COMMUNITY BANCORP /VT 10-Q

ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Period Ended March 31, 2023 The following discussion analyzes the consolidated financial condition of Community Bancorp. and its wholly-owned subsidiary, Community National Bank, as of March 31, 2023 and December 31, 2022, and its consolidated results of operations for the three--month interim period and one year period presented. The Company is considered a “smaller reporting company” and a “non-accelerated filer” under the disclosure rules of the SEC. Accordingly, the Company has elected to provide its audited statements of income, comprehensive income, cash flows and changes in shareholders’ equity for a two year, rather than a three year, period and intends to provide smaller reporting company scaled disclosures where management deems it appropriate. The following discussion should be read in conjunction with the Company’s audited consolidated financial statements and related notes contained in its 2022 Annual Report on Form 10-K filed with the SEC. Please refer to Note 1 in the accompanying audited consolidated financial statements for a listing of acronyms and defined terms used throughout the following discussion. FORWARD-LOOKING STATEMENTS This Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, regarding the results of operations, financial condition and business of the Company and its subsidiary. Words used in the discussion below such as "believes," "expects," "anticipates," "intends," "estimates," “projects”, "plans," “assumes”, "predicts," “may”, “might”, “will”, “could”, “should” and similar expressions, indicate that management of the Company is making forward-looking statements. Forward-looking statements are not guarantees of future performance. They necessarily involve risks, uncertainties and assumptions. Examples of forward looking statements included in this discussion include, but are not limited to, statements regarding the estimated contingent liability related to assumptions made within the asset/liability management process; management's expectations as to the future interest rate environment and the Company's related liquidity level; credit risk expectations relating to the Company's loan portfolio and off-balance sheet commitments; and management's general outlook for the future performance of the Company and the local or national economy. Although forward-looking statements are based on management's expectations and estimates as of the date they are made, many of the factors that could influence or determine actual results are unpredictable and not within the Company's control. Factors that may cause actual results to differ materially from those contemplated by these forward-looking statements include, among others, the following possibilities: · interest rates change in such a way as to negatively affect loan demand, the local economy or the Company's net income, asset valuations or margins; · general economic or business conditions, either nationally, regionally or locally, deteriorate, resulting in a decline in credit quality or a diminished demand for the Company's products and services; · the impact of inflation and slowing economic growth on the Company’s customers and on its financial results and performance; · changes in the United States monetary and fiscal policies, including the interest rate policies of the FRB and its regulation of the money supply; · changes in applicable accounting policies, practices and standards; · the geographic concentration of the Company’s loan portfolio and deposit base; · the planned phase out of three month LIBOR by June 30, 2023, which could adversely affect the Company’s interest costs in future periods on its $12,887,000 in principal amount of Junior Subordinated Debentures due December 12, 2037, which currently bear interest at a variable rate, adjusted quarterly, equal to 3-month LIBOR, plus 2.85%; · reductions in deposit levels, which necessitate increased borrowings to fund loans and sale of investment securities; · increases in the level of nonperforming assets and charge-offs; · changes in federal or state tax laws or policy; · changes in laws or government rules, including the rules of the federal Consumer Financial Protection Bureau, or the way in which courts or government agencies interpret or implement those laws or rules, increase our costs of doing business, causing us to limit or change our product offerings or pricing, or otherwise adversely affect the Company's business; 28 Table of Contents · regulatory responses to recent high profile bank failures increase our costs of operation, including through regulatory compliance changes and higher FDIC deposit insurance assessments to replenish the Bank Insurance Fund (BIF); · competitive pressures increase among financial service providers in the Company's northern New England market area or in the financial services industry generally, including competitive pressures from non-bank financial service providers, from increasing consolidation and integration of financial service providers, and from changes in technology and delivery systems; · cybersecurity risks could adversely affect the Company’s business, financial performance or reputation and could result in financial liability for losses incurred by customers or others due to data breaches or other compromise of the Company’s information security systems; · higher-than-expected costs are incurred relating to information technology or difficulties arise in implementing technological enhancements; · management’s risk management measures may not be completely effective; · changes in consumer and business spending, borrowing and savings habits; · operational and internal system failures due to changes in normal business practices, including remote working for Company staff; · increased cybercrime and payment system risk due to increased usage by customers of online, mobile and other remote banking channels; · the ongoing challenges to find qualified workers to maintain a stable workforce; · losses due to the fraudulent or negligent conduct of third parties, including the Company’s service providers, customers and employees; and · adverse changes in the credit rating of U.S. government debt. Readers are cautioned not to place undue reliance on such statements as they speak only as of the date they are made. The Company does not undertake, and disclaims any obligation, to revise or update any forward-looking statements to reflect the occurrence or anticipated occurrence of events or circumstances after the date of this Report, except as required by applicable law. The Company claims the protection of the safe harbor for forward-looking statements provided in the Private Securities Litigation Reform Act of 1995. NON-GAAP FINANCIAL MEASURES Under SEC Regulation G, public companies making disclosures containing financial measures that are not in accordance with GAAP must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure, as well as a statement of the company’s reasons for utilizing the non-GAAP financial measure. The SEC has exempted from the definition of non-GAAP financial measures certain commonly used financial measures that are not based on GAAP. However, three non-GAAP financial measures commonly used by financial institutions, namely tax-equivalent net interest income and tax-equivalent net interest margin (as presented in the tables in the section labeled Interest Income Versus Interest Expense (NII)) and core earnings (as defined and discussed in the Results of Operations section), have not been specifically exempted by the SEC, and may therefore constitute non-GAAP financial measures under Regulation G. We are unable to state with certainty whether the SEC would regard those measures as subject to Regulation G. Management believes that these non-GAAP financial measures are useful in evaluating the Company’s financial performance and facilitate comparisons with the performance of other financial institutions. However, that information should be considered supplemental in nature and not as a substitute for related financial information prepared in accordance with GAAP. OVERVIEW The Company’s consolidated assets on March 31, 2023 were $1.03 billion compared to $1.06 billion at December 31, 2022, a decrease of 2.4%. Significant changes in the asset base were due to a decrease of $33.5 million, or 47.1%, in cash and cash equivalents, which was partially offset by an increase in net loans of $9.5 million, or 1.3%. This demonstrates the Company’s efforts to deploy cash into higher earning assets. The increase in the loan portfolio was primarily attributable to an increase