FIRST KEYSTONE CORPORATION This quarterly report contains certain forward-looking statements, which are included pursuant to the "safeharbor" provisions of the Private Securities Litigation Reform Act of 1995, and reflect management's beliefs and expectations based on information currently available. These forward-looking statements are inherently subject to significant risks and uncertainties, including changes in general economic and financial market conditions, the Company's ability to effectively carry out its business plans and changes in regulatory or legislative requirements. Other factors that could cause or contribute to such differences are changes in competitive conditions, and pending or threatened litigation. Although management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.
CRITICAL ACCOUNTING ESTIMATES
The Company has chosen accounting policies that it believes are appropriate to accurately and fairly report its operating results and financial position, and the Company applies those accounting policies in a consistent manner. The Significant Accounting Policies are summarized in Note 1 to the consolidated financial statements included in the 2021 Annual Report on Form 10-K. There have been no changes to the Critical Accounting Estimates since the Company filed its Annual Report on Form 10-K for the year endedDecember 31, 2021 .
RESULTS OF OPERATIONS
Quarter ended
First Keystone Corporation realized earnings for the three months endedSeptember 30, 2022 of$3,504,000 , a decrease of$519,000 , or 12.9% from the third quarter of 2021. The decrease in net income for the three months endedSeptember 30, 2022 was primarily due to increases in interest paid on deposits, interest paid on short-term borrowings through theFederal Home Loan Bank , and salaries and employee benefits expenses, as well as a reduction in net gains on sales of mortgage loans, and less PPP fees. On a per share basis, for the three months endedSeptember 30, 2022 , net income was$0.58 versus$0.68 for the same three month period of 2021. Cash dividends amounted to$0.28 per share for the three months endedSeptember 30, 2022 and 2021. NET INTEREST INCOME The major source of operating income for the Company is net interest income, defined as interest and loan fee income less interest expense. In the three months endedSeptember 30, 2022 , interest income amounted to$11,897,000 , an increase of$1,181,000 or 11.0% from the three months endedSeptember 30, 2021 , while interest expense amounted to$2,378,000 in the three months endedSeptember 30, 2022 , an increase of$1,095,000 or 85.3% from the three months endedSeptember 30, 2021 . As a result, net interest income increased$86,000 or 0.9% to$9,519,000 from$9,433,000 for the same period in 2021.
The Company's net interest margin for the three months ended
PROVISION FOR LOAN LOSSES
The provision for loan losses for the three months endedSeptember 30, 2022 and 2021 was$219,000 and$185,000 , respectively. The increase in the provision for loan losses resulted from the Company's analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, loan portfolio growth, and other relevant factors. The provision for loan losses for the three months endedSeptember 30, 2022 is also reflective of management's assessment of the continued credit risk associated with the uncertainty surrounding geopolitical and 40 economic concerns. Charge-off and recovery activity in the allowance for loan losses resulted in net charge-offs of$168,000 and$21,000 for the the three months endedSeptember 30, 2022 and 2021, respectively. See Allowance for Loan Losses on page 46 for further discussion.
NON-INTEREST INCOME
Total non-interest income was
Net securities (losses) gains decreased$72,000 to ($50,000 ) for the three months endedSeptember 30, 2022 as compared to the three months endedSeptember 30, 2021 . This decrease was mainly due to the Company recognizing$50,000 in net losses on held equity securities in the third quarter of 2022 as compared to recognizing$18,000 in net gains on held equity securities in the same quarter of 2021. Trust department income decreased$7,000 or 2.9% to$236,000 for the three months endedSeptember 30, 2022 as compared to the same period in 2021.
Service charges and fee income increased
Net (losses) gains on sales of mortgage loans decreased$143,000 or 102.9% to ($4,000 ) due to the repurchase of two loans originally sold to Fannie Mae and no sales of mortgage loans in the third quarter of 2022 as the rate environment has led to many loans being sold at a loss and there have been fewer mortgages originated with intent to sell. Other non-interest income decreased$37,000 or 39.8% to$56,000 for the three months endedSeptember 30, 2022 . The decrease was due to lower retail investment income as income from annuities was lower in the third quarter of 2022 as compared to the same period in 2021.
NON-INTEREST EXPENSE
Total non-interest expense was
Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to$3,677,000 or 54.8% of total non-interest expense for the three months endedSeptember 30, 2022 , as compared to$3,303,000 or 52.7% for the three months endedSeptember 30, 2021 . The increase was mainly due to increased costs associated with medical insurance plus normal merit increases for employees and new hires as compared to the same period in 2021. Net occupancy, furniture and equipment, and computer expense amounted to$977,000 for the three months endedSeptember 30, 2022 , an increase of$64,000 or 7.0% which was due to the implementation of several new software programs throughout 2021 and early 2022 to increase security and efficiency. Professional services increased$51,000 or 20.9% to$295,000 as ofSeptember 30, 2022 . The increase was mainly the result of an increase in consulting expense as the result of strategic planning and consulting services associated with implementing new internal systems contracts.Pennsylvania shares tax expense amounted to$312,000 for the three months endedSeptember 30, 2022 , an increase of$3,000 or 1.0% as compared to the three months endedSeptember 30, 2021 .Federal Deposit Insurance Corporation ("FDIC") insurance expense amounted to$116,000 for the three months endedSeptember 30, 2022 , an increase of$13,000 or 12.6% as compared to the same period in 2021.FDIC insurance expense varies with changes in net asset size, risk ratings, andFDIC derived assessment rates. ATM and debit card fees expense amounted to$274,000 for the three months endedSeptember 30, 2022 , a decrease of$7,000 or 2.5% as compared to the three months endedSeptember 30, 2021 . Data processing expenses amounted to$205,000 for the three months endedSeptember 30, 2022 as compared to$295,000 for the same period of 2021, a decrease of$90,000 or 30.5%. This decrease was the result of negotiations of new internal systems contracts resulting in some lower fees and vendor relationship credits that were applied to the expenses related to those systems. 41 Advertising expense amounted to$96,000 in the third quarter of 2022, a decrease of$5,000 or 5.0% as compared to the three months endedSeptember 30, 2021 . Other non-interest expense amounted to$759,000 for the three months endedSeptember 30, 2022 , an increase of$41,000 or 5.7% as compared to 2021 mainly due to a fraud settlement related to a customer's deposit relationship in the third quarter of 2022. INCOME TAXES Income tax expense amounted to$578,000 for the three months endedSeptember 30, 2022 , as compared to$655,000 for the three months endedSeptember 30, 2021 , a decrease of$77,000 . The effective total income tax rate was 14.2% for the three months endedSeptember 30, 2022 as compared to 14.0% for the three months endedSeptember 30, 2021 . The increase in the effective tax rate was mainly due to fewer tax credits from low-income housing partnerships. The Company recognized$58,000 and$101,000 of tax credits from low-income housing partnerships in the three months endedSeptember 30, 2022 and 2021, respectively.
