability of its cost. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasurythat can be used to support it operations. There is not a public market for FHLB stock and the benefits of FHLB membership (e.g., liquidity and low-cost funding) add value to the stock beyond purely financial measures. If FHLB stock were deemed to be impaired, the write-down for the Bank could be significant. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment.
The loan portfolio decreased by 1.1% (
$10.9 million) in 2021, due primarily to $44.5 millionin forgiveness on PPP loans (included in the commercial loan line) partially offset by an increase in commercial real estate loans and in junior liens and lines of credit from the Bank's FlexLOC product. The FlexLOC was a new product introduced in 2021 that allows consumers to draw on a variable rate line-of-credit and then lock in a fixed rate and repayment term for a portion of the draw. Average gross loans for 2021 increased by $16.1 millionto $1.0 billioncompared to $992.0 millionin 2020. Commercial, mortgage and home equity loans and lines all showed an increase in average balances during the year, which was partially offset by a decline in consumer loans. The yield on the portfolio decreased in 2021 to 3.86% from 4.05% in 2020. Table 3 presents detail on the average balances and yields earned on loans for the past two years. The following table shows loans outstanding, by class, as of December 31for the past 2 years. Table 8. Loan Portfolio Change (Dollars in thousands) 2021 2020 Amount % Residential real estate 1-4 family Consumer first lien $ 71,828 $ 77,373 $ (5,545)(7.2) Commercial first lien 60,655 59,851 804 1.3 Total first liens 132,483 137,224 (4,741) (3.5) Consumer junior lien and lines of credit 67,103 60,935 6,168 10.1 Commercial junior liens and lines of credit 4,841 4,425 416 9.4 Total junior liens and lines of credit 71,944 65,360 6,584 10.1 Total residential real estate 1-4 family 204,427 202,584 1,843 0.9 Residential real estate construction Consumer 8,278 6,751 1,527 22.6 Commercial 12,379 9,558 2,821 29.5 Total residential real estate construction 20,657 16,309 4,348 26.7 Commercial real estate 522,779 503,977 18,802 3.7 Commercial 244,543 281,257 (36,714) (13.1) Total commercial 767,322 785,234 (17,912) (2.3) Consumer 6,406 5,577 829 14.9 Total loans 998,812 1,009,704 (10,892) (1.1) Less: Allowance for loan losses (15,066) (16,789) 1,723 (10.3) Net loans $ 983,746 $ 992,915 $ (9,169)(0.9) Residential real estate: This category is comprised of first lien loans and, to a lesser extent, junior liens and lines of credit secured by residential real estate. Total residential real estate loans increased $1.8 millionin 2021 from 2020, primarily in consumer junior lien and lines of credit. In 2021, the Bank originated $127.6 millionin mortgages compared to $125.4 millionin 2020, including approximately $107.7 millionfor sale in the secondary market. The Bank does not originate or hold any loans that would be considered sub-prime or Alt-A and does not generally originate mortgages outside of its primary market area. Commercial purpose loans in this category represent loans made for various business needs but are secured with residential real estate. In addition to the real estate collateral, it is possible that additional security is provided by personal guarantees or UCC filings. These loans are underwritten as commercial loans and are not originated to be sold. 27
Residential real estate construction: The largest component of this category represents loans to residential real estate developers and home builders of
$12.4 million, while loans for individuals to construct personal residences totaled $8.3 millionat December 31, 2021. The Bank's exposure to residential construction loans is concentrated primarily in south central Pennsylvania. Real estate construction loans, including residential real estate and land development loans, occasionally provide an interest reserve in order to assist the developer during the development stage when minimal cash flow is generated. Commercial real estate (CRE): This category includes commercial, industrial, and farm loans, where real estate serves as the primary collateral for the loan. This loan category increased by $18.8 millionover the prior year. The largest sectors (by collateral) in CRE are: hotel & motel ( $75.8 million), apartment units ( $69.7 million), office buildings ( $50.1 million), development land ( $49.2 million) and manufacturing ( $38.1 million). The majority of the Bank's hotel exposure is located along the Interstate 81( I-81) corridor through south-central Pennsylvania. The portfolio is comprised of properties operating under 18 flagged brands and 3 independent operators. Also included in CRE are real estate construction loans totaling $92.6 million. At December 31, 2021, the Bank had $25.8 millionin real estate construction loans funded with an interest reserve and capitalized $755 thousandof interest in 2021 from these reserves on active projects for commercial construction. Real estate construction loans are monitored on a regular basis by either an independent third-party inspector or the assigned loan officer depending on loan amount