of $5.9 million in commercial & industrial loans, $5.23 million in CRE loans and $1.8 million in municipal loans, which was partially offset by a decrease of $1.9 million in residential junior lien loans and $0.8 million in purchased BHG loans. Total deposits on March 31, 2023 were $888.5 million compared to $923.0 million on December 31, 2022, a decrease of $34.4 million, or 3.7% and an increase of $11.2 million, or 1.28%, compared to March 31, 2022. Year to date, demand and interest-bearing transaction accounts decreased in total by $29.9 million or 5.9%, followed by a decrease of $7.6 million, or 5.4% in money market funds. This was offset minimally by an increase of $3.6 million, or 3.6% in time deposits. An increase of $5.0 million, or 15.1%, in repurchase agreements is also noted since year end and $9.3 million, or 32.4%, since March 31, 2022. A decline in deposits in the first quarter is a normal occurrence for the Company primarily due to normal seasonal outflows. Pricing pressures as depositors look for alternative products with higher interest rates in the current rate environment has resulted in deposit outflows as well. 29 Table of Contents Total interest income increased $2.5 million, or 30.5%, for the first three months of 2023 compared to the same period in 2022. The increase in the loan portfolio, coupled with the increases in the fed funds rate throughout 2022 and in the first quarter of 2023 help to support the year over year increase in interest income. Total interest expense increased $1.6 million, or 224.1%, for the first three months of 2023 compared to the same period in 2022. The recent increases in the fed funds rate have put more pressure on competitive deposit pricing, resulting in an increase in the Company’s money market and time deposit rates. Please refer to the interest rate sensitivity discussion in the Interest Rate Risk and Asset and Liability Management section for more information on the impact that the actions of the FRB’s FOMC in regulating interest rates, and changes in the yield curve, could have on net interest income. The provision for credit losses for the quarter ended March 31, 2023 was determined under ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments, commonly referenced as the Current Expected Credit Losses, or CECL, which the Company adopted effective January 1, 2023. The provision for credit losses for the first three months of 2023 was $286,526 compared to $862,500 for the same period in 2022, a decrease of $575,974, or 66.8%. This decrease to the provision was driven primarily by a write-down on a non-performing CRE loan totaling $667,474 during March 2022. Please refer to Note 5 of the unaudited consolidated financial statements as well as the ACL and provisions discussion in the Credit Risk section of this MD&A. Consolidated net income for the first three months of 2023 increased $933,219 to $3.3 million compared to $2.4 million in the same period of 2022. Year over year, a $2.5 million increase in interest income was offset in part by an increase of $1.6 million in interest expense, but a decrease of $575,974 in the provision for credit losses between periods resulted in an increase of $1.6 million in net interest income after provision for credit losses. These changes, along with other significant changes in non-interest income and non-interest expense are discussed in the appropriate sections of this MD&A. Equity capital increased to $79.7 million, with a book value per share of $14.33 as of March 31, 2023, compared to $75.2 million and a book value of $13.55 as of December 31, 2022. This increase in equity capital is partially related to the decrease of unrealized losses in the investment portfolio of $2.7 million, net of tax, in accumulated other comprehensive loss in the shareholders’ equity portion of the balance sheet. This position is considered by management as temporary and does not impact the Company’s regulatory capital ratios. On March 15, 2023, the Company's Board of Directors declared a quarterly cash dividend of $0.23 per common share, payable on May 1, 2023 to shareholders of record on April 15, 2023. As of March 31, 2023, all of the Company’s capital ratios, and those of our subsidiary Bank, were in excess of applicable regulatory requirements. While we believe that we have sufficient capital to withstand an economic downturn from any headwinds related to inflation or recessionary periods, should one occur, our equity capital and regulatory capital ratios could be adversely impacted, including as a result of credit losses and other adverse impacts of the pandemic, deteriorating economic conditions, or government monetary policy. CRITICAL ACCOUNTING POLICIES The Company’s consolidated financial statements are prepared according to U.S. GAAP. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities in the consolidated financial statements and related notes. The SEC has defined a company’s critical accounting policies as those that are most important to the portrayal of the Company’s financial condition and results of operations, and which require the Company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Because of the significance of these estimates and assumptions, there is a high likelihood that materially different amounts would be reported for the Company under different conditions or using different assumptions or estimates. Management evaluates on an ongoing basis its judgment as to which policies are considered to be critical, and communicates all evaluations with the Company’s Audit Committee. The Company’s critical accounting policies govern: · the ACL; · OREO; · credit losses on debt securities; · valuation of residential MSRs; and · the carrying value of goodwill. 30 Table of Contents These policies are described in the Company’s 2022 Annual Report on Form 10-K in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” and in Note 1 (Significant Accounting Policies) to the audited consolidated financial statements. With the exception of the ACL policy, there were no material changes during the first three months of 2023 in the Company’s critical accounting policies. ACL - Management believes that the calculation of the ACL is a critical accounting policy that requires the most significant judgments and estimates used in the preparation of its consolidated financial statements. In estimating the ACL, management has adopted a methodology consistent with ASU No. 2016-13 that requires that expected credit losses for financial assets held at the reporting date that are accounted for at amortized cost be measured and recognized based on historical experience and current and reasonably supportable forecasted conditions to reflect the full amount of expected credit losses over the life of the loans at the measurement date. Further consideration is given to qualitative factors, including changes in current economic indicators and their probable impact on borrowers and collateral, trends in delinquent and non-performing loans, trends in criticized and classified assets, levels of exceptions, the impact of competition in the market, concentrations of credit risk in a variety of areas, including portfolio product mix, the level of loans to individual borrowers and their related interests, loans to industry segments and the geographic distribution of CRE loans. Management’s estimates used in calculating the ACL may increase or decrease based on changes in these factors, which in turn will affect the amount of the Company’s provision for credit losses charged against current period income. This evaluation is inherently subjective and actual results could differ significantly from these estimates under different assumptions, judgments or conditions. A modified version of these requirements applies to debt securities classified as available for sale, which eliminates OTTI impairment analysis and requires that if a decline in the fair value of debt securities AFS are deemed by management to be the result of credit losses rather than other factors, the credit losses on those securities will be recorded through an allowance for credit losses rather than a write-down of the security. The Company’s securities portfolio is evaluated for impairment on a quarterly basis. RESULTS OF OPERATIONS The Company’s net income for the first three months of 2023 was $3.3 million or $0.61 per common share, compared to $2.4 million or $0.44 per common share for the same period of 2022. Core earnings (NII) were $8.5 million for the first three months of 2023 compared to $7.6 million for the same period in 2022. Interest and fees on loans, the major component of interest