AUBURN NATIONAL BANCORPORATION, INC 10-K

ITEM 1. BUSINESS Auburn National Bancorporation, Inc. (the “Company”) is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company was incorporated in Delaware in 1990, and in 1994 it succeeded its Alabama predecessor as the bank holding company controlling AuburnBank, an Alabama state member bank with its principal office in Auburn, Alabama (the “Bank”). The Company and its predecessor have controlled the Bank since 1984. As a bank holding company, the Company may diversify into a broader range of financial services and other business activities than currently are permitted to the Bank under applicable laws and regulations. The holding company structure also provides greater financial and operating flexibility than is presently permitted to the Bank. The Bank has operated continuously since 1907 and currently conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank has been a member of the Federal Reserve System since April 1995. The Bank’s primary regulators are the Federal Reserve and the Alabama Superintendent of Banks (the “Alabama Superintendent”). The Bank has been a member of the Federal Home Loan Bank of Atlanta (the “FHLB”) since 1991. General The Company’s business is conducted primarily through the Bank and its subsidiaries. Although it has no immediate plans to conduct any other business, the Company may engage directly or indirectly in a number of activities that the Federal Reserve has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Table of Contents 5 The Company’s principal executive offices are located at 132 N. Gay Street, Auburn, Alabama 36830, and its telephone number at such address is (334) 821-9200. The Company maintains an Internet website at www.auburnbank.com . The Company’s website and the information appearing on the website are not included or incorporated in, and are not part of, this report. The Company files annual, quarterly and current reports, proxy statements, and other information with the SEC. You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for more information on the operation of the public reference rooms. The SEC maintains an Internet site at www.sec.gov that contains reports, proxy, and other information, where SEC filings are available to the public free of charge. Services The Bank offers checking, savings, transaction deposit accounts and certificates of deposit, and is an active residential mortgage lender in its primary service area. The Bank’s primary service area includes the cities of Auburn and Opelika, Alabama and nearby surrounding areas in East Alabama, primarily in Lee County. The Bank also offers commercial, financial, agricultural, real estate construction and consumer loan products and other financial services. The Bank is one of the largest providers of automated teller services in East Alabama and operates ATM machines in 13 locations in its primary service area. The Bank offers Visa ® Checkcards, which are debit cards with the Visa logo that work like checks but can be used anywhere Visa is accepted, including ATM s. The Bank’s Visa Checkcards can be used internationally through the Plus ® network. The Bank offers online banking, bill payment and other electronic services through its Internet website, www.auburnbank.com . Our online banking services, bill payment and electronic services are subject to certain cybersecurity risks. See “Risk Factors – Our information systems may experience interruptions and security breaches.” Competition The banking business in East Alabama, including Lee County, is highly competitive with respect to loans, deposits, and other financial services. The area is dominated by a number of regional and national banks and bank holding companies that have substantially greater resources, and numerous offices and affiliates operating over wide geographic areas. The Bank competes for deposits, loans and other business with these banks, as well as with credit unions, mortgage companies, insurance companies, and other local and nonlocal financial institutions, including institutions offering services through the mail, by telephone and over the Internet. As more and different kinds of businesses enter the market for financial services, competition from nonbank financial institutions may be expected to intensify further. Among the advantages that larger financial institutions have over the Bank are their ability to finance extensive advertising campaigns, to diversify their funding sources, and to allocate and diversify their assets among loans and securities of the highest yield in locations with the greatest demand. Many of the major commercial banks or their affiliates operating in the Bank’s service area offer services which are not presently offered directly by the Bank and they typically have substantially higher lending limits than the Bank. Banks also have experienced significant competition for deposits from mutual funds, insurance companies and other investment companies and from money center banks’ offerings of high-yield investments and deposits. Certain of these competitors are not subject to the same regulatory restrictions as the Bank. Selected Economic Data The U.S. Census Bureau estimates Lee County’s population was 174,241 in 2020, and has increased approximately 24.2% from 2010 to 2020. The largest employers in the area are Auburn University, East Alabama Medical Center, a Wal -Mart Distribution Center, Mando America Corporation, and Briggs & Stratton. Auto manufacturing and related suppliers are increasingly important along Interstate Highway 85 to the east and west of Auburn. Kia Motors has a large automobile factory in nearby West Point, Georgia, and Hyundai Motors has a large automobile factory in Montgomery, Alabama. Between 2010 and 2022, the Auburn-Opelika MSA grew an estimated 23.9%, the second fastest growing MSA in Alabama. The Auburn-Opelika MSA population is estimated to grow 6.73% from 2022 to 2027. During the same time, household income is estimated to increase 13.34%, to $67,593. Table of Contents 6 Loans and Loan Concentrations The Bank makes loans for commercial, financial and agricultural purposes, as well as for real estate mortgages, real estate acquisition, construction and development and consumer purposes. While there are certain risks unique to each type of lending, management believes that there is more risk associated with commercial, real estate acquisition, construction and development, agricultural and consumer lending than with residential real estate mortgage loans. To help manage these risks, the Bank has established underwriting standards used in evaluating each extension of credit on an individual basis, which are substantially similar for each type of loan. These standards include a review of the economic conditions affecting the borrower, the borrower’s financial strength and capacity to repay the debt, the underlying collateral and the borrower’s past credit performance. We apply these standards at the time a loan is made and monitor them periodically throughout the life of the loan. See “Lending Practices” for a discussion of regulatory guidance on commercial real estate lending. The Bank has loans outstanding to borrowers in all industries within our primary service area. Any adverse economic or other conditions affecting these industries would also likely have an adverse effect on the local workforce, other local businesses, and individuals in the community that have entered into loans with the Bank. For example, the auto manufacturing business and its suppliers have positively affected our local economy, but automobile manufacturing is cyclical and adversely affected by increases in interest rates. Decreases in automobile sales, including adverse changes due to interest rate increases, and the economic effects of the impact of COVID-19, including continuing supply chain disruptions, could adversely affect nearby Kia and Hyundai automotive plants and their suppliers' local spending and employment, and could adversely affect economic conditions in the markets we serve. However, management believes that due to the diversified mix of industries located within the Bank’s primary service area, adverse changes in one industry may not necessarily affect other area industries to the same degree or within the same time frame. The Bank’s primary service area also is subject to both local and national economic conditions and fluctuations. While most loans are made within our primary service area, some residential mortgage loans are originated outside the primary service area, and the Bank from time to time has purchased loan participations from outside its primary service area. Human Capital At December 31, 2021, the Company and its subsidiaries had 152 full-time equivalent employees, including 39 officers. In response to the COVID-19 pandemic, our business continuity plan worked to provide essential banking services to our communities and customers, while protecting our employees’ health. As part of our efforts to exercise social distancing in accordance with the guidelines of the Centers for Disease Control and the Governor of the State of Alabama, starting March 23, 2020, we limited branch lobby service to appointment only while continuing to operate our branch drive-thru facilities and ATMs. We continue to provide services through our online and other electronic channels. In addition, we established remote work access to help employees stay at home where job duties permit. We experienced little turnover as a result of the COVID-19 pandemic. We also have strong employee retention historically. Our average term of service is approximately 10 years. We seek to provide competitive compensation and benefits. We encourage and support the growth and development of our employees and, wherever possible, seek to fill positions by promotion and transfer from within the organization. Career development is advanced through ongoing performance and development conversations with employees, internally developed training programs and other training and development opportunities. Our employees are encouraged to be active in our communities as part of our commitment to these communities and our employees. Statistical Information Certain statistical information is included in response to Item 7 of this Annual Report on Form 10-K. Certain statistical information is also included in response to Item 6, Item 7A and Item 8 of this Annual Report on Form 10-K. Table of Contents 7 SUPERVISION AND REGULATION The Company and the Bank are extensively regulated under federal and state laws applicable to bank holding companies and banks. The supervision, regulation and examination of the Company and the Bank and their respective subsidiaries by the bank regulatory agencies are primarily intended to maintain the safety and soundness of depository institutions and the federal deposit insurance system, as well as the protection of depositors, rather than holders of Company capital stock and other securities. Any change in applicable law or regulation may have a material effect on the Company’s business. The following discussion is qualified in its entirety by reference to the particular laws and rules referred to below. Bank Holding Company Regulation The Company, as a bank holding company, is subject to supervision, regulation and examination by the Federal Reserve under the BHC Act. Bank holding companies generally are limited to the business of banking, managing or controlling banks, and certain related activities. The Company is required to file periodic reports and other information with the Federal Reserve. The Federal Reserve examines the Company and its subsidiaries. The State of Alabama currently does not regulate bank holding companies. The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. The BHC Act generally prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiary. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities that the Federal Reserve has determined by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. On January 30, 2020, the Federal Reserve adopted new rules, effective September 30, 2020 simplifying determinations of control of banking organizations for BHC Act purposes. Bank holding companies that are and remain “well-capitalized” and “well-managed,” as defined in Federal Reserve Regulation Y, and whose insured depository institution subsidiaries maintain “satisfactory” or better ratings under the Community Reinvestment Act of 1977 (the “CRA”), may elect to become “financial holding companies.” Financial holding companies and their subsidiaries are permitted to acquire or engage in activities such as insurance underwriting, securities underwriting, travel agency activities, broad insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary thereto. In addition, under the BHC Act’s merchant banking authority and Federal Reserve regulations, financial holding companies are authorized to invest in companies that engage in activities that are not financial in nature, as long as the financial holding company makes its investment, subject to limitations, including a limited investment term, no day-to-day management, and no cross-marketing with any depositary institutions controlled by the financial holding company. The Federal Reserve recommended repeal of the merchant banking powers in its September 16, 2016 study pursuant to Section 620 of the Dodd -Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), but has taken no action. The Company has not elected to become a financial holding company, but it may elect to do so in the future. Financial holding companies continue to be subject to Federal Reserve supervision, regulation and examination, but the Gramm-Leach-Bliley Act of 1999 the “GLB Act”) applies the concept of functional regulation to subsidiary activities. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. The BHC Act permits acquisitions of banks by bank holding companies, subject to various restrictions, including that the acquirer is “well capitalized” and “well managed”. Under the Alabama Banking Code, with the prior approval of the Alabama Superintendent, an Alabama bank may acquire and operate one or more banks in other states pursuant to a transaction in which the Alabama bank is the surviving bank. In addition, one or more Alabama banks may enter into a merger transaction with one or more out-of-state banks, and an out-of-state bank resulting from such transaction may continue to operate the acquired branches in Alabama. The Dodd-Frank Act permits banks, including Alabama banks, to branch anywhere in the United States. Table of Contents 8 The Company is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company. The Company and the Bank are subject to Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W thereunder. Section 23A defines “covered transactions,” which include extensions of credit, and limits a bank’s covered transactions with any affiliate to 10% of such bank’s capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank’s affiliates. Finally, Section 23A requires that all of a bank’s extensions of credit to its affiliates be appropriately secured by permissible collateral, generally United States government or agency securities. Section 23B of the Federal Reserve Act generally requires covered and other transactions among affiliates to be on terms and under circumstances, including credit standards, that are substantially the same as or at least as favorable to the bank or its subsidiary as those prevailing at the time for similar transactions with unaffiliated companies. Federal Reserve policy and the Federal Deposit Insurance Act, as amended by the Dodd-Frank Act, require a bank holding company to act as a source of financial and managerial strength to its FDIC-insured subsidiaries and to take measures to preserve and protect such bank subsidiaries in situations where additional investments in a bank subsidiary may not otherwise be warranted. In the event an FDIC-insured subsidiary becomes subject to a capital restoration plan with its regulators, the parent bank holding company is required to guarantee performance of such plan up to 5% of the bank’s assets, and such guarantee is given priority in bankruptcy of the bank holding company. In addition, where a bank holding company has more than one bank or thrift subsidiary, each of the bank holding company’s subsidiary depository institutions may be responsible for any losses to the FDIC’s Deposit Insurance Fund (“DIF”), if an affiliated depository institution fails. As a result, a bank holding company may be required to loan money to a bank subsidiary in the form of subordinate capital notes or other instruments which qualify as capital under bank regulatory rules. However, any loans from the holding company to such subsidiary banks likely will be unsecured and subordinated to such bank’s depositors and to other creditors of the bank. See “Capital.” As a result of legislation in 2014 and 2018, the Federal Reserve has revised its Small Bank Holding Company Policy Statement (the “Small BHC Policy”) to expand it to include thrift holding companies and increase the size of “small” for qualifying bank and thrift holding companies from $500 million to up to $3 billion of pro forma consolidated assets. The Federal Reserve confirmed in 2018 that the Company is eligible for treatment as a small banking holding company under the Small BHC Policy. As a result, unless and until the Company fails to qualify under the Small BHC Policy, the Company’s capital adequacy will continue to be evaluated on a bank only basis. See “Capital.” Bank Regulation The Bank is a state bank that is a member of the Federal Reserve. It is subject to supervision, regulation and examination by the Federal Reserve and the Alabama Superintendent, which monitor all areas of the Bank’s operations, including loans, reserves, mortgages, issuances and redemption of capital securities, payment of dividends, establishment of branches, capital adequacy and compliance with laws. The Bank is a member of the FDIC and, as such, its deposits are insured by the FDIC to the maximum extent provided by law, and is subject to various FDIC regulations. See “FDIC Insurance Assessments.” Alabama law permits statewide branching by banks. The powers granted to Alabama-chartered banks by state law include certain provisions designed to provide such banks competitive equality with national banks. Table of Contents 9 The Federal Reserve has adopted the Federal Financial Institutions Examination Council’s (“FFIEC”) rating system, which assigns each financial institution a confidential composite “CAMELS” rating based on an evaluation and rating of six essential components of an institution’s financial condition and operations: Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to market risk, as well as the quality of risk management practices. For most institutions, the FFIEC has indicated that market risk primarily reflects exposures to changes in interest rates. When regulators evaluate this component, consideration is expected to be given to: management’s ability to identify, measure, monitor and control market risk; the institution’s size; the nature and complexity of its activities and its risk profile; and the adequacy of its capital and earnings in relation to its level of market risk exposure. Market risk is rated based upon, but not limited to, an assessment of the sensitivity of the financial institution’s earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices or equity prices; management’s ability to identify, measure, monitor and control exposure to market risk; and the nature and complexity of interest rate risk exposure arising from non-trading positions. Composite ratings are based on evaluations of an institution’s managerial, operational, financial and compliance performance. The composite CAMELS rating is not an arithmetical formula or rigid weighting of numerical component ratings. Elements of subjectivity and examiner judgment, especially as these relate to qualitative assessments, are important elements in assigning ratings. The federal bank regulatory agencies are reviewing the CAMELS rating system and their consistency. The GLB Act and related regulations require banks and their affiliated companies to adopt and disclose privacy policies, including policies regarding the sharing of personal information with third parties. The GLB Act also permits bank subsidiaries to engage in “financial activities” similar to those permitted to financial holding companies. In December 2015, Congress amended the GLB Act as part of the Fixing America’s Surface Transportation Act. This amendment provided financial institutions that meet certain conditions an exemption to the requirement to deliver an annual privacy notice. On August 10, 2018, the federal Consumer Financial Protection Bureau (“CFPB”) announced that it had finalized conforming amendments to its implementing regulation, Regulation P. A variety of federal and state privacy laws govern the collection, safeguarding, sharing and use of customer information, and require that financial institutions have policies regarding information privacy and security. Some state laws also protect the privacy of information of state residents and require adequate security of such data, and certain state laws may, in some circumstances, require us to notify affected individuals of security breaches of computer databases that contain their personal information. These laws may also require us to notify law enforcement, regulators or consumer reporting agencies in the event of a data breach, as well as businesses and governmental agencies that own data. Community Reinvestment Act and Consumer Laws The Bank is subject to the provisions of the CRA and the Federal Reserve’s regulations thereunder. Under the CRA, all FDIC-insured institutions have a continuing and affirmative obligation, consistent with their safe and sound operation, to help meet the credit needs for their entire communities, including low- and moderate-income neighborhoods. The CRA requires a depository institution’s primary federal regulator to periodically assess the institution’s record of assessing and meeting the credit needs of the communities served by that institution, including