or complexity of the project. This monitoring process includes, at a minimum, the submission of invoices or AIA documents (depending on the complexity of the project) detailing costs incurred by the borrower, on-site inspections, and a signature by the assigned loan officer for disbursement of funds. All real estate construction loans are underwritten in the same manner, regardless of the use of an interest reserve. Commercial: This category includes commercial, industrial, farm, agricultural, and tax-free loans. Collateral for these loans may include business assets or equipment, personal guarantees, or other non-real estate collateral. Commercial loans decreased $36.7 millionover the 2020 ending balance, primarily due to PPP loan forgiveness. At December 31, 2021, the Bank had approximately $141 millionof tax-free loans in its portfolio. The largest sectors (by industry) are: utilities ( $52.0 million), public administration ( $49.0 million), real estate, rental and leasing ( $18.2 million) and manufacturing ( $13.5 million). This category also includes $7.8 millionof PPP loans that are 100% guaranteed by the SBA. Participations: At December 31, 2021, the outstanding commercial participations accounted for 10.1%, or $77.5 million, of commercial purpose loans compared to 8.7%, or $68.7 million, at the prior year-end. The Bank's total exposure (including unfunded commitments) to purchased participations was $95.9 millionat December 31, 2021and $84.0 millionat December 31, 2020. The commercial loan participations are comprised of $23.2 millionof commercial loans and $54.3 millionof CRE loans, reported in the respective loan segment. The Bank expects that commercial lending will continue to be the primary area of loan growth in the future via in-market lending.
Consumer loans: This category is mainly composed of unsecured personal lines of credit and shows an increase of
Table of Contents Table 9. Maturities and Interest Rate Terms of Selected Loans
The following table shows the declared maturities (or previous repayment dates) of the loans selected in
Less than Over (Dollars in thousands) 1 year 1-5 years 5-15 years 15 years Total Loans: Residential real estate 1-4 family Fixed rate
$ 961 $ 9,410 $ 43,214 $ 15,459 $ 69,044Variable rate 5,147 16,614 48,955 64,667 135,383 6,108 26,024 92,169 80,126 204,427 Residential real estate construction Fixed rate 8,702 - - - 8,702 Variable rate 9,417 2,538 - - 11,955 18,119 2,538 - - 20,657 Commercial real estate Fixed rate 2,190 42,004 50,076 - 94,270 Variable rate 33,675 115,893 235,137 43,804 428,509 35,865 157,897 285,213 43,804 522,779 Commercial Fixed rate 726 54,292 38,839 8,606 102,463 Variable rate 31,764 16,231 38,398 55,687 142,080 32,490 70,523 77,237 64,293 244,543 Consumer Fixed rate 90 2,443 27 1,688 4,248 Variable rate 1,135 398 625 - 2,158 1,225 2,841 652 1,688 6,406 $ 93,807 $ 259,823$
Loan Quality: Management utilizes a risk rating scale ranging from 1-Prime to 9-Loss to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either a pass or substandard rating based on the performance status of the loans. Substandard consumer loans are loans that are 90 days or more past due and still accruing. Loans rated 1 - 4 are considered pass credits. Loans that are rated 5-Pass Watch are credits that have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6-Other Asset Especially Mentioned (OAEM) or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7-Substandard or 8-Doubtful exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7-Substandard. The following represent some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt. The Bank monitors overall loan quality of the portfolio by reviewing three primary measurements: (1) loans rated 6-OAEM or worse (collectively "watch list"), (2) delinquent loans, and (3) net-charge-offs. Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list includes both performing and nonperforming loans. Watch list loans totaled
$36.6 millionat year-end compared to $66.1 millionone year earlier. During 2020, the Bank downgraded its hotel portfolio due to the pandemic. Many of these loans had the risk-rating upgraded during 2021 as the loans moved from a modified payment schedule to regular payment schedule. As a result, the watch list decreased year-over year. At year-end 2020, the Bank had $32.7 millionof hotel loans rated 6-OAEM and $14.5 millionrated 7-Substandard. At December 31, 2021, 6-rated hotels decreased to $17.1 millionand 7-rated hotels decreased to $13.4 million. Included in the watch list are $7.4 millionof nonaccrual loans. The composition of the watch list (loans rated 6, 7 or 8), by primary collateral, is shown in Note 6 of the accompanying financial statements. Delinquent loans are a result of borrowers' cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank's likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank. See Note 6 in the accompanying financial statements for information on the aging of payments in the loan portfolio. 29