income, increased $1.9 million, or 25.2% for the first three months of 2023 compared to the same period in 2022. Interest paid on deposits, which is the major component of total interest expense, increased $1.3 million, or 234.2%, year over year, driven primarily by the increases in the fed funds rate during 2022 and the first quarter of 2023. Return on average assets, which is net income divided by average total assets, measures how effectively a corporation uses its assets to produce earnings. Return on average equity, which is net income divided by average shareholders' equity, measures how effectively a corporation uses its equity capital to produce earnings. The following tables show these ratios annualized, as well as other equity ratios monitored by management, for the comparison periods presented. Three Months Ended March 31 2023 2022 Return on average assets 1.31 % 0.97 % Return on average equity 17.57 % 11.76 % Dividend payout ratio (1) 37.70 % 52.27 % Average equity to average assets 7.47 % 8.24 % (1) Dividends declared per common share divided by earnings per common share. INTEREST INCOME VERSUS INTEREST EXPENSE (NET INTEREST INCOME) The largest component of the Company’s operating income is NII, which is the difference between interest earned on loans and investments and the interest paid on deposits and other sources of funds (i.e., borrowings). The Company’s level of net interest income can fluctuate over time due to changes in the level and mix of earning assets and sources of funds (volume), and changes in the yield earned and costs of funds (rate). A portion of the Company’s income from loans to local municipalities is not subject to income taxes. Because the proportion of tax-exempt items in the Company's balance sheet varies from year-to-year, to improve comparability of information, the non-taxable income shown in the tables below has been converted to a tax equivalent basis. The Company’s corporate tax rate is 21%; therefore, to equalize tax-free and taxable income in the comparison, we divide the tax-free income by 79%, with the result that every tax-free dollar is equivalent to $1.27 in taxable income for the periods presented. The Company’s tax-exempt interest income of $291,954 and $224,094 for the three months ended March 31, 2023 and 2022, respectively, was derived from loans to local municipalities of $36.5 million and $48.7 million, and tax-exempt municipal investments of $11.6 million and $4.3 million, at March 31, 2023 and 2022, respectively. The following tables show the reconciliation between reported NII and tax equivalent NII for the comparison periods presented. Three Months Ended March 31, 2023 2022 Net interest income as presented $ 8,523,365 $ 7,558,230 Effect of tax-exempt income 77,608 62,745 Net interest income, tax equivalent $ 8,600,973 $ 7,620,975 31 Table of Contents The following tables present the daily average interest-earning assets and the daily average interest-bearing liabilities supporting earning assets for the respective comparison periods. Interest income (excluding interest on non-accrual loans) is expressed on a tax equivalent basis, both in dollars and as a yield/rate for the comparison periods presented. Net interest income, net interest spread and net interest margin are also expressed on a tax equivalent basis. Three Months Ended March 31, 2023 2022 Average Average Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate Average Assets Loans, net (1) $ 746,342,447 $ 9,429,534 5.12 % $ 685,633,810 $ 7,547,035 4.46 % Taxable investment securities 181,762,470 943,478 2.11 % 185,794,633 656,277 1.43 % Tax-exempt investment securities 11,458,866 114,757 4.06 % 2,232,280 13,859 2.52 % Sweep and interest-earning accounts 30,469,901 329,411 4.38 % 69,778,429 80,660 0.47 % Other investments (2) 1,778,480 30,653 6.99 % 1,779,400 16,460 3.75 % Total interest-earning assets 971,812,164 $ 10,847,833 4.53 % 945,218,552 $ 8,314,291 3.57 % Cash and due from banks 10,034,768 18,567,180 Premises and equipment 12,992,588 13,663,867 BOLI 5,160,130 5,080,119 Goodwill 11,574,269 11,574,269 Other assets 18,678,923 12,307,610 Total assets $ 1,030,252,842 $ 1,006,411,597 Average Liabilities and Shareholders' Equity Interest-bearing transaction accounts $ 279,908,863 $ 964,867 1.40 % $ 258,739,985 $ 160,078 0.25 % Money market funds 135,616,740 513,675 1.54 % 130,743,524 127,680 0.40 % Savings deposits 171,177,131 30,996 0.07 % 173,158,450 23,440 0.05 % Time deposits 102,310,661 335,209 1.33 % 106,635,720 240,761 0.92 % Borrowed funds 1,611,144 3,781 0.95 % 1,301,144 2 0.00 % Repurchase agreements 36,136,359 132,128 1.48 % 28,847,413 21,040 0.30 % Finance lease obligations 3,608,925 20,739 2.30 % 3,823,091 21,963 2.30 % Junior subordinated debentures 12,887,000 245,465 7.72 % 12,887,000 98,352 3.10 % Total interest-bearing liabilities 743,256,823 $ 2,246,860 1.23 % 716,136,327 $ 693,316 0.39 % Noninterest bearing deposits 203,297,212 203,509,006 Other liabilities 6,647,483 3,380,650 Total liabilities 953,201,518 923,025,983 Shareholders' equity 77,051,324 83,385,614 Total liabilities and shareholders' equity $ 1,030,252,842 $ 1,006,411,597 Net interest income $ 8,600,973 $ 7,620,975 Net interest spread (3) 3.30 % 3.18 % Net interest margin (4) 3.59 % 3.27 % (1) Included in net loans are non-accrual loans with average balances of $8,220,394 and $5,736,827 for the three months ended March 31 2023 and 2022, respectively. Loans are stated net of unearned discount and ACL, and include loans held-for-sale and tax-exempt loans to local municipalities with average balances of $35,177,595 and $49,022,025 for the three months ended March 31 2023 and 2022, respectively. (2) Included in other investments is the Company’s FHLBB Stock with average balances of $713,330 and $714,250, respectively, with a dividend rate of approximately 6.67% and 2.66%, respectively, for the three months ended March 31 2023 and 2022, respectively. (3) Net interest spread is the difference between the average yield on average interest-earning assets and the average rate paid on average interest-bearing liabilities. (4) Net interest margin is net interest income divided by average earning assets. 32 Table of Contents The average volume of interest-earning assets for the three-month period ended March 31, 2023 increased 2.8% compared to the same period last year, while the average yield on interest-earning assets increased 96 bps. The average volume of loans increased 8.9% over the three-month comparison period of 2023 versus 2022, and the average yield on loans increased 66 bps. Loans accounted for 76.8% of the average interest-earning asset portfolio for the three-month period ended March 31, 2023 compared to 72.5% for the same period last year. Interest earned on the loan portfolio as a percentage of total interest income was 86.9% for the first three months of 2023 compared to 90.8% for the same period in 2022. The average volume of the taxable investment portfolio (classified as AFS) decreased 2.2% during the three-month period ended March 31, 2023, compared to the same period last year, and the average yield increased 68 bps between periods. The average volume of the tax-exempt investment portfolio (classified as AFS) increased $9.2 million, or 5.0% for the three-month period ended March 31, 2023 and the tax equivalent yield increased 154 bps between periods. The Company began investing in these tax-exempt bonds during December 2021, and currently carries an average volume of $11.5 million as of March 31, 2023. The average volume of sweep and interest-earning accounts, which consists primarily of an interest-bearing account at the FRBB, decreased 56.3% for the three-month comparison period ended March 31, 2023 compared to the same period in 2022. The decrease in average volume is attributable to the funding of investments in 2022 and loan growth throughout 2022 and into 2023. The average yield on these funds increased 391 bps for the three-month period ended March 31, 2023 versus the same period in 2022. The average volume of interest-bearing liabilities for the three-month period ended March 31, 2023 increased 3.8%, compared to the same period in 2022, and the average rate paid on interest-bearing liabilities increased 84 bps. The average volume of interest-bearing transaction accounts increased 8.2% for the three-month period ended March 31, 2023 compared to the same period of 2022 and the average rate paid on these accounts increased 115 bps between comparison periods. Interest paid on interest-bearing transaction accounts as a percentage of total interest expense was 42.9% for the three-month period ended March 31, 2023, compared to 