Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements
The Company makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
|
|
•
|
general business conditions, as well as conditions within the financial markets;
|
|
|
•
|
general economic conditions, including unemployment levels and slowdowns in economic growth;
|
|
|
•
|
the Company’s branch and market expansions, technology initiatives and other strategic initiatives;
|
|
|
•
|
the impact of competition from banks and non-banks, including financial technology companies (Fintech);
|
|
|
•
|
the composition of the loan and deposit portfolio, including the types of accounts and customers, may change, which could impact the amount of net interest income and noninterest income in future periods, including revenue from service charges on deposits;
|
|
|
•
|
limited availability of financing or inability to raise capital;
|
|
|
•
|
reliance on third parties for key services;
|
|
|
•
|
the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses;
|
|
|
•
|
the impact of an increase in nonperforming assets and the significant amount of time to resolve these assets;
|
|
|
•
|
the level of net charge-offs on loans and the adequacy of the allowance for loan losses;
|
|
|
•
|
the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets;
|
|
|
•
|
the value of securities held in the Company's investment portfolio;
|
|
|
•
|
legislative or regulatory changes or actions, including the effects of changes in tax laws;
|
|
|
•
|
accounting principles, policies and guidelines and elections made by the Company thereunder;
|
|
|
•
|
cyber threats, attacks or events;
|
|
|
•
|
the ability to maintain adequate liquidity by retaining deposit customers and secondary funding sources, especially if the Company’s reputation would become damaged;
|
|
|
•
|
monetary and fiscal policies of the U.S. Government, including policies of the U.S. Department of the Treasury and the Federal Reserve Board, and the effect of those policies on interest rates and business in our markets;
|
|
|
•
|
changes in interest rates could have a negative impact on the Company’s net interest income and an unfavorable impact on the Company’s customers’ ability to repay loans; and
|
|
|
•
|
other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2018.
|
Because of these and other uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at September 30, 2019 and statements of income of the Company for the three and nine months ended September 30, 2019 and 2018 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the year ended December 31, 2018. The statements of income for the three and nine months ended September 30, 2019 may not be indicative of the results to be achieved for the year.
Executive Overview
The Company
First National Corporation (the Company) is the bank holding company of:
|
|
•
|
First Bank (the Bank). The Bank owns:
|
|
|
•
|
First Bank Financial Services, Inc.
|
|
|
•
|
Shen-Valley Land Holdings, LLC
|
|
|
•
|
First National (VA) Statutory Trust II (Trust II)
|
|
|
•
|
First National (VA) Statutory Trust III (Trust III and, together with Trust II, the Trusts)
|
First Bank Financial Services, Inc. invests in entities that provide title insurance and investment services. Shen-Valley Land Holdings, LLC was formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities and are not included in the Company’s consolidated financial statements in accordance with authoritative accounting guidance because management has determined that the Trusts qualify as variable interest entities.
Products, Services, Customers and Locations
The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank’s office locations are well-positioned in attractive markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in the Shenandoah Valley and central regions of Virginia. Within this market area, there are various types of industry including medical and professional services, manufacturing, retail, warehousing, Federal government, hospitality, and higher education.
The Bank’s products and services are delivered through 14 bank branch offices located throughout the Shenandoah Valley and central regions of Virginia, a loan production office, and a customer service center in a retirement village. The branch offices are comprised of 13 full service retail banking offices and one drive-thru express banking office. The location and general character of these properties is further described in Part I, Item 2 of the Form 10-K for the year ended December 31, 2018. Many of the Bank’s services are also delivered through the Bank’s mobile banking platform, its website, www.fbvirginia.com, and a network of ATMs located throughout its market area.
Revenue Sources and Expense Factors
The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services, and ATM and check card fees.
Primary expense categories are salaries and employee benefits, which comprised 56% of noninterest expenses for the nine months ended September 30, 2019, followed by occupancy and equipment expense, which comprised 13% of noninterest expenses. Historically, the provision for loan losses has also been a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for loan losses.
Quarterly Financial Performance
Net income decreased by $183 thousand to $2.5 million, or $0.50 per basic and diluted share, for the three months ended September 30, 2019, compared to $2.7 million, or $0.54 per basic and diluted share, for the same period in 2018. Return on average assets was 1.27% and return on average equity was 13.31% for the third quarter of 2019, compared to 1.41% and 16.89%, respectively, for the same period in 2018.
The $183 thousand decrease in net income for the three months ended September 30, 2019 resulted primarily from a $12 thousand decrease in net interest income and a $236 thousand, or 4%, increase in noninterest expenses, compared to the same period of 2018. These unfavorable variances were partially offset by a $13 thousand, or 1%, increase in noninterest income and a $52 thousand decrease in income tax expense.
Net interest income decreased from a lower net interest margin, which decreased 15 basis points to 3.87% for the third quarter of 2019, compared to 4.02% for the same period in 2018. Noninterest income increased primarily from higher wealth management fees and ATM and check card fees. Noninterest expense increased primarily from higher salaries and employee benefits expense and other operating expense. For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income," "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.
Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses was not required during the third quarter of 2019 or 2018. For a more detailed discussion of the provision for loan losses, see “Provision for Loan Losses” below.
Year-to-Date Financial Performance
Net income decreased by $974 thousand to $6.8 million, or $1.38 per basic and diluted share, for the nine months ended September 30, 2019, compared to $7.8 million, or $1.58 per basic and diluted share, for the same period in 2018. Return on average assets was 1.19% and return on average equity was 12.85% for the nine months ended September 30, 2019, compared to 1.38% and 17.17%, respectively, for the same period in 2018.
The $974 thousand decrease in net income for the nine months ended September 30, 2019 resulted primarily from a $100 thousand increase in provision for loan losses, a $667 thousand, or 10%, decrease in noninterest income, and an $834 thousand, or 5%, increase in noninterest expenses, compared to the same period of 2018. These unfavorable variances were partially offset by a $474 thousand, or 2%, increase in net interest income and a $153 thousand decrease in income tax expense.
Net interest income increased from a higher net interest margin and from higher average earning asset balances. Average earning asset balances increased 2%, and the net interest margin increased 2 basis points to 3.91% for the nine months ended September 30, 2019, compared to 3.89% for the same period in 2018. Noninterest income decreased primarily from lower service charges on deposit accounts, income from bank owned life insurance, and other operating income. Noninterest expense increased primarily from higher salaries and employee benefits expense, marketing expense, legal and professional fees, and other operating expense. For a more detailed discussion of the Company's year-to-date performance, see "Net Interest Income," "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.
Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses of $200 thousand was recorded during the nine months ended September 30, 2019, compared to a provision for loan losses of $100 thousand during the nine months ended September 30, 2018. For a more detailed discussion of the provision for loan losses, see “Provision for Loan Losses” below.
Non-GAAP Financial Measures
This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding OREO (expense)/income, amortization of intangibles, and losses on disposal of premises and equipment, by the sum of net interest income on a tax-equivalent basis and noninterest income. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).
|
|
|
Efficiency Ratio
|
|
|
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
|
Noninterest expense
|
|
$
|
6,186
|
|
|
$
|
5,950
|
|
|
$
|
18,514
|
|
|
$
|
17,680
|
|
|
Add/(Subtract): other real estate owned (expense)/income, net
|
|
|
—
|
|
|
|
(2
|
)
|
|
|
—
|
|
|
|
20
|
|
|
Subtract: amortization of intangibles
|
|
|
(71
|
)
|
|
|
(108
|
)
|
|
|
(241
|
)
|
|
|
(359
|
)
|
|
Subtract: losses on disposal of premises and equipment, net
|
|
|
—
|
|
|
|
(2
|
)
|
|
|
—
|
|
|
|
(2
|
)
|
|
|
|
$
|
6,115
|
|
|
$
|
5,838
|
|
|
$
|
18,273
|
|
|
$
|
17,339
|
|
|
Tax-equivalent net interest income
|
|
$
|
7,123
|
|
|
$
|
7,136
|
|
|
$
|
21,091
|
|
|
$
|
20,615
|
|
|
Noninterest income
|
|
|
2,191
|
|
|
|
2,178
|
|
|
|
6,211
|
|
|
|
6,878
|
|
|
|
|
$
|
9,314
|
|
|
$
|
9,314
|
|
|
$
|
27,302
|
|
|
$
|
27,493
|
|
|
Efficiency ratio
|
|
|
65.65
|
%
|
|
|
62.68
|
%
|
|
|
66.93
|
%
|
|
|
63.07
|
%
|
This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for both 2019 and 2018 is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).
|
|
|
Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income
|
|
|
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
|
GAAP measures:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest income – loans
|
|
$
|
7,429
|
|
|
$
|
6,917
|
|
|
$
|
21,625
|
|
|
$
|
19,768
|
|
|
Interest income – investments and other
|
|
|
925
|
|
|
|
1,064
|
|
|
|
2,966
|
|
|
|
3,211
|
|
|
Interest expense – deposits
|
|
|
(1,089
|
)
|
|
|
(702
|
)
|
|
|
(3,062
|
)
|
|
|
(1,957
|
)
|
|
Interest expense – federal funds purchased
|
|
|
(1
|
)
|
|
|
—
|
|
|
|
(1
|
)
|
|
|
—
|
|
|
Interest expense – subordinated debt
|
|
|
(90
|
)
|
|
|
(91
|
)
|
|
|
(269
|
)
|
|
|
(269
|
)
|
|
Interest expense – junior subordinated debt
|
|
|
(103
|
)
|
|
|
(105
|
)
|
|
|
(322
|
)
|
|
|
(292
|
)
|
|
Interest expense – other borrowings
|
|
|
—
|
|
|
|
—
|
|
|
|
(2
|
)
|
|
|
—
|
|
|
Total net interest income
|
|
$
|
7,071
|
|
|
$
|
7,083
|
|
|
$
|
20,935
|
|
|
$
|
20,461
|
|
|
Non-GAAP measures:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Tax benefit realized on non-taxable interest income – loans
|
|
$
|
9
|
|
|
$
|
12
|
|
|
$
|
30
|
|
|
$
|
33
|
|
|
Tax benefit realized on non-taxable interest income – municipal securities
|
|
|
43
|
|
|
|
41
|
|
|
|
126
|
|
|
|
121
|
|
|
Total tax benefit realized on non-taxable interest income
|
|
$
|
52
|
|
|
$
|
53
|
|
|
$
|
156
|
|
|
$
|
154
|
|
|
Total tax-equivalent net interest income
|
|
$
|
7,123
|
|
|
$
|
7,136
|
|
|
$
|
21,091
|
|
|
$
|
20,615
|
|
Critical Accounting Policies
General
The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or relieving a liability. The Bank uses historical losses as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.
Presented below is a discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the allowance for loan losses, see Notes 3 and 4 to the Consolidated Financial Statements included in this Form 10-Q.
The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The Company performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company's primary credit quality indicator. The Company has various committees that review and ensure that the allowance for loans losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.
The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of the collateral, overall portfolio quality, and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:
|
|
•
|
1-4 family residential mortgage loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral.
|
|
|
•
|
Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget, and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project.
|
|
|
•
|
Other real estate loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project.
|
|
|
•
|
Commercial and industrial loans carry risks associated with the successful operation of a business because repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability.
|
|
|
•
|
Consumer and other loans carry risk associated with the continued creditworthiness of the borrower and the value of the collateral, if any. These loans are typically either unsecured or secured by rapidly depreciating assets such as automobiles. They are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances.
|
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, fair value of collateral less estimated costs to sell, or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are typically performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.
The general component covers loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors. The historical loss experience is calculated by loan type and uses an average loss rate during the preceding twelve quarters. The qualitative factors are assigned by management based on delinquencies and asset quality, national and local economic trends, effects of the changes in the value of underlying collateral, trends in volume and nature of loans, effects of changes in the lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system, and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan type. The general allowance estimates losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses, see Note 4 to the Consolidated Financial Statements included in this Form 10-Q.
Lending Policies
General
In an effort to manage risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and level of experience. The Management Loan Committee can approve new loans up to their authority. The Board Loan Committee approves all loans which exceed the authority of the Management Loan Committee. The full Board of Directors must approve loans which exceed the authority of the Board Loan Committee, up to the Bank’s legal lending limit. The Board Loan Committee currently consists of five directors, four of which are non-management directors. The Board Loan Committee approves the Bank’s Loan Policy and reviews risk management reports, including watch list reports and concentrations of credit. The Board Loan Committee meets on a monthly basis and the Chairman of the Committee then reports to the Board of Directors.
Residential loan originations are primarily generated by mortgage loan officer solicitations and referrals by employees, real estate professionals, and customers. Commercial real estate loan originations and commercial and industrial loan originations are primarily obtained through direct solicitation and additional business from existing customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment, and credit history of the applicant. The Bank also participates in commercial real estate loans and commercial and industrial loans originated by other financial institutions that are typically outside its market area. In addition, the Bank purchases consumer loans originated by other financial institutions that are typically outside its market area. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines depending on the type of loan involved. Except for loan participations with other financial institutions, real estate collateral is valued by independent appraisers who have been pre-approved by the Board Loan Committee.
