ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION AND FORWARD-LOOKING STATEMENTS
Introduction
The following is management’s discussion and analysis of the significant changes in the financial condition, results of operations, comprehensive income, capital resources, and liquidity presented in its accompanying consolidated financial statements for ACNB Corporation (the Corporation or ACNB), a financial holding company. Please read this discussion in conjunction with the consolidated financial statements and disclosures included herein. Current performance does not guarantee, assure or indicate similar performance in the future.
Forward-Looking Statements
In addition to historical information, this Form 10-Q contains forward-looking statements. Examples of forward-looking statements include, but are not limited to, (a) projections or statements regarding future earnings, expenses, net interest income, other income, earnings or loss per share, asset mix and quality, growth prospects, capital structure, and other financial terms, (b) statements of plans and objectives of management or the Board of Directors, and (c) statements of assumptions, such as economic conditions in the Corporation’s market areas. Such forward-looking statements can be identified by the use of forward-looking terminology such as “believes”, “expects”, “may”, “intends”, “will”, “should”, “anticipates”, or the negative of any of the foregoing or other variations thereon or comparable terminology, or by discussion of strategy. Forward-looking statements are subject to certain risks and uncertainties such as local economic conditions, competitive factors, and regulatory limitations. Actual results may differ materially from those projected in the forward-looking statements. Such risks, uncertainties and other factors that could cause actual results and experience to differ from those projected include, but are not limited to, the following: the effects of governmental and fiscal policies, as well as legislative and regulatory changes; the effects of new laws and regulations, specifically the impact of the Tax Cuts and Jobs Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act; impacts of the capital and liquidity requirements of the Basel III standards; the effects of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters; ineffectiveness of the business strategy due to changes in current or future market conditions; future actions or inactions of the United States government, including the effects of short- and long-term federal budget and tax negotiations and a failure to increase the government debt limit or a prolonged shutdown of the federal government; the effects of economic conditions particularly with regard to the negative impact of severe, wide-ranging and continuing disruptions caused by the spread of Coronavirus Disease 2019 (COVID-19) and responses thereto on current customers and the operation of the Corporation, specifically the effect of the economy on loan customers’ ability to repay loans; the effects of competition, and of changes in laws and regulations on competition, including industry consolidation and development of competing financial products and services; the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities, and interest rate protection agreements, as well as interest rate risks; difficulties in acquisitions and integrating and operating acquired business operations, including information technology difficulties; challenges in establishing and maintaining operations in new markets; the effects of technology changes; volatilities in the securities markets; the effect of general economic conditions and more specifically in the Corporation’s market areas; the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities; acts of war or terrorism; disruption of credit and equity markets; the ability to manage current levels of impaired assets; the loss of certain key officers; the ability to maintain the value and image of the Corporation’s brand and protect the Corporation’s intellectual property rights; continued relationships with major customers; and, potential impacts to the Corporation from continually evolving cybersecurity and other technological risks and attacks, including additional costs, reputational damage, regulatory penalties, and financial losses. We caution readers not to place undue reliance on these forward-looking statements. They only reflect management’s analysis as of this date. The Corporation does not revise or update these forward-looking statements to reflect events or changed circumstances. Please carefully review the risk factors described in other documents the Corporation files from time to time with the Securities and Exchange Commission, including the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and any Current Reports on Form 8-K.
CRITICAL ACCOUNTING POLICIES
The accounting policies that the Corporation’s management deems to be most important to the portrayal of its financial condition and results of operations, and that require management’s most difficult, subjective or complex judgment, often result
in the need to make estimates about the effect of such matters which are inherently uncertain. The following policies are deemed to be critical accounting policies by management:
The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio. Management makes numerous assumptions, estimates and adjustments in determining an adequate allowance. The Corporation assesses the level of potential loss associated with its loan portfolio and provides for that exposure through an allowance for loan losses. The allowance is established through a provision for loan losses charged to earnings. The allowance is an estimate of the losses inherent in the loan portfolio as of the end of each reporting period. The Corporation assesses the adequacy of its allowance on a quarterly basis. The specific methodologies applied on a consistent basis are discussed in greater detail under the caption, Allowance for Loan Losses, in a subsequent section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The evaluation of securities for other-than-temporary impairment requires a significant amount of judgment. In estimating other-than-temporary impairment losses, management considers various factors including the length of time the fair value has been below cost, the financial condition of the issuer, and the Corporation’s intent to sell, or requirement to sell, the security before recovery of its value. Declines in fair value that are determined to be other than temporary are charged against earnings.
Accounting Standard Codification (ASC) Topic 350, Intangibles — Goodwill and Other, requires that goodwill is not amortized to expense, but rather that it be assessed or tested for impairment at least annually. Impairment write-downs are charged to results of operations in the period in which the impairment is determined. The Corporation did not identify any impairment on RIG’s outstanding goodwill from its most recent testing, which was performed as of October 1, 2019. A qualitative assessment on the Bank’s outstanding goodwill, resulting from the 2017 New Windsor acquisition, was performed on the anniversary date of the merger which showed no impairment. Subsequent to that evaluation, ACNB concluded that it would be preferable to evaluate goodwill in the fourth quarter at year-end. This date was preferable from the anniversary date measurement as events happening nearer to year-end could be factored in if necessary. The second evaluation again revealed no impairment and it was agreed to continue to evaluate goodwill for the Bank at or near year-end. If certain events occur which might indicate goodwill has been impaired, the goodwill is tested for impairment when such events occur. The Corporation has not identified any such events and, accordingly, has not tested goodwill resulting from the acquisition of New Windsor Bancorp, Inc. (New Windsor) for impairment during the nine months ended September 30, 2020. Other acquired intangible assets that have finite lives, such as core deposit intangibles, customer relationship intangibles and renewal lists, are amortized over their estimated useful lives and subject to periodic impairment testing. Core deposit intangibles are primarily amortized over ten years using accelerated methods. Customer renewal lists are amortized using the straight line method over their estimated useful lives which range from eight to fifteen years.
RESULTS OF OPERATIONS
Quarter ended September 30, 2020, compared to Quarter ended September 30, 2019
Executive Summary
Net income for the three months ended September 30, 2020, was $6,771,000, compared to net income of $6,310,000 for the same quarter in 2019, an increase of $461,000 or 7.3%. Basic earnings per share for the three month period was $0.79 in 2020 and $0.89 in 2019, or a 11.2% decrease. The higher net income for the third quarter of 2020 was primarily a result of higher net interest income. Net interest income for the quarter ended September 30, 2020 increased $3,321,000, or 22.1%, as increases in total interest income were greater than increases in total interest expense. Provision for loan losses was $1,550,000 for the quarter ended September 30, 2020, compared to $150,000 for the same quarter in 2019, based on the adequacy analysis including estimation of COVID-19 losses (that even though not realized are believed to be embedded in the loan portfolio), resulting in an allowance to total loans of 1.13% (1.52% of non-acquired loans) at September 30, 2020. Other income increased $71,000, or 1.4%, due in part to increases in bank fees from selling mortgages into the secondary market. Other expenses increased $1,336,000, or 11.2%, due in part to increased staffing expense in connection with the acquisition of Frederick County Bancorp, Inc. in the Frederick County, Maryland market (FCBI) in January 2020, including increases in customer contact salaries/benefits and other expenses for the larger organization. During the third quarter of 2020 there were $0 in merger/system conversion related expenses for the acquisition of FCBI that was effective on January 11, 2020. Although profitable, ACNB was profoundly impacted by the COVID-19 events, as were all community banks.
Net Interest Income
Net interest income totaled $18,366,000 for the three months ended September 30, 2020, compared to $15,045,000 for the same period in 2019, an increase of $3,321,000, or 22.1%. Net interest income increased due to an increase in interest income to a greater extent than an increase in interest expense. Interest income increased $3,627,000, or 20.5%, due to the acquisition of FCBI increasing average earning assets, in addition to volume from organic growth and increased purchase accounting adjustments net of decreased rates due to market events. The increase in interest expense resulted from deposit rate increases in addition to FCBI related and organic deposit growth. Increased loans outstanding was a result of active participation in the SBA Payroll Protection Program (PPP), the acquisition of FCBI and a concerted effort by management to offset the recent year trend of the market area’s heightened competition and the COVID-19 related declines in the U.S. Treasury yields and other market driver interest rates. The third quarter saw much lower market yields and the difference between longer term rates and shorter term rates was generally modest. These driver rates affect new loan originations and are indexed to a portion of the loan portfolio in that a change in the driver rates changes the yield on new loans and on existing loans at subsequent interest rate reset dates. From these changes, interest income yield was negatively affected as new loans replace paydowns on existing loans and variable rate loans reset to new current rates in these years. Partially offsetting lower yields were FCBI purchase accounting adjustments that increased yield. Interest income increased on investment securities due to new purchases. An amount of earning assets remained in short-term, low-rate money market type accounts during the third quarter of 2020; and there exists ample ability to borrow for liquidity needs. The ability to increase lending is contingent on the effects of COVID-19 on current and potential customers even with intense competition that has reduced new loans and may result in the payoff of existing loans, as economic conditions in the Corporation’s marketplace eventually return to its previous stable state. As to funding costs, interest rates on alternative funding sources, such as the FHLB, and other market driver rates are factors in rates the Corporation and the local market pay for deposits. However, during the recent quarter, rates on transaction, savings and time deposits were sharply cut in order to better match the equally steep decline in earning asset rates. Interest expense increased $306,000, or 11.5%, due to the acquisition of FCBI and higher organic volume net of lower rates on transaction deposits, certificate of deposit rates increases and by less use of higher cost borrowings. The medical need to stop the spread of COVID-19 caused government officials to close or restrict operations of many businesses and their workers. One of the responses was for the Federal Reserve to decrease rates to 0% to 0.25%. The effects of these rate actions and a host of other responses cannot be predicted currently. Over the longer term, the Corporation continues its strategic direction to increase asset yield and interest income by means of loan growth and rebalancing the composition of earning assets to commercial loans.
The net interest spread for the third quarter of 2020 was 2.78% compared to 3.58% during the same period in 2019. Also comparing the third quarter of 2020 to 2019, the yield on interest earning assets decreased by 0.75% and the cost of interest bearing liabilities decreased by 0.05%. The net interest margin was 3.21% for the third quarter of 2020 and 3.80% for the third quarter of 2019. The net interest margin decrease was net of higher purchase accounting adjustments which increased 21 basis points, but was decreased by sharp market rate decreases and less loans as a percentage in the earning asset mix and more lower yielding investments and liquidity assets.