Nine months ended
First Keystone Corporation realized earnings for the nine months endedSeptember 30, 2022 of$10,869,000 , a decrease of$637,000 , or 5.5% from the same period in 2021. The decrease in net income for the nine months endedSeptember 30, 2022 was primarily due to less PPP loan fees, an increase in interest expense, and a decrease in non-interest income, mainly due to fewer sales of mortgage loans and net securities losses.
On a per share basis, net income was
NET INTEREST INCOME The major source of operating income for the Company is net interest income, defined as interest and loan fee income less interest expense. For the nine months endedSeptember 30, 2022 , interest income amounted to$33,637,000 , an increase of$2,387,000 or 7.6% from the nine months endedSeptember 30, 2021 , while interest expense amounted to$4,881,000 in the nine months endedSeptember 30, 2022 an increase of$1,005,000 or 25.9% from the nine months endedSeptember 30, 2021 . As a result, net interest income increased$1,382,000 or 5.0% to$28,756,000 from$27,374,000 for the same period in 2021. The Company's net interest margin for the nine months endedSeptember 30, 2022 was 3.26% compared to 3.25% for same period in 2021. The increase in net interest margin was a result of an increase in yield earned on securities and restricted stock. PROVISION FOR LOAN LOSSES
The provision for loan losses for the nine months endedSeptember 30, 2022 and 2021 was$656,000 and$455,000 , respectively. The increase in the provision for loan losses resulted from the Company's analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, loan portfolio growth, and other relevant factors. The provision for loan losses for the nine months endedSeptember 30, 2022 is also reflective of management's assessment of the continued credit risk associated with the uncertainty surrounding geopolitical and economic concerns. Charge-off and recovery activity in the allowance for loan losses resulted in net charge-offs of$125,000 and 100,000 for the nine months endedSeptember 30, 2022 and 2021, respectively. See Allowance for Loan Losses on page 46 for further discussion.
NON-INTEREST INCOME
Total non-interest income was
42
losses on the sales of mortgage loans and net securities losses on held equity
securities during the first nine months of 2022 as compared to recognizing net
gains on both during the same period of 2021.
ATM fees and debit card income decreased $41,000 or 2.5% to $1,598,000 for the
nine months ended September 30, 2022 due to decreased ATM surcharge fees as the
result of decreased transaction volume. Service charges and fee income increased
$279,000 for the nine months ended September 30, 2022 . The increase was mainly
due to increased overdraft fees on DDA accounts. Gains on sales of mortgage
loans decreased $839,000 or 104.7% due to a low number of individual loans sold
in the first nine months of 2022 and many of the loans sold in 2022 being sold
at a loss. These factors were due to the current rate environment and fewer
loans being originated with the intent to sell in 2022.
Trust department income was $754,000 for the nine months ended
September 30, 2022 a decrease of $7,000 or 0.9% as compared to the same period
in 2021. Net securities (losses) gains decreased $346,000 or 209.7% to
($181,000 ) for the nine months ended September 30, 2022 as compared to the nine
months ended September 30, 2021 . The decrease was due to the Company recognizing
$181,000 in net losses on held equity securities in the first nine months of
2022 as compared to recognizing $161,000 in net gains on held equity securities
in the same period in 2021.
NON-INTEREST EXPENSE
Total non-interest expense was
Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to$10,693,000 or 53.9% of total non-interest expense for the nine months endedSeptember 30, 2022 , as compared to$10,064,000 or 52.9% for the nine months endedSeptember 30, 2021 . The increase was mainly due to normal merit increases and new hires along with an increase in medical insurance costs as compared to the first nine months of 2021. Net occupancy, furniture and equipment, and computer expense amounted to$2,977,000 for the nine months endedSeptember 30, 2022 , an increase of$219,000 or 7.9%. The increase is the result of the implementation of several new software programs in 2022 to increase security and efficiency. Professional services increased$187,000 or 24.1% to$963,000 for the nine months endedSeptember 30, 2022 . The increase was mainly the result of an increase in consulting expense as the result of strategic planning and consulting services associated with implementing new internal systems contracts along with normal increases in annual audit expenses.Pennsylvania shares tax expense amounted to$960,000 for the nine months endedSeptember 30, 2022 , an increase of$25,000 or 2.7% as compared to the nine months endedSeptember 30, 2021 .
ATM and debit card fees expense amounted to$644,000 for the nine months endedSeptember 30, 2022 , a decrease of$120,000 or 15.7% as compared to the nine months endedSeptember 30, 2021 . The decrease was the result of negotiations of new internal systems contracts resulting in some lower fees and vendor relationship credits that were applied to the expenses related to those systems. Data processing expenses amounted to$714,000 for the nine months endedSeptember 30, 2022 , a decrease of$198,000 or 21.7% as compared to the nine months endedSeptember 30, 2021 . This decrease was also the result of the negotiations of new systems contracts. Advertising expense increased$4,000 or 1.4% during the nine months endedSeptember 30, 2022 . Other non-interest expense amounted to$2,212,000 for the nine months endedSeptember 30, 2022 , an increase of$5,000 or 0.2% as compared to the nine months endedSeptember 30, 2021 .
INCOME TAXES
Income tax expense amounted to
43
was 14.2% for the nine months ended September 30, 2022 as compared to 13.8% for
the nine months ended September 30, 2021 . The increase in the effective tax rate
was mainly due to fewer tax credits from low-income housing partnerships in the
current year. The Company recognized $191,000 and $303,000 of tax credits from
low-income housing partnerships in the nine months ended September 30, 2022 and 2021, respectively. FINANCIAL CONDITION SUMMARY Total assets increased to$1,324,250,000 as ofSeptember 30, 2022 , an increase of$3,900,000 from year-end 2021. Total assets as ofDecember 31, 2021 amounted to$1,320,350,000 . Total debt securities available-for-sale decreased$51,347,000 or 11.7% to$386,569,000 as ofSeptember 30, 2022 fromDecember 31, 2021 . The decrease was mainly due to a decrease in the market value of the portfolio as a result of the current interest rate environment and principal paydowns.
Total loans increased
Total deposits decreased
The Company continues to maintain and manage its asset growth. The Company's strong equity capital position provides an opportunity to further leverage its asset growth. Total borrowings increased in the nine months endedSeptember 30, 2022 by$57,371,000 to$119,748,000 from$62,377,000 as ofDecember 31, 2021 . Borrowings increased mainly due to decreased deposit balances and growth in the loan portfolio. Total stockholders' equity amounted to$115,423,000 atSeptember 30, 2022 , a decrease of$33,132,000 or 22.3% fromDecember 31, 2021 due to a decrease in the market value of the securities portfolio resulting in a tax-effected accumulated other comprehensive loss position.
SEGMENT REPORTING
Currently, management measures the performance and allocates the resources of the Company as a single segment.