As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, certain appraisals are analyzed by management or by an outsourced appraisal review specialist throughout the year in order to ensure standards of quality are met. The Company also obtains an independent review of loans within the portfolio on an annual basis to analyze loan risk ratings and validate specific reserves on impaired loans.
In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its financial statements, including commitments to extend credit. At September 30, 2019, commitments to extend credit, stand-by letters of credit, and rate lock commitments totaled $113.4 million.
Construction and Land Development Lending
The Bank makes local construction loans, including residential and land acquisition and development loans. These loans are secured by the property under construction and the underlying land for which the loan was obtained. The majority of these loans mature in one year. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction and land development loans sometimes involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction and land development lending is the fact that loan funds are advanced upon the security of the land or property under construction, which value is estimated based on the completion of construction. Thus, there is risk associated with failure to complete construction and potential cost overruns. To mitigate the risks associated with this type of lending, the Bank generally limits loan amounts relative to the appraised value and/or cost of the collateral, analyzes the cost of the project and the creditworthiness of its borrowers, and monitors construction progress. The Bank typically obtains a first lien on the property as security for its construction loans, typically requires personal guarantees from the borrower’s principal owners, and typically monitors the progress of the construction project during the draw period.
1-4 Family Residential Real Estate Lending
1-4 family residential lending activity may be generated by Bank loan officer solicitations and referrals by real estate professionals and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment, and credit history of the applicant. Residential mortgage loans generally are made on the basis of the borrower’s ability to make payments from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In addition to the Bank’s underwriting standards, loan quality may be analyzed based on guidelines issued by a secondary market investor. The valuation of residential collateral is generally provided by independent fee appraisers who have been approved by the Board Loan Committee. In addition to originating mortgage loans with the intent to sell to correspondent lenders or broker to wholesale lenders, the Bank also originates and retains certain mortgage loans in its loan portfolio.
Commercial Real Estate Lending
Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, hotels, industrial buildings, and religious facilities. Commercial real estate loan originations are primarily obtained through direct solicitation of customers and potential customers. The valuation of commercial real estate collateral is provided by independent appraisers who have been approved by the Board Loan Committee. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history, and reputation. The Bank typically requires personal guarantees of the borrowers’ principal owners and considers the valuation of the real estate collateral.
Commercial and Industrial Lending
Commercial and industrial loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business. The loans may be unsecured or secured by business assets, such as accounts receivable, equipment, and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, any collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much reliability as real estate.
Consumer Lending
Loans to individual borrowers may be secured or unsecured, and include unsecured consumer loans and lines of credit, automobile loans, deposit account loans, and installment and demand loans. These consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss, or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on a proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income.
Also included in this category are loans purchased through a third-party lending program. These portfolios include consumer loans and carry risks associated with the borrower, changes in the economic environment, and the vendor itself. The Company manages these risks through policies that require minimum credit scores and other underwriting requirements, robust analysis of actual performance versus expected performance, as well as ensuring compliance with the Company's vendor management program.
Results of Operations
General
Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income, and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts, revenue from wealth management services, ATM and check card income, revenue from other customer services, income from bank owned life insurance, general and administrative expenses, amortization expense, and other real estate owned (expense) income.
Net Interest Income
For the three months ended September 30, 2019, net interest income decreased $12 thousand to $7.1 million, compared to the third quarter of 2018. Average earning asset balances increased by 4%, while the net interest margin decreased 15 basis points to 3.87% for the quarter ended September 30, 2019, compared to 4.02% for the same period in 2018. The decrease in the net interest margin resulted from a 19 basis point increase in interest expense as a percent of average earning assets, which was partially offset by a 3 basis point increase in the yield on total earning assets.
The increase in interest expense as a percent of average earning assets was primarily attributable to higher interest rates paid on deposits, which was impacted by higher short-term market rates and competition. Money market accounts and time deposits had the largest impact as their costs increased by 50 basis points and 39 basis points, respectively, when comparing the periods. The higher yield on earning assets was attributable to the change in the earning asset composition, as loans increased from 76% to 79% of average earning assets, while securities decreased from 22% to 19% of average earning assets.
For the nine months ended September 30, 2019, net interest income increased $474 thousand, or 2%, to $20.9 million, compared to $20.5 million for the same period in 2018. The increase resulted from a higher net interest margin and higher average earning asset balances. Average earning asset balances increased 2%, and the net interest margin increased 2 basis points to 3.91% for the nine months ended September 30, 2019, compared to 3.89% for the same period in 2018. The increase in the net interest margin resulted from a 21 basis point increase in the yield on total earning assets, which was partially offset by a 20 basis point increase in interest expense as a percent of average earning assets.
The higher yield on earning assets was attributable to a change in the earning asset composition and an increase in yields on loans and interest-bearing deposits with other institutions. The change in the earning asset composition favorably impacted the yield on average earning assets as loans increased from 74% to 78% of average earning assets, securities decreased from 21% to 19% of average earning assets, and interest-bearing deposits with other institutions decreased from 5% to 3% of average earning assets. The yields on loans and interest-bearing deposits with other institutions benefited from increases in market rates. The 13 basis point increase in the yield on loans had the largest impact on the increase in the yield on earning assets, when comparing the periods.
The increase in interest expense as a percent of average earning assets was primarily attributable to higher interest rates paid on deposits, which was impacted by higher short-term market rates and competition. The cost of interest-bearing checking accounts and money market accounts had the largest impact as their costs increased by 26 basis points and 50 basis points, respectively, when comparing the periods.