Nonaccruing loans generally represent Management's determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank's policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more, nonaccrual loans, or impaired loans. Further, it is the Bank's policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7-Substandard. The Bank's Loan Management Committee reviews these loans and risk ratings on a quarterly basis in order to proactively identify and manage problem loans. In addition, a committee meets monthly to discuss possible workout strategies for all credits rated 7-Substandard or worse and OREO. Management also tracks other commercial loan risk measurements including high loan to value loans, concentrations, participations and policy exceptions and reports these to the
Credit Risk Oversight Committeeof the Board of Directors. The Bank also uses a third-party consultant to assist with internal loan review with a goal of reviewing 80% of commercial loans each year. The FDICdefines certain supervisory loan-to-value lending limits. The Bank's internal loan-to-value limits are all equal to or less than the supervisory loan-to-value limits. However, in certain circumstances, the Bank may make a loan that exceeds the supervisory loan-to-value. At December 31, 2021, the Bank had loans of $17.9 million(1.8% of gross loans) that exceeded the supervisory loan-to value limit, compared to 2.3% at the prior year end. Nonaccrual loans decreased by $1.3 millionfrom year-end 2020, primarily in the commercial real estate category as a result of paydowns during the year. The most significant nonaccrual loan is a $5.6 millionhotel loan that has been on nonaccrual since September 2020but was current on its payments as of December 31, 2021. The Bank continues to work with the borrower and the hotel management company to monitor operations. The Bank has established a $698 thousandspecific reserve on this loan. In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings (TDR). A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans (excluding consumer purpose loans) and TDR loans are considered impaired. A loan is considered a troubled debt restructuring (TDR) if the creditor (the Bank), for economic or legal reasons related to the debtor's financial difficulties, grants a concession to the debtor that it would not otherwise consider. These concessions may include lowering the interest rate, extending the maturity, reamortization of payment, or a combination of multiple concessions. The Bank reviews all loans rated 6-OAEM or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance. In accordance with financial accounting standards, TDR loans are always considered impaired until they are paid-off or in certain circumstances refinanced. However, an impaired TDR loan can be a performing loan under its modified terms. Impaired loans totaled $11.6 millionat year-end compared to $17.3 millionat the prior year end. The decrease was due primarily to a refinancing of a TDR loan to a new loan at market rates and terms and therefore being removed from TDR. Included in the impaired loan totals are $5.6 millionof TDR loans. Paycheck Protection Program. In March 2020, Congresspassed the CARES Act to provide economic relief to small business and consumers affect by the COVID-19 pandemic. Included in this Act was the Paycheck Protection Program (PPP) administered by the Small Business Administration(SBA). The PPP is a small business loan program designed to assist in allowing small businesses to keep workers on the payroll during the COVID-19 pandemic. When workers are kept on the payroll for the qualifying period, the loan could be forgiven if the small business incurs eligible expenses. The PPP loans are 100 percent guaranteed by the SBA and have a maturity of two-years or five-years with a fixed interest rate of 1% for the life of the loan. Borrowers of PPP loans do not have to make payments on the loan for the first six months, and the loans will fully amortize for the remainder of the two- or five-year terms. In December 2020, Congresspassed a second stimulus package that provided for a second round of funding for small business, that meet certain eligibility requirements, through the PPP. PPP loans under the second round of funding are for a 5-year term with a fixed interest rate of 1% and initial principal payments deferred for up to 10 months under certain circumstances. The SBA paid originating banks a processing fee ranging from 1% to 5% of the loan, depending on the loan balance for round 1 of PPP funding. The SBA will pay processing fees to originating banks for round 2 of PPP funding at levels similar to those paid in round 1. The Bank will recognize these fees in interest income over the contractual life (two or five years) of the loan. As PPP loans are granted forgiveness by the SBA, fee recognition will accelerate. At December 31, 2021, the Bank had $7. 8 million in PPP loans and $370 thousandof PPP fees remaining to be recognized. 30
The PPP loans are 100% guaranteed by the SBA, thereby presenting no credit risk to the Bank once the SBA guarantee is fulfilled, if necessary. However, the PPP loan is only designed to cover short-term operating needs of the borrower. If the economy does not recover quickly from the pandemic and the borrower experiences long-term operational problems beyond the PPP funding, the performance of other loans to these customers could begin to deteriorate.