Average earning assets were $2,273,000,000 during the third quarter of 2020, an increase of $702,000,000 from the average for the third quarter of 2019. Average interest bearing liabilities were $1,789,000,000 in the third quarter of 2020, an increase of $603,000,000 from the same period in 2019. Non-interest demand deposits increased $239,000,000 on average. All increases were in large part due to the acquisition of FCBI; deposit increases were also a result of COVID-19 related slow economic activity that tend to concentrate increased liquidity into the banking system, including PPP loan proceeds.
Provision for Loan Losses
The provision for loan losses was $1,550,000 in the third quarter of 2020 and $150,000 in the third quarter of 2019. The determination of the provision was a result of the analysis of the adequacy of the allowance for loan losses calculation. The allowance for loan and lease losses does not include the loans acquired from the FCBI acquisition or the New Windsor Bancorp, Inc. acquisition in 2017 (New Windsor), which were recorded at fair value as the acquisition dates. Total impaired loans at September 30, 2020 were 37.5% higher when compared to December 31, 2019. Nonaccrual loans increased by 75.7%, or $2,966,000, since December 31, 2019; all substandard loans increased by 45.7% in that period. Each quarter, the Corporation assesses risk in the loan portfolio compared with the balance in the allowance for loan losses and the current evaluation factors. The third quarter 2020 provision was calculated to be much higher due to the qualitative factor developed that attempts to measure the impact of the COVID-19 pandemic related closure of and impact of restrictions on many of the Bank’s business customers for an extended and undetermined time period. This customer base includes businesses in the hospitality/tourism industry, restaurants and related businesses and lessors of commercial real estate properties. The estimated increase in this qualitative factor for this event was approximately $900,000 for a total of $1,550,000 in provision expense. The remainder of the provision was due to higher loss history from the 2020 charge-offs, increased economic conditions qualitative factors, and adjustment to the New Windsor acquired portfolio. Otherwise Management concluded that before the COVID-19 pandemic and
the unanticipated deficiencies in the unsecured loans, the loan portfolio exhibited continued general improvement in quantitative and qualitative measurements as shown in the tables and narrative in this Management’s Discussion and Analysis and the Notes to the Consolidated Financial Statements. The effect of the ongoing COVID-19 event cannot be currently estimated other than the calculation that resulted in the above mentioned special qualitative factors. This same analysis concluded that the unallocated allowance should be in the same range in 2020 compared with the previous quarter. For more information, please refer to Allowance for Loan Losses in the following Financial Condition section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. ACNB charges confirmed loan losses to the allowance and credits the allowance for recoveries of previous loan charge-offs. For the third quarter of 2020, the Corporation had net charge-offs of $703,000, as compared to net charge-offs of $283,000 for the third quarter of 2019.
Other Income
Total other income was $5,012,000 for the three months ended September 30, 2020, up $71,000, or 1.4%, from the third quarter of 2019. Fees from deposit accounts decreased by $190,000, or 18.7%, due to COVID-19-related decrease in economic activity that reduced fee generating activity. Fee volume varies with balance levels, account transaction activity, and customer-driven events such as overdrawing account balances. Various specific government regulations effectively limit fee assessments related to deposit accounts, making future revenue levels uncertain. Revenue from ATM and debit card transactions increased by $157,000 or 24.1%, to $809,000 due to FCBI inclusion in volume and mix. The longer term trend had been increases resulting from consumer desire to use more electronic delivery channels (Internet and mobile applications); however, regulations or legal challenges for large financial institutions may impact industry pricing for such transactions and fees in connection therewith in future periods, the effect of which cannot be currently quantified. A more immediate challenge to this revenue source is the general COVID-19 event and related impact caused decrease in retail activity and the retail system-wide security breaches in the merchant base that are negatively affecting consumer confidence in the debit card channel. Income from fiduciary, investment management and brokerage activities, which includes fees from both institutional and personal trust, investment management services, estate settlement and brokerage services, totaled $659,000 for the three months ended September 30, 2020, as compared to $651,000 for the third quarter of 2019, a 1.2% net increase as a net result of higher fee volume from increased assets under management, lower sporadic estate fee income and varying fees on brokerage relationship transactions. Earnings on bank-owned life insurance increased by $69,000, or 23.3%, as a result of more insurance in place and varying crediting rates. At the Corporation’s wholly-owned insurance subsidiary, Russell Insurance Group, Inc. (RIG), revenue was down by $75,000, or 4.3%, to $1,688,000 during the period due to lower insurance carrier contingent commissions and variations in commission volume, net of volume on new books of business purchased in the interim period. A continuing risk to RIG revenue is nonrenewal of large commercial accounts and actions by insurance carriers to reduce commissions paid to agencies such as RIG. Contingent or extra commission payments from insurance carriers are received in the second quarter of each year. Contingent commissions in 2020 were $317,000, or 57% lower than 2019, due to specific claims at RIG and trends in the entire insurance marketplace in general. Heightened pressure on commissions is expected to continue in this business line from insurance company actions. Estimation of upcoming contingent commissions is not practicable at September 30, 2020. There were no gains or losses on sales of securities during the third quarter of 2020 and 2019. A $82,000 net loss was recognized on local bank and CRA-related equity securities during the third quarter of 2020 due to COVID-19 related market value changes in publicly-traded stocks, compared to a $31,000 net gain during the third quarter of 2019. Other income in the three months ended September 30, 2020, was up by $215,000, or 40.5%, to $746,000 due to higher sales of residential mortgages, net of other fee income variances, mostly volume related.
Other Expenses
Other expenses for the quarter ended September 30, 2020 were $13,310,000, an increase of $1,336,000 or 11.2%.
The largest component of other expenses is salaries and employee benefits, which increased by $1,285,000, or 17.5%, when comparing the third quarter of 2020 to the same period a year ago. Overall, the increase in salaries and employee benefits was the result of increases as follows:
•continuing to pay all customer-facing staff despite COVID-19 slow activity due to a competitive labor market;
•the customer-facing staff retained to service the FCBI market;
•increased business and locations at RIG;
•increased staff in support functions and higher skilled mix of employees necessitated by regulations and growth;
•varying performance-based commissions, restricted stock grants and incentives;
•market changes in actively managing employee benefit plan costs, including health insurance;
•varying cost of 401(k) plan and non-qualified retirement plan benefits; and,
•defined benefit pension expense, which was down by $112,000, or 215.4%, when comparing the three months ended September 30, 2020, to the three months ended September 30, 2019, resulting from the change in discount rates which increases or decreases the future pension obligations (creating volatility in the expense), return on assets at the latest annual evaluation date due to market conditions (equity markets were at good at the 2019 year-end valuation date) and changes in actuarial assumptions reflecting increased longevity.
The Corporation’s overall pension plan investment strategy is to achieve a mix of investments to meet the long-term rate of return assumption and near-term pension obligations with a diversification of asset types, fund strategies, and fund managers. The mix of investments is adjusted periodically by retaining an advisory firm to recommend appropriate allocations after reviewing the Corporation’s risk tolerance on contribution levels, funded status, plan expense, as well as any applicable regulatory requirements. However, the determination of future benefit expense is also dependent on the fair value of assets and the discount rate on the year-end measurement date, which in recent years has experienced fair value volatility and low discount rates. The expense could also be higher in future years due to volatility in the discount rates at the latest measurement date, lower plan returns, and change in mortality tables utilized.
Net occupancy expense increased by $118,000, or 16.0% during the period, mostly due to additional offices included in the FCBI acquisition. Equipment expense increased by $119,000, or 10.2%, due to tech equipment expenditures including those for the FCBI market. Equipment expense is subject to ever-increasing technology demands and the need for system upgrades for security and reliability purposes. Technology investments and training allowing staff to work from home proved invaluable.
Professional services expense totaled $265,000 during the third quarter of 2020, as compared to $263,000 for the same period in 2019, an increase of $2,000, or 0.8%. This category includes expenses related to legal corporate governance, risk, compliance management and audit engagements, and legal counsel matters in connection with loans. It varies with specific engagements that are not on a regular recurring basis.
Marketing and corporate relations expenses were $101,000 for the third quarter of 2020, or 23.5% lower, as compared to the same period of 2019. Marketing expense varies with the timing and amount of planned advertising production and media expenditures, typically related to the promotion of certain in-market banking and trust products.
Foreclosed assets held for resale consist of the fair value of real estate acquired through foreclosure on real estate loan collateral or the acceptance of ownership of real estate in lieu of the foreclosure process. Fair values are based on appraisals that consider the sales prices of similar properties in the proximate vicinity less estimated selling costs. Foreclosed real estate (income) expense recovery (from prior year losses) was $(89,000) and $46,000 for the three months ended September 30, 2020 and 2019, respectively. The expense varies based upon the number and mix of commercial and residential real estate properties, unpaid property taxes, and deferred maintenance required upon acquisition. In addition, some properties suffer decreases in value after acquisition, requiring write-downs to fair value during the prolonged marketing cycles for these distressed properties. The higher expense recovery in 2020 was related to expense recoveries through final liquidation. Foreclosed assets held for resale expenses or recoveries will vary in the remainder of 2020 depending on the unknown expenses related to new properties acquired and final disposition. Foreclosure actions could be delayed in the COVID-19 environment.
Other tax expense increased by $52,000, or 19.3%, comparing the three months ended September 30, 2020 and 2019, including higher Pennsylvania Bank Shares Tax. The Pennsylvania Bank Shares Tax is a shareholders’ equity-based tax and is subject to increases based on state government parameters and the level of the stockholders’ equity base that increased with retained earnings equity. Supplies and postage expense decreased by 11.0% due to variation in timing of sporadic refills. FDIC and regulatory expense increased 298.1% due to prior periods use of credits that will not repeat in future periods. Intangible amortization increased 103.2% due to the FCBI acquisition and new RIG books of business purchases. Other operating expenses increased by $143,000, or 12.6%, in the third quarter of 2020, as compared to the third quarter of 2019. Increases included electronic banking, insurance and lending related costs. In addition, other expenses include the expense of reimbursing debit card customers for unauthorized transactions to their accounts and other third-party fraudulent use, added approximately $47,000 to other expenses in the third quarter of 2020 compared to $37,000 in the third quarter of 2019. Third-party breaches also cause additional card inventory and processing costs to the Corporation, none of which is expected to be recovered from the third-party merchants or other parties where the breaches occur. The debit card electronic delivery channel is valued by customers and provides significant revenue to the Corporation. The expense related to reimbursements is unpredictable and varying, but ACNB has policies and procedures to limit exposure.
Provision for Income Taxes
The Corporation recognized income taxes of $1,747,000, or 20.5% of pretax income, during the third quarter of 2020, as compared to $1,552,000, or 19.7% of pretax income, during the same period in 2019. The variances from the federal statutory rate of 21% in the respective periods are generally due to tax-exempt income from investments in and loans to state and local units of government at below-market rates (an indirect form of taxation), investment in bank-owned life insurance, and investments in low-income housing partnerships (which qualify for federal tax credits). In addition, both years include Maryland corporation income taxes. Low-income housing tax credits were $66,000 and $72,000 for the three months ended September 30, 2020 and 2019, respectively.