23.1% for the same comparison period in 2022. The average volume of money market accounts increased 3.7% for the three-month period ended March 31, 2023 compared to the same period of 2022, and the average rate paid on these deposits increased 114 bps. The average volume of savings accounts decreased 1.1% for the three-month period ended March 31, 2023 compared to the same period in 2022, while the average rate paid on these accounts increased two bps year over year. The average volume of time deposits decreased 4.1% for the three-month period ended March 31, 2023 compared to the same period in 2022, while the average rate paid increased 41 bps. Historically, the average volume of time deposits included brokered deposits, which provided an alternate source of funding, but as the Company’s retail deposits increased over the last two years, the need for these funds diminished. Management still considers the brokered deposit market to be a beneficial source of funding in appropriate circumstances to help smooth out the fluctuations in core deposit balances without the need to disrupt deposit pricing in the Company’s local markets. These funds can be obtained relatively quickly on an as-needed basis, making them a valuable alternative to traditional term borrowings from the FHLBB. Refer to the “Liquidity and Capital Resources” section for more discussion on this topic. The average volume of borrowed funds increased 23.8% for the three-month period ended March 31, 2023 compared to the same period in 2022. In 2022, borrowed funds consisted of only JNE funds at zero percent interest, however, during the first three months of 2023, as the Company’s balance at FRBB decreased, the need for overnight borrowings increased for a short period of time in February. The average volume of repurchase agreements increased 25.3% for the three-month period ended March 31, 2023 compared to the same period in 2022 and the average rate paid increased 118 bps between comparison periods. In summary, between the three-month periods ended March 31, 2023 and 2022, the average yield on interest-earning assets increased 96 bps and the average rate paid on interest-bearing liabilities increased 84 bps. Net interest spread increased 12 bps for the first three months of 2023 versus 2022 and net interest margin increased 32 bps between periods, reflecting the rising interest rate environment. 33 Table of Contents The following table summarizes the variances in interest income and interest expense on a fully tax-equivalent basis for the interim periods presented for 2023 and 2022 resulting from volume changes in daily average assets and daily average liabilities and fluctuations in average rates earned and paid. Three Months Ended March 31 Variance Variance Due to Due to Total Rate (1) Volume (1) Variance Average Interest-Earning Assets Loans $ 1,214,870 $ 667,629 $ 1,882,499 Taxable investment securities 308,179 (20,978 ) 287,201 Tax-exempt investment securities 43,567 57,331 100,898 Sweep and interest-earning accounts 673,283 (424,532 ) 248,751 Other investments 14,209 (16 ) 14,193 Total $ 2,254,108 $ 279,434 $ 2,533,542 Average Interest-Bearing Liabilities Interest-bearing transaction accounts $ 791,740 $ 13,049 $ 804,789 Money market funds 381,189 4,806 385,995 Savings deposits 7,898 (342 ) 7,556 Time deposits 108,632 (14,184 ) 94,448 Borrowed funds 3,779 0 3,779 Repurchase agreements 105,696 5,392 111,088 Finance lease obligations (9 ) (1,215 ) (1,224 ) Junior subordinated debentures 147,113 0 147,113 Total $ 1,546,038 $ 7,506 $ 1,553,544 Changes in net interest income $ 708,070 $ 271,928 $ 979,998 (1) Items which have shown a year-to-year increase in volume have variances allocated as follows: Variance due to rate = Change in rate x new volume Variance due to volume = Change in volume x old rate Items which have shown a year-to-year decrease in volume have variances allocated as follows: Variance due to rate = Change in rate x old volume Variances due to volume = Change in volume x new rate 34 Table of Contents NON-INTEREST INCOME AND NON-INTEREST EXPENSE Non-interest Income The components of non-interest income for the periods presented were as follows: Three Months Ended March 31 Change 2023 2022 Income Percent Service fees $ 880,288 $ 862,887 $ 17,401 2.02 % Income from sold loans 107,535 203,842 (96,307 ) (47.25 %) Other income from loans 428,572 271,260 157,312 57.99 % Other income Income from CFS Partners 252,051 225,870 26,181 11.59 % Other miscellaneous income 90,331 122,570 (32,239 ) (26.30 %) Total non-interest income $ 1,758,777 $ 1,686,429 $ 72,348 4.29 % Total non-interest income increased $72,348, or 4.3%, for the first three months of 2023 compared to the same period in 2022, with significant changes noted in the following: · The decrease in income from sold loans is due primarily to a lower volume of loans sold into the secondary market during the first three months of 2023 versus 2022, as the rising interest rate environment has adversely affected residential mortgage lending activity. · An increase in CRE loan volume in 2023 resulted in a significant increase in documentation fees collected at origination as well as commercial rate lock fees collected, accounting for the increase in other income from loans for the first three months of 2023 versus 2022. · Income from CFS Partners increased between periods due in part to the late rebound of market prices during the latter part of the first quarter of 2023. CFS Partners has a small portion of its equity capital invested in the stock market, and as a result is sensitive to general stock market conditions. · Included in other miscellaneous income for 2022 is a one-time payment totaling $23,400 associated with a renegotiated contract with the Company’s check printing vendor, accounting for a portion of the decrease for the first three months of 2023 versus 2022. 35 Table of Contents Non-interest Expense The components of non-interest expense for the periods presented were as follows: Three Months Ended March 31 Change 2023 2022 Expense Percent Salaries and wages $ 2,288,760 $ 2,040,000 $ 248,760 12.19 % Employee benefits 754,270 772,052 (17,782 ) (2.30 %) Occupancy expenses, net 770,986 753,364 17,622 2.34 % Other expenses Service contracts - administrative 155,500 138,505 16,995 12.27 % Audit fees 126,937 100,728 26,209 26.02 % FDIC insurance 131,643 89,984 41,659 46.30 % Collection & non-accruing loan expense 25,500 36,000 (10,500 ) (29.17 %) ATM fees 160,826 140,890 19,936 14.15 % State deposit tax 256,872 240,478 16,394 6.82 % Other miscellaneous expenses 1,208,408 1,141,587 66,821 5.85 % Total non-interest expense $ 5,879,702 $ 5,453,588 $ 426,114 7.81 % Total non-interest expense increased $426,114, or 7.8% for the first three months of 2023 compared to the same period in 2022, with significant changes noted in the following: · In addition to normal salary increases, the increase in salaries and wages year over year is attributable to new hires in the area of commercial lending as well as the hiring of a new Executive Officer during the last quarter of 2022. Also contributing to the increase was a one-time salary adjustment in November of 2022 of $2,000 to all employees below vice president status that impacted the year over year comparison by $57,500. · The increase in service contracts - administrative is due to a combination of an increase in pricing for contracts that transaction based and inflationary adjustment factors that are higher than historical increase adjustments. · The increase in audit fees reflects increased audit services due to additional audit requirements required by FDICIA due to the Company surpassing $1.0 billion asset size. · The Company increased the 2023 monthly accrual for FDIC insurance in anticipation of an increase in the assessment multiplier, as announced by the FDIC in late 2022. · Collection & non-accruing loan expense is lower year over year due to a decrease of expenses associated with properties in the Company’s non-accruing loan portfolio. · ATM fees are based on increased customer activity as well as annual contractual price adjustments. · State deposit tax increased year over year due primarily to the increase in deposits. The calculation is based on an average of month-end deposit totals over a 12 month period. 