Allowance for loan losses:
Management monitors loan performance on a monthly basis and performs a quarterly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan's collateral. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6-OAEM or worse and obtains a new appraisal or asset valuation for any loans placed on nonaccrual and rated 7 - Substandard or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy quarterly to the
Credit Risk Oversight Committeeof the Board of Directors. Management believes that the allowance for loan losses at December 31, 2021is adequate. The analysis for determining the ALL is consistent with guidance set forth in generally accepted accounting principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The analysis has three components: specific, general and unallocated. The specific component addresses specific reserves established for impaired loans. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Collateral values discounted for market conditions and selling costs are used to establish specific allocations for impaired loans. However, it is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. Commercial loans with a balance less than $250 thousand, and all consumer purpose loans are not included in the specific reserve analysis as impaired loans but are added to the general allocation pool. Loans that are evaluated for a specific reserve, but not needing a specific reserve are not added back to the general allocation pool. The Bank has one loan for $5.8 millionwith a specific reserve ( $698 thousand) at December 31, 2021. Note 6 of the accompanying financial statements provides additional information about the ALL established for impaired loans. The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates its loan portfolio into the following segments based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (commercial non-real estate), and consumer. Each segment may be further segregated by type of collateral, lien position, or owner/nonowner occupied properties. PPP loans, because of the SBA guarantee, were excluded from the quantitative analysis. The quantitative analysis uses the Bank's twenty quarter rolling historical loan loss experience as determined for each loan segment to determine a loss factor applicable to each loan segment. The allowance established as a result of the quantitative analysis was $2.8 millioncompared to $3.7 millionat year-end 2020. The decrease in the quantitative component was due primarily to a decrease in the twenty-quarter historical loss factor as older higher loss rates came out of the rolling average. The qualitative analysis utilizes a risk matrix that incorporates four primary risk factors: economic conditions, delinquency, classified loans, and level of risk, and assigns a risk level (as measured in basis points) to each factor. In determining the risk level for these primary factors, consideration is given to operational factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. The level of risk (as measured in basis points) for each primary factor is set for six risk levels ranging from minimal risk to extreme risk and is determined independently for commercial loans, residential mortgage loans and consumer loans. During 2020, as a result of the negative effects of the pandemic on the economy, the Bank increased the basis point risk factor for certain qualitative components. During 2021, as the level of risk picture became clearer, the Bank reduced certain qualitative risk factors. In addition, in 2021 the Bank discontinued its carve out of modified loans for a separate qualitative assessment that it implemented in 2020. As a result of these changes, the qualitative component of the ALL decreased from $12.1 millionat year-end 2020 to $11.0 millionat December 31, 2021. The unallocated component is maintained to cover uncertainties that could affect Management's estimate of probable loss. The unallocated component of the ALL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The unallocated allowance was $589 thousandat December 31, 2021. 31
Real estate appraisals and collateral valuations are an important part of the Bank's process for determining potential loss on collateral dependent loans and thereby have a direct effect on the determination of loan reserves, charge-offs and the calculation of the allowance for loan losses. As long as the loan remains a performing loan, no further updates to appraisals are required. If a loan or relationship migrates to nonaccrual and a risk rating of 7-Substandard or worse, an evaluation for impairment status is made based on the current information available at the time of downgrade and a new appraisal or collateral valuation is obtained. We believe this practice complies with the regulatory guidance. In determining the allowance for loan losses, Management, at its discretion, may determine that additional adjustments to the fair value obtained from an appraisal or collateral valuation are required. Adjustments will be made as necessary based on factors, including, but not limited to the economy, deferred maintenance, industry, type of property or equipment etc., and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. If an appraisal is not available, Management may make its best estimate of the real value of the collateral or use last known market value and apply appropriate discounts. If an adjustment is made to the collateral valuation, this will be documented with appropriate support and reported to the Loan Management Committee.