Nine Months ended September 30, 2020, compared to Nine Months ended September 30, 2019
Executive Summary
Net income for the nine months ended September 30, 2020, was $11,345,000, compared to $18,640,000 for the same nine months in 2019, a decrease of $7,295,000 or 39.1%. Basic earnings per share for the nine month period was $1.32 in 2020 and $2.64 in 2019 or a 50.0% decrease over the prior period. The lower net income for the first three quarters of 2020 was primarily a result of merger related expenses in the first quarter and higher provision expense. Net interest income for the nine months ended September 30, 2020 increased $9,486,000, or 21.2%, as increases in total interest income were greater than increases in total interest expense. Provision for loan losses was $8,100,000 for the nine months ended September 30, 2020, compared to $425,000 for the same nine months in 2019, based on the adequacy analysis including estimation of COVID-19 related losses (that even though not realized are believed could be embedded in the loan portfolio), resulting in an allowance to total loans of 1.13% (1.52% of non-acquired loans) at September 30, 2020. Other income increased $370,000, or 2.7%, due to increased sale of residential mortgages into the secondary market. Other expenses increased $11,302,000, or 32.4%, due in large part to merger and conversion expenses for the acquisition of FCBI, increases in salaries and benefits and other expenses for a larger organization. During the nine months ended September 30, 2020, there were $5,965,000 in first quarter merger/system conversion related expenses for the acquisition of FCBI that was effective on January 11, 2020.
Net Interest Income
Net interest income totaled $54,166,000 for the nine months ended September 30, 2020, compared to $44,680,000 for the same period in 2019, an increase of $9,486,000, or 21.2%. Net interest income increased due to an increase in interest income to a greater extent than an increase in interest expense. Interest income increased $11,781,000, or 22.6%, due to the acquisition of FCBI increasing average earning assets, in addition to volume from organic growth (including the SBA Paycheck Protection Program (PPP)) and increased purchase accounting adjustments net of decreased rates due to market events. The increase in interest expense resulted from FCBI related addition and organic deposit growth net of deposit rate decreases. Increased loans outstanding was a result of the active participation in the PPP enacted in response to the COVID-19 crisis, to the acquisition of FCBI and to concerted effort by management to offset the recent year trend of the market area’s heightened competition and declines in the U.S. Treasury yields and other market driver interest rates. The first three quarters of 2020 saw much lower market yields and the difference between longer term rates and shorter term rates was modest. These driver rates affect new loan originations and are indexed to a portion of the loan portfolio in that a change in the driver rates changes the yield on new loans and on existing loans at subsequent interest rate reset dates. From these changes, interest income yield was negatively affected as new loans replace paydowns on existing loans and variable rate loans reset to new current rates in these years. Partially offsetting lower yields were FCBI purchase accounting adjustments that increased yield. Interest income increased on investment securities due to new purchases. An elevated amount of earning assets remained in short-term, low-rate money market type accounts during the first nine months of 2020; and there exists ample ability to borrow for liquidity needs. The ability to increase lending is contingent on the effects of intense competition that has reduced new loans and may result in the payoff of existing loans, as well as economic conditions in the Corporation’s marketplace. As to funding costs, interest rates on alternative funding sources, such as the FHLB, and other market driver rates are factors in rates the Corporation and the local market pay for deposits. However, during the recent quarter, rates on transaction, savings and time deposits were sharply reduced in order to match sharply reduced market earning asset yields. Interest expense increased $2,295,000, or 31.2%, due to the FCBI acquisition and large organic volume and year over year rates variances, partially offset by less use of higher cost borrowings. The medical need to stop the spread of COVID-19 caused government officials to close or restrict the operations of many businesses and their workers. One of the responses was for the Federal Reserve to decrease rates to 0% to 0.25%. The effects of these rate actions and a host of other responses cannot be predicted currently. Over the longer term, the Corporation continues its strategic direction to increase asset yield and interest income by means of loan growth and rebalancing the composition of earning assets to commercial loans.
The net interest spread for the first nine months of 2020 was 3.18% compared to 3.66% during the same period in 2019. Also comparing the first nine months of 2020 to 2019, the yield on interest earning assets decreased by 0.48% and the cost of interest bearing liabilities decreased by 0.00%. The net interest margin was 3.42% for the first nine months of 2020 and 3.87% for the first nine months of 2019. The net interest margin decrease was net of higher purchase accounting adjustments which increased 23 basis points, but was decreased by less loans as a percentage in the earning asset mix and more lower yielding PPP loans, investments and liquidity assets.
Average earning assets were $2,117,000,000 during the first nine months of 2020, an increase of $574,000,000 from the average for the first nine months of 2019. Average interest bearing liabilities were $1,531,000,000 in the first nine months of 2020, an increase of $361,000,000 from the same period in 2019. Non-interest demand deposits increased $168,000,000 on average. All increases were in large part due to the acquisition of FCBI and to the COVID-19 related effect of money parked in the banking system during government-mandated shutdowns.
Provision for Loan Losses
The provision for loan losses was $8,100,000 in the first nine months of 2020 and $425,000 in the first nine months of 2019. The determination of a need for a provision was a result of the analysis of the adequacy of the allowance for loan losses calculation. The allowance for loan and lease losses does not include the loans acquired from the FCBI acquisition or the New Windsor Bancorp Inc. acquisition in 2017 (New Windsor), which were recorded at fair value as of the acquisition dates. Total impaired loans at September 30, 2020 were 37.5% higher compared to December 31, 2019. Nonaccrual loans increased by 75.7%, or $2,966,000, since December 31, 2019; all substandard loans increased by 45.7% in that period. Each quarter, the Corporation assesses risk in the loan portfolio compared with the balance in the allowance for loan losses and the current evaluation factors. The first nine months of 2020 provision was calculated to be much higher due to higher charge-offs including a first quarter charge-off of a $2,000,000 loan after the death of the borrower and a third quarter COVID-19 related $675,000 charge-off based on principal forgiveness to achieve a projected fourth quarter loan payoff. The second cause for the large increase was a qualitative factor developed that attempts to measure the impact of the COVID-19 pandemic related closure of and impact of restrictions on many of the Bank’s business customers for an undetermined time period. This customer base includes businesses in the hospitality/tourism industry, restaurants and related businesses and lessors of commercial real estate properties. The estimation of the qualitative factor for this event was approximately $3,100,000, for a total of $8,100,000 in provision expense. The remainder was due to the above-mentioned charge-offs, increase in economic qualitative factors, and adjustment to the New Windsor acquired portfolio. Otherwise, Management concluded that before the COVID-19 pandemic and the unanticipated deficiencies in the unsecured loans, the loan portfolio exhibited continued general improvement in quantitative and qualitative measurements as shown in the tables and narrative in this Management’s Discussion and Analysis and the Notes to the Consolidated Financial Statements. The effect of the ongoing COVID-19 event cannot be currently estimated other than the calculation that resulted in the above mentioned special qualitative factor. This same analysis concluded that the unallocated allowance should be in the same range in 2020 compared with the previous quarter. For more information, please refer to Allowance for Loan Losses in the following Financial Condition section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. ACNB charges confirmed loan losses to the allowance and credits the allowance for recoveries of previous loan charge-offs. For the first nine months of 2020, the Corporation had net charge-offs of $2,735,000, as compared to net charge-offs of $465,000 for the first nine months of 2019.
Other Income
Total other income was $14,071,000 for the nine months ended September 30, 2020, up $370,000, or 2.7%, from the first nine months of 2019. Fees from deposit accounts decreased by $441,000, or 15.2%, due to COVID-19 related slow economic conditions that reduced fee generating activity. Fee volume varies with balance levels, account transaction activity, and customer-driven events such as overdrawing account balances. Various specific government regulations effectively limit fee assessments related to deposit accounts, making future revenue levels uncertain. Revenue from ATM and debit card transactions increased by $336,000 or 18.4%, to $2,161,000 due to variations in volume and mix, including the new FCBI market. The longer term trend had been increases resulting from consumer desire to use more electronic delivery channels (Internet and mobile applications); however, regulations or legal challenges for large financial institutions may impact industry pricing for such transactions and fees in connection therewith in future periods, the effect of which cannot be currently quantified. A more immediate challenge to this revenue source is the general COVID-19 event and related impact caused decrease in retail activity and the retail system-wide security breaches in the merchant base that are negatively affecting consumer confidence in the debit card channel. Income from fiduciary, investment management and brokerage activities, which includes fees from both institutional and personal trust, investment management services, estate settlement and brokerage services, totaled $1,982,000 for the nine months ended September 30, 2020, as compared to $1,841,000 for the first nine months of 2019, a 7.7% net increase as a net result of higher fee volume from increased assets under management, lower sporadic estate fee income and varying fees on brokerage relationship transactions. Earnings on bank-owned life insurance
increased by $221,000, or 25.4%, as a result of more insurance in place and varying crediting rates. At the Corporation’s wholly-owned insurance subsidiary, Russell Insurance Group, Inc. (RIG), revenue was down by $252,000 from lower contingent commissions, or 5.0%, to $4,745,000 during the period that experienced increased commission volume on new books of business purchased in the interim period. A continuing risk to RIG revenue is nonrenewal of large commercial accounts and actions by insurance carriers to reduce commissions paid to agencies such as RIG. Contingent or extra commission payments from insurance carriers are received in the second quarter of each year. Contingent commissions in 2020 were lower than 2019 due to specific sporadic loss events at RIG and the higher losses in the entire insurance marketplace in general. Heightened pressure on commissions is expected to continue in this business line from insurance company actions. There were no gains or losses on sales of securities during the first nine months of 2020 and 2019. A $483,000 net loss was recognized on local bank and CRA-related equity securities during the first nine months of 2020 due to the COVID-19 related market value changes in publicly-traded stocks, compared to a $193,000 net gain during the first nine months of 2019. Other income in the nine months ended September 30, 2020, was up by $1,041,000, or 96.8%, to $2,116,000 due to higher sales of residential mortgages and net other fee income increases, mostly volume related.
Other Expenses
Other expenses for the nine months ended September 30, 2020 were $46,222,000, an increase of $11,302,000 or 32.4%. Acquisition and integration costs related to the FCBI acquisition totaled $5,965,000 for the first nine months of 2020 compared to $516,000 for the first nine months of 2019. Merger expenses included legal and consulting expenses to effect the legal merger, investment banking and preparing purchase accounting adjustments. Integration expenses included severance payments to FCBI staff separated by the merger, consultant costs to integrate FCBI systems into ACNB’s and the cost to terminate all FCBI core banking and electronic technology systems contracts. These costs were all necessary to provide requisite internal controls and cost effective core banking technology systems going forward. The costs of integrating all systems into one system was important to the merger viability and ongoing system integrity and quality.