36 Table of Contents APPLICABLE INCOME TAXES The provision for income taxes increased $254,124, or 48.6%, for the first three months of 2023 compared to the same period in 2022 and is proportional to the increase in income before income taxes totaling $1.2 million. Tax credits related to limited partnership investments amounted to $67,128 and $96,237, respectively, for the first three months of 2023 and 2022. Amortization expense related to limited partnership investments is included as a component of income tax expense and amounted to $67,128 and $67,092, respectively, for the first three months of 2023 and 2022. These investments provide tax benefits, including tax credits, and are designed to provide a targeted effective annual yield between 7% and 10%. CHANGES IN FINANCIAL CONDITION The following table reflects the composition of the Company's major categories of assets and liabilities as a percentage of total assets or liabilities and shareholders’ equity, as the case may be, as of the balance sheet dates: March 31, 2023 December 31, 2022 Assets Loans $ 758,586,712 73.61 % $ 748,548,608 70.88 % AFS securities 192,679,330 18.70 % 192,918,109 18.27 % Liabilities Demand deposits 200,311,094 19.44 % 216,093,534 20.46 % Interest-bearing transaction accounts 279,977,413 27.17 % 294,050,079 27.84 % Money market funds 132,554,229 12.86 % 140,117,086 13.27 % Savings deposits 170,452,633 16.54 % 171,072,921 16.20 % Time deposits 105,249,729 10.21 % 101,638,659 9.62 % Long-term advances 1,300,000 0.13 % 1,300,000 0.12 % The following table reflects the changes in the composition of the Company's major categories of assets and liabilities between the balance sheet dates, as disclosed in the table above: Volume Change Percentage Assets Loans $ 10,038,104 1.34 % AFS securities (238,779 ) (0.12 %) Liabilities Demand deposits (15,782,440 ) (7.30 %) Interest-bearing transaction accounts (14,072,666 ) (4.79 %) Money market funds (7,562,857 ) (5.40 %) Savings deposits (620,288 ) (0.36 %) Time deposits 3,611,070 3.55 % The increase in the loan portfolio during the first three months of 2023 was attributable to increases totaling $13.0 million in commercial & industrial CRE and municipal loans, which was partially offset by decreases of $0.8 million in purchased BHG loans, $1.9 million in residential junior lien loans and $0.6 million in consumer loans. The Company has experienced strong loan activity among its commercial customers, but only minimal consumer loan activity. There were no securities AFS purchased during the first three months of 2023. The change in the securities AFS portfolio is attributable to maturities amounting to $0.6 million, as well as principal payments on various securities totaling $3.1 million. These changes were almost totally offset by a decrease of $3.4 million in unrealized losses arising during the first three months of 2023, which is reflected in OCI. In management’s view, the size of the securities AFS portfolio is appropriate and proportional to the overall asset base, as this portfolio serves an important role in the Company’s liquidity position. The decrease in the demand deposit accounts was entirely made up of business DDAs. The decrease in interest-bearing transaction accounts consists of a decrease of $13.1 million, or 10.6%, in consumer interest-bearing transaction accounts, a decrease of $11.6 million, or 28.8%, in municipal deposit accounts and a decrease of $11.0 million, or 12.9% in ICS deposit accounts. These decreases were partially offset by a combined increase of $21.6 million, or 48.7% in health savings accounts and the deposit account of the Company’s trust and asset management affiliate, CFSG. The decrease in money market funds was driven by decreases of $6.5 million, or 21.9% in ICS accounts and $4.6 million, or 4.5% in retail money market funds. These decreases were partially offset by an increase in municipal accounts of $3.5 million or 39.6%. The increase in time deposits is attributable to customer response to periodic certificate of deposit specials that have been offered. 37 Table of Contents CERTAIN TIME DEPOSITS Increments of maturity of time CDs of $250,000 or more outstanding on March 31, 2023 are summarized as follows: 3 months or less $ 4,166,139 Over 3 through 6 months 1,872,753 Over 6 through 12 months 4,274,743 Over 12 months 6,424,279 Total $ 16,737,914 Interest Rate Risk and Asset and Liability Management - Management actively monitors and manages the Company’s interest rate risk exposure and attempts to structure the balance sheet to maximize net interest income while controlling its exposure to interest rate risk. The Company's ALCO is made up of the Executive Officers and certain Vice Presidents of the Bank representing major business lines. The ALCO formulates strategies to manage interest rate risk by evaluating the impact on earnings and capital of such factors as current interest rate forecasts and economic indicators, potential changes in such forecasts and indicators, liquidity and various business strategies. The ALCO meets at least quarterly to review financial statements, liquidity levels, yields and spreads to better understand, measure, monitor and control the Company’s interest rate risk. In the ALCO process, the committee members apply policy limits set forth in the Asset Liability, Liquidity and Investment policies approved and periodically reviewed by the Company’s Board of Directors. The ALCO's methods for evaluating interest rate risk include an analysis of the effects of interest rate changes on net interest income and an analysis of the Company's interest rate sensitivity "gap", which provides a static analysis of the maturity and repricing characteristics of the entire balance sheet. The ALCO Policy also includes a contingency funding plan to help management prepare for unforeseen liquidity restrictions, including hypothetical severe liquidity crises. Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with the Company’s financial instruments also change, thereby impacting NII, the primary component of the Company’s earnings. Fluctuations in interest rates can also have an impact on liquidity. The ALCO uses an outside consultant to perform rate shock simulations to the Company's net interest income, as well as a variety of other analyses. It is the ALCO’s function to provide the assumptions used in the modeling process. Assumptions used in prior period simulation models are regularly tested by comparing projected NII with actual NII. The ALCO utilizes the results of the simulation model to quantify the estimated exposure of NII and liquidity to sustained interest rate changes. The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest-earning assets and interest-bearing liabilities reflected on the Company’s balance sheet. The model also simulates the balance sheet’s sensitivity to a prolonged flat rate environment. All rate scenarios are simulated assuming a parallel shift of the yield curve; however further simulations are performed utilizing non-parallel changes in the yield curve. The results of this sensitivity analysis are compared to the ALCO policy limits which specify a maximum tolerance level for NII exposure over a 1-year horizon, assuming no balance sheet growth, given a 200 bp shift upward and a 100 bp shift downward in interest rates. Under the Company’s interest rate sensitivity modeling, with the continued asset sensitive balance sheet, in a rising rate environment NII initially trends upward as the short-term asset base (cash and adjustable rate loans) quickly cycle upward while the retail funding base (deposits) lags the market. If rates paid on deposits have to be increased more and/or more quickly than projected due to competitive pressures, the expected benefit to rising rates would be reduced. In a falling rate environment, NII is expected to trend slightly downward compared with the current rate environment scenario for the first year of the simulation as asset yield erosion is not fully offset by decreasing funding costs. Thereafter, net interest income is projected to experience sustained downward pressure as funding costs reach their assumed floors and asset yields continue to reprice into the lower rate environment. The current rising rate environment has had a positive impact to the Company’s NII however market expectations for higher deposit rates are applying increasing pressure to the spread between interest income and interest expense. 