The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):
Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis)
|
|
|
Three Months Ended
|
|
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
|
|
|
Average Balance
|
|
|
Interest Income/Expense
|
|
|
Yield/Rate
|
|
|
Average Balance
|
|
|
Interest Income/Expense
|
|
|
Yield/Rate
|
|
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable
|
|
$
|
108,336
|
|
|
$
|
645
|
|
|
|
2.36
|
%
|
|
$
|
123,878
|
|
|
$
|
797
|
|
|
|
2.55
|
%
|
|
Tax-exempt (1)
|
|
|
27,555
|
|
|
|
200
|
|
|
|
2.87
|
%
|
|
|
26,415
|
|
|
|
197
|
|
|
|
2.97
|
%
|
|
Restricted
|
|
|
1,786
|
|
|
|
26
|
|
|
|
5.93
|
%
|
|
|
1,590
|
|
|
|
23
|
|
|
|
5.84
|
%
|
|
Total securities
|
|
$
|
137,677
|
|
|
$
|
871
|
|
|
|
2.51
|
%
|
|
$
|
151,883
|
|
|
$
|
1,017
|
|
|
|
2.66
|
%
|
|
Loans: (2)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable
|
|
$
|
571,105
|
|
|
$
|
7,392
|
|
|
|
5.13
|
%
|
|
$
|
531,234
|
|
|
$
|
6,875
|
|
|
|
5.13
|
%
|
|
Tax-exempt (1)
|
|
|
4,139
|
|
|
|
46
|
|
|
|
4.47
|
%
|
|
|
4,749
|
|
|
|
54
|
|
|
|
4.52
|
%
|
|
Total loans
|
|
$
|
575,244
|
|
|
$
|
7,438
|
|
|
|
5.13
|
%
|
|
$
|
535,983
|
|
|
$
|
6,929
|
|
|
|
5.13
|
%
|
|
Interest-bearing deposits with other institutions
|
|
|
17,944
|
|
|
|
97
|
|
|
|
2.15
|
%
|
|
|
16,028
|
|
|
|
88
|
|
|
|
2.18
|
%
|
|
Total earning assets
|
|
$
|
730,865
|
|
|
$
|
8,406
|
|
|
|
4.56
|
%
|
|
$
|
703,894
|
|
|
$
|
8,034
|
|
|
|
4.53
|
%
|
|
Less: allowance for loan losses
|
|
|
(4,965
|
)
|
|
|
|
|
|
|
|
|
|
|
(4,934
|
)
|
|
|
|
|
|
|
|
|
|
Total non-earning assets
|
|
|
54,476
|
|
|
|
|
|
|
|
|
|
|
|
51,659
|
|
|
|
|
|
|
|
|
|
|
Total assets
|
|
$
|
780,376
|
|
|
|
|
|
|
|
|
|
|
$
|
750,619
|
|
|
|
|
|
|
|
|
|
|
Liabilities and Shareholders’ Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest bearing deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Checking
|
|
$
|
161,880
|
|
|
$
|
352
|
|
|
|
0.86
|
%
|
|
$
|
156,170
|
|
|
$
|
281
|
|
|
|
0.71
|
%
|
|
Regular savings
|
|
|
104,880
|
|
|
|
17
|
|
|
|
0.06
|
%
|
|
|
122,573
|
|
|
|
23
|
|
|
|
0.07
|
%
|
|
Money market accounts
|
|
|
118,144
|
|
|
|
388
|
|
|
|
1.30
|
%
|
|
|
86,852
|
|
|
|
176
|
|
|
|
0.80
|
%
|
|
Time deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$100,000 and over
|
|
|
51,752
|
|
|
|
199
|
|
|
|
1.52
|
%
|
|
|
48,487
|
|
|
|
127
|
|
|
|
1.04
|
%
|
|
Under $100,000
|
|
|
65,002
|
|
|
|
131
|
|
|
|
0.80
|
%
|
|
|
72,186
|
|
|
|
95
|
|
|
|
0.52
|
%
|
|
Brokered
|
|
|
852
|
|
|
|
2
|
|
|
|
0.99
|
%
|
|
|
307
|
|
|
|
—
|
|
|
|
0.10
|
%
|
|
Total interest-bearing deposits
|
|
$
|
502,510
|
|
|
$
|
1,089
|
|
|
|
0.86
|
%
|
|
$
|
486,575
|
|
|
$
|
702
|
|
|
|
0.57
|
%
|
|
Federal funds purchased
|
|
|
119
|
|
|
|
1
|
|
|
|
2.59
|
%
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
%
|
|
Subordinated debt
|
|
|
4,976
|
|
|
|
90
|
|
|
|
7.23
|
%
|
|
|
4,959
|
|
|
|
91
|
|
|
|
7.25
|
%
|
|
Junior subordinated debt
|
|
|
9,279
|
|
|
|
103
|
|
|
|
4.43
|
%
|
|
|
9,279
|
|
|
|
105
|
|
|
|
4.51
|
%
|
|
Total interest-bearing liabilities
|
|
$
|
516,884
|
|
|
$
|
1,283
|
|
|
|
0.99
|
%
|
|
$
|
500,813
|
|
|
$
|
898
|
|
|
|
0.71
|
%
|
|
Non-interest bearing liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand deposits
|
|
|
187,306
|
|
|
|
|
|
|
|
|
|
|
|
185,608
|
|
|
|
|
|
|
|
|
|
|
Other liabilities
|
|
|
1,895
|
|
|
|
|
|
|
|
|
|
|
|
1,316
|
|
|
|
|
|
|
|
|
|
|
Total liabilities
|
|
$
|
706,085
|
|
|
|
|
|
|
|
|
|
|
$
|
687,737
|
|
|
|
|
|
|
|
|
|
|
Shareholders’ equity
|
|
|
74,291
|
|
|
|
|
|
|
|
|
|
|
|
62,882
|
|
|
|
|
|
|
|
|
|
|
Total liabilities and Shareholders’ equity
|
|
$
|
780,376
|
|
|
|
|
|
|
|
|
|
|
$
|
750,619
|
|
|
|
|
|
|
|
|
|
|
Net interest income
|
|
|
|
|
|
$
|
7,123
|
|
|
|
|
|
|
|
|
|
|
$
|
7,136
|
|
|
|
|
|
|
Interest rate spread
|
|
|
|
|
|
|
|
|
|
|
3.57
|
%
|
|
|
|
|
|
|
|
|
|
|
3.82
|
%
|
|
Cost of funds
|
|
|
|
|
|
|
|
|
|
|
0.72
|
%
|
|
|
|
|
|
|
|
|
|
|
0.52
|
%
|
|
Interest expense as a percent of average earning assets
|
|
|
|
|
|
|
|
|
|
|
0.70
|
%
|
|
|
|
|
|
|
|
|
|
|
0.51
|
%
|
|
Net interest margin
|
|
|
|
|
|
|
|
|
|
|
3.87
|
%
|
|
|
|
|
|
|
|
|
|
|
4.02
|
%
|
|
(1)
|
Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $52 and $53 thousand for the three months ended September 30, 2019 and 2018, respectively.
|
|
(2)
|
Loans on non-accrual status are reflected in the balances.