low - and moderate-income neighborhoods. The bank regulatory agency’s CRA assessment is publicly available. Further, consideration of the CRA is required of any FDIC-insured institution that has applied to: (i) charter a national bank; (ii) obtain deposit insurance coverage for a newly- chartered institution; (iii) establish a new branch office that accepts deposits; (iv) relocate an office; or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, an FDIC-insured financial institution. In the case of bank holding company applications to acquire a bank or other bank holding company, the Federal Reserve will assess the records of each subsidiary depository institution of the applicant bank holding company, and such records may be the basis for denying the application. A less than satisfactory CRA rating will slow, if not preclude, acquisitions, and new branches and other expansion activities and may prevent a company from becoming a financial holding company. CRA agreements with private parties must be disclosed and annual CRA reports must be made to a bank’s primary federal regulator. A financial holding company election, and such election and financial holding company activities are permitted to be continued, only if any affiliated bank has not received less than a “satisfactory” CRA rating. The federal CRA regulations require that evidence of discriminatory, illegal or abusive lending practices be considered in the CRA evaluation. On December 13, 2019, the FDIC and OCC issued a joint notice of proposed rulemaking seeking comment on modernizing the agencies’ CRA regulations. The OCC issued final revised CRA Rules effective October 1, 2020, which were repealed in 2021. The Federal bank regulators are cooperating and working on new CRA regulations, which are expected to be proposed around the end of March 2022. Table of Contents 10 The Bank is also subject to, among other things, the Equal Credit Opportunity Act (the “ECOA”) and the Fair Housing Act and other fair lending laws, which prohibit discrimination based on race or color, religion, national origin, sex and familial status in any aspect of a consumer or commercial credit or residential real estate transaction. The Department of Justice (the “DOJ”), and the federal bank regulatory agencies have issued an Interagency Policy Statement on Discrimination in Lending to provide guidance to financial institutions in determining whether discrimination exists, how the agencies will respond to lending discrimination, and what steps lenders might take to prevent discriminatory lending practices. The DOJ has prosecuted what it regards as violations of the ECOA, the Fair Housing Act, and the fair lending laws, generally. The federal bank regulators have updated their guidance several times on overdrafts, including overdrafts incurred at automated teller machines and point of sale terminals. Overdrafts also have been a CFPB concern, and in 2021 began refocusing on this issue with a view to “insure that banks continue to evolve their businesses to reduce reliance on overdraft and not sufficient funds fees.” Among other things, the federal regulators require banks to monitor accounts and to limit the use of overdrafts by customers as a form of short-term, high-cost credit, including, for example, giving customers who overdraw their accounts on more than six occasions where a fee is charged in a rolling 12 month period a reasonable opportunity to choose a less costly alternative and decide whether to continue with fee-based overdraft coverage. It also encourages placing appropriate daily limits on overdraft fees, and asks banks to consider eliminating overdraft fees for transactions that overdraw an account by a de minimis amount. Overdraft policies, processes, fees and disclosures are frequently the subject of litigation against banks in various jurisdictions. The federal bank regulators continue to consider responsible small dollar lending, including overdrafts and related fee issues and issued principals for offering small-dollar loans in a responsible manner on May 20, 2020. The CFPB proposed on February 6, 2019 to rescind its mandatory underwriting standards for loans covered by its 2017 Payday, Vehicle Title and Certain High-Cost Installment Loans rule, and has separately proposed delaying the effectiveness of such 2017 rule. The CFPB has a broad mandate to regulate consumer financial products and services, whether or not offered by banks or their affiliates. The CFPB has the authority to adopt regulations and enforce various laws, including fair lending laws, the Truth in Lending Act, the Electronic Funds Transfer Act, mortgage lending rules, the Truth in Savings Act, the Fair Credit Reporting Act and Privacy of Consumer Financial Information rules. Although the CFPB does not examine or supervise banks with less than $10 billion in assets, banks of all sizes are affected by the CFPB’s regulations, and the precedents set in CFPB enforcement actions and interpretations. Residential Mortgages CFPB regulations require that lenders determine whether a consumer has the ability to repay a mortgage loan. These regulations establish certain minimum requirements for creditors when making ability to repay determinations, and provide certain safe harbors from liability for mortgages that are "qualified mortgages" and are not “higher-priced.” Generally, these CFPB regulations apply to all consumer, closed-end loans secured by a dwelling including home-purchase loans, refinancing and home equity loans—whether first or subordinate lien. Qualified mortgages must generally satisfy detailed requirements related to product features, underwriting standards, and requirements where the total points and fees on a mortgage loan cannot exceed specified amounts or percentages of the total loan amount. Qualified mortgages must have: (1) a term not exceeding 30 years; (2) regular periodic payments that do not result in negative amortization, deferral of principal repayment, or a balloon payment; (3) and be supported with documentation of the borrower and its credit. On December 10, 2020, the CFPB issued final rules related to “qualified mortgage” loans. Lenders are required under the law to determine that consumers have the ability to repay mortgage loans before lenders make those loans. Loans that meet standards for QM loans are presumed to be loans for which consumers have the ability to repay. We focus our residential mortgage origination on qualified mortgages and those that meet our investors’ requirements, but we may make loans that do not meet the safe harbor requirements for “qualified mortgages.” The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (the “2018 Growth Act”) provides that certain residential mortgages held in portfolio by banks with less than $10 billion in consolidated assets automatically are deemed “qualified mortgages.” This relieves smaller institutions from many of the requirements to satisfy the criteria listed above for “qualified mortgages.” Mortgages meeting the “qualified mortgage” safe harbor may not have negative amortization, must follow prepayment penalty limitations included in the Truth in Lending Act, and may not have fees greater than 3% of the total value of the loan. Table of Contents 11 The Bank generally services the loans it originates, including those it sells. The CFPB’s mortgage servicing standards include requirements regarding force-placed insurance, certain notices prior to rate adjustments on adjustable rate mortgages, and periodic disclosures to borrowers. Servicers are prohibited from processing foreclosures when a loan modification is pending, and must wait until a loan is more than 120 days delinquent before initiating a foreclosure action. Servicers must provide borrowers with direct and ongoing access to its personnel, and provide prompt review of any loss mitigation application. Servicers must maintain accurate and accessible mortgage records for the life of a loan and until one year after the loan is paid off or transferred. These standards increase the cost and compliance risks of servicing mortgage loans, and the mandatory delays in foreclosures could result in loss of value on collateral or the proceeds we may realize from a sale of foreclosed property. The Federal Housing Finance Authority (“FHFA”) updated, effective January 1, 2016, The Federal National Mortgage Association’s (“Fannie Mae’s”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac’s”) (individually and collectively, “GSE”) repurchase rules, including the kinds of loan defects that could lead to a repurchase request to, or alternative remedies with, the mortgage loan originator or seller. These rules became effective January 1, 2016. FHFA also has updated these GSEs’ representations and warranties framework and provided an independent dispute resolution (“IDR”) process to allow a neutral third party to resolve demands after the GSEs’ quality control and appeal processes have been exhausted. The Bank is subject to the CFPB’s integrated disclosure rules under the Truth in Lending Act and the Real Estate Settlement Procedures Act, referred to as “TRID”, for credit transactions secured by real property. Our residential mortgage strategy, product offerings, and profitability may change as these regulations are interpreted and applied in practice, and may also change due to any restructuring of Fannie Mae and Freddie Mac as part of the resolution of their conservatorships. The 2018 Growth Act reduced the scope of TRID rules by eliminating the wait time for a mortgage, if an additional creditor offers a consumer a second offer with a lower annual percentage rate. Congress encouraged federal regulators to provide better guidance on TRID in an effort to provide a clearer understanding for consumers and bankers alike. The law also provides partial exemptions from the collection, recording and reporting requirements under Sections 304(b)(5) and (6) of the Home Mortgage Disclosure Act (“HMDA”), for those banks with fewer than 500 closed-end mortgages or less than 500 open-end lines of credit in both of the preceding two years, provided the bank’s rating under the CRA for the previous two years has been at least “satisfactory.” On August 31, 2018, the CFPB issued an interpretive and procedural rule to implement and clarify these requirements under the 2018 Growth Act. The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted on March 27, 2020. Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” provides banks the option to temporarily suspend certain requirements under ASC 340-10 TDR classifications for a limited period of time to account for the effects of COVID-19. On April 7, 2020, the Federal Reserve and the other banking agencies and regulators issued a statement, “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working With Customers Affected by the Coronavirus (Revised)” (the “Interagency Statement on COVID-19 Loan Modifications”), to encourage banks to work prudently with borrowers and to describe the agencies’ interpretation of how accounting rules under ASC 310-40, “Troubled Debt Restructurings by Creditors,” apply to covered modifications. The Interagency Statement on COVID-19 Loan Modifications was supplemented on June 23, 2020 by the Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions. If a loan modification is eligible, a bank may elect to account for the loan under section 4013 of the CARES Act. If a loan modification is not eligible under section 4013, or if the bank elects not to account for the loan modification under section 4013, the Revised Statement includes criteria when a bank may presume a loan modification is not a TDR in accordance with ASC 310-40. Section 4021 of the CARES Act allows borrowers under 1-to-4 family residential mortgage loans sold to Fannie Mae to request forbearance to the servicer after affirming that such borrower is experiencing financial hardships during the COVID-19 emergency. Such forbearance will be up to 180 days, subject to up to a 180 day extension. During forbearance, no fees, penalties or interest shall be charged beyond those applicable if all contractual payments were fully and timely paid. Except for vacant or abandoned properties, Fannie Mae servicers may not initiate foreclosures on similar procedures or related evictions or sales until December 31, 2020. On February 9. 2021, the forbearance period was extended to March 31, 2021 after being extended to February 28, 2021. Borrowers who are on a COVID-19 forbearance plan as of February 28, 2021 may apply for an additional forbearance extension of up to three additional months. The Bank sells mortgage loans to Fannie Mae and services these on an actual/actual basis. As a result, the Bank is not obligated to make any advances to Fannie Mae on principal and interest on such mortgage loans where the borrower is entitled to forbearance. FinCEN published a request for information and comment on December 15, 2021 seeking ways to streamline, modernize the United States AML and countering the financing of terrorists. Table of Contents 12 Anti-Money Laundering and Sanctions The International Money Laundering Abatement and Anti-Terr orism Funding Act of 2001 specifies “know your customer” requirements that obligate financial institutions to take actions to verify the identity of the account holders in connection with opening an account at any U.S. financial institution. Bank regulators are required to consider compliance with anti- money laundering laws in acting upon merger and acquisition and other expansion proposals under the BHC Act and the Bank Merger Act, and sanctions for violations of this Act can be imposed in an amount equal to twice the sum involved in the violating transaction, up to $1 million. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as to enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. The USA PATRIOT Act requires financial institutions to establish anti-money laundering programs, and sets forth minimum standards, or “pillars” for these programs, including: ● the development of internal policies, procedures, and controls; ● the designation of a compliance officer; ● an ongoing employee training program; ● an independent audit function to test the programs; and ● ongoing customer due diligence and monitoring. Federal Financial Crimes Enforcement Network (“FinCEN”) rules effective May 2018 require banks to know the beneficial owners of customers that are not natural persons, update customer information in order to develop a customer risk profile, and generally monitor such matters. On August 13, 2020, the federal bank regulators issued a joint statement clarifying that isolated or technical violations or deficiencies are generally not considered the kinds of problems that would result in an enforcement action. The statement addresses how the agencies evaluate violations of individual pillars of the Bank Secrecy Act and anti-money laundering (“AML/BSA”) compliance program. It describes how the agencies incorporate the customer due diligence regulations and recordkeeping requirements issued by the U.S. Department of the Treasury (“Treasury”) as part of the internal controls pillar of a financial institution's AML/BSA compliance program. On September 16, 2020, FinCEN issued an advanced notice of proposed rulemaking seeking public comment on a wide range of potential regulatory amendments under the Bank Secrecy Act. The proposal seeks comment on incorporating an “effective and reasonably designed” AML/BSA program component to empower financial institutions to allocate resources more effectively. This component also would seek to implement a common understanding between supervisory agencies and financial institutions regarding the necessary AML/BSA program elements, and would seek to impose minimal additional obligations on AML programs that already comply under the existing supervisory framework. On October 23, 2020, FinCEN and the Federal Reserve invited comment on a proposed rule that would amend the recordkeeping and travel rules under the Bank Secrecy Act, which would lower the applicable threshold from $3,000 to $250 for international transactions and apply these to transactions using convertible virtual currencies and digital assets with legal tender status. On January 1, 2021, Congress enacted the Anti-Money Laundering Act of 2020 and the Corporate Transparency Act (collectively, the “AML Act”), to strengthen anti-money laundering and countering terrorism financing programs. Among other things, the AML Act: • specifies uniform disclosure of beneficial ownership information for all U.S. and foreign entities conducting business in the U.S.; • increases potential fines and penalties for BSA violations and improves whistleblower incentives; Table of Contents 13 • codifies the risk-based approach to AML compliance; • modernizes AML systems; • expands the duties and powers FinCEN; and • emphasizes coordination and information-sharing among financial institutions, U.S. financial regulators and foreign financial regulators. The United States has imposed various sanctions upon various foreign countries, such as China, Iran, North Korea, Russia and Venezuela, and their certain government officials and persons. Banks are required to comply with these sanctions, which require additional customer screening and transaction monitoring. Other Laws and Regulations The Company is also required to comply with various corporate governance and financial reporting requirements under the Sarbanes-Oxley Act of 2002, as well as related rules and regulations adopted by the SEC, the Public Company Accounting Oversight Board and Nasdaq. In particular, the Company is required to report annually on internal controls as part of its annual report pursuant to Section 404 of the Sarbanes-Oxley Act. The Company has evaluated its controls, including compliance with the SEC rules on internal controls, and expects to continue to spend significant amounts of time and money on compliance with these rules. If the Company fails to comply with these internal control rules in the future, it may materially adversely affect its reputation, its ability to obtain the necessary certifications to its financial statements, its relations with its regulators and other financial institutions with which it deals, and its ability to access the capital markets and offer and sell Company securities on terms and conditions acceptable to the Company. The Company’s assessment of its financial reporting controls as of December 31, 2021 are included in this report with no material weaknesses reported. Payment of Dividends and Repurchases of Capital Instruments The Company is a legal entity separate and distinct from the Bank. The Company’s primary source of cash is dividends from the Bank. Prior regulatory approval is required if the total of all dividends declared by a state member bank (such as the Bank) in any calendar year will exceed the sum of such bank’s net profits for the year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. During 2021, the Bank paid total cash dividends of approximately $3.7 million to the Company. At December 31, 2021, the Bank could have declared and paid additional dividends of approximately $8.3 million without prior regulatory approval. In addition, the Company and the Bank are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums. The appropriate federal and state regulatory authorities are authorized to determine when the payment of dividends would be an unsafe or unsound practice, and may prohibit such dividends. The Federal Reserve has indicated that paying dividends that deplete a state member bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve has indicated that depository institutions and their holding companies should generally pay dividends only out of current year’s operating earnings. Federal Reserve Supervisory Letter SR-09-4 (February 24, 2009), as revised December 21, 2015, applies to dividend payments, stock redemptions and stock repurchases. Prior consultation with the Federal Reserve supervisory staff is required before: • redemptions or repurchases of capital instruments when the bank holding company is experiencing financial weakness; and • redemptions and purchases of common or perpetual preferred stock which would reduce such Tier 1 capital at end of the period compared to the beginning of the period. Table of Contents 14 Bank holding company directors must consider different factors to ensure that its dividend level is prudent relative to maintaining a strong financial position, and is not based on overly optimistic earnings scenarios, such as potential events that could affect its ability to pay, while still maintaining a strong financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer or significantly reduce the bank holding company’s dividends if: • its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; • its prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or • It will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. The Basel III Capital Rules further limit permissible dividends, stock repurchases and discretionary bonuses by the Company and the Bank, respectively, unless the Company and the Bank meet capital conservation buffer requirement effective January 1, 2019. See "Basel III Capital Rules." Under a new provision of the capital rules, effective January 1, 2021, if a bank’s capital ratios are within its buffer requirements, the maximum amount of capital distributions it can make is based on its eligible retained income. Eligible retained income equals the greater of: • net income for the four preceding calendar quarters, net of any distributions and associated tax effects not already reflected in net income; or • the average net income over the preceding four quarters. Regulatory Capital Changes Simplification The federal bank regulators issued final rules on July 22, 2019 simplifying their capital rules. The last of these changes become effective on April 1, 2020. The principal changes for standardized approaches institutions, such the Company and the Bank are: ● Deductions from capital for certain items, such as temporary difference DTAs, MSAs and investments in unconsolidated were decreased to those amounts that individually exceed 25% of CET1; ● Institutions can elect to deduct