38 Table of Contents The following table summarizes the estimated impact on the Company's NII over a twelve month period, assuming a gradual parallel shift of the yield curve beginning March 31, 2023: Rate Change Percent Change in NII Down 100 bps (0.2 %) Up 200 bps (2.0 %) The estimated amounts shown in the table above are within the ALCO Policy limits. However, those amounts do not represent a forecast and should not be relied upon as indicative of future results. The ALCO model also provides alternate scenarios including a sustained flat, or inverted yield curve. While assumptions used in the ALCO process, including the interest rate simulation analyses, are developed based upon current economic and local market conditions, and expected future conditions, the Company cannot provide any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change. As the market rates continue to increase, the impact of a falling rate environment is more pronounced, and the possibility more plausible than during the last several years of near zero short-term rates. As of March 31, 2023, the Company had outstanding $12,887,000 in principal amount of Junior Subordinated Debentures due December 15, 2037, which bear a quarterly floating rate of interest equal to the 3-month London Interbank Offered Rate (LIBOR), plus 2.85%. As previously announced by the Financial Conduct Authority in the United Kingdom, the entity that administers LIBOR, 3-month LIBOR for U.S. dollar denominated deposits will be phased out as of June 30, 2023. The Indenture governing the terms of the Company’s Debentures contains detailed fallback provisions in the event 3-month LIBOR is not available, empowering the Trustee to obtain substitute quotations from other leading banks. However, under the federal Adjustable Interest Rate (LIBOR) Act enacted in March 2022 (the “LIBOR Act”), fallback provisions like those in the Company’s Indenture that are based on a “determining person” (such as an indenture trustee) obtaining quotations of interbank lending or deposit rates are deemed “ineffective” and will be replaced as a matter of law, without need to amend contract documents, with a benchmark interest rate identified in regulations promulgated by the Federal Reserve. As required under the LIBOR Act, the Federal Reserve-identified benchmark rates specified in the final regulations for various tenors of LIBOR are based on the Secured Overnight Financing Rate (SOFR) published by the Federal Reserve Bank of New York and each includes an appropriate “tenor spread adjustment” to reflect historical spreads between LIBOR and SOFR. The replacement benchmark rate for ineffective fallback provisions will take effect on the first London banking day after June 30, 2023, (the “LIBOR Replacement Date”). The Indenture Trustee has informed the Company that it views the fallback provisions in the Indenture as ineffective under the LIBOR Act, and that, absent either an amendment to the Indenture and related Debenture documents to adopt a new interest rate or a change in applicable law, effective on and after the LIBOR Replacement Date, 3-month LIBOR will be replaced by 3-month CME SOFR, as adjusted by a spread adjustment factor of 0.26161 percent, in accordance with the LIBOR Act and FRB regulations. The Company does not intend to seek an amendment of the Indenture or other Debenture documents. Accordingly, as of the LIBOR Replacement Date, the Debentures will bear interest at a quarterly floating rate equal to 3-month CME SOFR, as adjusted by a spread adjustment of 0.26161 percent, plus 2.85%. Aside from the Debentures, the Company does not have any other exposures to the phase out of LIBOR. The Company has not generally utilized LIBOR as an interest rate benchmark for its variable rate commercial, residential or other loans and does not utilize derivatives or other financial instruments tied to LIBOR for hedging or investment purposes. Accordingly, management expects that the Company’s exposure to the phase out of LIBOR will be limited to the effect on the interest rate paid on its Debentures. Credit Risk - As a financial institution, one of the primary risks the Company manages is credit risk, the risk of loss stemming from borrowers’ failure to repay loans or inability to meet other contractual obligations. The Company’s Board of Directors prescribes policies for managing credit risk, including Loan, Appraisal and Environmental policies. These policies are supplemented by comprehensive underwriting standards and procedures. The Company maintains a Credit Administration department whose function includes credit analysis and monitoring of and reporting on the status of the loan portfolio, including delinquent and non-performing loan trends. The Company also monitors concentration of credit risk in a variety of areas, including portfolio mix, the level of loans to individual borrowers and their related interests, loans to industry segments, and the geographic distribution of commercial real estate loans. Loans are reviewed periodically by an independent loan review firm to help ensure accuracy of the Company's internal risk ratings and compliance with various internal policies, procedures and regulatory guidance. Residential mortgage loans represented 30.4% of the Company’s loan balances at March 31, 2023, compared to 31.2% at December 31, 2022. The Company maintains a residential mortgage loan portfolio of traditional mortgage products and does not offer higher risk loan products, such as option adjustable rate mortgage products, high loan-to-value products, interest only mortgages, subprime loans and products with deeply discounted teaser rates. Residential mortgages with loan-to-value ratios exceeding 80% are generally covered by PMI. A 90% loan-to-value residential mortgage product without PMI is only available to borrowers with excellent credit and low debt-to-income ratios and has not been widely originated. As of March 31, 2023, junior lien home equity products made up 13.8% of the residential mortgage portfolio with maximum loan-to-value ratios (including prior liens) of 80%. The Company also originates some home equity loans greater than 80% under an insured loan program with stringent underwriting criteria. 39 Table of Contents Consistent with the strategic focus on commercial lending, the commercial & industrial and CRE loan portfolios have seen solid growth over recent years. Commercial & industrial, purchased, CRE and municipal loans collectively comprised 69.1% of the Company’s loan portfolio at March 31, 2023, compared to 68.4% at December 31, 2022. The largest components of the CRE portfolio were $99.4 million in owner-occupied CRE and $139.0 million in non-owner occupied CRE at March 31, 2023. Risk in the Company’s commercial & industrial and CRE loan portfolios is mitigated in part by government guarantees issued by federal agencies such as the SBA and RD. At March 31, 2023, the Company had $26.2 million in guaranteed loans with guaranteed balances of $17.0 million, compared to $27.0 million in guaranteed loans with guaranteed balances of $18.3 million at December 31, 2022. PPP loans with outstanding balances of $116,299 and $199,664 at March 31, 2023 and December 31, 2022, respectively, are included in these totals, all of which carry a 100% guarantee through the SBA, subject to borrower eligibility requirements. The Company works actively with customers early in the delinquency process to help them to avoid default and foreclosure. Commercial & industrial and CRE loans are generally placed on non-accrual status when there is deterioration in the financial position of the borrower, payment in full of principal and interest is not expected, and/or principal or interest has been in default for 90 days or more. However, such a loan need not be placed on non-accrual status if it is both well secured and in the process of collection. Residential mortgages and home equity loans are considered for non-accrual status at 90 days past due and are evaluated on a case-by-case basis. The Company obtains current property appraisals or market value analyses and considers the cost to carry and sell collateral in order to assess the level of specific allocations required. Consumer loans are generally not placed in non-accrual but are charged off by the time they reach 120 days past due. When a loan is placed in non-accrual status, the Company reverses the accrued interest against current period income and discontinues the accrual of interest until the borrower clearly demonstrates the ability and intention to resume normal payments, typically demonstrated by regular timely payments for a period of not less than six months. Interest payments received on non-accrual or impaired loans are generally applied as a reduction of the loan book balance. Provision for Credit Losses The provision for credit losses was made up of the following components for the periods indicated: Three Months Ended March 31, Change 2023 2022 $ % Provision for credit losses on loans $ 207,540 $ 862,500 $ (654,960 ) (75.94 %) Provision for credit losses on OBS credit exposure 78,986 0 78,986 100.00 % Provision for credit losses $ 286,526 $ 862,500 $ (575,974 ) (66.78 %) ACL and