EARNING ASSETS
Earning assets are defined as those assets that produce interest income. By maintaining a healthy asset utilization rate, i.e., the volume of earning assets as a percentage of total assets, the Company maximizes income. The earning asset ratio (average interest earning assets divided by average total assets) equaled 94.0% atSeptember 30, 2022 and 94.1% atSeptember 30, 2021 . This indicates that the management of earning assets is a priority and non-earning assets, primarily cash and due from banks, fixed assets and other assets, are maintained at minimal levels. The primary earning assets are loans and securities. Our primary earning asset, total loans, increased to$845,675,000 as ofSeptember 30, 2022 , up$92,834,000 , or 12.3% since year-end 2021. The loan portfolio continues to be well diversified. Non-performing assets decreased since year-end 2021, and overall asset quality has remained consistent. Total non-performing assets were$6,082,000 as ofSeptember 30, 2022 , a decrease of$984,000 , or 13.9% from$7,066,000 reported in non-performing assets as ofDecember 31, 2021 . Total allowance for loan losses to total non-performing assets was 151.45% as ofSeptember 30, 2022 and 122.84% atDecember 31, 2021 . See the Non-Performing Assets section on page 48 for more information. 44 In addition to loans, another primary earning asset is our overall securities portfolio, which decreased in size fromDecember 31, 2021 toSeptember 30, 2022 . Debt securities available-for-sale amounted to$386,569,000 as ofSeptember 30, 2022 , a decrease of$51,347,000 from year-end 2021. The decrease in debt securities available-for-sale is mainly due to a$50,924,000 decrease in the market value of the portfolio as a result of the current interest rate environment and$29,444,000 in principal paydowns on debt securities, offset by the deployment of$38,349,000 in cash to purchase debt securities, along with other portfolio activity. Interest-bearing deposits in other banks decreased as ofSeptember 30, 2022 , to$1,803,000 from$51,738,000 at year-end 2021 due to decreased cash held at theFederal Reserve Bank . Time deposits with other banks were$0 atSeptember 30, 2022 and$247,000 atDecember 31, 2021 due to the maturity of
the one remaining time deposit. LOANS
Total loans increased to
Steady demand for borrowing by businesses accounted for the 12.3% increase in the loan portfolio fromDecember 31, 2021 toSeptember 30, 2022 . Overall, the Commercial and Industrial portfolio (which includes tax-free commercial and industrial loans) increased$3,329,000 or 4.0% from$82,526,000 atDecember 31, 2021 to$85,855,000 atSeptember 30, 2022 . The increase in the Commercial and Industrial portfolio during the nine months endedSeptember 30, 2022 was mainly attributable to the portion of the Commercial and Industrial portfolio excluding SBA PPP loans which increased$8,098,000 during the nine months endedSeptember 30, 2022 , mainly resulting from$15,100,000 in new loan originations for the nine months endedSeptember 30, 2022 and an increase in utilization of existing Commercial and Industrial lines of credit of$3,361,000 , offset by loan payoffs of$5,054,000 and regular principal payments and other typical fluctuations in the Commercial and Industrial portfolio during the nine months endedSeptember 30, 2022 . This was offset by a reduction of$4,769,000 in the portion of the Commercial and Industrial portfolio attributable to SBA PPP loans, the balance of which decreased from$4,894,000 atDecember 31, 2021 to$125,000 atSeptember 30, 2022 , as a result of loan forgiveness. TheCommercial Real Estate portfolio (which includes tax-free commercial real estate loans) increased$78,414,000 or 15.0% from$521,654,000 atDecember 31, 2021 to$600,068,000 atSeptember 30, 2022 . The increase is mainly attributable to new loan originations of$137,509,000 for the nine months endedSeptember 30, 2022 , offset by loan payoffs of$52,118,000 , offset by a decrease in utilization of existingCommercial Real Estate lines of credit of$591,000 and regular principal payments and other typical amortization in theCommercial Real Estate portfolio during the nine months endedSeptember 30, 2022 .Residential Real Estate loans increased$10,941,000 or 7.6% from$143,383,000 atDecember 31, 2021 to$154,324,000 atSeptember 30, 2022 . The increase was mainly the result of$26,129,000 in new loan originations and an increase in utilization of existingResidential Real Estate (Home Equity) lines of credit of$2,255,000 , offset by net loans sold of$2,719,000 , loan payoffs of$12,821,000 (of which$4,154,000 was refinanced with the Bank during the nine months endedSeptember 30, 2022 with the new refinanced loan balances included in the new loan origination total), and regular principal payments and other typical amortization in theResidential Real Estate portfolio during the nine months endedSeptember 30, 2022 . Net loans sold for the nine months endedSeptember 30, 2022 consisted of total loans sold during the nine months endedSeptember 30, 2022 of$4,463,000 , offset with loans opened and sold in the same quarter during the first three quarters of 2022 which amounted to$1,744,000 . The Company continues to originate and sell certain long-term fixed rate residential mortgage loans, which conform to secondary market requirements, when the market pricing is favorable. The Company derives ongoing income from the servicing of mortgages sold in the secondary market. The Company continues its efforts to lend to creditworthy borrowers.Management believes that the loan portfolio is well diversified. The total commercial portfolio was$685,923,000 atSeptember 30, 2022 . Of total loans,$600,068,000 or 71.0% were secured by commercial real estate, primarily lessors of residential buildings and dwellings and lessors of non-residential buildings. The Company continues to monitor these portfolios. Overall, the portfolio risk profile as measured by loan grade is considered low risk, as$822,498,000 or 97.4% of gross loans are graded Pass;$895,000 or 0.1% are graded Special Mention;$21,102,000 or 2.5% are graded Substandard; and$0 are graded Doubtful. The rating is intended to represent the best assessment of risk available at a given point in time, based upon a review of the borrower's financial statements, credit analysis, payment history with the 45
Bank, credit history and lender knowledge of the borrower. See Note 4 - Loans and Allowance for Loan Losses for risk grading tables.