investments in unconsolidated subsidiaries or subject them to capital requirements; and ● Minority interests would be includable up to 10% of (i) CET1 capital, (ii) Tier 1 capital and (iii) total capital. HVCRE In December 2019, the federal banking regulators published a final rule, effective April 1, 2020, to implement the “high volatility commercial real estate,” or “HVCRE” changes in Section 214 of the 2018 Growth Act. The new rules define HVCRE loans as loans secured by land or improved real property that: ● finance or refinance the acquisition, development, or construction of real property; ● the purpose of such loans must be to acquire, develop, or improve such real property into income producing property; and ● the repayment of the loan must depend on the future income or sales proceeds from, or refinancing of, such real property. Table of Contents 15 Various exclusions from HVCRE are specified. Banking institutions and their holding companies are required to assign 150% risk weight to HVCRE loans. Community Capital Rule On October 29, 2019, the federal banking regulators adopted, effective January 1, 2020, an optional community banking leverage ratio framework applicable to depository institutions and their holding companies intended to reduce regulatory burdens for qualifying community banking organizations that do not use advanced approaches capital measures, and that have: ● less than $10 billion of assets; ● a leverage ratio greater than 9%; ● off-balance sheet exposures of 25% or less of total consolidated assets; and ● trading assets plus trading liabilities of less than 5% of total consolidated assets. The leverage ratio would be Tier 1 capital divided by average total consolidated assets, taking into account the capital simplification discussed above and the CECL related capital transitions. The community bank leverage ratio will be the sole capital measure, and electing institutions will not have to calculate or use any other capital measure. It is estimated that 85% of depository institutions will be eligible to use this rule. The Company expects it would be eligible to make such election, if the Company determined it desirable. After preliminary consideration, the Company believes that it would still need to calculate the regulatory capital ratios, which investors would find helpful in comparing the Company to others. Capital The Federal Reserve has risk-based capital guidelines for bank holding companies and state member banks, respectively. These guidelines required at year end 2019 a minimum ratio of capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) and capital conservation buffer of 10.5%. Tier 1 capital includes common equity and related retained earnings and a limited amount of qualifying preferred stock, less goodwill and certain core deposit intangibles. Voting common equity must be the predominant form of capital. Tier 2 capital consists of non– qualifying preferred stock, qualifying subordinated, perpetual, and/or mandatory convertible debt, term subordinated debt and intermediate term preferred stock, up to 45% of pretax unrealized holding gains on available for sale equity securities with readily determinable market values that are prudently valued, and a limited amount of general loan loss allowance. Tier 1 and Tier 2 capital equals total capital. In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies not subject to the Small BHC Policy, and state member banks, which provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets (“leverage ratio”) equal to 4%. However, bank regulators expect banks and bank holding companies to operate with a higher leverage ratio. The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Higher capital may be required in individual cases and depending upon a bank holding company’s risk profile. All bank holding companies and banks are expected to hold capital commensurate with the level and nature of their risks including the volume and severity of their problem loans. Lastly, the Federal Reserve’s guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 leverage ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity. The level of Tier 1 capital to risk-adjusted assets is becoming more widely used by the bank regulators to measure capital adequacy. The Federal Reserve has not advised the Company or the Bank of any specific minimum leverage ratio or tangible Tier 1 leverage ratio applicable to them. Under Federal Reserve policies, bank holding companies are generally expected to operate with capital positions well above the minimum ratios. The Federal Reserve believes the risk-based ratios do not fully take into account the quality of capital and interest rate, liquidity, market and operational risks. Accordingly, supervisory assessments of capital adequacy may differ significantly from conclusions based solely on the level of an organization’s risk -based capital ratio. Table of Contents 16 The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, requires the federal banking agencies to take “prompt corrective action” regarding depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation. See “Prompt Corrective Action Rules.” Basel III Capital Rules The Federal Reserve and the other bank regulators adopted in June 2013 final capital rules for bank holding companies and banks implementing the Basel Committee on Banking Supervision’s “Basel III: A Global Regulatory Framework for more Resilient Banks and Banking Systems.” These new U.S. capital rules are called the “Basel III Capital Rules,” and generally were fully phased-in on January 1, 2019. The Basel III Capital Rules limit Tier 1 capital to common stock and noncumulative perpetual preferred stock, as well as certain qualifying trust preferred securities and cumulative perpetual preferred stock issued before May 19, 2010, each of which were grandfathered in Tier 1 capital for bank holding companies with less than $15 billion in assets. The Company had no qualifying trust preferred securities or cumulative preferred stock outstanding at December 31, 2020. The Basel III Capital Rules also introduced a new capital measure, “Common Equity Tier I Capital” or “CET1.” CET1 includes common stock and related surplus, retained earnings and, subject to certain adjustments, minority common equity interests in subsidiaries. CET1 is reduced by deductions for: ● Goodwill and other intangibles, other than mortgage servicing assets (“MSRs”), which are treated separately, net of associated deferred tax liabilities (“DTLs”); ● Deferred tax assets (“DTAs”) arising from operating losses and tax credit carryforwards net of allowances and DTLs; ● Gains on sale from any securitization exposure; and ● Defined benefit pension fund net assets (i.e., excess plan assets), net of associated DTLs. The Company made a one-time election in 2015 and, as a result, CET1 will not be adjusted for certain accumulated other comprehensive income (“AOCI”). Additional “threshold deductions” of the following that are individually greater than 10% of CET1 or collectively greater than 15% of CET1 (after the above deductions are also made): ● MSAs, net of associated DTLs; ● DTAs arising from temporary differences that could not be realized through net operating loss carrybacks, net of any valuation allowances and DTLs; and ● Significant common stock investments in unconsolidated financial institutions, net of associated DTLs. As discussed below, recent regulations change these items to simplify and improve their capital treatment. Noncumulative perpetual preferred stock and Tier 1 minority interest not included in CET1, subject to limits, will qualify as additional Tier I capital. All other qualifying preferred stock, subordinated debt and qualifying minority interests will be included in Tier 2 capital. In addition to the minimum risk-based capital requirements, a new “capital conservation buffer” of CET1 capital of at least 2.5% of total risk weighted assets, will be required. The capital conservation buffer will be calculated as the lowest of: ● the banking organization’s CET1 capital ratio minus 4.5%; ● the banking organization’s tier 1 risk-based capital ratio minus 6.0%; and Table of Contents 17 ● the banking organization’s total risk-based capital ratio minus 8.0%. Full compliance with the capital conservation buffer was required by January 1, 2019. At such time, permissible dividends, stock repurchases and discretionary bonuses will be limited to the following percentages based on the capital conservation buffer as calculated above, subject to any further regulatory limitations, including those based on risk assessments and enforcement actions: Buffer % Buffer % Limit More than 2.50% None > 1.875% - 2.50% 60.0% > 1.250% - 1.875% 40.0% > 0.625% - 1.250% 20.0% ≤ 0.625 - 0 - Effective March 20, 2020, the Federal Reserve and the other federal banking regulators adopted an interim final rule that amended the capital conservation buffer in light of the disruptive effects of the COVID-19 pandemic. The interim final rule was adopted as a final rule on August 26, 2020. The new rule revises the definition of “eligible retained income” for purposes of the maximum payout ratio to allow banking organizations to more freely use their capital buffers to promote lending and other financial intermediation activities, by making the limitations on capital distributions more gradual. The eligible retained income is now the greater of (i) net income for the four preceding quarters, net of distributions and associated tax effects not reflected in net income; and (ii) the average of all net income over the preceding four quarters. The interim final rule only affects the capital buffers, and banking organizations were encouraged to make prudent capital distribution decisions. The various capital elements and total capital under the Basel III Capital Rules, as fully phased in on January 1, 2019 are: Fully Phased In January 1, 2019 Minimum CET1 4.50% CET1 Conservation Buffer 2.50% Total CET1 7.0% Deductions from CET1 100% Minimum Tier 1 Capital 6.0% Minimum Tier 1 Capital plus conservation buffer 8.5% Minimum Total Capital 8.0% Minimum Total Capital plus conservation buffer 10.5% Changes in Risk-Weightings The Basel III Capital Rules significantly change the risk weightings used to determine risk weighted capital adequacy. Among various other changes, the Basel III Capital Rules apply a 250% risk-weighting to MSRs, DTAs that cannot be realized through net operating loss carry-backs and significant (greater than 10%) investments in other financial institutions. A 150% risk-weighted category applies to “high volatility commercial real estate loans,” or “HVCRE,” which are credit facilities for the acquisition, construction or development of real property, excluding one-to-four family residential properties or commercial real estate projects where: (i) the loan-to-value ratio is not in excess of interagency real estate lending standards; and (ii) the borrower has contributed capital equal to not less than 15% of the real estate’s “as completed” value before the loan was made. Table of Contents 18 The Basel III Capital Rules also changed some of the