|
|
|
|
Nine Months Ended
|
|
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
|
|
|
Average Balance
|
|
|
Interest Income/Expense
|
|
|
Yield/Rate
|
|
|
Average Balance
|
|
|
Interest Income/Expense
|
|
|
Yield/Rate
|
|
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable
|
|
$
|
111,652
|
|
|
$
|
2,078
|
|
|
|
2.49
|
%
|
|
$
|
119,197
|
|
|
$
|
2,253
|
|
|
|
2.53
|
%
|
|
Tax-exempt (1)
|
|
|
27,109
|
|
|
|
598
|
|
|
|
2.95
|
%
|
|
|
26,014
|
|
|
|
578
|
|
|
|
2.97
|
%
|
|
Restricted
|
|
|
1,726
|
|
|
|
76
|
|
|
|
5.93
|
%
|
|
|
1,584
|
|
|
|
67
|
|
|
|
5.68
|
%
|
|
Total securities
|
|
$
|
140,487
|
|
|
$
|
2,752
|
|
|
|
2.62
|
%
|
|
$
|
146,795
|
|
|
$
|
2,898
|
|
|
|
2.64
|
%
|
|
Loans: (2)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable
|
|
$
|
556,410
|
|
|
$
|
21,509
|
|
|
|
5.17
|
%
|
|
$
|
521,662
|
|
|
$
|
19,645
|
|
|
|
5.03
|
%
|
|
Tax-exempt (1)
|
|
|
4,365
|
|
|
|
146
|
|
|
|
4.49
|
%
|
|
|
4,789
|
|
|
|
156
|
|
|
|
4.37
|
%
|
|
Total loans
|
|
$
|
560,775
|
|
|
$
|
21,655
|
|
|
|
5.16
|
%
|
|
$
|
526,451
|
|
|
$
|
19,801
|
|
|
|
5.03
|
%
|
|
Interest-bearing deposits with other institutions
|
|
|
20,637
|
|
|
|
340
|
|
|
|
2.20
|
%
|
|
|
34,752
|
|
|
|
434
|
|
|
|
1.67
|
%
|
|
Total earning assets
|
|
$
|
721,899
|
|
|
$
|
24,747
|
|
|
|
4.58
|
%
|
|
$
|
707,998
|
|
|
$
|
23,133
|
|
|
|
4.37
|
%
|
|
Less: allowance for loan losses
|
|
|
(4,951
|
)
|
|
|
|
|
|
|
|
|
|
|
(5,141
|
)
|
|
|
|
|
|
|
|
|
|
Total non-earning assets
|
|
|
53,829
|
|
|
|
|
|
|
|
|
|
|
|
51,999
|
|
|
|
|
|
|
|
|
|
|
Total assets
|
|
$
|
770,777
|
|
|
|
|
|
|
|
|
|
|
$
|
754,856
|
|
|
|
|
|
|
|
|
|
|
Liabilities and Shareholders’ Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest bearing deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Checking
|
|
$
|
162,389
|
|
|
$
|
1,082
|
|
|
|
0.89
|
%
|
|
$
|
158,828
|
|
|
$
|
753
|
|
|
|
0.63
|
%
|
|
Regular savings
|
|
|
108,332
|
|
|
|
53
|
|
|
|
0.07
|
%
|
|
|
124,080
|
|
|
|
70
|
|
|
|
0.08
|
%
|
|
Money market accounts
|
|
|
109,888
|
|
|
|
1,031
|
|
|
|
1.25
|
%
|
|
|
86,992
|
|
|
|
488
|
|
|
|
0.75
|
%
|
|
Time deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$100,000 and over
|
|
|
50,497
|
|
|
|
545
|
|
|
|
1.44
|
%
|
|
|
48,591
|
|
|
|
357
|
|
|
|
0.98
|
%
|
|
Under $100,000
|
|
|
66,838
|
|
|
|
347
|
|
|
|
0.69
|
%
|
|
|
74,103
|
|
|
|
288
|
|
|
|
0.52
|
%
|
|
Brokered
|
|
|
586
|
|
|
|
4
|
|
|
|
0.91
|
%
|
|
|
472
|
|
|
|
1
|
|
|
|
0.34
|
%
|
|
Total interest-bearing deposits
|
|
$
|
498,530
|
|
|
$
|
3,062
|
|
|
|
0.82
|
%
|
|
$
|
493,066
|
|
|
$
|
1,957
|
|
|
|
0.53
|
%
|
|
Federal funds purchased
|
|
|
41
|
|
|
|
1
|
|
|
|
2.59
|
%
|
|
|
2
|
|
|
|
—
|
|
|
|
2.16
|
%
|
|
Subordinated debt
|
|
|
4,972
|
|
|
|
269
|
|
|
|
7.23
|
%
|
|
|
4,954
|
|
|
|
269
|
|
|
|
7.26
|
%
|
|
Junior subordinated debt
|
|
|
9,279
|
|
|
|
322
|
|
|
|
4.65
|
%
|
|
|
9,279
|
|
|
|
292
|
|
|
|
4.21
|
%
|
|
Other borrowings
|
|
|
55
|
|
|
|
2
|
|
|
|
6.21
|
%
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
%
|
|
Total interest-bearing liabilities
|
|
$
|
512,877
|
|
|
$
|
3,656
|
|
|
|
0.95
|
%
|
|
$
|
507,301
|
|
|
$
|
2,518
|
|
|
|
0.66
|
%
|
|
Non-interest bearing liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand deposits
|
|
|
184,964
|
|
|
|
|
|
|
|
|
|
|
|
185,330
|
|
|
|
|
|
|
|
|
|
|
Other liabilities
|
|
|
1,788
|
|
|
|
|
|
|
|
|
|
|
|
1,377
|
|
|
|
|
|
|
|
|
|
|
Total liabilities
|
|
$
|
699,629
|
|
|
|
|
|
|
|
|
|
|
$
|
694,008
|
|
|
|
|
|
|
|
|
|
|
Shareholders’ equity
|
|
|
71,148
|
|
|
|
|
|
|
|
|
|
|
|
60,848
|
|
|
|
|
|
|
|
|
|
|
Total liabilities and Shareholders’ equity
|
|
$
|
770,777
|
|
|
|
|
|
|
|
|
|
|
$
|
754,856
|
|
|
|
|
|
|
|
|
|
|
Net interest income
|
|
|
|
|
|
$
|
21,091
|
|
|
|
|
|
|
|
|
|
|
$
|
20,615
|
|
|
|
|
|
|
Interest rate spread
|
|
|
|
|
|
|
|
|
|
|
3.63
|
%
|
|
|
|
|
|
|
|
|
|
|
3.71
|
%
|
|
Cost of funds
|
|
|
|
|
|
|
|
|
|
|
0.70
|
%
|
|
|
|
|
|
|
|
|
|
|
0.49
|
%
|
|
Interest expense as a percent of average earning assets
|
|
|
|
|
|
|
|
|
|
|
0.68
|
%
|
|
|
|
|
|
|
|
|
|
|
0.48
|
%
|
|
Net interest margin
|
|
|
|
|
|
|
|
|
|
|
3.91
|
%
|
|
|
|
|
|
|
|
|
|
|
3.89
|
%
|
|
(1)
|
Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $156 thousand and $154 thousand for the nine months ended September 30, 2019 and 2018, respectively.