provisions – As stated in Note 2 of the accompanying notes to the Company’s unaudited interim consolidated financial statements, effective January 1, 2023, the Company was required to recognize credit losses under the guidance of ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , The new guidance, which is referred to as the current expected credit loss, or CECL model, requires that expected credit losses for financial assets held at the reporting date that are accounted for at amortized cost be measured and recognized based on historical experience and current and reasonably supportable forecasted conditions to reflect the full amount of expected credit losses over the life of the loans. The adjustment from the adoption of CECL amounted to $549,113, net of tax and was recorded as an adjustment to retained earnings and will affect calculation of regulatory capital ratios. Changes in forecasts used in the model could produce different results, quarter to quarter. The Company’s board of directors has approved an ACL policy that provides guidance in maintaining an adequate methodology for establishing, estimating and maintaining allowances for credit losses under ASC 326. The policy creates a measurement model to establish a proper ACL based on current expected credit losses rather than incurred losses. The Company maintains an ACL at a level that management believes is appropriate to absorb losses inherent in the loan portfolio as of the measurement date (See Note 5 to the accompanying unaudited interim consolidated financial statements). Although the Company, in establishing the ACL, considers the inherent losses in individual loans and pools of loans, the ACL is a general reserve available to absorb all credit losses in the loan portfolio. No part of the ACL is segregated to absorb losses from any particular loan or segment of loans. When establishing the ACL each quarter, the Company applies a combination of significant key assumptions and methodologies, as discussed in the ACL section under Critical Accounting Policies in this MD&A, and also presented in Note 5 of the accompanying unaudited interim consolidated financial statements. 40 Table of Contents The following table summarizes the Company’s credit risk ratios for the balance sheet dates presented: March 31 December 31, 2023 2022 ACL to total loans outstanding 1.22 % 1.16 % ACL $ 9,256,170 $ 8,709,225 Loans outstanding $ 758,586,712 $ 748,548,608 Non-accruing loans to loans outstanding 1.12 % 1.05 % Non-accruing loans $ 8,480,354 $ 7,890,020 Loans outstanding $ 758,586,712 $ 748,548,608 ACL to non-accruing loans 109.15 % 110.38 % ACL $ 9,256,170 $ 8,709,225 Non-accruing loans $ 8,480,354 $ 7,890,020 The provision for credit losses for the three months ended March 31, 2023 was $286,526, compared to $862,500 for the same period in 2022. The $575,974 year over year decrease was driven in part by a write-down totaling $667,474, on a single non-performing loan, in March of 2022. The first quarter ACL analysis indicates that the reserve balance of $9.3 million at March 31, 2023 is sufficient to cover expected credit losses that are probable and estimable as of the measurement date. Management believes the reserve balance continues to be directionally consistent with the overall risk profile of the Company’s loan portfolio and credit risk appetite. While the ACL is described as consisting of separate allocated portions, the entire ACL is available to support loan losses, regardless of category. The adequacy of the ACL is presented to the full Board for approval quarterly. 41 Table of Contents Net recoveries (charge-offs) during the periods presented to average loans outstanding were as follows: For the Three Months Ended March 31 2023 2022 Commercial & industrial (0.01 %) (0.02 %) Net charge-offs during the period $ (10,203 ) $ (17,650 ) Average amount outstanding $ 117,162,692 $ 111,436,341 Purchased 0.00 % 0.00 % Net charge-offs during the period $ 0 $ 0 Average amount outstanding $ 7,086,337 $ 9,368,594 Commercial real estate 0.01 % (0.22 %) Net recoveries (charge-offs) during the period $ 22,000 $ (667,474 ) Average amount outstanding $ 360,454,697 $ 304,057,825 Municipal 0.00 % 0.00 % Net charge-offs during the period $ 0 $ 0 Average amount outstanding $ 35,177,595 $ 49,022,024 Residential real estate - 1st lien 0.04 % 0.00 % Net recoveries during the period $ 72,326 $ 2,276 Average amount outstanding $ 198,536,712 $ 182,305,338 Residential real estate - Jr lien 0.08 % 0.01 % Net recoveries during the period $ 25,548 $ 1,210 Average amount outstanding $ 32,704,333 $ 33,230,645 Consumer (0.36 %) (0.01 %) Net charge-offs during the period $ (13,642 ) $ (470 ) Average amount outstanding $ 3,786,350 $ 3,580,266 Total loans 0.01 % (0.10 %) Net recoveries (charge-offs) during the period $ 96,029 $ (682,108 ) Average amount outstanding $ 754,908,716 $ 693,001,033 In addition to credit risk in the Company’s loan and investment portfolios and its off-balance sheet commitments, and liquidity risk in its loan and deposit-taking operations, the Company’s business activities also generate market risk. Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices and equity prices. Declining capital markets and changes in interest rates can result in fair value adjustments to asset valuations or the need to create a related reserve or allowance. The Company does not have any market risk sensitive instruments acquired for trading purposes. The Company’s market risk arises primarily from interest rate risk inherent in its lending, deposit taking and investment activities. During recessionary periods, a declining housing market can result in an increase in loan loss reserves or ultimately an increase in foreclosures. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to loan prepayment risks, early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes vary by product. Rapid changes in prevailing interest rates, particularly after a long period of relative stability, create a challenging interest rate environment. As discussed above under "Interest Rate Risk and Asset and Liability Management", the Company actively monitors and manages its interest rate risk through the ALCO process. COMMITMENTS, CONTINGENCIES AND OFF-BALANCE-SHEET ARRANGEMENTS The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and risk-sharing commitments on certain sold loans. Such instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. During the first three months of 2023, the Company did not engage in any activity that created any additional types of off-balance sheet risk. 42 Table of Contents With the adoption of ASU 2016-13 (CECL), the Company is required to establish an allowance for expected credit losses on OBS credit exposures. Expected credit losses are estimated by management over the contractual period during which the Company is exposed to credit risk under a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. Upon adoption of ASU 2016-13, the Company recorded an adjustment to retained earnings of $451,704 to reflect an allowance for credit losses for unfunded commitments. The allowance for credit losses for OBS credit exposures is presented in the "Accrued interest and other liabilities" line of the consolidated balance sheets. There were no changes to the allowance for credit losses for OBS credit exposures during the three months ended March 31, 2023. LIQUIDITY AND CAPITAL RESOURCES Managing liquidity risk is essential to maintaining both depositor confidence and stability in earnings. Liquidity management refers to the ability of the Company to adequately cover fluctuations in assets and liabilities. Meeting loan demand (assets) and covering the withdrawal of deposit funds (liabilities) are two key components of the liquidity management process. The Company’s principal sources of funds are deposits, amortization and prepayment of loans and securities, maturities of investment securities, sales of loans available-for-sale, and earnings and funds provided from operations. Maintaining a relatively stable funding base, which is achieved by diversifying funding sources, competitively pricing deposit products, and extending the contractual maturity of liabilities, reduces the Company’s exposure to rollover risk on deposits and limits reliance on volatile short-term borrowed funds. Short-term funding needs arise from declines in deposits or other funding sources and from funding requirements for loan commitments. The Company’s strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and lower-cost funds. The Company recognizes that, at times, when loan demand exceeds deposit growth or the Company has other