Other than acquisition and integration costs, the largest component of other expenses is salaries and employee benefits, which increased by $4,237,000, or 19.7%, when comparing the first nine months of 2020 to the same period a year ago. Overall, the increase in salaries and employee benefits was the result of increases as follows:
•replacing and maintaining customer-facing staff through the COVID-19 event due to a competitive labor market;
•the customer-facing staff retained to service the FCBI market;
•increased business and locations at RIG;
•increased staff in support functions and higher skilled mix of employees necessitated by regulations and growth;
•normal merit increases to employees and associated payroll taxes;
•varying performance-based commissions, restricted stock grants and incentives;
•market changes in actively managing employee benefit plan costs, including health insurance;
•varying cost of 401(k) plan and non-qualified retirement plan benefits; and,
•defined benefit pension expense, which was down by $337,000, or 214.6%, when comparing the nine months ended September 30, 2020, to the nine months ended September 30, 2019, resulting from the change in discount rates which increases or decreases the future pension obligations (creating volatility in the expense), return on assets at the latest annual evaluation date due to market conditions (equity markets were at good at the 2019 year-end valuation date) and changes in actuarial assumptions reflecting increased longevity.
The Corporation’s overall pension plan investment strategy is to achieve a mix of investments to meet the long-term rate of return assumption and near-term pension obligations with a diversification of asset types, fund strategies, and fund managers. The mix of investments is adjusted periodically by retaining an advisory firm to recommend appropriate allocations after reviewing the Corporation’s risk tolerance on contribution levels, funded status, plan expense, as well as any applicable regulatory requirements. However, the determination of future benefit expense is also dependent on the fair value of assets and the discount rate on the year-end measurement date, which in recent years has experienced fair value volatility and low discount rates. The expense could also be higher in future years due to volatility in the discount rates at the latest measurement date, lower plan returns, and change in mortality tables utilized.
Net occupancy expense increased by $373,000, or 16.0%, mostly due to additional offices as part of the FCBI acquisition. Equipment expense increased by $552,000, or 15.8%, due to tech equipment expenditures including those for the FCBI market. Equipment expense is subject to ever-increasing technology demands and the need for system upgrades for security and reliability purposes. Technology investments and training allowing staff to work from home is currently proving invaluable.
Professional services expense totaled $921,000 during the first nine months of 2020, as compared to $746,000 for the same period in 2019, an increase of $175,000, or 23.5%. This category includes expenses related to legal corporate governance, risk, compliance management and audit engagements, and legal counsel matters in connection with loans. It varies with specific engagements that are not on a regular recurring basis.
Marketing and corporate relations expenses were $442,000 for the first nine months of 2020 and 2019. Marketing expense varies with the timing and amount of planned advertising production and media expenditures, typically related to the promotion of certain in-market banking and trust products; and to promote and inform the FCBI marketplace of the ACNB acquisition, and ACNB’s products and systems.
Foreclosed assets held for resale consist of the fair value of real estate acquired through foreclosure on real estate loan collateral or the acceptance of ownership of real estate in lieu of the foreclosure process. Fair values are based on appraisals that consider the sales prices of similar properties in the proximate vicinity less estimated selling costs. Foreclosed real estate expense recovery was $182,000 and $10,000 for the nine months ended September 30, 2020 and 2019, respectively. The expense varies based upon the number and mix of commercial and residential real estate properties, unpaid property taxes, and deferred maintenance required upon acquisition. In addition, some properties suffer decreases in value after acquisition, requiring write-downs to fair value during the prolonged marketing cycles for these distressed properties. The higher net expense recovery in 2020 was related to varying expenses on unrelated properties and varying expense recoveries (some expenses were incurred in prior years) through liquidation. Foreclosed assets held for resale expenses or recoveries will vary in the remainder of 2020 depending on the unknown expenses related to new properties acquired and final disposition. Foreclosure actions could be delayed in the COVID-19 related environment.
Other tax expense increased by $162,000, or 20.1%, comparing the nine months ended September 30, 2020 and 2019, in part due to higher Pennsylvania Bank Shares Tax. The Pennsylvania Bank Shares Tax is a shareholders’ equity-based tax and is subject to increases based on state government parameters and the level of the stockholders’ equity base that increased with retained earnings equity. Supplies and postage expense increased by 1.3% due to variation in timing of sporadic refills. FDIC and regulatory expense increased 3.9% caused by FDIC credits received in past periods based on the FDIC fund reaching a particular funding ratio; this credit will not likely repeat in future periods depending on the change in the funding ratio. Intangible amortization increased 103.6% due to the FCBI acquisition and new RIG books of business purchases. Other operating expenses increased by $20,000, or 0.5%, in the first nine months of 2020, as compared to the first nine months of 2019. Decreases included travel and training categories in which expense was limited by travel and congregation restrictions. Other expenses including the expense of reimbursing debit card customers for unauthorized transactions to their accounts and other third-party fraudulent use, added approximately $91,000 to other expenses in the first nine months of 2020 compared to $83,000 in the first nine months of 2019. Third-party breaches also cause additional card inventory and processing costs to the Corporation, none of which is expected to be recovered from the third-party merchants or other parties where the breaches occur. The debit card electronic delivery channel is valued by customers and provides significant revenue to the Corporation. The expense related to reimbursements is unpredictable and varying, but ACNB has policies and procedures in place to limit exposure.
Provision for Income Taxes
The Corporation recognized income taxes of $2,570,000, or 18.5% of pretax income, during the first nine months of 2020, as compared to $4,396,000, or 19.1% of pretax income, during the same period in 2019. The variances from the federal statutory rate of 21% in the respective periods are generally due to tax-exempt income from investments in and loans to state and local units of government at below-market rates (an indirect form of taxation), investment in bank-owned life insurance, and investments in low-income housing partnerships (which qualify for federal tax credits). In addition, both years includes Maryland corporation income taxes. Low-income housing tax credits were $193,000 and $215,000 for the nine months ended September 30, 2020 and 2019, respectively.
FINANCIAL CONDITION
Assets totaled $2,503,049,000 at September 30, 2020, compared to $1,720,253,000 at December 31, 2019, and $1,735,849,000 at September 30, 2019. Average earning assets during the nine months ended September 30, 2020, increased to $2,117,000,000 from $1,543,050,000 during the same period in 2019. Average interest bearing liabilities increased in 2020 to $1,531,000,000 from $1,170,000,000 in 2019.
Investment Securities
ACNB uses investment securities to generate interest and dividend income, manage interest rate risk, provide collateral for certain funding products, and provide liquidity. The changes in the securities portfolio were the net result of purchases and matured securities to provide proper collateral for public deposits. Investing into investment security portfolio assets over the past several years was made more challenging due to the Federal Reserve Bank’s program commonly called Quantitative Easing in which, by the Federal Reserve’s open market purchases, the yields were maintained at a lower level than would otherwise be the case. The investment portfolio is comprised of U.S. Government agency, municipal, and corporate securities. These securities provide the appropriate characteristics with respect to credit quality, yield and maturity relative to the management of the overall balance sheet.
At September 30, 2020, the securities balance included a net unrealized gain on available for sale securities of $4,874,000, net of taxes, on amortized cost of $307,404,000 versus a net unrealized gain of $1,261,000, net of taxes, on amortized cost of $189,208,000 at December 31, 2019, and a net unrealized gain of $1,263,000, net of taxes, on amortized cost of $183,046,000 at September 30, 2019. The change in fair value of available for sale securities during 2020 was a result of the higher amount of investments in the available for sale portfolio and by an increase in fair value from a decrease in the U.S. Treasury yield curve rates and the spread from this yield curve required by investors on the types of investment securities that ACNB owns. The Federal Reserve reinstituted their Quantitative Easing program in the current COVID-19 crisis; and after increasing the fed funds rate in mid-December 2015 through December 2018 the Federal Reserve decreased the target rate to 0% to 0.25% in the ongoing COVID-19 crisis; both action causing the U.S. Treasury yield curve to decrease in the time relevant to the investment securities in the Corporation’s portfolio as of September 30, 2020. However, fair values were volatile on any given day in all periods presented and such volatility will continue. The changes in value are deemed to be related solely to changes in interest rates as the credit quality of the portfolio is high.
At September 30, 2020, the securities balance included held to maturity securities with an amortized cost of $13,606,000 and a fair value of $14,110,000, as compared to an amortized cost of $19,234,000 and a fair value of $19,281,000 at December 31, 2019, and an amortized cost of $22,443,000 and a fair value of $22,518,000 at September 30, 2019. The held to maturity securities are U.S. government agency debentures and pass-through mortgage-backed securities in which the full payment of principal and interest is guaranteed; however, they were not classified as available for sale because these securities are generally used as required collateral for certain eligible government accounts or repurchase agreements. They are also held for possible pledging to access additional liquidity for banking subsidiary needs in the form of FHLB borrowings. Due to changes in accounting rules, no held to maturity securities were added in the past several years. No held to maturity securities were acquired from FCBI.
The Corporation does not own investments consisting of pools of Alt-A or subprime mortgages, private label mortgage-backed securities, or trust preferred investments.
The fair values of securities available for sale (carried at fair value) are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1) or by matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific security but rather by relying on the security’s relationship to other benchmark quoted prices. The Corporation uses independent service providers to provide matrix pricing. Please refer to Note 8 — “Securities” in the Notes to Consolidated Financial Statements for more information on the security portfolio and Note 10 — “Fair Value Measurements” in the Notes to Consolidated Financial Statements for more information about fair value.