|
|
(2)
|
Loans on non-accrual status are reflected in the balances.
|
Provision for Loan Losses
The Bank did not record a provision for loan losses during the third quarter of 2019 or 2018, which resulted in a total allowance for loan losses of $4.9 million, or 0.86% of total loans, at September 30, 2019. This compared to an allowance for loan losses of $4.8 million, or 0.89% of total loans, at September 30, 2018. The allowance for loan losses was $5.0 million, or 0.92% of total loans, at December 31, 2018.
For the quarter ended September 30, 2019, the Bank did not record a provision for loan losses as net charge-offs on loans were offset by decreases in the specific and general reserve components of the allowance for loan losses. Net charge-offs totaled $83 thousand for the third quarter of 2019, compared to $238 thousand of net charge-offs for the same period of 2018. The specific reserve decreased during the third quarter, primarily from principal payments received on impaired loans. The decrease in the general reserve resulted from the impact of a decrease in loan balances during the quarter and improvements in the historical loss rate of the loan portfolio, which were partially offset by changes in qualitative adjustments.
A provision for loan losses was not recorded during the third quarter of 2018 as net charge-offs on loans and an increase in the specific reserve component of the allowance for loan losses were offset by a decrease in the general reserve component. The specific reserve increased during the third quarter of 2018, primarily from the addition of newly identified impaired loans for which specific reserves were calculated. The general reserve decreased primarily from improvements in the historical loss rate of the loan portfolio and from changes in qualitative adjustments.
For the nine months ended September 30, 2019, the Bank recorded a provision for loan losses of $200 thousand as net charge-offs on loans and an increase in the general component of the allowance for loan losses were only partially offset by a decrease in the specific reserve component. Net charge-offs totaled $297 thousand for the first nine months of 2019, compared to $625 thousand of net charge-offs for the same period of 2018. The increase in the general reserve resulted primarily from the impact of loan growth during the first nine months of 2019 and changes in qualitative adjustments. The specific reserve decreased from improvements in collateral positions on impaired loans, principal payments received, and the resolution of certain impaired loans.
The Bank recorded a provision for loan losses of $100 thousand for the nine months ended September 30, 2018 as net charge-offs on loans and an increase in the specific reserve component of the allowance for loan losses were only partially offset by a decrease in the general reserve component. The increased net charge-offs during the first nine months of 2018 was comprised primarily of charge-offs on consumer loans. The specific reserve increased during the period, primarily from the addition of newly identified impaired loans for which specific reserves were calculated. The general reserve decreased primarily from improvements in the historical loss rate of the loan portfolio and from changes in qualitative adjustments.
Noninterest Income
Noninterest income increased $13 thousand, or 1%, to $2.2 million for the three months ended September 30, 2019, compared to the same period in 2018. The increase in noninterest income was primarily attributable to a $46 thousand, or 9%, increase in ATM and check card fees, a $54 thousand, or 13%, increase in wealth management fees, a $34 thousand, or 24%, increase in fees for other customer services, and a $24 thousand, or 22%, increase in income from bank owned life insurance, when comparing the periods. The increase in ATM and check card fees was primarily attributable to an increase in customer check card transactions. The increase in wealth management fees resulted primarily from higher balances of assets under management during the third quarter of 2019 compared to the same period one year ago. Assets under management increased as a result of new business relationships and market growth. The increase in fees for other customer services was primarily attributable to increased fee income for brokered mortgage loans. The increase in income from bank owned life insurance was primarily attributable to the purchase of additional policies in 2019. These increases were partially offset by a $61 thousand, or 7%, decrease in service charges on deposit accounts and a $79 thousand decrease in other operating income. The decrease in service charges on deposit accounts was a result of lower overdraft revenue. The decrease in other operating income was primarily attributable to revenue earned during the prior year from a settlement and release agreement related to brokerage services, which is no longer being earned in the current year.
For the nine months ended September 30, 2019, noninterest income decreased $667 thousand, or 10%, to $6.2 million, compared to $6.9 million for the same period in 2018. The decrease in noninterest income was primarily attributable to a $191 thousand, or 8%, decrease in service charges on deposit accounts, a $410 thousand decrease in income from bank owned life insurance, and a $337 thousand decrease in other operating income. The decrease in service charges on deposit accounts was a result of lower overdraft revenue. The decrease in income from bank owned life insurance resulted primarily from $469 thousand of life insurance benefits recorded during the first quarter of 2018 due to the death of an employee. The decrease in other operating income was primarily attributable to revenue earned during the prior year from a settlement and release agreement related to brokerage services. Other operating income also decreased as a result of the termination of the pension plan and the subsequent distribution of plan assets in the prior year, which resulted in a one-time increase in other operating income of $126 thousand during the first quarter of 2018. These decreases were partially offset by a $62 thousand, or 4%, increase in ATM and check card fees, a $133 thousand, or 11%, increase in wealth management fees, and a $58 thousand, or 13%, increase in fees for other customer services, when comparing the periods. The increase in ATM and check card fees was primarily attributable to an increase in customer check card transactions. The increase in wealth management fees resulted primarily from higher balances of assets under management during the first nine months of 2019 compared to the same period one year ago. Assets under management increased as a result of new business relationships and market growth. The increase in fees for other customer services was primarily attributable to increased fee income from letters of credit.
Noninterest Expense
Noninterest expense increased $236 thousand, or 4%, to $6.2 million for the quarter ended September 30, 2019, compared to $6.0 million for the same period in 2018. The increase in noninterest expense was primarily attributable to a $185 thousand, or 5%, increase in salaries and employee benefits, a $20 thousand, or 16%, increase in marketing expense, an $18 thousand, or 15%, increase in bank franchise tax, and an $86 thousand, or 16%, increase in other operating expense. The increase in salaries and employee benefits resulted primarily from annual increases to employee salaries and expense associated with the supplemental executive retirement plans entered into during 2019. The increases in salaries and employee benefits were partially offset by a decrease in accrued bonuses. Marketing expense increased primarily from advertising expenses related to strategic initiatives. The increase in bank franchise tax was primarily attributable to an increase in the Bank's taxable capital compared to the prior year. The increase in other operating expense was primarily attributable to an increase in fraud losses on ATM and debit card transactions. These increases were partially offset by an $84 thousand decrease in FDIC assessment and a $37 thousand, or 34%, decrease in amortization expense. The decrease in FDIC assessment was primarily attributable to small bank assessment credits received and lower assessment rates. Amortization expense continued to decrease as a result of the accelerated amortization method of core deposit intangibles.