liquidity demands, it may be desirable to utilize alternative sources of deposit funding to augment retail deposits and borrowings. One-way deposits acquired through the CDARS program provide an alternative funding source when needed. At March 31, 2023 and December 31, 2022, the Company had no one-way CDARS outstanding. In addition, two-way (reciprocal) CDARS deposits, as well as reciprocal ICS money market and demand deposits, enhance the Company’s ability to retain larger deposit balances by allowing the Company to provide FDIC deposit insurance to its customers in excess of account coverage limits through the exchange of deposits with other participating FDIC-insured financial institutions. At March 31, 2023 and December 31, 2022, the Company reported $2.8 million in reciprocal CDARS deposits. The balance in ICS reciprocal money market deposits was $23.0 million at March 31, 2023, compared to $29.5 million at December 31, 2022, and the balance in ICS reciprocal demand deposits as of those dates was $74.3 million and $85.3 million, respectively. At March 31, 2023 and December 31, 2022, borrowing capacity of $110.3 million and $112.3 million, respectively, was available through the FHLBB, secured by the Company's qualifying loan portfolio (generally, residential mortgage and commercial loans), reduced by outstanding advances and by collateral pledges securing FHLBB letters of credit collateralizing public unit deposits. The Company also has an unsecured Federal Funds credit line with the FHLBB with an available balance of $500,000 and no outstanding advances during any of the respective comparison periods. Interest is chargeable at a rate determined daily, approximately 25 bps higher than the rate paid on federal funds sold. The Company has a BIC arrangement with the FRBB secured by eligible commercial & industrial loans, CRE loans and home equity loans, resulting in an available credit line of $52.8 million and $56.1 million, respectively, at March 31, 2023 and December 31, 2022. Credit advances under this FRBB lending program are overnight advances with interest chargeable at the primary credit rate (generally referred to as the discount rate), currently 500 bps. The Company had no outstanding advances through this facility at March 31, 2023 or December 31, 2022. As of March 31, 2023, the Company had additional potential borrowing capacity, subject to pledging of required collateral, under the FRB’s Term Funding Program, which was established in March 2023 to provide banks with an additional source of liquidity. The Company did not have any advances under the Term Funding Program at March 31, 2023. The following table reflects the Company’s outstanding advances under the FHLBB’s JNE program as of the dates indicated: March 31, December 31, 2023 2022 Long-Term Advances(1) FHLBB term advance, 0.00%, due September 22, 2023 $ 200,000 $ 200,000 FHLBB term advance, 0.00%, due November 12, 2025 300,000 300,000 FHLBB term advance, 0.00%, due November 13, 2028 800,000 800,000 $ 1,300,000 $ 1,300,000 (1) Under the JNE program, the FHLBB provides a subsidy, funded by the FHLBB’s earnings, to write down interest rates to zero percent on advances that finance qualifying loans to small businesses. JNE advances must support small business in New England that create and/or retain jobs, or otherwise contribute to overall economic development activities. 43 Table of Contents The Company has unsecured lines of credit with two correspondent banks with aggregate available borrowing capacity totaling $20.5 million as of the balance sheet dates presented in this quarterly report. The Company had no outstanding advances against these credit lines as of the balance sheet dates presented. Management believes that the combination of high levels of potentially liquid assets, unencumbered securities, cash flows from operations, and additional borrowing capacity are sufficient to meet the Company’s liquidity and capital needs. The following table illustrates the changes in shareholders' equity from December 31, 2022 to March 31, 2023: Balance at December 31, 2022 (book value $13.55 per common share) $ 75,176,363 Cumulative change in accounting principle (Note 2) (549,113 ) Net income 3,338,761 Issuance of common stock through the DRIP 319,877 Dividends declared on common stock (1,250,794 ) Dividends declared on preferred stock (28,125 ) Change in AOCI on AFS securities, net of tax 2,672,818 Balance at March 31 2023 (book value $14.33 per common share) $ 79,679,787 The primary objective of the Company’s capital planning process is to balance appropriately the retention of capital to support operations and future growth, with the goal of providing shareholders an attractive return on their investment. To that end, management monitors capital retention and dividend policies on an ongoing basis. As described in more detail in Note 23 to the audited consolidated financial statements contained in the Company’s 2022 Annual Report on Form 10-K and under the caption “LIQUIDITY AND CAPITAL RESOURCES” in the MD&A section of that report, the Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies pursuant to which they must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. As of March 31, 2023, the Bank was considered well capitalized under the standard regulatory capital framework for Prompt Corrective Action and the Company exceeded currently applicable consolidated regulatory guidelines for capital adequacy. While we believe that the Company has sufficient capital to withstand an extended economic downturn, our regulatory capital ratios could be adversely impacted by future credit losses and other operational impacts of deteriorating economic conditions and inflation. 44 Table of Contents The following table shows the Company’s actual capital ratios and those of its subsidiary, as well as currently applicable regulatory capital requirements, as of the dates indicated. The calculations as of March 31, 2023 reflect adoption of ASU 2016-13 (CECL), including the beginning period cumulative effect adjustment of $549,113, which reduced retained earnings. Minimum Minimum Minimum For Capital To Be Well For Capital Adequacy Purposes Capitalized Under Adequacy with Conservation Prompt Corrective Actual Purposes Buffer(1) Action Provisions(2) Amount Ratio Amount Ratio Amount Ratio Amount Ratio (Dollars in Thousands) March 31, 2023 Common equity tier 1 capital (to risk-weighted assets) Company $ 84,601 11.88 % $ 32,054 4.50 % $ 49,861 7.00 % N/A N/A Bank $ 98,355 13.82 % $ 32,033 4.50 % $ 49,829 7.00 % $ 46,270 6.50 % Tier 1 capital (to risk-weighted assets) Company $ 98,988 13.90 % $ 42,738 6.00 % $ 60,546 8.50 % N/A N/A Bank $ 98,355 13.82 % $ 42,710 6.00 % $ 60,506 8.50 % $ 56,947 8.00 % Total capital (to risk-weighted assets) Company $ 107,904 15.15 % $ 56,984 8.00 % $ 74,792 10.50 % N/A N/A Bank $ 107,265 15.07 % $ 56,947 8.00 % $ 74,743 10.50 % $ 71,184 10.00 % Tier 1 capital (to average assets) Company $ 98,988 9.53 % $ 41,532 4.00 % N/A N/A N/A N/A Bank $ 98,355 9.48 % $ 41,515 4.00 % N/A N/A $ 51,894 5.00 % December 31, 2022: Common equity tier 1 capital (to risk-weighted assets) Company $ 82,770 11.74 % $ 31,731 4.50 % $ 49,359 7.00 % N/A N/A Bank $ 96,112 13.64 % $ 31,703 4.50 % $ 49,315 7.00 % $ 45,793 6.50 % Tier 1 capital (to risk-weighted assets) Company $ 97,157 13.78 % $ 42,308 6.00 % $ 59,936 8.50 % N/A N/A Bank $ 96,112 13.64 % $ 42,270 6.00 % $ 59,883 8.50 % $ 56,361 8.00 % Total capital (to risk-weighted assets) Company $ 105,971 15.03 % $ 56,410 8.00 % $ 74,038 10.50 % N/A N/A Bank $ 104,918 14.89 % $ 56,361 8.00 % $ 73,973 10.50 % $ 70,451 10.00 % Tier 1 capital (to average assets) Company $ 97,157 9.24 % $ 42,047 4.00 % N/A N/A N/A N/A Bank $ 96,112 9.15 % $ 42,025 4.00 % N/A N/A $ 52,531 5.00 % (1) Conservation Buffer is calculated based on risk-weighted assets and does not apply to calculations of average assets. (2) Applicable to banks, but not bank holding companies. The Company's ability to pay dividends to its shareholders is largely dependent on the Bank's ability to pay dividends to the Company. In general, a national bank may not pay dividends that exceed net income for the current and preceding two years. Regardless of statutory restrictions, as a matter of regulatory policy, banks and bank holding companies should pay dividends only out of current earnings and only if, after paying such dividends, they remain adequately capitalized. 45 Table of Contents ITEM 3. Quantitative and Qualitative Disclosures about Market Risk Omitted, in accordance with the regulatory relief available to smaller reporting companies in SEC Release Nos. 33-10513 and 34-83550.