Overall, non-pass grades decreased to$21,997,000 atSeptember 30, 2022 , as compared to$24,737,000 atDecember 31, 2021 . Commercial and Industrial non-pass grades decreased to$736,000 as ofSeptember 30, 2022 as compared to$796,000 as ofDecember 31, 2021 .Commercial Real Estate non-pass grades decreased to$20,224,000 as ofSeptember 30, 2022 as compared to$22,346,000 as ofDecember 31, 2021 . TheResidential Real Estate and Consumer loan non-pass grades decreased to$1,037,000 as ofSeptember 30, 2022 as compared to$1,595,000 as ofDecember 31, 2021 . The decrease inCommercial Real Estate non-pass grades fromDecember 31, 2021 toSeptember 30, 2022 is mainly the result of a payoff that was completed during the second quarter of 2022 on a Substandard non-accrual loan to a contractor specializing in modular construction that carried a balance of$1,000,000 atDecember 31, 2021 . Four loans to the owners/operators of an indoor family entertainment complex that carried an aggregate balance of$753,000 atDecember 31, 2021 were also upgraded from Substandard to pass-grade status during the nine months endedSeptember 30, 2022 . There were also$256,000 in principal payments and paydowns completed during the nine months endedSeptember 30, 2022 on a loan to the owner/operator of a multi-unit apartment building that was classified as Special Mention status at bothDecember 31, 2021 andSeptember 30, 2022 . The Company continues to internally underwrite each of its loans to comply with prescribed policies and approval levels established by its Board of Directors. Total Loans (Dollars in thousands) September 30, December 31, 2022 2021 Commercial and Industrial $ 85,855$ 82,526 Commercial Real Estate 600,068 521,654 Residential Real Estate 154,324 143,383 Consumer 5,428 5,278 Total Loans$ 845,675 $ 752,841 ALLOWANCE FOR LOAN LOSSES The allowance for loan losses constitutes the amount available to absorb losses within the loan portfolio. As ofSeptember 30, 2022 , the allowance for loan losses was$9,211,000 as compared to$8,680,000 as ofDecember 31, 2021 . The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for possible loan losses when management believes that the collectability of the principal is unlikely. The risk characteristics of the loan portfolio are managed through various control processes, including credit evaluations of individual borrowers, periodic reviews, and diversification by industry. Risk is further mitigated through the application of lending procedures such as the holding of adequate collateral and the establishment of contractual guarantees. Management performs a quarterly analysis to determine the adequacy of the allowance for loan losses. The methodology in determining adequacy incorporates specific and general allocations together with a risk/loss analysis on various segments of the portfolio according to an internal loan review process. This assessment results in an allocated allowance. Management maintains its loan review and loan classification standards consistent with those of its regulatory supervisory authority. Management considers, based upon its methodology, that the allowance for loan losses is adequate to cover foreseeable future losses. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future. On a quarterly basis, management evaluates the qualitative factors utilized in the calculation of the Company's allowance for loan losses and various adjustments are made to these factors as deemed necessary at the time of evaluation. The uncertain economic climate has played a large 46 role in the qualitative factor adjustments that have been implemented throughout 2021 and the first nine months of 2022. Qualitative factors remained unchanged during the first quarter of 2021, as the economy and unemployment levels showed marked improvement over the prior quarter. During the second quarter of 2021, the qualitative factors related to the local/regional economy were decreased by one basis point across all loan segments, as the economy and job growth in the Company's market areas demonstrated marked improvement over the prior quarter, and the qualitative factor related to collateral values was increased by one basis point for both theCommercial Real Estate andResidential Real Estate portfolio segments due to an artificial increase in market values in the real estate sector as individuals' willingness to pay above-average market prices has sparked uncertainty surrounding collateral values in the real estate market. Qualitative factors remained unchanged during the third quarter of 2021. During the fourth quarter of 2021, the qualitative factors related to external factors/conditions were increased by one basis point across all loan segments due increased inflation rates, as well as elevated unemployment levels (although improved from 2020 and early 2021) and the uncertainty of how broad the changes implemented by theFederal Reserve would be. The qualitative factors related to collateral values were also increased by one basis point across all loan segments during the fourth quarter of 2021, as collateral values continued to artificially increase as individuals were willing to pay above-average market prices in all sectors. During the first quarter of 2022, the qualitative factors related to the local/regional economy were increased by one basis point across all loan segments due to ongoing economic uncertainty resulting from supply chain disruptions caused by the COVID-19 pandemic, conflicts in foreign countries causing inflationary pressures due to reductions/disruptions in the production of the commodities controlled by these countries, increased interest rates, and the overall inflation rate continuing to rise. During the second quarter of 2022, the qualitative factors remained unchanged. During the third quarter of 2022, the qualitative factors related to the management and review systems components were each decreased by two basis points across all loan segments due to consistency and experience within the Company's management and satisfactory exam results related to the Company's loan review process. Modifications granted in compliance with Section 4013 of the CARES Act were highest in theCommercial Real Estate portfolio segment, the long-term effects of which are still very unclear, as there is still uncertainty related to the lagging economic effects of the COVID-19 pandemic, especially in relation to this segment of the Company's loan portfolio. See Allowance for Loan Losses on page 17 for further discussion. The Analysis of Allowance for Loan Losses table contains an analysis of the allowance for loan losses indicating charge-offs and recoveries for the nine months endedSeptember 30, 2022 and 2021. Net charge-offs as a percentage of average loans was 0.02% and 0.01% for the nine months endedSeptember 30, 2022 and 2021, respectively. Net charge-offs amounted to$125,000 the nine months endedSeptember 30, 2022 as compared to$100,000 for the nine months endedSeptember 30, 2021 . For the nine months endedSeptember 30, 2022 , the provision for loan losses was$656,000 as compared to$455,000 for the nine months endedSeptember 30, 2021 . The provision, net of charge-offs and recoveries, resulted in the quarter end allowance for loan losses of$9,211,000 of which 7.8% was attributed to the Commercial and Industrial component; 65.7% attributed to theCommercial Real Estate component; 17.5% attributed to theResidential Real Estate component; 0.8% attributed to the Consumer component; and 8.2% being the unallocated component (refer to the activity in Note 4 - Loans and Allowance for Loan Losses on page 14). The Company determined that the provision for loan losses made during the current quarter was sufficient to maintain the allowance for loan losses at a level necessary for the probable losses inherent in the loan portfolio as ofSeptember 30, 2022 . 47
Analysis of Allowance for Loan Losses
(Dollars in thousands)
September 30 ,September 30 , As of and for the nine months ended: 2022
2021
Beginning balance $ 8,680 $ 7,933
Charge-offs:
Commercial and Industrial 158 13
Commercial Real Estate - 29
Residential Real Estate 12 65
Consumer 16 33
186 140
Recoveries:
Commercial and Industrial 2 -
Commercial Real Estate 38 30
Residential Real Estate 16 2
Consumer 5 8
61 40
Net charge-offs 125 100Additions charged to operations 656 455 Balance at end of period $ 9,211
$ 8,288
Ratio of net charge-offs during the period to 0.02 % 0.01 % average loans outstanding during the period Allowance for loan losses to average loans 1.16 % 1.13 %
outstanding during the period
It is the policy of management and the Company's Board of Directors to make a provision for both identified and unidentified losses inherent in its loan portfolio. A provision for loan losses is charged to operations based upon an evaluation of the potential losses in the loan portfolio. This evaluation takes into account such factors as portfolio concentrations, delinquency trends, trends of non-accrual and classified loans, economic conditions, and other relevant factors. The loan review process, which is conducted quarterly, is an integral part of the Bank's evaluation of the loan portfolio. A detailed quarterly analysis to determine the adequacy of the Company's allowance for loan losses is reviewed by the Board of Directors. With the Bank's manageable level of net charge-offs and recoveries along with the additions to the reserve from the provision out of operations, the allowance for loan losses as a percentage of year-to-date average loans amounted to 1.16% and 1.13% atSeptember 30, 2022 and 2021, respectively.