risk weightings used to determine risk-weighted capital adequacy. Among other things, the Basel III Capital Rules: ● Assigned a 250% risk weight to MSRs; ● Assigned up to a 1,250% risk weight to structured securities, including private label mortgage securities, trust preferred CDOs and asset backed securities; ● Retained existing risk weights for residential mortgages, but assign a 100% risk weight to most commercial real estate loans and a 150% risk-weight for HVCRE; ● Assigned a 150% risk weight to past due exposures (other than sovereign exposures and residential mortgages); ● Assigned a 250% risk weight to DTAs, to the extent not deducted from capital (subject to certain maximums); ● Retained the existing 100% risk weight for corporate and retail loans; and ● Increased the risk weight for exposures to qualifying securities firms from 20% to 100%. HVCRE loans currently have a risk weight of 150%. Section 214 of the 2018 Growth Act, restricts the federal bank regulators from applying this risk weight except to certain ADC loans. The federal bank regulators issued a notice of a proposed rule on September 18, 2018 to implement Section 214 of the 2018 Growth Act, by revising the definition HVCRE. If this proposal is adopted, it is expected that this proposal could reduce the Company’s risk weighted assets and thereby may increase the Company’s risk-weighted capital. The Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Update (“ASU”) No. 2016-13 “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” on June 16, 2016, which changed the loss model to take into account current expected credit losses (“CECL”) in place of the incurred loss method. The Federal Reserve and the other federal banking agencies adopted rules effective on April 1, 2019 that allows banking organizations to phase in the regulatory capital effect of a reduction in retained earnings upon adoption of CECL over a three year period. On May 8, 2020, the agencies issued a statement describing the measurement of expected credit losses using the CECL methodology, and updated concepts and practices in existing supervisory guidance that remain applicable. CECL is effective for the Company beginning January 1, 2023 and has not been adopted early. CECL’s effects upon the Company have not yet been determined. Prompt Corrective Action Rules All of the federal bank regulatory agencies’ regulations establish risk-adjusted measures and relevant capital levels that implement the “prompt corrective action” standards. The relevant capital measures are the total risk-based capital ratio, Tier 1 risk-based capital ratio, Common equity tier 1 capital ratio, as well as, the leverage capital ratio. Under the regulations, a state member bank will be: ● well capitalized if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 8% or greater, a Common equity tier 1 capital ratio of 6.5% or greater, a leverage capital ratio of 5% or greater and is not subject to any written agreement, order, capital directive or prompt corrective action directive by a federal bank regulatory agency to maintain a specific capital level for any capital measure; ● “adequately capitalized” if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 6% or greater, a Common Equity Tier 1 capital ratio of 4.5% or greater, and generally has a leverage capital ratio of 4% or greater; ● “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 6%, a Common Equity Tier 1 capital ratio of less than 4.5% or generally has a leverage capital ratio of less than 4%; Table of Contents 19 ● “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 4%, a Common Equity Tier 1 capital ratio of less than 3%, or a leverage capital ratio of less than 3%; or ● “critically undercapitalized” if its tangible equity is equal to or less than 2% to total assets. The federal bank regulatory agencies have authority to require additional capital, and have indicated that higher capital levels may be required in light of market conditions and risk. Depository institutions that are “adequately capitalized” for bank regulatory purposes must receive a waiver from the FDIC prior to accepting or renewing brokered deposits, and cannot pay interest rates or brokered deposits that exceeds market rates by more than 75 basis points. Banks that are less than “adequately capitalized” cannot accept or renew brokered deposits. FDICIA generally prohibits a depository institution from making any capital distribution (including paying dividends) or paying any management fee to its holding company, if the depository institution thereafter would be “undercapitalized”. Institutions that are “undercapitalized” are subject to growth limitations and are required to submit a capital restoration plan for approval. A depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of 5% of the depository institution’s total assets at the time it became undercapitalized and the amount necessary to bring the institution into compliance with applicable capital standards. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized”. If the controlling holding company fails to fulfill its obligations under FDICIA and files (or has filed against it) a petition under the federal Bankruptcy Code, the claim against the holding company’s capital restoration obligation would be entitled to a priority in such bankruptcy proceeding over third party creditors of the bank holding company. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized”, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator. Because the Company and the Bank exceed applicable capital requirements, Company and Bank management do not believe that the provisions of FDICIA have had or are expected to have any material effect on the Company and the Bank or their respective operations. Section 201 of the 2018 Growth Act provides that banks and bank holding companies with consolidated assets of less than $10 billion that meet a “community bank leverage ratio,” established by the federal bank regulators between 8% and 10%, are deemed to satisfy applicable risk-based capital requirements necessary to be considered “well capitalized.” The federal banking agencies have the discretion to determine that an institution does not qualify for such treatment due to its risk profile. An institution’s risk profile may be assessed by its off-balance sheet exposure, trading of assets and liabilities, notional derivatives’ exposure, and other methods. The federal bank regulators implemented a CARES Act provision by replacing interim final rules adopted in March 2020, temporarily reducing the community bank leverage ratio threshold. The threshold is 8% through the end of 2020, 8.5% for 2021, and 9% beginning January 1, 2022. Two quarter grace periods are allowed to permit banks that temporarily fall below these thresholds to remain well-capitalized for regulatory purposes. FDICIA FDICIA directs that each federal bank regulatory agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth composition, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares, safety and soundness, and such other standards as the federal bank regulatory agencies deem appropriate. Table of Contents 20 Enforcement Policies and Actions The Federal Reserve and the Alabama Superintendent monitor compliance with laws and regulations. The CFPB monitors compliance with laws and regulations applicable to consumer financial products and services. Violations of laws and regulations, or other unsafe and unsound practices, may result in these agencies imposing fines, penalties and/or restitution, cease and desist orders, or taking other formal or informal enforcement actions. Under certain circumstances, these agencies may enforce these remedies directly against officers, directors, employees and others participating in the affairs of a bank or bank holding company, in the form of fines, penalties, or the recovery, or claw-back, of compensation. The federal prudential banking regulators have been bringing more enforcement actions recently. Fiscal and Monetary Policy Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, the earnings and growth of the Company and the Bank, as well as the values of, and earnings on, its assets and the costs of its deposits and other liabilities are subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the setting of discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits. The Federal Reserve has been paying interest on depository institutions’ required and excess reserve balances since October 2008. The payment of interest on excess reserve balances was expected to give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target rate established by the Federal Open Market Committee. The Federal Reserve has indicated that it may use this authority to implement a mandatory policy to reduce excess liquidity, in the event of inflation or the threat of inflation. In April 2010, the Federal Reserve Board amended Regulation D (Reserve Requirements of Depository Institutions) authorizing the Reserve Banks to offer term deposits to certain institutions. Term deposits, which are deposits with specified maturity dates, will be offered through a Term Deposit Facility. Term deposits will be one of several tools that the Federal Reserve could employ to drain reserves when policymakers judge that it is appropriate to begin moving to a less accommodative stance of monetary policy. In 2011, the Federal Reserve repealed its historical Regulation Q to permit banks to pay interest on demand deposits. On March 3, 2020, the Federal Reserve reduced the Federal Funds rate target by 50 basis points to 1.00-1.25%. The Federal Reserve further reduced the Federal Funds Rate target by an additional 100 basis points to 0-0.25% on March 16, 2020. The Federal Reserve established various liquidity facilities pursuant to section 13(3) of the Federal Reserve Act to help stabilize the financial system. As a result of inflation, the decline in serious COVID-19 cases, and the strengthening of the economy following the March 2020 outbreak of the COVID-19 pandemic, the Federal Reserve is considering increasing the discount rate and reducing its holdings of securities. In light of disruptions in economic conditions caused by the outbreak of COVID-19 and the stress in U.S. financial markets, the Federal Reserve, Congress and the Department of the Treasury took a host of fiscal and monetary measures to minimize the economic effect of COVID-19. The CARES Act provided a $2 trillion stimulus package and various measures to provide relief from the COVID-19 pandemic, including: ● The Paycheck Protection Program (“PPP”), which expands eligibility for special new SBA guaranteed loans, forgivable loans and other relief to small businesses affected by COVID-19. ● A new $500 billion federal stimulus program for air carriers and other companies in severely distressed sectors of the American economy. The lending programs impose stock buyback, dividend, executive compensation, and other restrictions on direct loan recipients. ● Optional temporary suspension of certain requirements under ASC 340-10 TDR classifications for a limited period of time to account for the effects of