For the nine months ended September 30, 2019, noninterest expense increased $834 thousand, or 5%, to $18.5 million, compared to $17.7 million for the same period in 2018. The increase in noninterest expense was primarily attributable to a $393 thousand, or 4%, increase in salaries and employee benefits, a $130 thousand, or 33%, increase in marketing expense, a $132 thousand, or 21%, increase in legal and professional fees, and a $208 thousand, or 13%, increase in other operating expense. The increase in salaries and employee benefits resulted primarily from annual increases to employee salaries and expense associated with the supplemental executive retirement plans entered into during 2019. The increases in salaries and employee benefits were partially offset by a decrease in accrued bonuses. Marketing expense increased primarily from advertising expenses related to strategic initiatives. The increase in legal and professional fees resulted primarily from legal costs related to certain corporate initiatives, an increase in investment advisory expense of the wealth management department, and consulting expenses for bank compliance testing and the implementation of new accounting standards. The increase in investment advisory expense correlated with the increase in wealth management revenue when comparing the periods. The increase in other operating expense was primarily attributable to an increase in fraud losses on ATM and debit card transactions, additional costs of listing the Company's common stock on the Nasdaq Capital Market stock exchange, and higher education and training expenses. These increases were partially offset by a $128 thousand, or 57%, decrease in FDIC assessment and an $118 thousand, or 33%, decrease in amortization expense. The decrease in FDIC assessment was primarily attributable to small bank assessment credits received and lower assessment rates. Amortization expense continued to decrease as a result of the accelerated amortization method of core deposit intangibles.
Income Taxes
Income tax expense decreased by $52 thousand for the third quarter of 2019 and decreased by $153 thousand for the nine months ended September 30, 2019, compared to the same periods one year ago. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three and nine months ended September 30, 2019 and 2018. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.
Financial Condition
General
Total assets increased by $24.2 million to $777.2 million at September 30, 2019, compared to $753.0 million at December 31, 2018. The increase was primarily attributable to a $28.5 million increase in net loans, which was partially offset by a $10.4 million decrease in securities.
At September 30, 2019, total liabilities increased by $15.6 million to $701.9 million, compared to $686.3 million at December 31, 2018. The increase was primarily attributable to a $15.1 million increase in total deposits. The increase in total deposits resulted primarily from a $7.8 million increase in noninterest-bearing demand deposits and a $6.7 million increase in savings and interest-bearing deposits.
Total shareholders' equity increased by $8.6 million to $75.3 million at September 30, 2019, compared to $66.7 million at December 31, 2018. The Company's capital ratios continue to exceed the minimum capital requirements for regulatory purposes.
Loans
Loans, net of the allowance for loan losses, increased $28.5 million to $566.3 million at September 30, 2019, compared to $537.8 million at December 31, 2018. Commercial real estate loans increased by $13.5 million during the first nine months of 2019, followed by residential real estate loans and commercial and industrial loans that increased by $10.9 million and $6.0 million, respectively. These increases were partially offset by consumer loans and construction loans that decreased by $1.3 million and $674 thousand, respectively.
The Company, through its banking subsidiary, grants mortgage, commercial, and consumer loans to customers. The Bank segments its loan portfolio into real estate loans, commercial and industrial loans, and consumer and other loans. Real estate loans are further divided into the following classes: Construction and Land Development; 1-4 Family Residential; and Other Real Estate Loans. Descriptions of the Company’s loan classes are as follows:
Real Estate Loans – Construction and Land Development: The Company originates construction loans for the acquisition and development of land and construction of commercial buildings, condominiums, townhomes, and one-to-four family residences.
Real Estate Loans – 1-4 Family: This class of loans includes loans secured by one-to-four family homes. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.
Real Estate Loans – Other: This loan class consists primarily of loans secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, industrial and warehouse buildings, hotels, and religious facilities.
Commercial and Industrial Loans: Commercial loans may be unsecured or secured with non-real estate commercial property. The Company's banking subsidiary makes commercial loans to businesses located within its market area and also to businesses outside of its market area through loan participations with other financial institutions.
Consumer and Other Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used automobile loans, unsecured loans, and lines of credit. The Company's banking subsidiary makes consumer loans to individuals located within its market area and also to individuals outside of its market through the purchase of loans from another financial institution.
A substantial portion of the loan portfolio is represented by residential and commercial loans secured by real estate throughout the Bank's market area. The ability of the Bank’s debtors to honor their contracts may be impacted by the real estate and general economic conditions in this area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled $113 thousand at September 30, 2019, compared to $235 thousand at December 31, 2018. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.
All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.
Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.
Impaired Loans
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management generally evaluates substandard and doubtful loans greater than $250 thousand for impairment. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company typically does not separately identify individual consumer, residential, and certain small commercial loans that are less than $250 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below. The recorded investment in impaired loans totaled $1.6 million and $3.4 million at September 30, 2019 and December 31, 2018, respectively.
Troubled Debt Restructurings (TDR)
In situations where, for economic or legal reasons related to a borrower’s financial condition, management grants a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status, and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were $371 thousand and $467 thousand in loans classified as TDRs as of September 30, 2019 and December 31, 2018, respectively.
Asset Quality
Management classifies non-performing assets as non-accrual loans and OREO. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch operations or expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank did not have any assets classified as OREO at September 30, 2019 or December 31, 2018.
Non-performing assets totaled $1.6 million at September 30, 2019 and $3.2 million at December 31, 2018, representing 0.20% and 0.42% of total assets, respectively. Non-performing assets consisted only of non-accrual loans at September 30, 2019 and December 31, 2018.
At September 30, 2019, 44% of non-performing assets were residential real estate loans, 32% were commercial real estate loans, and 24% were construction and land development loans. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $3.8 million and $3.5 million at September 30, 2019 and December 31, 2018, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.
Loans greater than 90 days past due and still accruing totaled $113 thousand at September 30, 2019, which was comprised of one loan expected to pay all principal and interest amounts contractually due to the Bank and seven purchased consumer loans. Consumer loans purchased at origination are charged-off when they are greater than 120 days past due. Loans that were greater than 90 days past due and still accruing totaled $235 thousand at December 31, 2018.