NON-PERFORMING ASSETS
The table on page 51 details the Company's non-performing assets and impaired
loans as of the dates indicated. Generally, a loan is classified as non-accrual
and the accrual of interest on such a loan is discontinued when the contractual
payment of principal or interest has become 90 days past due or management has
serious doubts about further collectability of principal or interest. A loan may
remain on accrual status if it is in the process of collection and is either
guaranteed or well secured. When a loan is placed on non-accrual status, unpaid
interest credited to income in the current year is reversed and unpaid interest
accrued in prior years is charged against current period income. A modification
of a loan constitutes a TDR when a borrower is experiencing financial difficulty
and the modification constitutes a concession that the Company would not
otherwise consider. Modifications to loans classified as TDRs generally include
reductions in contractual interest rates, principal deferments and extensions of
maturity dates at a stated interest rate lower than the current market for a new
loan with similar risk characteristics. While unusual, there may be instances of
loan principal forgiveness. Any loan modifications made in response to the
COVID-19 pandemic
48
were not considered TDRs as long as the criteria set forth in Section 4013 of
the CARES Act were met. Foreclosed assets held for resale represent property
acquired through foreclosure, or considered to be an in-substance foreclosure.
Total non-performing assets amounted to $6,082,000 as of September 30, 2022 , as
compared to $7,066,000 as of December 31, 2021 . The economy is very unstable.
Inflation is at a four-decade high. The war between Ukraine and Russia is
creating worldwide turmoil. The unemployment rate has dropped significantly
compared to the beginning of the COVID-19 pandemic, but the labor force
participation rate has also fallen. The need for workers has driven wages up in
most sectors. Inflation is causing extreme concerns in all areas of the economy.
The war abroad and its effects on various commodities are pushing inflationary
concerns. Values of new and used homes and automobiles continue to climb. The
Federal Reserve has indicated a plan to continue to raise interest rates at an
accelerated level throughout the year. There has also been a resurgence of the
COVID-19 pandemic in some areas of the country and world. These forces have had
a direct effect on the Company's non-performing assets. The Company is closely
monitoring all segments of its loan portfolio because of the current uncertain
economic environment. Non-accrual loans totaled $5,917,000 as of
September 30, 2022 , as compared to $7,066,000 as of December 31, 2021 . The
decrease in non-accrual loans from December 31, 2021 to September 30, 2022 was
mainly the result of the payoff of one non-accrual loan to a contractor
specializing in modular construction which carried a balance of $1,000,000 at
December 31, 2021 . There were no foreclosed assets held for resale as of
September 30, 2022 and December 31, 2021 . There was one loan past-due 90 days or
more and still accruing interest at September 30, 2022 that carried a balance of
$165,000 and was well-secured by residential real estate and in the process of
collection. There were no loans past-due 90 days or more and still accruing
interest as of December 31, 2021 .
Non-performing assets to total loans was 0.72% at September 30, 2022 and 0.94%
at December 31, 2021 . Non-performing assets to total assets was 0.46% at
September 30, 2022 and 0.54% at December 31, 2021 . The allowance for loan losses
to total non-performing assets was 151.45% as of September 30, 2022 as compared
to 122.84% as of December 31, 2021 . Additional detail can be found on page 51 in
the Non-Performing Assets and Impaired Loans table and page 27 in the
Non-Performing Assets table. Asset quality is a priority and the Company retains
a full-time loan review officer to closely track and monitor overall loan
quality, along with a full-time loan workout department to manage collection and
liquidation efforts.
Performing substandard loans which are not deemed to be impaired have
characteristics that cause management to have doubts regarding the ability of
the borrower to perform under present loan repayment terms and which may result
in reporting these loans as non-performing loans in the future. Performing
substandard loans not deemed to be impaired amounted to $10,645,000 at
September 30, 2022 , compared to $10,463,000 at December 31, 2021 .
Impaired loans were $12,177,000 at September 30, 2022 and $13,673,000 at
December 31, 2021 . The largest impaired loan relationship at September 30, 2022
and December 31, 2021 consisted of a non-performing loan to a student housing
holding company which is secured by commercial real estate. At September 30,
2022 , the loan carried a balance of $3,090,000 , net of $1,989,000 that had been
charged off to date, compared to December 31, 2021 when the loan carried a
balance of $3,090,000 , net of $1,989,000 that had been charged off to date. The
second largest impaired loan relationship at September 30, 2022 and December 31,
2021 consisted of one performing loan to a student housing holding company,
which is classified as a TDR. The loan is secured by commercial real estate and
carried a balance of $2,812,000 as of September 30, 2022 , net of $943,000 that
had been charged off to date, compared to December 31, 2021 when the loan
carried a balance of $2,864,000 , net of $943,000 that had been charged off to
date. The third largest impaired loan relationship at September 30, 2022 and
December 31, 2021 consisted of five non-performing loans to a plastic processing
company focused on non-post-consumer recycling. Three loans are classified in
the Commercial and Industrial portfolio and modified as TDRs and two loans are
secured by commercial real estate. The loans carried an aggregate balance of
$1,096,000 at September 30, 2022 , compared to December 31, 2021 when the loans
carried an aggregate balance of $1,176,000 .
The Company estimates impairment based on its analysis of the cash flows or
collateral estimated at fair value less cost to sell. For collateral dependent
loans, the estimated appraisal or other qualitative adjustments and cost to
sell percentages are determined based on the market area in which the real
estate securing the loan is located, among other factors, and therefore, can
differ from one loan to another. Of the $12,177,000 in impaired loans at
September 30, 2022 , none were located outside of the Company's primary market
area.
49
The outstanding recorded investment of TDRs as of September 30, 2022 and
December 31, 2021 was $7,589,000 and $8,020,000 , respectively. The decrease in
TDRs at September 30, 2022 as compared to December 31, 2021 is mainly
attributable to regular principal payments and paydowns on existing TDRs that
were completed during the nine months ended September 30, 2022 . Of the thirty
restructured loans at September 30, 2022 , four loans were classified in the
Commercial and Industrial portfolio, twenty-five loans were classified in the
Commercial Real Estate portfolio, and one loan was classified in the Residential
Real Estate portfolio. Troubled debt restructurings at September 30, 2022
consisted of ten term modifications beyond the original stated term, three rate
modifications, and sixteen payment modifications. There was also one troubled
debt restructuring that experienced all three types of modifications-payment,
rate, and term. TDRs are separately evaluated for payment disclosures, and if
necessary, a specific allocation is established. There were no specific
allocations attributable to the TDRs at September 30, 2022 or December 31, 2021 .
There were no unfunded commitments attributable to the TDRs at September 30,
2022 and December 31, 2021 .