COVID-19. ● The creation of rapid tax rebates and expansion of unemployment benefits to provide relief to individuals. Table of Contents 21 ● Substantial federal spending and significant changes for health care companies, providers, and patients. Over $525 billion of PPP loans were made in 2020. On December 27, 2020, the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Economic Aid Act”) was signed into law. The Economic Aid Act provides a second $900 billion stimulus package, including $325 billion in additional PPP loans, changed the eligibility rules to focus more on smaller business, further enhances other Small Business Association programs. The nature and timing of any changes in monetary policies and their effect on the Company and the Bank cannot be predicted. The turnover of a majority of the Federal Reserve Board and the members of its FOMC and the appointment of a new Federal Reserve Chairman may result in changes in policy and the timing and amount of monetary policy normalization. FDIC Insurance Assessments The Bank’s deposits are insured by the FDIC’s DIF, and the Bank is subject to FDIC assessments for its deposit insurance. Assessments by the FDIC to pay interest on Financing Corporation (“FICO”) bonds ended in September 2019. Since 2011, and as discussed above under “Recent Regulatory Developments”, the FDIC has been calculating assessments based on an institution’s average consolidated total assets less its average tangible equity (the “FDIC Assessment Base”) in accordance with changes mandated by the Dodd-Frank Act. The FDIC changed its assessment rates which shifted part of the burden of deposit insurance premiums toward depository institutions relying on funding sources other than deposits. In 2016, the FDIC again changed its deposit insurance pricing and eliminated all risk categories and now uses “financial ratios method” based on CAMELS composite ratings to determine assessment rates for small established institutions with less than $10 billion in assets (“Small Banks”). The financial ratios method sets a maximum assessment for CAMELS 1 and 2 rated banks, and set minimum assessments for lower rated institutions. All basis points are annual amounts. The following table shows the FDIC assessment schedule for 2020 applicable to Small Banks, such as the Bank. Established Small Institution CAMELS Composite 1 or 2 3 4 or 5 Initial Base Assessment Rule 3 to 16 basis points 6 to 30 basis points 16 to 30 basis points Unsecured Debt Adjustment -5 to 0 basis points -5 to 0 basis points -5 to 0 basis points Total Base Assessment Rate 1.5 to 16 basis points 3 to 30 basis points 11 to 30 basis points On March 15, 2016 the FDIC implemented Dodd-Frank Act provisions by raising the DIF’s minimum Reserve Ratio from 1.15% to 1.35%. The FDIC imposed a 4.5 basis point annual surcharge on insured depository institutions with total consolidated assets of $10 billion or more (“Large Banks”). The new rules grant credits to smaller banks for the portion of their regular assessments that contribute to increasing the reserve ratio from 1.15% to 1.35%. The FDIC’s reserve ratio reached 1.36% on September 30, 2018, exceeding the minimum requirement. As a result, deposit insurance surcharges on Large Banks ceased, and smaller banks will receive credits against their deposit assessments from the FDIC for their portion of assessments that contributed to the growth in the reserve ratio from 1.15% to 1.35%. The Bank’s credit was $0.2 million, and was received and applied against the Bank’s deposit insurance assessments during 2019 and 2020. Given the extraordinary growth in deposits in the first six months of 2020 due to the pandemic and government stimulus, the reserve ratio declined below 1.35% to 1.30%. The FDIC issued a restoration plan on September 15, 2020 designed to restore the reserve ratio to at least the statutory minimum of 1.35% within 8 years. Although the FDIC maintained current assessment rates, the FDIC may increase deposit assessment rates by up to two basis points without notice, or more following notice and a comment period, to meet the required reserve ratio. Table of Contents 22 On June 22, 2020, the FDIC issued a final rule designed to mitigate the deposit insurance assessment effect of the PPP and the related liquidity programs established by the Federal Reserve. Specifically , the rule removes the effects of participating in PPP and liquidity facilities from the various risk measures used to calculate assessment rates and provides an offset to assessments for the increase in assessment base rates attributed to participation in the PPP and liquidity facilities. Prior to June 30, 2016, when the new assessment system became effective, the Bank’s overall rate for assessment calculations was 9 basis points or less, which was within the range of assessment rates for the lowest “risk category” under the former FDIC assessment rules. The Company recorded FDIC insurance premiums expenses of $0.3 and $0.1 million in 2021 and 2020, respectively. Lending Practices The federal bank regulatory agencies released guidance in 2006 on “Concentrations in Commercial Real Estate Lending” (the “Guidance”). The Guidance defines CRE loans as exposures secured by raw land, land development and construction (including 1-4 family residential construction), multi-family property, and non-farm nonresidential property where the primary or a significant source of repayment is derived from rental income associated with the property (that is, loans for which 50% or more of the source of repayment comes from third party, non-affiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of this property. Loans to REITs and unsecured loans to developers that closely correlate to the inherent risks in CRE markets would also be considered CRE loans under the Guidance. Loans on owner occupied CRE are generally excluded. In December 2015, the Federal Reserve and other bank regulators issued an interagency statement to highlight prudent risk management practices from existing guidance that regulated financial institutions and made recommendations regarding maintaining capital levels commensurate with the level and nature of their CRE concentration risk. The Guidance requires that appropriate processes be in place to identify, monitor and control risks associated with real estate lending concentrations. This could include enhanced strategic planning, CRE underwriting policies, risk management, internal controls, portfolio stress testing and risk exposure limits as well as appropriately designed compensation and incentive programs. Higher allowances for loan losses and capital levels may also be required. The Guidance is triggered when either: Total reported loans for construction, land development, and other land of 100% or more of a bank’s total capital; or Total reported loans secured by multifamily and nonfarm nonresidential properties and loans for construction, land development, and other land are 300% or more of a bank’s total risk-based capital. This Guidance was supplemented by the Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending (December 18, 2015). The Guidance also applies when a bank has a sharp increase in CRE loans or has significant concentrations of CRE secured by a particular property type. The Guidance did not apply to the Bank’s CRE lending activities during 2020 or 2021. At December 31, 2021, the Bank had outstanding $32.4 million in construction and land development loans and $229.8 million in total CRE loans (excluding owner occupied), which represent approximately 30.8% and 218.5%, respectively, of the Bank’s total risk-based capital at December 31, 2021. The Company has always had significant exposures to loans secured by commercial real estate due to the nature of its markets and the loan needs of both its retail and commercial customers. The Company believes its long term experience in CRE lending, underwriting policies, internal controls, and other policies currently in place, as well as its loan and credit monitoring and administration procedures, are generally appropriate to manage its concentrations as required under the Guidance. In 2013, the Federal Reserve and other banking regulators issued their “Interagency Guidance on Leveraged Lending” highlighting standards for originating leveraged transactions and managing leveraged portfolios, as well as requiring banks to identify their highly leveraged transactions, or HLTs. The Government Accountability Office issued a statement on October 23, 2017 that this guidance constituted a “rule” for purposes of the Congressional Review Act, which provides Congress with the right to review the guidance and issue a joint resolution for signature by the President disapproving it. No such action was taken, and instead, the federal bank regulators issued a September 11, 2018 “Statement Reaffirming the Role of Supervisory Guidance.” This Statement indicated that guidance does not have the force or effect of law or provide the basis for enforcement actions, but this guidance can outline supervisory agencies’ views of supervisory expectations and priorities, and appropriate practices. The federal bank regulators continue to identify elevated risks in leveraged loans and shared national credits. Table of Contents 23 The Bank did not have any loans at year-end 2021 or 2020 that were leveraged loans subject to the Interagency Guidance on Leveraged Lending or that were shared national credits. Other Dodd-Frank Act Provisions In addition to the capital, liquidity and FDIC deposit insurance changes discussed above, some of the provisions of the Dodd-Frank Act we believe may affect us are set forth below. Executive Compensation The Dodd-Frank Act provides shareholders of all public companies with a say on executive compensation. Under the Dodd-Frank Act, each company must give its shareholders the opportunity to vote on the compensation of its executives, on a non-binding advisory basis, at least once every three years. The Dodd-Frank Act also adds disclosure and voting requirements for golden parachute compensation that is payable to named executive officers in connection with sale transactions. The SEC is required under the Dodd-Frank Act to issue rules obligating companies to disclose in proxy materials for annual shareholders meetings, information that shows the relationship between executive compensation actually paid to their named executive officers and their financial performance, taking into account any change in the value of the shares of a company’s stock and dividends or distributions. The Dodd-Frank Act also provides that a company’s compensation committee may only select a consultant, legal counsel or other advisor on methods of compensation after taking into consideration factors to be identified by the SEC that affect the independence of a compensation consultant, legal counsel or other advisor. Section 954 of the Dodd-Frank Act added section 10D to the Exchange Act. Section 10D directs the SEC to adopt rules prohibiting a national securities exchange or association from listing a company unless it develops, implements, and discloses a policy regarding the