Loans
Loans outstanding increased by $412,598,000, or 32.0%, from September 30, 2019, to September 30, 2020, and increased by $428,282,000, or 33.7%, from December 31, 2019, to September 30, 2020. The increase year to date is primarily attributable to the FCBI acquisition and active participation in the Paycheck Protection Program (PPP), net of selling most new residential mortgages and early payoffs of other loans. The year over year increase in loan volume was a result of active participation in the PPP and the FCBI new loans, net of payoff and paydowns. These results came from the focused efforts by management to
lend to creditworthy borrowers subject to the Corporation’s disciplined underwriting standards, despite intense competition. In all periods, residential real estate lending and refinance activity was sold to the secondary market and commercial loans were subject to refinancing to competition for different rates or terms. In the normal course of business, more payoffs were anticipated in the remainder of 2020 from either customers’ cash reserves or refinancing at competing banks and markets, and currently lending actions are continuing while dealing with modifications and the ongoing work involved with the PPP Small Business Administration (SBA) guaranteed loans. During the first nine months of 2020, total commercial purpose loans increased and local market portfolio residential mortgages increased, largely from the acquisition of FCBI and active participation in the PPP program. Total commercial purpose segments increased $406,673,000, or 54.8%, as compared to December 31, 2019. $160,037,000 of this increase was PPP loans written in 2020 to existing ACNB commercial customer base. Otherwise these loans are spread among diverse categories that include municipal governments/school districts, commercial real estate, commercial real estate construction, and commercial and industrial. Included in the commercial, financial and agricultural category are loans to Pennsylvania school districts, municipalities (including townships) and essential purpose authorities. In most cases, these loans are backed by the general obligation of the local government body. In many cases, these loans are obtained through a bid process with other local and regional banks. The loans are bank qualified for mostly tax free interest income treatment for federal income taxes. These loans totaled $73,839,000 at September 30, 2020, an increase of 15.1% from $64,137,000 held at the end of 2019; these loans are especially subject to refinancing in a declining rate environment. Residential real estate mortgage lending, which includes smaller commercial purpose loans secured by the owner’s home, increased by $21,389,000, or 4.1%, as compared to December 31, 2019. These loans are to local borrowers who preferred loan types that would not be sold into the secondary mortgage market. Of the $537,773,000 total in residential mortgage loans at September 30, 2020, $41,483,000 were secured by junior liens or home equity loans, which are also in many cases junior liens. Junior liens inherently have more credit risk by virtue of the fact that another financial institution may have a senior security position in the case of foreclosure liquidation of collateral to extinguish the debt. Generally, foreclosure actions could become more prevalent if the real estate market weakens, property values deteriorate, or rates increase sharply. Non-real estate secured consumer loans comprise 0.8% of the portfolio, with automobile-secured loans representing less than 0.1% of the portfolio.
The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, was signed into law on March 27, 2020, and provided over $2.0 trillion in emergency economic relief to individuals and businesses impacted by the COVID-19 pandemic. The CARES Act authorized the SBA to temporarily guarantee loans under a new 7(a) loan program called the PPP. As a qualified SBA lender, the Corporation was automatically authorized to originate PPP loans. As of September 30, 2020, the Corporation had originated approximately 1,440 loans in the amount of $160,857,603 under the PPP. Fee income was received for $6,100,000, before costs, $1,417,000 was recognized as adjustment to interest income yield through the third quarter of 2020 and the balance will be recognized in future quarters as an adjustment of interest income yield.
Most of the Corporation’s lending activities are with customers located within southcentral Pennsylvania and in the northern Maryland area. This region currently and historically has lower unemployment rates than the U.S. as a whole. Included in commercial real estate loans are loans made to lessors of non-residential properties that total $364,944,000, or 21.5% of total loans, at September 30, 2020. These borrowers are geographically dispersed throughout ACNB’s marketplace and are leasing commercial properties to a varied group of tenants including medical offices, retail space, and other commercial purpose facilities. Because of the varied nature of the tenants, in aggregate, management believes that these loans present an acceptable risk when compared to commercial loans in general. ACNB does not originate or hold Alt-A or subprime mortgages in its loan portfolio.
Allowance for Loan Losses
ACNB maintains the allowance for loan losses at a level believed to be adequate by management to absorb probable losses in the loan portfolio, and it is funded through a provision for loan losses charged to earnings. On a quarterly basis, ACNB utilizes a defined methodology in determining the adequacy of the allowance for loan losses, which considers specific credit reviews, past loan losses, historical experience, and qualitative factors. This methodology results in an allowance that is considered appropriate in light of the high degree of judgment required and that is prudent and conservative, but not excessive.
Management assigns internal risk ratings for each commercial lending relationship. Utilizing historical loss experience, adjusted for changes in trends, conditions, and other relevant factors, management derives estimated losses for non-rated and non-classified loans. When management identifies impaired loans with uncertain collectibility of principal and interest, it evaluates a specific reserve on a quarterly basis in order to estimate potential losses. Management’s analysis considers:
•adverse situations that may affect the borrower’s ability to repay;
•the current estimated fair value of underlying collateral; and,
•prevailing market conditions.
If management determines a loan is not impaired, a specific reserve allocation is not required. Management then places the loan in a pool of loans with similar risk factors and assigns the general loss factor to determine the reserve. For homogeneous loan types, such as consumer and residential mortgage loans, management bases specific allocations on the average loss ratio for the previous twelve quarters for each specific loan pool. Additionally, management adjusts projected loss ratios for other factors, including the following:
•lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices;
•national, regional and local economic and business conditions, as well as the condition of various market segments, including the impact on the value of underlying collateral for collateral dependent loans;
•nature and volume of the portfolio and terms of loans;
•experience, ability and depth of lending management and staff;
•volume and severity of past due, classified and nonaccrual loans, as well as other loan modifications; and,
•existence and effect of any concentrations of credit and changes in the level of such concentrations.
•For 2020 a special unallocated allowance was developed to quantify a current expected incurred loss as a result of the COVID-19 crisis. The factor considered the loan mix effects of businesses likely to be harder hit by quarantine closure orders, the relative amount of COVID-19 related modifications requested to date, the estimated regional infection stage and geopolitical factors. A large unknown in this factor is the expected duration of the quarantine period.
Management determines the unallocated portion of the allowance for loan losses, which represents the difference between the reported allowance for loan losses and the calculated allowance for loan losses, based on the following criteria:
•the risk of imprecision in the specific and general reserve allocations;
•the perceived level of consumer and small business loans with demonstrated weaknesses for which it is not practicable to develop specific allocations;
•other potential exposure in the loan portfolio;
•variances in management’s assessment of national, regional and local economic conditions; and,
•other internal or external factors that management believes appropriate at that time, such as COVID-19.
The unallocated portion of the allowance is deemed to be appropriate as it reflects an uncertainty that remains in the loan portfolio; specifically reserves where the Corporation believes that tertiary losses are probable above the loss amount derived using appraisal-based loss estimation, where such additional loss estimates are in accordance with regulatory and GAAP guidance. Appraisal-based loss derivation does not fully develop the loss present in certain unique, ultimately bank-owned collateral. The Corporation has determined that the amount of provision in 2020 and the resulting allowance at September 30, 2020, are appropriate given the continuing level of risk in the loan portfolio. Further, management believes the unallocated allowance is appropriate, because even though the impaired loans added since 2019 demonstrate generally low risk due to adequate real estate collateral, the value of such collateral can decrease; plus, the growth in the loan portfolio is centered around commercial real estate which continues to have little increase in value and low liquidity. In addition, there are certain loans that, although they did not meet the criteria for impairment, management believes there was a strong possibility that these loans represented potential losses at September 30, 2020. The amount of the unallocated portion of the allowance was $845,000 at September 30, 2020. Before the COVID-19 event, management concluded that the loan portfolio exhibited continued general improvement in quantitative and qualitative measurements.
Management believes the above methodology materially reflects losses inherent in the portfolio. Management charges actual loan losses to the allowance for loan losses. Management periodically updates the methodology and the assumptions discussed above.
Management bases the provision for loan losses, or lack of provision, on the overall analysis taking into account the methodology discussed above, which is consistent with recent quarters’ improvement in the credit quality in the loan portfolio, but the large unanticipated charge-offs ($2,665,000) with increased risk from the impact of the COVID-19 crisis (an additional $3,100,000). The provision for year-to-date September 30, 2020 and 2019, was $8,100,000 and $425,000, respectively. More specifically, as total loans increased from year-end 2019 and the provision expense increased year over year, the allowance for loan losses was derived with data that most existing impaired credits were, in the opinion of management, adequately collateralized.
Federal and state regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses and may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management. Based on management’s comprehensive analysis of the loan portfolio and economic conditions, management believes the current level of the allowance for loan losses is adequate.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 requires credit losses on most financial assets measured at amortized cost and certain other instruments to be measured using an expected credit loss model (referred to as the current expected credit loss (CECL) model). Under this model, entities will estimate credit losses over the entire contractual term of the instrument (considering estimated prepayments, but not expected extensions or modifications unless reasonable expectation of a troubled debt restructuring exists) from the date of initial recognition of that instrument. Upon adoption, the change in this accounting guidance could result in an increase in the Corporation’s allowance for loan losses and require the Corporation to record loan losses more rapidly. In October 2019, FASB voted to delay implementation of the CECL standard for certain companies, including those companies that qualify as a smaller reporting company under SEC rules until January 1, 2023. As a result ACNB will likely be able to defer implementation of the CECL standard for a period of time.
The allowance for loan losses at September 30, 2020, was $19,200,000, or 1.13% of total loans (1.52% of non-acquired loans), as compared to $13,924,000, or 1.08% of loans, at September 30, 2019, and $13,835,000, or 1.09% of loans, at December 31, 2019. The increase from year-end resulted from charge-offs of $2,735,000 net of recoveries and $8,100,000 in provisions, as shown in the table below. In the following discussion, acquired loans from FCBI and New Windsor were recorded at fair value at the acquisition date and are not included in the tables and information below, see more information in Note 9 — “Loans” in the Notes to Consolidated Financial Statements.
Changes in the allowance for loan losses were as follows:
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In thousands
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|
Nine Months Ended September 30, 2020
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|
Year Ended
December 31, 2019
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Nine Months Ended September 30, 2019
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Beginning balance – January 1
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$
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13,835
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$
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13,964
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$
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13,964
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Provisions charged to operations
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8,100
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|
|
600
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|
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425
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Recoveries on charged-off loans
|
|
141
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|
|
188
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|
|
100
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|
Loans charged-off
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|
(2,876)
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|
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(917)
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(565)
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Ending balance
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$
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19,200
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$
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13,835
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$
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13,924
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Loans past due 90 days and still accruing were $1,743,000 and nonaccrual loans were $6,885,000 as of September 30, 2020. $143,000 of the nonaccrual balance at September 30, 2020, were in troubled debt restructured loans. $3,707,000 of the impaired loans were accruing troubled debt restructured loans. Loans past due 90 days and still accruing were $1,731,000 at September 30, 2019, while nonaccruals were $3,146,000. $207,000 of the nonaccrual balance at September 30, 2019, was in troubled debt restructured loans. $3,809,000 of the impaired loans were accruing troubled debt restructured loans. Loans past due 90 days and still accruing were $1,219,000 at December 31, 2019, while nonaccruals were $3,919,000. $191,000 of the nonaccrual balance at December 31, 2019, were in troubled debt restructured loans. $3,783,000 of the impaired loans were accruing troubled debt restructured loans. Total additional loans classified as substandard (potential problem loans) at September 30, 2020, September 30, 2019, and December 31, 2019, were approximately $5,181,000, $2,754,000 and $2,943,000, respectively.