At September 30, 2022 , three commercial and industrial loans classified as TDRs
with a combined recorded investment of $670,000 and four commercial real estate
loans classified as TDRs with a combined recorded investment of $107,000 were
not in compliance with the terms of their restructure, compared to September 30,
2021 when three commercial and industrial loans classified as TDRs with a
combined recorded investment of $724,000 , eight commercial real estate loans
classified as TDRs with a combined recorded investment of $541,000 , and one
residential real estate loan classified as a TDR with a recorded investment of
$15,000 were not in compliance with the terms of their restructure.
Of the loans that were modified as TDRs within the twelve months preceding
September 30, 2022 , no loans experienced payment defaults during the three or
nine months ended September 30, 2022 . Of the loans that were modified as TDRs
during the twelve months preceding September 30, 2021 , three commercial real
estate loans totaling $291,000 experienced payment defaults during the nine
months ended September 30, 2021 . No loans that were modified as TDRs during the
twelve months preceding September 30, 2021 experienced payment defaults during
the three months ended September 30, 2021 .
The Company's non-accrual loan valuation procedure for any loans greater than
$250,000 requires an appraisal to be obtained and reviewed annually at year end,
unless the Board of Directors waives such requirement for a specific loan, in
favor of obtaining a Certificate of Inspection instead, defined as an internal
evaluation completed by the Company. A quarterly collateral evaluation is
performed which may include a site visit, property pictures and discussions with
realtors and other similar business professionals to ascertain current values.
For non-accrual loans less than $250,000 upon classification and typically
at year end, the Company completes a Certificate of Inspection, which includes
the results of an onsite inspection, and may consider value indicators such as
insured values, tax assessed values, recent sales comparisons and a review of
the previous evaluations.
Improving loan quality is a priority. The Company actively works with borrowers
to resolve credit problems and will continue its close monitoring efforts in
2022. Excluding the assets disclosed in the Non-Performing Assets and Impaired
Loans tables below and the Troubled Debt Restructurings section in Note 4 -
Loans and Allowance for Loan Losses, management is not aware of any information
about borrowers' possible credit problems which cause serious doubt as to their
ability to comply with present loan repayment terms.
In addition, regulatory authorities, as an integral part of their examinations,
periodically review the allowance for possible loan losses. They may require
additions to allowances based upon their judgments about information available
to them at the time of examination.
The economic climate remains in a very frail state. The war between Ukraine and
Russia has exacerbated the difficulties in the national and state economy and
experts at all levels are attempting to calculate the intermediate or long term
affects. The Company may experience difficulties collecting payments on time
from its borrowers, and certain types of loans may need to be modified, which
could cause a rise in the level of impaired loans, non-performing assets,
charge-offs, and delinquencies. Should such metrics increase, additions to the
balance of the Company's allowance for loan losses could be required. The extent
of the impact of these stressors on the Company's operational and financial
50
performance will depend on certain developments including inflationary controls
enacted, the labor force, supply bottlenecks, the longevity of the war, and the
effectiveness in controlling the lingering effects of the COVID-19 outbreak,
etc. and any after-effects of these factors. These factors may not immediately
impact the Company's operational and financial performance, as the effects of
these factors may lag into the future. The Company is also susceptible to the
impact of economic and fiscal policy factors that may evolve in the current
economic environment.
A concentration of credit exists when the total amount of loans to borrowers,
who are engaged in similar activities that are similarly impacted by economic or
other conditions, exceed 10% of total loans. As of September 30, 2022 and
December 31, 2021 , management is of the opinion that there were no loan
concentrations exceeding 10% of total loans.
Non-Performing Assets and Impaired Loans
(Dollars in thousands) September 30, December 31,
2022 2021
Non-performing assets
Non-accrual loans $ 5,917 $ 7,066Foreclosed assets held for resale - - Loans past-due 90 days or more and still accruing interest 165 - Total non-performing assets $ 6,082
$ 7,066 Impaired loans Non-accrual loans $ 5,917 $ 7,066 Accruing TDRs 6,260 6,607 Total impaired loans 12,177 13,673
Allocated allowance for loan losses - - Net investment in impaired loans$ 12,177
Impaired loans with a valuation allowance $ - $ - Impaired loans without a valuation allowance 12,177
13,673
Total impaired loans$ 12,177
Allocated valuation allowance as a percent of impaired loans - % - % Impaired loans to total loans 1.44 % 1.81 % Non-performing assets to total loans 0.72 % 0.94 % Non-performing assets to total assets 0.46 % 0.54 % Allowance for loan losses to impaired loans 75.64 % 63.48 % Allowance for loan losses to total non-performing assets 151.45 %
122.84 %
Real estate mortgages comprise 89.2% of the loan portfolio as ofSeptember 30, 2022 , as compared to 88.3% as ofDecember 31, 2021 . Real estate mortgages consist of both residential and commercial real estate loans. The real estate loan portfolio is well diversified in terms of borrowers, collateral, interest rates, and maturities. Also, the residential real estate loan portfolio is largely comprised of fixed rate mortgages. The real estate loans are concentrated primarily in the Company's market area and are subject to risks associated with the local economy. The commercial real estate loans typically reprice approximately every three to five years and are also concentrated in the Company's market area. The Company's loss exposure on its impaired loans continues to be mitigated by collateral positions on these loans. The allocated allowance for loan losses associated with impaired loans is generally computed based upon the related collateral value of the loans. The collateral values are determined by recent appraisals or Certificates of Inspection, but are generally discounted by management based on historical dispositions, changes in market conditions since the last valuation and management's expertise and knowledge of the borrower and the borrower's business.
DEPOSITS, OTHER BORROWED FUNDS AND SUBORDINATED DEBT
Consumer and commercial retail deposits are attracted primarily by the Bank's
eighteen full service office locations, one loan production office and through
its internet banking presence. The Bank offers a broad selection of
51
deposit products and continually evaluates its interest rates and fees on
deposit products. The Bank regularly reviews competing financial institutions'
interest rates, especially when establishing interest rates on certificates of
deposit and municipal deposits.
Total deposits decreased $19,660,000 to $1,058,309,000 as of September 30, 2022
as non-interest bearing deposits increased by $2,854,000 and interest bearing
deposits decreased by $22,514,000 from year-end 2021. The decrease in deposits
was the result of a $84,608,000 decrease in municipal deposits and other normal
fluctuations. Total short-term and long-term borrowings increased to
$119,748,000 as of September 30, 2022 , from $62,377,000 at year-end 2021, an
increase of $57,371,000 or 92.0%. The increase in total borrowings was mainly
the result of increased short-term borrowings due to decreased deposits and
growth in the loan portfolio.
On December 10, 2020 , the Corporation issued $25,000,000 aggregate principal
amount of Subordinated Notes due December 31, 2030 (the "2020 Notes"). The 2020
Notes are intended to be treated as Tier 2 capital for regulatory capital
purposes. The 2020 Notes bear a fixed interest rate of 4.375% per year for the
first five years and then float based on a benchmark rate (as defined).