The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s current estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $4.9 million at September 30, 2019 and $5.0 million at December 31, 2018, representing 0.86% and 0.92% of total loans, respectively. For further discussion regarding the allowance for loan losses, see “Provision for Loan Losses” above.
Recoveries of loan losses of $119 thousand and $71 thousand were recorded in the construction and land development and 1-4 family residential loan classes, respectively, during the nine months ended September 30, 2019. The recovery of loan losses in the construction and land development loan class resulted primarily from net recoveries of loans charged off in prior periods and a decrease in the specific reserve. The decrease in the specific reserve for the construction and land development loan class resulted from improvements in collateral positions on impaired loans and principal payments received. The recovery of loan losses in the 1-4 family residential loan class resulted primarily from a decrease in the specific reserve. The decrease in the specific reserve for the 1-4 family residential loan class resulted from principal payments received and the resolution of certain impaired loans. These recoveries were offset by provision for loan losses totaling $390 thousand in the other real estate, commercial and industrial, and consumer and other loan classes. For more detailed information regarding the provision for loan losses, see Note 4 to the Consolidated Financial Statements.
Impaired loans totaled $1.6 million and $3.4 million at September 30, 2019 and December 31, 2018, respectively. The related allowance for loan losses provided for these loans totaled $74 thousand and $243 thousand at September 30, 2019 and December 31, 2018, respectively. The average recorded investment in impaired loans during the nine months ended September 30, 2019 and the year ended December 31, 2018 was $2.1 million and $3.5 million, respectively. Included in the impaired loans total are loans classified as TDRs totaling $371 thousand and $467 thousand at September 30, 2019 and December 31, 2018, respectively. Loans classified as TDRs represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of September 30, 2019, none of these TDRs were performing under the restructured terms and all were considered non-performing assets.
Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports, and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the qualitative factors underlying management’s estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company’s market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see “Critical Accounting Policies” above.
Securities
The securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity and serves as a source of liquidity. The portfolio is used as needed to meet collateral requirements, such as those related to secure public deposits and balances with the Reserve Bank. The investment portfolio consists of held to maturity, available for sale, and restricted securities. Securities are classified as available for sale or held to maturity based on the Company’s investment strategy and management’s assessment of the intent and ability to hold the securities until maturity. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Restricted securities, including Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock, are generally viewed as long-term investments because there is minimal market for the stock and are carried at cost.
Securities at September 30, 2019 totaled $134.6 million, a decrease of $10.4 million, or 7%, from $145.0 million at December 31, 2018. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of September 30, 2019, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $1.6 million and $75 thousand at September 30, 2019 and December 31, 2018, respectively. Gross unrealized losses in the available for sale portfolio totaled $185 thousand and $2.4 million at September 30, 2019 and December 31, 2018, respectively. Gross unrealized gains in the held to maturity portfolio totaled $108 thousand and $29 thousand at September 30, 2019 and December 31, 2018, respectively. Gross unrealized losses in the held to maturity portfolio totaled $71 thousand and $1.0 million at September 30, 2019 and December 31, 2018, respectively. Investments in an unrealized loss position were considered temporarily impaired at September 30, 2019 and December 31, 2018. The change in the unrealized gains and losses of investment securities from December 31, 2018 to September 30, 2019 was related to changes in market interest rates and was not related to credit concerns of the issuers.
Deposits
At September 30, 2019, deposits totaled $685.6 million, an increase of $15.1 million, from $670.6 million at December 31, 2018. There was a slight change in the deposit mix when comparing the periods. At September 30, 2019, noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 28%, 55%, and 17% of total deposits, respectively, compared to 27%, 55%, and 18% at December 31, 2018.
Liquidity
Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities, and loans maturing within one year as liquid assets. As part of the Bank’s liquidity risk management, stress tests and cash flow modeling are performed quarterly.
As a result of the Bank’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs.
At September 30, 2019, cash, interest-bearing and noninterest-bearing deposits with banks, securities, and loans maturing within one year totaled $113.6 million. At September 30, 2019, 14% or $80.8 million of the loan portfolio matures within one year. Non-deposit sources of available funds totaled $212.4 million at September 30, 2019, which included $138.9 million available from Federal Home Loan Bank of Atlanta (FHLB), $61.0 million of unsecured federal funds lines of credit with other correspondent banks, and $12.5 million available through the Federal Reserve Discount Window.
Capital Resources
The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board’s Small Bank Holding Company Policy Statement, and is not obligated to report consolidated regulatory capital.
Effective January 1, 2015, the Bank became subject to new capital rules adopted by federal bank regulators implementing the Basel III regulatory capital reforms adopted by the Basel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act.
The minimum capital level requirements applicable to the Bank under the final rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer was phased-in over four years and, as fully implemented on January 1, 2019, requires a buffer of 2.5% of risk-weighted assets. This results in the following minimum capital ratios beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Management believes, as of September 30, 2019 and December 31, 2018, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.
The following table shows the Bank’s regulatory capital ratios at September 30, 2019:
|
|
|
First Bank
|
|
|
Total capital to risk-weighted assets
|
|
|
14.57
|
%
|
|
Tier 1 capital to risk-weighted assets
|
|
|
13.71
|
%
|
|
Common equity Tier 1 capital to risk-weighted assets
|
|
|
13.71
|
%
|
|
Tier 1 capital to average assets
|
|
|
10.09
|
%
|
|
Capital conservation buffer ratio(1)
|
|
|
6.57
|
%
|
|
(1)
|
Calculated by subtracting the regulatory minimum capital ratio requirements from the Company’s actual ratio for Common equity Tier 1, Tier 1, and Total risk based capital. The lowest of the three measures represents the Bank’s capital conservation buffer ratio.
|
The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The Bank met the requirements to qualify as "well capitalized" as of September 30, 2019 and December 31, 2018.
On September 17, 2019 the Federal Deposit Insurance Corporation finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. 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%, 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 Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital.
The CBLR framework will be available for banks to use in their March 31, 2020, Call Report. The Company is currently evaluating whether to opt into the CBLR framework.
Contractual Obligations
There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.
Off-Balance Sheet Arrangements
The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.
Commitments to extend credit, which amounted to $93.8 million at September 30, 2019, and $91.1 million at December 31, 2018, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.
Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed.
Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At September 30, 2019 and December 31, 2018, the Bank had $10.4 million and $9.9 million in outstanding standby letters of credit, respectively.
At September 30, 2019, the Bank had $9.2 million in locked-rate commitments to originate mortgage loans. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.