recovery or “claw-back” of executive compensation in certain circumstances. The policy must require that, in the event an accounting restatement due to material noncompliance with a financial reporting requirement under the federal securities laws, the company will recover from any current or former executive officer any incentive-based compensation (including stock options) received during the three year period preceding the date of the restatement, which is in excess of what would have been paid based on the restated financial statements. There is no requirement of wrongdoing by the executive, and the claw-back is mandatory and applies to all executive officers. Section 954 augments section 304 of the Sarbanes-Oxley Act, which requires the CEO and CFO to return any bonus or other incentive or equity-based compensation received during the 12 months following the date of similarly inaccurate financial statements, as well as any profit received from the sale of employer securities during the period, if the restatement was due to misconduct. Unlike section 304, under which only the SEC may seek recoupment, the Dodd -Frank Act requires the Company to seek the return of compensation. The SEC adopted rules in September 2013 to implement pay ratios pursuant to Section 953 of the Dodd-Frank Act, which apply to fiscal year 2017 annual reports and proxy statements. The SEC proposed Rule 10D-1 under Section 954 on July 1, 2015 which would direct Nasdaq and the other national securities exchanges to adopt listing standards requiring companies to adopt policies requiring executive officers to pay back erroneously awarded incentive-based compensation. In February 2017, the acting SEC Chairman indicated interest in reconsidering the pay ratio rule. The Dodd-Frank Act, Section 955, requires the SEC, by rule, to require that each company disclose in the proxy materials for its annual meetings whether an employee or board member is permitted to purchase financial instruments designed to hedge or offset decreases in the market value of equity securities granted as compensation or otherwise held by the employee or board member. The SEC proposed implementing rules in February 2015, though the rules have not been implemented to date. Section 956 of the Dodd-Frank Act prohibits incentive-based compensation arrangements that encourage inappropriate risk taking by covered financial institutions, are deemed to be excessive, or that may lead to material losses. In June 2010, the federal bank regulators adopted Guidance on Sound Incentive Compensation Policies, which, although targeted to larger, more complex organizations than the Company, includes principles that have been applied to smaller organizations similar to the Company. This Guidance applies to incentive compensation to executives as well as employees, who, “individually or a part of a group, have the ability to expose the relevant banking organization to material amounts of risk.” Incentive compensation should: Provide employees incentives that appropriately balance risk and reward; Table of Contents 24 Be compatible with effective controls and risk-management; and Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. The federal bank regulators, the SEC and other regulators proposed regulations implementing Section 956 in April 2011, which would have been applicable to, among others, depository institutions and their holding companies with $1 billion or more in assets. An advance notice of a revised proposed joint rulemaking under Section 956 was published by the financial services regulators in May 2016, but these rules have not been adopted. Debit Card Interchange Fees The “Durbin Amendment” to the Dodd-Frank Act and implementing Federal Reserve regulations provide that interchanged transaction fees for electronic debit transactions be “reasonable” and proportional to certain costs associated with processing the transactions. The Durbin Amendment and the Federal Reserve rules thereunder are not applicable to banks with assets less than $10 billion. Other Legislative and Regulatory Changes Various legislative and regulatory proposals, including substantial changes in banking, and the regulation of banks, thrifts and other financial institutions, compensation, and the regulation of financial markets and their participants and financial instruments, and the regulators of all of these, as well as the taxation of these entities, are being considered by the executive branch of the federal government, Congress and various state governments, including Alabama. President Biden has frozen new rulemaking generally, and has rescinded various of his predecessor’s executive orders, including the February 3, 2017 executive order containing “Core Principles for Regulating the United States Financial System” (“Core Principles”). The Core Principles directed the Secretary of the Treasury to consult with the heads of Financial Stability Oversight Council’s members and report to the President periodically thereafter on how laws and government policies promote the Core Principles and to identify laws, regulations, guidance and reporting that inhibit financial services regulation. The President has also issued an Executive Order 14036 on Promoting Competition in the American Economy (July 9, 2021), which may affect the federal bank regulators’ reviews of bank and bank holding company mergers. The OCC, the FDIC and the CFPB have made proposals to further scrutinize mergers, especially where the confirming institutions have assets greater than $100 million. The President’s Working Group and various agencies have also been working on the regulation of crypto assets, including stable coin, and access to the payments system. Table of Contents 25 The 2018 Growth Act, which, was enacted on May 24, 2018, amends the Dodd -Frank Act, the BHC Act, the Federal Deposit Insurance Act and other federal banking and securities laws to provide regulatory relief in these areas: • consumer credit and mortgage lending; • capital requirements; • Volcker Rule compliance; • stress testing and enhanced prudential standards; • increased the asset threshold under the Federal Reserve’s Small BHC Policy from $1 billion to $3 billion; and • capital formation. We believe the 2018 Growth Act has positively affected our business. The following provisions of the 2018 Growth Act may be especially helpful to banks of our size as regulations adopted in 2019 became effective: • “qualifying community banks,” defined as institutions with total consolidated assets of less than $10 billion, which meet a “community bank leverage ratio” of 8.00% to 10.00%, may be deemed to have satisfied applicable risk based capital requirements as well as the capital ratio requirements; • section 13(h) of the BHC Act, or the “Volcker Rule,” is amended to exempt from the Volcker Rule, banks with total consolidated assets valued at less than $10 billion (“community banking organizations”), and trading assets and liabilities comprising not more than 5.00% of total assets; • “reciprocal deposits” will not be considered “brokered deposits” for FDIC purposes, provided such deposits do not exceed the lesser of $5 billion or 20% of the bank’s total liabilities; and The Volcker Rule change may enable us to invest in certain collateralized loan obligations that are treated as “covered funds” prohibited to banking entities by the Volcker Rule. Reciprocal deposits, such as CDARs, may expand our funding sources without being subjected to FDIC limitations and potential insurance assessments increases for brokered deposits. On July 9, 2019, the federal banking agencies, together with the SEC and the Commodities Futures Trading Commission (“CFTC”), issued a final rule excluding qualifying community banking organizations from the Volcker Rule pursuant to the 2018 Growth Act. The Volcker Rule change may enable us to invest in certain collateralized loan obligations that are treated as “covered funds” and other investments prohibited to banking entities by the Volcker Rule. The applicable agencies also issued final rules simplifying the Volcker Rule proprietary trading restrictions effective January 1, 2020. On June 25, 2020, the agencies adopted a final rule simplifying the Volcker Rule’s covered fund provisions effective October 1, 2020. The FDIC announced on December 19, 2018 a final rule allows reciprocal deposits to be excluded from “brokered deposits” up to the lesser of $5 billion or 20% of their total liabilities. Institutions that are not both well capitalized and well rated are permitted to exclude reciprocal deposits from brokered deposits in certain circumstances. The FDIC issued comprehensive changes to its brokered deposit rules effective April 1, 2021. The revised rules establishes new standards for determining whether an entity meets the statutory definition of “deposit broker,” and identifies a number of business that automatically meet the “primary purpose exception” from a “deposit broker.” The revisions also provide an application process for entities that seek a “primary purpose exception,” but do not meet one of the designated exceptions.” The new rules may provide us greater future flexibility, but we had no brokered deposits at December 31, 2020 or 2021, and historically have not relied on brokered deposits. Table of Contents 26 On November 20, 2020, the Federal Reserve and the other federal bank regulators issued temporary relief for community banks with less than $10 billion in total assets as of December 31, 2019 related to certain regulations and reporting requirements that largely result from growth due to the various relief and stimulus actions in response to the COVID-19 pandemic. In particular, the interim final rule permits these institutions to use asset data as of December 31, 2019, to determine the applicability of various regulatory asset thresholds during calendar years 2020 and 2021. For the same reasons, the Federal Reserve temporarily revised the instructions to a number of its regulatory reports to provide that community banking organizations may use asset data as of December 31, 2019, in order to determine reporting requirements for reports due in calendar years 2020 or 2021. On November 30, 2020, the bank regulators issued a statement urging banks to cease entering into new contracts using U.S. dollar LIBOR rates as soon as practicable and in any event by December 31, 2021, to effect orderly, and safe and sound LIBOR transition. Banks were reminded that operating with insufficient fallback interest rates could undermine financial stability and banks’ safety and soundness. Any alternative reference rate may be used that a bank determines is appropriate for its funding and customer needs. Alabama passed the LIBOR Discontinuance and Replacement Act of 2021 in April 202 to deal with the LIBOR transition. Congress is also considering LIBOR transition legislation. Certain of these new rules, and proposals, if adopted, these proposals could significantly change the regulation or operations of banks and the financial services industry. New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of the nation’s financial institutions.