The following table shows the breakdown of the allowance for loan losses and other loan performance ratios at
Table 10. Loan Performance Ratios (Dollars in thousands)
Residential Real Estate
Junior Liens & Commercial First Liens Lines of Credit Construction Real Estate Commercial Consumer Unallocated Total 2021 Loans at December 31, 2021
$ 132,483 $ 71,944 $ 20,657 $ 522,779 $ 244,543 $ 6,406$ - $ 998,812Average Loans for 2021 133,452 69,083 20,389 509,706 264,772 6,836 - 1,004,237 Nonaccrual Loans at December 31, 2021 50 38 424 6,812 60 - - 7,384 Allowance for Loan Losses at December 31, 2021 555 226 294 9,163 5,679 97 775 16,789 Net Recoveries/(Charge-offs) for 2021 4 (10) - 490 (195) (91) - 198 Loans/Total Gross Loans at December 31, 2021 13% 7% 2% 52% 24% 1% - 100% Nonaccrual Loans/Total Gross Loans at December 31, 2021 0.04% 0.05% 2.05% 1.30% 0.02% 0.00% - 0.74% Allowance for Loan Loss/Gross Loans at December 31, 2021 0.42% 0.31% 1.42% 1.75% 2.32% 1.51% - 1.68% Net Recoveries (Charge-offs)/Average Loans for 2021 0.00% -0.01% 0.00% 0.10% -0.07% -1.33% - 0.02% Allowance for Loan Loss/Nonaccrual Loans at December 31, 2021 227.37% 2020 Loans at December 31, 2020 $ 137,224 $ 65,360 $ 16,309 $ 503,977 $ 281,257 $ 5,577$ - $ 1,009,704Average Loans for 2020 141,265 57,409 14,896
500,325 275,037 6,366 – 995,297 Loans not accrued at
41 10 512 8,033 108 - - 8,704 Allowance for Loan Losses at December 31, 2020 475 252 325
8,168 5,127 130,589 15,066 Net recoveries/(charges) for 2020
- 170 (28) (56) 455 (164) - 377 Loans/Total Gross Loans at December 31, 2020 14% 6% 2% 50% 28% 1% - 100% Nonaccrual Loans/Total Gross Loans at December 31, 2020 0.03% 0.02%
3.14% 1.59% 0.04% 0.00% – 0.86% Allowance for loan losses/Gross loans at
1.99% 1.62% 1.82% 2.33% – 1.49% Net Collections/(Charges)/Average Loans for 2020
0.00% 0.30% -0.19% -0.01% 0.17% -2.58% - 0.04% Allowance for Loan Loss/Nonaccrual Loans at December 31, 2020 173.09% Goodwill: The Bank has
$9.0 millionof goodwill recorded on its balance sheet as the result of corporate acquisitions. Goodwillis not amortized, nor deductible for tax purposes. However, goodwill is tested for impairment at least annually in accordance with ASC Topic 350. Goodwillwas tested for impairment as of August 31, 2021. The 2021 test was conducted using a qualitative assessment method that requires the use of significant assumptions in order to make a determination of impairment. These assumptions may include, but are not limited to: macroeconomic factors, banking industry conditions, banking merger and acquisition trends, the 32
Historical financial performance of the Bank, share price of the Company, forecast of the financial performance of the Bank and bonuses for change of control. Management has determined that the Bank’s goodwill was not impaired in 2021.
The 2020 impairment test was conducted using several quantitative methods, including an income approach, market value approach and a change of control acquisition approach. Each of these quantitative approaches included different scenarios with different assumptions. These scenarios were weighted based upon Management's judgement. Based upon this assessment, the estimated fair value of the Corporation exceeded its carrying value by 24% and Management determined the Bank's goodwill was not impaired. At
December 31, 2021, Management subsequently considered certain qualitative factors affecting the Corporation and determined that it was not likely that the results of the prior test had changed, and it determined that goodwill was not impaired at year-end. Deposits: The Bank depends on deposits generated in the normal course of business as its primary source of funds. The Bank offers numerous deposit products including demand deposits (noninterest and interest-bearing accounts), savings, money management accounts, and time deposits (certificates of deposits/CDs) to retail, commercial, and municipal customers. Table 11 shows a comparison of the major deposit categories over a two-year period at December 31, including balances and the percentage change in balances year-over-year. Table 3, presented previously, shows the average balance of the major deposit categories and the average cost of these deposits over a two-year period. Table 11. Deposits Change (Dollars in thousands) 2021 2020 Amount % Noninterest-bearing checking $ 298,403 $ 259,060 $ 39,34315.2 Interest-bearing checking 511,969 409,178 102,791 25.1 Money management 579,826 501,017 78,809 15.7 Savings 119,908 109,153 10,755 9.9 Time deposits 74,253 76,165 (1,912) (2.5) Total $ 1,584,359 $ 1,354,573 $ 229,78617.0 Noninterest-bearing checking: This category increased year over year by $39.3 million, primarily in commercial accounts, while the average balance increased by $53.0 millionfor the year. As a noninterest bearing account, these deposits contribute approximately 9 basis points to the net interest margin. Interest-bearing checking: This category saw an increase in both the ending and average balance for the year compared to prior year-end, while the cost of these accounts decreased year over year. Both commercial and retail accounts grew during 2021. Money management: The year over year balance increased $78.8 million, in both retail and commercial accounts and the average balance increased $76.6 millioncompared to the 2020 average balance. The cost of this product decreased during the year as market rates decreased. Savings: Savings accounts increased $10.8 millionduring the year and represents the thirteenth consecutive year of growth, mostly in regular savings accounts in 2021. The cost of this product decreased during the year as market rates decreased.