CAPITAL STRENGTH
Normal increases in capital are generated by net income, less dividends paid out. During the nine months endedSeptember 30, 2022 , net income less dividends paid increased capital by$5,860,000 . Accumulated other comprehensive (loss) income derived from net unrealized gains on debt securities available-for-sale also impacts capital. AtDecember 31, 2021 accumulated other comprehensive income was$7,588,000 . Accumulated other comprehensive loss stood at$32,642,000 atSeptember 30, 2022 , a decrease of$40,230,000 . Fluctuations in interest rates have regularly impacted the gain/loss position in the Bank's securities portfolio, as well as its decision to sell securities at a gain or loss. The fluctuations from net unrealized gains on debt securities available-for-sale do not affect regulatory capital, as the Bank elected to opt-out of the inclusion of this item with the filing of theMarch 31, 2015 Call Report. The Company held 231,611 and 231,612 shares of common stock as treasury stock atSeptember 30, 2022 andDecember 31, 2021 , respectively. This had an effect of reducing our total stockholders' equity by$5,709,000 as ofSeptember 30, 2022 andDecember 31, 2021 .
Total stockholders' equity was
AtSeptember 30, 2022 the Bank met the definition of a "well-capitalized" institution under the regulatory framework for prompt corrective action and the minimum capital requirements under Basel III. The following table presents the Bank's capital ratios as ofSeptember 30, 2022 andDecember 31, 2021 : To Be Well Capitalized Under Prompt September 30, December 31, Corrective Action 2022 2021 Regulations
Tier 1 leverage ratio (to average assets) 10.47 % 10.14 % 5.00 % Common Equity Tier 1 capital ratio (to risk-weighted assets) 14.89 % 15.52 % 6.50 % Tier 1 risk-based capital ratio (to risk-weighted assets) 14.89 % 15.52 % 8.00 % Total risk-based capital ratio 15.90 % 16.57 % 10.00 % Under the final capital rules that became effective onJanuary 1, 2015 , there was a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement was phased in over three years beginning in 2016. The capital buffer requirement effectively raises the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5%, and the total capital ratio 52
to 10.5% on a fully phased-in basis as of
The Corporation's capital ratios are not materially different than those of the Bank.
LIQUIDITY The Company's objective is to maintain adequate liquidity to meet funding needs at a reasonable cost and provide contingency plans to meet unanticipated funding needs or a loss of funding sources, while minimizing interest rate risk. Adequate liquidity is needed to provide the funding requirements of depositors' withdrawals, loan growth, and other operational needs.
Sources of liquidity are as follows:
? Growth in the core deposit base;
? Proceeds from sales or maturities of securities;
? Payments received on loans and mortgage-backed securities;
? Overnight correspondent bank borrowings on various credit lines, notes, etc.,
with various levels of capacity;
? Securities sold under agreements to repurchase; and
? Brokered CDs.
AtSeptember 30, 2022 the Company had$468,873,000 in maximum borrowing capacity at FHLB (inclusive of the outstanding balances of FHLB long-term notes, FHLB short-term borrowings, and irrevocable standby letters of credit issued by FHLB); the maximum borrowing capacity at ACBB was$15,000,000 and the maximum borrowing capacity of the Federal Discount Window was$2,389,000 . The Company enters into "Repurchase Agreements" in which it agrees to sell securities subject to an obligation to repurchase the same or similar securities. Because the agreement both entitles and obligates the Company to repurchase the assets, the Company may transfer legal control of the securities while still retaining effective control. As a result, the repurchase agreements are accounted for as collateralized financing agreements (secured borrowings) and act as an additional source of liquidity. Securities sold under agreements to repurchase were$28,519,000 atSeptember 30, 2022 . Asset liquidity is provided by securities maturing in one year or less, other short-term investments, federal funds sold, and cash and due from banks. The liquidity is augmented by repayment of loans and cash flows from mortgage-backed and asset-backed securities. Liability liquidity is accomplished primarily by maintaining a core deposit base, acquired by attracting new deposits and retaining maturing deposits. Also, short-term borrowings provide funds to meet liquidity needs. Net cash flows provided by operating activities were$11,392,000 and$11,261,000 atSeptember 30, 2022 and 2021, respectively. Net income amounted to$10,869,000 for the nine months endedSeptember 30, 2022 and$11,506,000 for the nine months endedSeptember 30, 2021 . During the nine months endedSeptember 30, 2022 and 2021, net premium amortization on securities amounted to$2,346,000 and$2,124,000 , respectively. Net losses on sales of mortgage loans amounted to$38,000 for the nine months endedSeptember 30, 2022 , compared to net gains on sales of mortgage loans of$801,000 for the nine months endedSeptember 30, 2021 . Originations from sales of mortgage loans originated for resale exceeded proceeds (net of gains/losses) from sales of mortgage loans originated for resale by$2,819,000 for the nine months endedSeptember 30, 2022 and$1,383,000 for the nine months endedSeptember 30, 2021 . Net securities losses amounted to$181,000 for the nine months endedSeptember 30, 2022 , compared to net securities gains of$165,000 for the nine months endedSeptember 30, 2021 . Accrued interest receivable increased by$118,000 and decreased by$261,000 during the nine months endedSeptember 30, 2022 and 2021, respectively. Other assets increased by$85,000 and$1,422,000 during the nine months endedSeptember 30, 2022 and 2021, respectively. Other liabilities decreased by$363,000 during the nine months endedSeptember 30, 2022 and increased by$44,000 during the nine months endedSeptember 30, 2021 . 53 Investing activities used cash of$96,167,000 and$107,970,000 during the nine months endedSeptember 30, 2022 and 2021, respectively. Net activity in the available-for-sale securities portfolio (including proceeds from sale, maturities, and redemptions, net against purchases) used cash of$1,924,000 during the nine months endedSeptember 30, 2022 , compared to$73,548,000 for the nine months endedSeptember 30, 2021 . Changes in restricted investment in bank stocks used cash of$2,489,000 and$57,000 during the nine months endedSeptember 30, 2022 and 2021, respectively. Net cash used to originate loans amounted to$90,178,000 for the nine months endedSeptember 30, 2022 , compared to$34,091,000 for the nine months endedSeptember 30, 2021 . Purchase of investment in real estate ventures used cash of$1,548,000 during the nine months endedSeptember 30, 2022 , compared to$0 for the nine months endedSeptember 30, 2021 . Financing activities provided cash of$33,917,000 and$204,577,000 during the nine months endedSeptember 30, 2022 and 2021, respectively. Deposits decreased by$19,660,000 during the nine months endedSeptember 30, 2022 , compared to an increase of$208,016,000 during the nine months endedSeptember 30, 2021 . Short-term borrowings increased by$67,371,000 and$10,359,000 during the nine months endedSeptember 30, 2022 and 2021, respectively. Repayment of long-term borrowings used cash of$10,000,000 at bothSeptember 30, 2022 and 2021, respectively. Dividends paid amounted to$5,009,000 for the nine months endedSeptember 30, 2022 , compared to$4,897,000 for the nine months endedSeptember 30, 2021 . Managing liquidity remains an important segment of asset/liability management. The overall liquidity position of the Company is maintained by an active asset/liability management committee. The Company believes that its core deposit base is stable even in periods of changing interest rates. Liquidity and funds management are governed by policies and are measured on a monthly basis. These measurements indicate that liquidity generally remains stable and exceeds the Company's minimum defined levels of adequacy. Other than the trends of continued competitive pressures and volatile interest rates, there are no known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way. Given our financial strength, we expect to be able to maintain adequate liquidity as we manage through the current environment, utilizing current funding options and possibly utilizing new options.