The acquisition of FCBI and New Windsor loans at fair value did not require a provision expense. More specifically, even with the manageable level of nonaccrual loans and with substandard loans in the third quarter of 2020, a $8,100,000 provision
addition to the allowance was necessary due to unanticipated charge-offs of $2,665,000 and a special allowance for COVID-19 of $3,126,000.
The Corporation has received significant numbers of requests to modify loan terms and/or defer principal and/or interest payments, and has agreed to appropriate deferrals or are in the process of doing so. Under Section 4013 of the CARES Act, loans less than 30 days past due as of December 31, 2019, will be considered current for COVID-19 related modifications. A financial institution can then use FASB agreed upon temporary changes to GAAP for loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring (TDR), and suspend any determination of a loan modified as a result of COVID-19 being a TDR, including the requirement to determine impairment for accounting purposes. Similarly, FASB has confirmed that short-term modifications made on a good-faith basis in response to COVID-19 to loan customers who were current prior to any relief are not TDRs.
Beginning the week of March 16, 2020, the Corporation began receiving requests for temporary modifications to the repayment structure for borrower loans. The modifications are grouped into deferred payments of no more than six months, interest only, lines of credit only and other. As of September 30, 2020, the Corporation had 65 temporary modifications with principal balances totaling $64,845,189.
Details with respect to actual loan modifications are as follows:
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Type of Loans
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Number of Loans
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Deferral Period
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Balance
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Percentage of Tier 1 Capital
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Commercial Purpose
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46
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Up to 6 months
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$
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63,048,586
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24.56
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%
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Consumer Purpose
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19
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Up to 6 months
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1,796,603
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0.70
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65
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$
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64,845,189
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As to nonaccrual and substandard loans, management believes that adequate collateralization generally exists for these loans in accordance with GAAP. Each quarter, the Corporation assesses risk in the loan portfolio compared with the balance in the allowance for loan losses and the current evaluation factors.
Information on nonaccrual loans, by collateral type rather than loan class, at September 30, 2020, as compared to December 31, 2019, is as follows:
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Dollars in thousands
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Number of
Credit
Relationships
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Balance
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Specific Loss
Allocations
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Current
Year
Charge-Offs
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Location
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Originated
|
September 30, 2020
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Owner occupied commercial real estate
|
|
8
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|
$
|
5,239
|
|
|
$
|
95
|
|
|
$
|
675
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|
|
In market
|
|
2008- 2017
|
Investment/rental residential real estate
|
|
3
|
|
1,600
|
|
|
118
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|
|
—
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|
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In market
|
|
2009 - 2015
|
Commercial and industrial
|
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1
|
|
46
|
|
|
23
|
|
|
—
|
|
|
In market
|
|
2012
|
Total
|
|
12
|
|
$
|
6,885
|
|
|
$
|
236
|
|
|
$
|
675
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2019
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Owner occupied commercial real estate
|
|
6
|
|
$
|
1,845
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
In market
|
|
2007 - 2014
|
Investment/rental residential real estate
|
|
3
|
|
2,009
|
|
|
—
|
|
|
—
|
|
|
In market
|
|
2009 - 2015
|
Commercial and industrial
|
|
1
|
|
65
|
|
|
42
|
|
|
—
|
|
|
In market
|
|
2012
|
Total
|
|
10
|
|
$
|
3,919
|
|
|
$
|
42
|
|
|
$
|
—
|
|
|
|
|
|
Management deemed it appropriate to provide this type of more detailed information by collateral type in order to provide additional detail on the loans.
All nonaccrual impaired loans are to borrowers located within the market area served by the Corporation in southcentral
Pennsylvania and nearby areas of Maryland. All nonaccrual impaired loans were originated by ACNB’s banking subsidiary, except for one participation loan discussed below, for purposes listed in the classifications in the table above.
The Corporation had no impaired and nonaccrual loans included in commercial real estate construction at September 30, 2020.
Owner occupied commercial real estate at September 30, 2020, includes eight unrelated loan relationships. A $1,051,000 relationship in food service that was performing when acquired was added in the first quarter of 2020 after becoming 90 days past due early in the year. Collateral valuation resulted in a $22,000 specific allocation. An unrelated $2,199,000 relationship in the recreational industry was added in the third quarter of 2020 after the Bank negotiated an impending, which occurred during October, payoff after forgiving and charging off $675,000. An unrelated $802,000 loan relationship for a light manufacturing enterprise which was performing when acquired is on hold in bankruptcy court. An unrelated $395,000 credit was added to this category in the second quarter of 2020 when ACNB was notified that property was scheduled for tax sale and subsequent analysis identified the lack of the borrowers’ ability to continue payments. The other loans in this category have balances of less than $260,000 each, for which the real estate is collateral and is used in connection with a business enterprise that is suffering economic stress or is out of business. The loans in this category were originated between 2008 and 2017 and are business loans impacted by specific borrower credit situations. Most loans in this category are making principal payments. Collection efforts will continue unless it is deemed in the best interest of the Corporation to initiate foreclosure procedures.
Investment/rental residential real estate at September 30, 2020, includes three unrelated loan relationships totaling $1,600,000 for which the real estate is collateral and the purpose of which is for speculation, rental, or other non-owner occupied uses. One $1,311,000 participation loan (after partial payoff in the third quarter 2020) was added in the fourth quarter of 2019 and appears to be adequately collateralized. Another unrelated loan in this category at April 2015, was stayed from further foreclosure action by a bankruptcy filing. A third loan added in the third quarter of 2019 involves settling an estate and appears to be adequately collateralized.
There was one impaired commercial and industrial loan at September 30, 2020 with a balance of $46,000 and a specific allocation of $23,000; this loan is currently making payments.
The Corporation utilizes a systematic review of its loan portfolio on a quarterly basis in order to determine the adequacy of the allowance for loan losses. In addition, ACNB engages the services of an outside independent loan review function and sets the timing and coverage of loan reviews during the year. The results of this independent loan review are included in the systematic review of the loan portfolio. The allowance for loan losses consists of a component for individual loan impairment, primarily based on the loan’s collateral fair value and expected cash flow. A watch list of loans is identified for evaluation based on internal and external loan grading and reviews. Loans other than those determined to be impaired are grouped into pools of loans with similar credit risk characteristics. These loans are evaluated as groups with allocations made to the allowance based on historical loss experience adjusted for current trends in delinquencies, trends in underwriting and oversight, concentrations of credit, and general economic conditions within the Corporation’s trading area. The provision expense was based on the loans discussed above, as well as current trends in the watch list and the local economy as a whole. The charge-offs discussed elsewhere in this Management’s Discussion and Analysis create the recent loss history experience and result in the qualitative adjustment which, in turn, affects the calculation of losses inherent in the portfolio. The provision for loan losses for 2020 and 2019 was a result of the measurement of the adequacy of the allowance for loan losses at each period.
Premises and Equipment
During the quarter ended June 30, 2016, a building was sold and the Corporation is leasing back a portion of that building. In connection with these transactions, a gain of $1,147,000 was realized, of which $447,000 was recognized in the quarter ended June 30, 2016 and the remaining $700,000 deferred for future recognition over the lease back term. A reduction of lease expense of $70,000 was recognized in the first nine months of 2020 and 2019, respectively. ACNB valued six buildings acquired from New Windsor at $8,624,000 at July 1, 2017 and five properties acquired from FCBI at $7,514,000 at January 11, 2020.
Foreclosed Assets Held for Resale
Foreclosed assets held for resale consists of the fair value of real estate acquired through foreclosure on real estate loan collateral or the acceptance of ownership of real estate in lieu of the foreclosure process. These fair values, less estimated costs to sell, become the Corporation’s new cost basis. Fair values are based on appraisals that consider the sales prices of similar properties in the proximate vicinity less estimated selling costs. The carrying value of real estate acquired through foreclosure totaled $680,000 for two properties and unrelated borrowers at September 30, 2020, compared to $364,000 for three properties and borrowers at December 31, 2019. The increase in the carrying value was due to the addition of the two properties including
one acquired from FCBI after the three properties from 2019 were sold in 2020. All properties are actively marketed. The Corporation expects to obtain and market additional foreclosed assets through the remainder of 2020; however, the total amount and timing is currently not certain.
Deposits
ACNB relies on deposits as a primary source of funds for lending activities with total deposits of $2,115,576,000 as of September 30, 2020. Deposits increased by $697,966,000, or 49.2%, from September 30, 2019, to September 30, 2020, and increased by $703,316,000, or 49.8%, from December 31, 2019, to September 30, 2020. Deposits acquired from FCBI totaled $374,058,000 on January 11, 2020. Deposits increased in the third quarter of 2020 from PPP proceeds deposited to customer’s accounts and from increased balances in a broad base of accounts from lack of economic activity due to the COVID-19 event. Otherwise, deposits vary between quarters mostly reflecting different levels held by local government and school districts during different times of the year. ACNB’s deposit pricing function employs a disciplined pricing approach based upon alternative funding rates, but also strives to price deposits to be competitive with relevant local competition, including a local government investment trust, credit unions and larger regional banks. During the recession and subsequent slow recovery, deposit growth mix experienced a shift to transaction accounts as customers put more value in liquidity and FDIC insurance. Products, such as money market accounts and interest-bearing transaction accounts that had suffered declines in past years, continued with recovered balances; however, it is expected that a return to more normal, lower balances will occur when the economy improves. ACNB’s ability to maintain and add to its deposit base may be impacted by the reluctance of consumers to accept community banks’ lower rates (as compared to Internet-based competition) and by larger competition willing to pay above market rates to attract market share. Alternatively, if rates rise rapidly, or when the equity markets are high, funds could leave the Corporation or be priced higher to maintain deposits.
Borrowings
Short-term Bank borrowings are comprised primarily of securities sold under agreements to repurchase and short-term borrowings from the FHLB. As of September 30, 2020, short-term Bank borrowings were $52,721,000, as compared to $33,435,000 at December 31, 2019, and $41,509,000 at September 30, 2019. Agreements to repurchase accounts are within the commercial and local government customer base and have attributes similar to core deposits. Investment securities are pledged in sufficient amounts to collateralize these agreements. In comparison to year-end 2019, repurchase agreement balances were up $19,286,000, or 57.7%, due to changes in the cash flow position of ACNB’s commercial and local government customer base and competition from non-bank sources. There were no short-term FHLB borrowings at September 30, 2020 and 2019, or December 31, 2019. Short-term FHLB borrowings are used to even out Bank funding from seasonal and daily fluctuations in the deposit base. Long-term borrowings consist of longer-term advances from the FHLB that provides term funding of loan assets, and Corporate borrowings that were acquired or originated in regards to the acquisitions. Long-term borrowings totaled $57,113,000 at September 30, 2020, versus $66,296,000 at December 31, 2019, and $72,068,000 at September 30, 2019. Long-term borrowings decreased 20.8% from September 30, 2019. $22.5 million was the net decrease to FHLB term Bank borrowings to balance loan demand and deposit growth. FHLB fixed-rate term Bank advances that matured after the first quarter of 2019 were not renewed due to adequate deposit funding sources. A second quarter of 2017 $4.6 million Corporation loan was paid down to $1.5 million outstanding balance on a borrowing from a local bank that had been made to fund the cash payment to shareholders of the New Windsor acquisition. RIG borrowed $1.0 million from a local bank at the end of the third quarter of 2018 to fund a book of business purchase. The balance of this loan at September 30, 2020 was $240,000. In addition, $5 million and $8.7 million was Corporation debt acquired from New Windsor and FCBI, respectively. Please refer to the Liquidity discussion below for more information on the Corporation’s ability to borrow.