Term deposits: Term deposits declined in 2021 as customers transferred funds to more liquid accounts and rates fell.
Reciprocal deposits: At year-end 2021, the Bank had
$256.7 millionplaced in the IntraFi Network deposit program ( $185.0 millionin interest-bearing checking and $71.7 millionin money management) and $4.1 millionof time deposits placed into the CDARS program. These programs allow the Bank to offer full FDICcoverage to large depositors, but with the convenience to the customer of only having to deal with one bank. The Bank solicits these deposits from within its market and it believes they present no greater risk than any other local deposit. Only reciprocal deposits that exceed 20% of liabilities are considered brokered deposits. At December 31, 2021, the Bank's reciprocal deposits were 16.0% of total liabilities. The Bank continually reviews different methods of funding growth that include traditional deposits and other wholesale sources. Competition from other local financial institutions, internet banks and brokerages will continue to be a challenge for the Bank in its efforts to attract new and retain existing deposit accounts. This competition is not expected to lessen in the future. Uninsured deposits: Estimated uninsured deposits at December 31, 2021were $142.0 million(9.0% of total deposits) compared to $150.6 million(11.1% of total deposits at December 31, 2020). The insured deposit data for 2021 and 2020 reflect deposits at an aggregate level, but do not include public funds secured by collateral. 33
Table 12. Time Deposits of
$250,000or More Individual Instruments that Time Deposits Meet or Exceed that Meet or FDIC Insurance Exceed FDIC (Dollars in thousands) Limit Insurance Limit Maturity distribution: Within three months $ 3,254 $ 5,254 Over three through six months 5,409
Over six through twelve months 1,072 2,572 Over twelve months 171 421 Total $ 9,906 $ 15,156 Borrowings: Short-term Borrowings: The Bank has access to short-term borrowings from the FHLB in the form of a revolving term commitment used to fund the short-term liquidity needs of the Bank. These borrowings reprice on a daily basis and the interest rate fluctuates with short-term market interest rates. The Bank's maximum borrowing capacity with the FHLB at
December 31, 2021was $369.9 millionwith $369.9 millionavailable to borrow. The Bank had no short-term borrowings at December 31, 2021and 2020. Long-term Debt: On August 4, 2020, the Corporation completed the sale of a subordinated debt note offering. The Corporation sold $15.0 millionof subordinated debt notes with a maturity date of September 1, 2030. These notes are noncallable for 5 years and carry a fixed interest rate of 5% per year for 5 years and then convert to a floating rate of SOFR plus 4.93% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The Corporation also sold $5.0 millionof subordinated debt notes with a maturity date of September 1, 2035. These notes are noncallable for 10 years and carry a fixed interest rate of 5.25% per year for 10 years and then convert to a floating rate of SOFR plus 4.92% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank. The Corporation paid an issuance fee of 2% of the total issue that will be amortized to the call date of each issue on a pro-rata basis. The notes are recorded on the consolidated balance sheet net of unamortized debt issuance costs. The proceeds are intended to be used for general corporate purposes.
Shareholders' equity increased by
$11.9 millionto $157.1 millionat December 31, 2021. The increase was the result of 2021 net income of $19.6 million, offset by $5.5 millionin dividends ( $1.25per share), and a decrease of $3.7 millionin accumulated other comprehensive income due primarily to a decrease of the fair value of the investment portfolio. The dividend payout ratio was 28.2% in 2021 compared to 40.8% in 2020. The Board of Directors frequently authorizes the repurchase of the Corporation's $1.00par value common stock. Information regarding stock repurchase plans in place during the year are included in Item 5 Market for Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities. Additional information on Shareholders' Equity is reported in Note 19 of the accompanying consolidated financial statements. The Corporation's dividend reinvestment plan (DRIP) allows for shareholders to purchase additional shares of the Corporation's common stock by reinvesting cash dividends paid on their shares or through optional cash payments. The Dividend Reinvestment Plan (DRIP) added $2.4 millionto capital during 2021. This total was comprised of $1.0 millionfrom the reinvestment of quarterly dividends and $1.4 millionof optional cash contributions. A strong capital position is important to the Corporation as it provides a solid foundation for the future growth of the Corporation, as well as instills confidence in the Bank by depositors, regulators and investors, and is considered essential by Management. The Corporation is continually exploring other sources of capital as part of its capital management plan for the Corporation and the Bank. Common measures of adequate capitalization for banking institutions are capital ratios. These ratios indicate the proportion of permanently committed funds to the total asset base. Guidelines issued by federal and state regulatory authorities require both banks and bank holding companies to meet minimum leverage capital ratios and risk-based capital ratios. The leverage ratio compares Tier 1 capital to average assets while the risk-based ratio compares Tier 1 and total capital to risk-weighted assets and off-balance-sheet activity in order to make capital levels more sensitive to the risk profiles of individual banks. 34
Tier 1 capital includes common stock, additional contributed capital, retained earnings and items of other comprehensive income, less goodwill and other intangible assets. Total capital includes Tier 1 capital plus the allowable portion of the loan loss allowance.