MARKET RISK
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. The Company's market risk is composed primarily of interest rate risk. The Company's interest rate risk results from timing differences in the repricing of assets, liabilities, off-balance sheet instruments, and changes in relationships between rate indices and the potential exercise of explicit or embedded options. Increases in the level of interest rates also may adversely affect the fair value of the Company's securities and other earning assets. Generally, the fair value of fixed-rate instruments fluctuates inversely with changes in interest rates. As a result, increases in interest rates have and could result in further decreases in the fair value of the Company's interest-earning assets, which could adversely affect the Company's results of operations if sold, or, in the case of interest-earning assets classified as available-for-sale, the Company's stockholders' equity, if retained. Under FASB ASC 320-10, Investments -Debt Securities , changes in the unrealized gains and losses, net of taxes, on debt securities classified as available-for-sale are reflected in the Company's stockholders' equity. The Company does not own any trading assets.
Asset/Liability Management
The principal objective of asset/liability management is to manage the
sensitivity of the net interest margin to potential movements in interest rates
and to enhance profitability through returns from managed levels of interest
rate risk. The Company actively manages the interest rate sensitivity of its
assets and liabilities. Several techniques are used for measuring interest rate
sensitivity. Interest rate risk arises from the mismatches in the repricing of
rates on assets and liabilities within a given time period, referred to as a
rate sensitivity gap. If more assets than liabilities mature or reprice within
the time frame, the Company is asset sensitive. This position would contribute
positively to net interest income in a rising rate environment. Conversely, if
more liabilities mature or reprice, the Company is liability sensitive. This
54
position would contribute positively to net interest income in a falling rate
environment. The Company's cumulative gap at one year indicates the Company is
liability sensitive at September 30, 2022 .
Earnings at Risk
The Bank's Asset/Liability Committee ("ALCO") is responsible for reviewing the
interest rate sensitivity position and establishing policies to monitor and
limit exposure to interest rate risk. The guidelines established by ALCO are
reviewed by the Company's Board of Directors. The Company recognizes that more
sophisticated tools exist for measuring the interest rate risk in the balance
sheet beyond interest rate sensitivity gap. Although the Company continues to
measure its interest rate sensitivity gap, the Company utilizes additional
modeling for interest rate risk in the overall balance sheet. Earnings at risk
and economic values at risk are analyzed.
Earnings simulation modeling addresses earnings at risk and net present value
estimation addresses economic value at risk. While each of these interest rate
risk measurements has limitations, taken together they represent a reasonably
comprehensive view of the magnitude of interest rate risk to the Company.
Earnings Simulation Modeling
The Company's net income is affected by changes in the level of interest rates. Net income is also subject to changes in the shape of the yield curve. For example, a flattening of the yield curve would result in a decline in earnings due to the compression of earning asset yields and increased liability rates, while a steepening would result in increased earnings as earning asset and interest-bearing liability yields widen. Earnings simulation modeling is the primary mechanism used in assessing the impact of changes in interest rates on net interest income. The model reflects management's assumptions related to asset yields and rates paid on liabilities, deposit sensitivity, size and composition of the balance sheet. The assumptions are based on what management believes at that time to be the most likely interest rate environment. Earnings at risk is the change in net interest income from a base case scenario under various scenarios of rate shock increases and decreases in the interest rate earnings simulation model. The table on the next page presents an analysis of the changes in net interest income and net present value of the balance sheet resulting from various increases or decreases in the level of interest rates, such as two percentage points (200 basis points) in the level of interest rates. The calculated estimates of change in net interest income and net present value of the balance sheet are compared to current limits approved by ALCO and the Board of Directors. The earnings simulation model projects net interest income would decrease 9.88%, 19.46% and 28.01% in the 100, 200 and 300 basis point increasing rate scenarios presented. In addition, the earnings simulation model projects net interest income would increase 4.56% and 6.34% in the 100 and 200 basis point decreasing rate scenarios presented. All of these forecasts are within the Company's one year policy guidelines, aside from the 300 basis point immediate increase scenario at (28.01)% vs. the policy limit of (25.00)%. The analysis and model used to quantify the sensitivity of net interest income becomes less reliable in a decreasing rate scenario given the current interest rate environment with federal funds trading in the 300 - 325 basis point range and many deposit accounts still lagging at lower rates. Results of the decreasing basis point declining scenarios are affected by the fact that many of the Company's interest-bearing liabilities are at rates below 1% and therefore likely may not decline 100 or more basis points. However, the Company's interest-sensitive assets are able to decline by these amounts. For the nine months endedSeptember 30, 2022 , the cost of interest-bearing liabilities averaged 0.70%, and the yield on interest-earning assets, on a fully taxable equivalent basis, averaged 3.79%.
Net Present Value Estimation
The net present value measures economic value at risk and is used for helping to determine levels of risk at a point in time present in the balance sheet that might not be taken into account in the earnings simulation model. The net present value of the balance sheet is defined as the discounted present value of asset cash flows minus the discounted present value of liability cash flows. AtSeptember 30, 2022 , net present value is projected to decrease 3.56%, 10.68%, 55 and 19.38% in the 100, 200, and 300 basis point immediate increase scenarios, respectively. Additionally, the 100 and 200 basis point immediate decrease scenarios are estimated to affect net present value with a decrease of 2.77% and 16.15%, respectively. All of these scenarios presented are within the Company's policy limits. The computation of the effects of hypothetical interest rate changes are based on many assumptions. They should not be relied upon solely as being indicative of actual results, since the computations do not account for actions management could undertake in response to changes in interest rates.
Effect of Change in Interest Rates
Projected Change
Effect on Net Interest Income
1-Year Net Income Simulation Projection
+300 bp Shock vs. Stable Rate (28.01) %
+200 bp Shock vs. Stable Rate (19.46) %
+100 bp Shock vs. Stable Rate (9.88) %
Flat rate
-100 bp Shock vs. Stable Rate 4.56 %
-200 bp Shock vs. Stable Rate 6.34 %
Effect on Net Present Value of Balance Sheet
Static Net Present Value Change
+300 bp Shock vs. Stable Rate (19.38) %
+200 bp Shock vs. Stable Rate (10.68) %
+100 bp Shock vs. Stable Rate (3.56) %
Flat rate
-100 bp Shock vs. Stable Rate (2.77) %
-200 bp Shock vs. Stable Rate (16.15) %© Edgar Online, source