Capital
ACNB’s capital management strategies have been developed to provide an appropriate rate of return, in the opinion of management, to shareholders, while maintaining its “well-capitalized” regulatory position in relationship to its risk exposure. Total shareholders’ equity was $256,723,000 at September 30, 2020, compared to $189,516,000 at December 31, 2019, and $186,074,000 at September 30, 2019. Shareholders’ equity increased in the first nine months of 2020 by $67,207,000 primarily due to the equity consideration and issuance of the FCBI acquisition, net of $4,836,000 in retained earnings from 2020 earnings net of dividends.
The acquisition of New Windsor resulted in 938,360 new ACNB shares of common stock issued to the New Windsor shareholders valued at $28,620,000 in 2017. The acquisition of FCBI resulted in 1,590,547 new ACNB shares of common stock issued to the FCBI shareholders valued at $57,721,000.
A $4,007,000 decrease in accumulated other comprehensive loss was a result of a net increase in the fair value of the
investment portfolio and changes in the net funded position of the defined benefit pension plan. Other comprehensive income or loss is mainly caused by fixed-rate investment securities gaining or losing value in different interest rate environments and changes in the net funded position of the defined benefit pension plan.
The primary source of additional capital to ACNB is earnings retention, which represents net income less dividends declared.
During the first nine months of 2020, ACNB earned $11,345,000 and paid dividends of $6,509,000 for a dividend payout ratio of 57.4%. During the first nine months of 2019, ACNB earned $18,640,000 and paid dividends of $5,151,000 for a dividend payout ratio of 27.6%.
ACNB Corporation has a Dividend Reinvestment and Stock Purchase Plan that provides registered holders of ACNB Corporation common stock with a convenient way to purchase additional shares of common stock by permitting participants in the plan to automatically reinvest cash dividends on all or a portion of the shares owned and to make quarterly voluntary cash payments under the terms of the plan. Participation in the plan is voluntary, and there are eligibility requirements to participate in the plan. Year-to-date September 30, 2020, 13,935 shares were issued under this plan with proceeds in the amount of $332,000. Year-to-date September 30, 2019, 12,504 shares were issued under this plan with proceeds in the amount of $328,000. Proceeds were used for general corporate purposes.
ACNB Corporation has a Restricted Stock plan available to selected officers and employees of the Bank, to advance the best interest of ACNB Corporation and its shareholders. The plan provides those persons who have responsibility for its growth with additional incentive by allowing them to acquire an ownership in ACNB Corporation and thereby encouraging them to contribute to the success of the Corporation. As of September 30, 2020, there were 25,945 shares of common stock granted as restricted stock awards to employees of the subsidiary bank. The restricted stock plan expired by its own terms after 10 years on February 24, 2019, and no further shares may be issued under the plan. Proceeds are used for general corporate purposes.
On May 1, 2018, stockholders approved and ratified the ACNB Corporation 2018 Omnibus Stock Incentive Plan, effective as of March 20, 2018, in which awards shall not exceed, in the aggregate, 400,000 shares of common stock, plus any shares that are authorized, but not issued, under the 2009 Restricted Stock Plan. As of September 30, 2020, 35,587 shares were issued under this plan and 538,468 shares were available for grant. Proceeds are used for general corporate purposes.
ACNB is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on ACNB. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, ACNB must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require ACNB to maintain minimum amounts and ratios of total and Tier 1 capital to average assets. Management believes, as of September 30, 2020, and December 31, 2019, that ACNB’s banking subsidiary met all minimum capital adequacy requirements to which it is subject and is categorized as “well capitalized” for regulatory purposes. There are no subsequent conditions or events that management believes have changed the banking subsidiary’s category.
Regulatory Capital Changes
In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations began January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) began compliance effective January 1, 2014. The final rules call for the following capital requirements:
•a minimum ratio of common Tier 1 capital to risk-weighted assets of 4.5%;
•a minimum ratio of Tier 1 capital to risk-weighted assets of 6.0%;
•a minimum ratio of total capital to risk-weighted assets of 8.0%; and,
•a minimum leverage ratio of 4.0%.
In addition, the final rules establish a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organizations began on January 1, 2016.
Under the initially proposed rules, accumulated other comprehensive income (AOCI) would have been included in a banking organization’s common equity Tier 1 capital. The final rules allow community banks to make a one-time election not to include these additional components of AOCI in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. The opt-out election must be made in the first call report or FR Y-9 series report that is filed after the financial institution becomes subject to the final rule. The Corporation elected to opt-out.
The rules permanently grandfather non-qualifying capital instruments (such as trust preferred securities and cumulative perpetual preferred stock) issued before May 19, 2010, for inclusion in the Tier 1 capital of banking organizations with total consolidated assets of less than $15 billion as of December 31, 2009, and banking organizations that were mutual holding companies as of May 19, 2010.
The proposed rules would have modified the risk-weight framework applicable to residential mortgage exposures to require banking organizations to divide residential mortgage exposures into two categories in order to determine the applicable risk weight. In response to commenter concerns about the burden of calculating the risk weights and the potential negative effect on credit availability, the final rules do not adopt the proposed risk weights, but retain the current risk weights for mortgage exposures under the general risk-based capital rules.
Consistent with the Dodd-Frank Act, the new rules replace the ratings-based approach to securitization exposures, which is based on external credit ratings, with the simplified supervisory formula approach in order to determine the appropriate risk weights for these exposures. Alternatively, banking organizations may use the existing gross-up approach to assign securitization exposures to a risk weight category or choose to assign such exposures a 1,250 percent risk weight.
Under the new rules, mortgage servicing assets and certain deferred tax assets are subject to stricter limitations than those applicable under the current general risk-based capital rule. The new rules also increase the risk weights for past due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.
The Corporation calculated regulatory ratios as of September 30, 2020, and confirmed no material impact on the capital, operations, liquidity, and earnings of the Corporation and the banking subsidiary from the changes in the regulations.
Risk-Based Capital
ACNB Corporation considers the capital ratios of the banking subsidiary to be the relevant measurement of capital adequacy.
In 2019, the federal banking agencies issued a final rule to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, including the community bank leverage ratio (CBLR) framework. Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a CBLR of greater than 9% (subsequently reduced to 8% as a COVID-19 relief measure). Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework. The CBLR framework was available for banks to use in their March 31, 2020 Call Report. The Corporation has performed changes to capital adequacy and reporting requirements within the quarterly Call Report, and it opted out of the CBLR framework on September 30, 2020.
The banking subsidiary’s capital ratios are as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2020
|
|
December 31, 2019
|
|
To Be Well Capitalized
Under Prompt
Corrective Action
Regulations
|
Tier 1 leverage ratio (to average assets)
|
9.22
|
%
|
|
9.93
|
%
|
|
5.00
|
%
|
Common Tier 1 capital ratio (to risk-weighted assets)
|
13.04
|
%
|
|
14.13
|
%
|
|
6.50
|
%
|
Tier 1 risk-based capital ratio (to risk-weighted assets)
|
13.04
|
%
|
|
14.13
|
%
|
|
8.00
|
%
|
Total risk-based capital ratio
|
14.17
|
%
|
|
15.28
|
%
|
|
10.00
|
%
|
Liquidity
Effective liquidity management ensures the cash flow requirements of depositors and borrowers, as well as the operating cash needs of ACNB, are met.
ACNB’s funds are available from a variety of sources, including assets that are readily convertible such as interest bearing deposits with banks, maturities and repayments from the securities portfolio, scheduled repayments of loans receivable, the core deposit base, and the ability to borrow from the FHLB. At September 30, 2020, ACNB’s banking subsidiary had a borrowing capacity of approximately $863,976,000 from the FHLB, of which $805,010,000 was available. Because of various restrictions and requirements on utilizing the available balance, ACNB considers $589,000,000 to be the practicable additional borrowing capacity, which is considered to be sufficient for operational needs. The FHLB system is self-capitalizing, member-owned, and its member banks’ stock is not publicly traded. ACNB creates its borrowing capacity with the FHLB by granting a security interest in certain loan assets with requisite credit quality. ACNB has reviewed information on the FHLB system and the FHLB of Pittsburgh, and has concluded that they have the capacity and intent to continue to provide both operational and contingency liquidity. The FHLB of Pittsburgh instituted a requirement that a member’s investment securities must be moved into a safekeeping account under FHLB control to be considered in the calculation of maximum borrowing capacity. The Corporation currently has securities in safekeeping at the FHLB of Pittsburgh; however, the safekeeping account is under the Corporation’s control. As better contingent liquidity is maintained by keeping the securities under the Corporation’s control, the Corporation has not moved the securities which, in effect, lowered the Corporation’s maximum borrowing capacity. However, there is no practical reduction in borrowing capacity as the securities can be moved into the FHLB-controlled account promptly if they are needed for borrowing purposes.
Another source of liquidity is securities sold under repurchase agreements to customers of ACNB’s banking subsidiary totaling approximately $52,721,000 and $33,435,000 at September 30, 2020, and December 31, 2019, respectively. These agreements vary in balance according to the cash flow needs of customers and competing accounts at other financial organizations.
The liquidity of the parent company also represents an important aspect of liquidity management. The parent company’s cash outflows consist principally of dividends to shareholders and corporate expenses. The main source of funding for the parent company is the dividends it receives from its subsidiaries. Federal and state banking regulations place certain legal restrictions and other practicable safety and soundness restrictions on dividends paid to the parent company from the subsidiary bank.
ACNB manages liquidity by monitoring projected cash inflows and outflows on a daily basis, and believes it has sufficient funding sources to maintain sufficient liquidity under varying degrees of business conditions.
Off-Balance Sheet Arrangements
The Corporation is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and, to a lesser extent, standby letters of credit. At September 30, 2020, the Corporation had unfunded outstanding commitments to extend credit of approximately $381,841,000 and outstanding standby letters of credit of approximately $9,680,000. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements.