The Corporation, as a bank holding company, is required to comply with the capital adequacy standards established by
Federal Reserve Board. The Bank is required to comply with capital adequacy standards established by the FDIC. In addition, the Pennsylvania Department of Bankingalso requires state-chartered banks to maintain a 6% leverage capital level and 10% risk-based capital, defined substantially the same as the federal regulations. The Corporation and the Bank are subject to the capital requirements contained in the regulation generally referred to as Basel III. The Basel III standards were effective for the Corporation and the Bank, effective January 1, 2015. Basel III imposes significantly higher capital requirements and more restrictive leverage and liquidity ratios than those previously in place. The capital ratios to be considered "well capitalized" under Basel III are: (1) Common Equity Tier 1(CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capitalof 8%, and (4) Total Risk-Based Capitalof 10%. The CET1 ratio is a new capital ratio under Basel III and the Tier 1 risk-based capital ratio of 8% has been increased from 6%. The rules also included changes in the risk weights of certain assets to better reflect credit and other risk exposures. In addition, a capital conservation buffer of 2.50% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum ("adequately capitalized") for each respective capital measurement. The Bank's capital conservation buffer at December 31, 2021was 8.54%. Compliance with the capital conservation buffer is required in order to avoid limitations on certain capital distributions, especially dividends. As of December 31, 2021, the Bank was "well capitalized' under the Basel III requirements. For additional information on the capital ratios see the section titled Shareholders' Equity, and Table 13. On August 4, 2020, the Corporation completed the sale of a $20 millionsubordinated debt note offering. The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank. In 2019, the Community Bank Leverage Ratio (CBLR) was approved by federal banking agencies as an optional capital measure available to Qualifying Community Banking Organizations (QCBO). If a bank qualifies as a QCBR and maintains a CBLR of 9% or greater, the bank would be considered "well-capitalized" for regulatory capital purposes and exempt from complying with the Basel III risk-based capital rule. The CBLR rule was effective January 1, 2020and banks could opt-in through an election in the first quarter 2020 regulatory filings. The Bank meets the criteria of a QCBO but did not opt-in to the CBLR. The consolidated asset limit on small bank holding companies is $3 billionand a company with assets under that limit is not subject to the consolidated capital rules but may file reports that include capital amounts and ratios. The Corporation has elected to file those reports. The following table presents capital ratios for the Corporation at December 31: Table 13. Capital Ratios 2021 2020 Corporation Bank Corporation Bank Common Equity Tier 1 risk-based capital ratio 15.20% 15.28% 14.32% 14.07% Total risk-based capital ratio 18.41% 16.54% 17.69% 15.33% Tier 1 risk-based capital ratio 15.20% 15.28% 14.32% 14.07% Tier 1 leverage ratio 8.52% 8.57% 8.69% 8.54%
For further information on capital adequacy, refer to Note 2 of the accompanying consolidated financial statements.
The local economy
The Corporation's primary market area includes
Franklin, Fulton, Cumberlandand Huntingdon County, PA.This area is diverse in demographic and economic makeup. County populations range from a low of approximately 15,000 in Fulton Countyto over 260,000 in Cumberland County. Unemployment in the Bank's market area decreased during 2021 over 2020 as the local economy recovered from the worst effects of the COVID-19 pandemic shutdowns. The market area has a diverse economic base and local industries include, warehousing, truck and rail shipping centers, light and heavy manufacturers, health care, higher education institutions, farming and agriculture, and a varied service sector. The market area provides easy access to the major metropolitan markets on the east coast via trucking and rail transportation. Because of this, warehousing and distribution companies continue to find the area attractive. The local economy is not overly dependent on any one industry or business and Management believes that the Bank's primary market area continues to be well suited for growth. The following provides selected economic data for the Bank's primary market at December 31: 35
Table of Contents Economic Data 2021 2020 Unemployment Rate (seasonally adjusted) Market area range (1) 3.6% - 5.2% 4.8% - 10.1% Pennsylvania 5.7% 6.6% United States 4.2% 6.7% Housing Price Index - year over year change PA, nonmetropolitan statistical area 11.5%
Building permits – year to year variation -12 months Harrisburg-
Multifamily, estimated -24.0%
The assets and liabilities of the Corporation are financial in nature, as such, the pricing of products, customer demand for certain types of products, and the value of assets and liabilities are greatly influenced by interest rates. As such, interest rates and changes in interest rates may have a more significant effect on the Corporation's financial results than on other types of industries. Because of this, the Corporation watches the actions of the Federal Reserve Open Market Committee (FOMC) as it makes decisions about interest rate changes and monetary policy. In
January 2022, the FOMCrelease included this: "Indicators of economic activity and employment have continued to strengthen. The sectors most adversely affected by the pandemic have improved in recent months but are being affected by the recent sharp rise in COVID-19 cases. Job gains have been solid in recent months, and the unemployment rate has declined substantially. Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S.households and businesses." With the Federal Reservedecreasing its level of bond purchases, and economic improvement coupled with inflation, the possibility of rate increases by the FOMCappears more likely. Over the long-term, the Bank benefits from higher interest rates, but any increase in rates in 2022 is not expected to have a material effect on the Corporation. Liquidity
The Company conducts substantially all of its business through its banking subsidiary. The Company’s cash needs are funded primarily by the banking subsidiary, supplemented by cash from its dividend reinvestment plan.