Market Risks
Financial institutions can be exposed to several market risks that may impact the value or future earnings capacity of the organization. These risks involve interest rate risk, foreign currency exchange risk, commodity price risk, and equity market
price risk. ACNB’s primary market risk is interest rate risk. Interest rate risk is inherent because, as a financial institution, ACNB derives a significant amount of its operating revenue from “purchasing” funds (customer deposits and wholesale borrowings) at various terms and rates. These funds are then invested into earning assets (primarily loans and investments) at various terms and rates.
Acquisition of Frederick County Bancorp, Inc.
ACNB Corporation, the parent financial holding company of ACNB Bank, a Pennsylvania state-chartered, FDIC-insured community bank, headquartered in Gettysburg, Pennsylvania, completed the acquisition of Frederick County Bancorp, Inc. (FCBI) and its wholly-owned subsidiary, Frederick County Bank, headquartered in Frederick, Maryland, effective January 11, 2020. FCBI was merged with and into a wholly-owned subsidiary of ACNB Corporation immediately followed by the merger of Frederick County Bank with and into ACNB Bank. ACNB Bank operates in the Frederick County, Maryland, market as “FCB Bank, A Division of ACNB Bank”.
Under the terms of the Reorganization Agreement, FCBI stockholders received 0.9900 share of ACNB Corporation common stock for each share of FCBI common stock that they owned as of the closing date. As a result, ACNB Corporation issued 1,590,547 shares of its common stock and cash in exchange for fractional shares based upon $36.43, the determined market share price of ACNB Corporation common stock in accordance with the Reorganization Agreement.
With the combination of the two organizations, ACNB Corporation, on a consolidated basis, has approximately $2.2 billion in assets, $1.8 billion in deposits, and $1.6 billion in loans with 33 community banking offices and three loan offices located in the counties of Adams, Cumberland, Franklin, Lancaster and York in Pennsylvania and the counties of Baltimore, Carroll and Frederick in Maryland. Further discussion of the risk factors involved with the merger of FCBI into the Corporation can be found in Part II, Item 1A – Risk Factors.
RECENT DEVELOPMENTS
BANK SECRECY ACT (BSA) – The Bank Secrecy Act, as amended by the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT Act), imposes obligations on U.S. financial institutions, including banks and broker-dealer subsidiaries, to implement policies, procedures and controls which are reasonably designed to detect and report instances of money laundering and the financing of terrorism. Financial institutions also are required to respond to requests for information from federal banking agencies and law enforcement agencies. Information sharing among financial institutions for the above purposes is encouraged by an exemption granted to complying financial institutions from the privacy provisions of the Gramm-Leach-Bliley Act and other privacy laws. Financial institutions that hold correspondent accounts for foreign banks or provide banking services to foreign individuals are required to take measures to avoid dealing with certain foreign individuals or entities, including foreign banks with profiles that raise money laundering concerns, and are prohibited from dealing with foreign “shell banks” and persons from jurisdictions of particular concern. The primary federal banking agencies and the Secretary of the Treasury have adopted regulations to implement several of these provisions. Effective May 11, 2018, the Bank began compliance with the new Customer Due Diligence Rule, which clarified and strengthened the existing obligations for identifying new and existing customers and includes risk-based procedures for conducting ongoing customer due diligence. All financial institutions are also required to establish internal anti-money laundering programs. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act. The Corporation’s banking subsidiary has a BSA and USA PATRIOT Act compliance program commensurate with its risk profile and appetite.
TAX CUTS AND JOBS ACT – On December 22, 2017, the Tax Cuts and Jobs Act was signed into law. Among other changes, the Tax Cuts and Jobs Act reduced the federal corporate tax rate from 35% to 21% effective January 1, 2018. ACNB anticipates that this tax rate change should reduce its federal income tax liability in future years, as it did in 2018. However, the Corporation did recognize certain effects of the tax law changes in 2017. U.S. generally accepted accounting principles require companies to revalue their deferred tax assets and liabilities as of the date of enactment, with resulting tax effects accounted for in the reporting period of enactment. Since the enactment took place in December 2017, the Corporation revalued its net deferred tax assets in the fourth quarter of 2017, resulting in an approximately $1.7 million reduction to earnings in 2017.
DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT (DODD-FRANK) – In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. Dodd-Frank was intended to effect a fundamental restructuring of federal banking regulation. Among other things, Dodd-Frank created the Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. Dodd-Frank additionally created a new independent federal regulator to administer federal consumer protection laws. Dodd-Frank has had and will continue to have a significant impact on ACNB’s business operations as its provisions take
effect. It is expected that, as various implementing rules and regulations are released, they will increase ACNB’s operating and compliance costs and could increase the banking subsidiary’s interest expense. Among the provisions that are likely to affect ACNB are the following:
Holding Company Capital Requirements
Dodd-Frank requires the Federal Reserve to apply consolidated capital requirements to bank holding companies that are no less stringent than those currently applied to depository institutions. Under these standards, trust preferred securities are excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010, by a bank holding company with less than $15 billion in assets as of December 31, 2009. Dodd-Frank additionally requires that bank regulators issue countercyclical capital requirements so that the required amount of capital increases in times of economic expansion, consistent with safety and soundness.
Deposit Insurance
Dodd-Frank permanently increased the maximum deposit insurance amount for banks, savings institutions, and credit unions to $250,000 per depositor. Dodd-Frank also broadened the base for FDIC insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution. Dodd-Frank requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. Dodd-Frank also eliminated the federal statutory prohibition against the payment of interest on business checking accounts.
Corporate Governance
Dodd-Frank requires publicly-traded companies to give stockholders a non-binding vote on executive compensation at least every three years, a non-binding vote regarding the frequency of the vote on executive compensation at least every six years, and a non-binding vote on “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by the stockholders. Additionally, Dodd-Frank directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether the company is publicly traded. Dodd-Frank also gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.
Prohibition Against Charter Conversions of Troubled Institutions
Dodd-Frank prohibits a depository institution from converting from a state to a federal charter, or vice versa, while it is the subject of a cease and desist order or other formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter unless the appropriate federal banking agency gives notice of the conversion to the federal or state authority that issued the enforcement action and that agency does not object within 30 days. The notice must include a plan to address the significant supervisory matter. The converting institution must also file a copy of the conversion application with its current federal regulator, which must notify the resulting federal regulator of any ongoing supervisory or investigative proceedings that are likely to result in an enforcement action and provide access to all supervisory and investigative information relating thereto.
Interstate Branching
Dodd-Frank authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted. Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks are able to enter new markets more freely.
Limits on Interstate Acquisitions and Mergers
Dodd-Frank precludes a bank holding company from engaging in an interstate acquisition — the acquisition of a bank outside its home state — unless the bank holding company is both well capitalized and well managed. Furthermore, a bank may not engage in an interstate merger with another bank headquartered in another state unless the surviving institution will be well capitalized and well managed. The previous standard in both cases was adequately capitalized and adequately managed.
Limits on Interchange Fees
Dodd-Frank amended the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over
$10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.
Consumer Financial Protection Bureau
Dodd-Frank created the independent federal agency called the Consumer Financial Protection Bureau (CFPB), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act, and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions are subject to rules promulgated by the CFPB, but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. Dodd-Frank authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, Dodd-Frank allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. Dodd-Frank permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.
ABILITY-TO-REPAY AND QUALIFIED MORTGAGE RULE – Pursuant to Dodd-Frank as highlighted above, the CFPB issued a final rule on January 10, 2013 (effective on January 10, 2014), amending Regulation Z as implemented by the Truth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine the consumer’s ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (1) current or reasonably expected income or assets; (2) current employment status; (3) the monthly payment on the covered transaction; (4) the monthly payment on any simultaneous loan; (5) the monthly payment for mortgage-related obligations; (6) current debt obligations, alimony, and child support; (7) the monthly debt-to-income ratio or residual income; and, (8) credit history. Alternatively, the mortgage lender can originate “qualified mortgages”, which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage, the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Loans which meet these criteria will be considered qualified mortgages and, as a result, generally protect lenders from fines or litigation in the event of foreclosure. Qualified mortgages that are “higher-priced” (e.g., subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not “higher-priced” (e.g., prime loans) are given a safe harbor of compliance. The impact of the final rule, and the subsequent amendments thereto, on the Corporation’s lending activities and the Corporation’s statements of income or condition has had little or no impact; however, management will continue to monitor the implementation of the rule for any potential effects on the Corporation’s business.
DEPARTMENT OF DEFENSE MILITARY LENDING RULE – In 2015, the U.S. Department of Defense issued a final rule which restricts pricing and terms of certain credit extended to active duty military personnel and their families. This rule, which was implemented effective October 3, 2016, caps the interest rate on certain credit extensions to an annual percentage rate of 36% and restricts other fees. The rule requires financial institutions to verify whether customers are military personnel subject to the rule. The impact of this final rule, and any subsequent amendments thereto, on the Corporation’s lending activities and the Corporation’s statements of income or condition has had little or no impact; however, management will continue to monitor the implementation of the rule for any potential effects on the Corporation’s business.
SUPERVISION AND REGULATION
Dividends
ACNB is a legal entity separate and distinct from its subsidiary bank. ACNB’s revenues, on a parent company only basis, result primarily from dividends paid to the Corporation by its subsidiaries. Federal and state laws regulate the payment of dividends by ACNB’s subsidiary bank. For further information, please refer to Regulation of Bank below.
Regulation of Bank
The operations of the subsidiary bank are subject to statutes applicable to banks chartered under the banking laws of Pennsylvania, to state nonmember banks of the Federal Reserve, and to banks whose deposits are insured by the FDIC. The
subsidiary bank’s operations are also subject to regulations of the Pennsylvania Department of Banking and Securities, Federal Reserve, and FDIC.
The Pennsylvania Department of Banking and Securities, which has primary supervisory authority over banks chartered in Pennsylvania, regularly examines banks in such areas as reserves, loans, investments, management practices, and other aspects of operations. The subsidiary bank is also subject to examination by the FDIC for safety and soundness, as well as consumer compliance. These examinations are designed for the protection of the subsidiary bank’s depositors rather than ACNB’s shareholders. The subsidiary bank must file quarterly and annual reports to the Federal Financial Institutions Examination Council, or FFIEC.
Monetary and Fiscal Policy
ACNB and its subsidiary bank are affected by the monetary and fiscal policies of government agencies, including the Federal Reserve and FDIC. Through open market securities transactions and changes in its discount rate and reserve requirements, the Board of Governors of the Federal Reserve exerts considerable influence over the cost and availability of funds for lending and investment. The nature and impact of monetary and fiscal policies on future business and earnings of ACNB cannot be predicted at this time. From time to time, various federal and state legislation is proposed that could result in additional regulation of, and restrictions on, the business of ACNB and the subsidiary bank, or otherwise change the business environment. Management cannot predict whether any of this legislation will have a material effect on the business of ACNB.