The Bank must meet the financial needs of the customers that it serves, while providing a satisfactory return on the shareholders' investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. The Bank regularly reviews it liquidity position by measuring its projected net cash flows (in and out) at a 30 and 90-day interval. The Bank stress tests this measurement by assuming a level of deposit out-flows that have not historically been realized. In addition to this forecast, other funding sources are reviewed as a method to provide emergency funding if necessary. The objective of this measurement is to identify the amount of cash that could be raised quickly without the need to liquidate assets. The Bank also stresses its liquidity position utilizing different longer-term scenarios. The varying degrees of stress create pressure on deposit flows in its local market, reduce access to wholesale funding and limit access of funds available through brokered deposit channels. In addition to stressing cash flow, specific liquidity risk indicators are monitored to help identify risk areas. This analysis helps identify and quantify the potential cash surplus/deficit over a variety of time horizons to ensure the Bank has adequate funding resources. Assumptions used for liquidity stress testing are subjective. Should an evolving liquidity situation or business cycle present new data, potential assumption changes will be considered. The Bank believes it can meet all anticipated liquidity demands. Historically, the Bank has satisfied its liquidity needs from earnings, repayment of loans, amortizing and maturing investment securities, loan sales, deposit growth and its ability to access existing lines of credit. All investment securities are classified as available for sale; therefore, securities that are unencumbered (approximately
$378.8 millionfair value) as collateral for borrowings are an additional source of readily available liquidity, either by selling the security or, more preferably, to provide collateral for additional borrowing. The Bank also has access to other wholesale funding via the brokered CD market. The FHLB system has always been a major source of funding for community banks. There are no indicators that lead the Bank to believe the FHLB will discontinue its lending function or restrict the Bank's ability to borrow. If either of these events were to occur, 36
it would have a negative effect on the Bank, and it is unlikely that the Bank could replace the level of FHLB funding in a short time. The Bank has also established credit at the Federal Reserve Discount Window and an unsecured line of credit at a correspondent bank. The following table shows the Bank's available liquidity at
December 31, 2021. (Dollars in thousands) Liquidity Source Capacity Outstanding Available Federal Home Loan Bank $ 369,860$ - $ 369,860Federal Reserve Bank Discount Window 22,125 - 22,125 Correspondent Banks 56,000 - 56,000 Total $ 447,985$ - $ 447,985
Off-balance sheet commitments
The Corporation's financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet loans and lines of credit. Because these unfunded instruments have fixed maturity dates and many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation. Unused commitments and standby letters of credit totaled
$375.6 millionand $23.3 million, respectively, at December 31, 2021, compared to $312.0 millionand $22.3 million, respectively, at December 31, 2020. In the second quarter of 2018, the Bank established a $2.4 millionallowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy in the second quarter of 2018. In the first quarter of 2020, the Bank was notified that one letter of credit for $250 thousandwas cancelled and the amount was reversed from the liability with an offsetting amount recorded in other expense. In the second quarter of 2021, the Bank was notified that a second letter of credit for $636 thousandwas cancelled and the amount was reversed from the liability with an offsetting amount recorded in other expense. At December 31, 2021, this reserve was $1.5 million. Management believes that any amounts actually drawn upon can be funded in the normal course of operations. The Corporation has no investment in or financial relationship with any unconsolidated entities that are reasonably likely to have a material effect on liquidity.
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