Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Market Risk
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates, and equity prices. The Company’s market risk is composed primarily of interest rate risk inherent in the normal course of lending, investing and deposit-taking activities. We do not have any trading assets or activities.
Interest Rate Risk
Net interest income is our most significant component of earnings and we consider interest rate risk to be our most significant market risk. Our net interest income results from the difference between the yields we earn on our interest-earning assets, primarily loans and investments, and the rates that we pay on our interest-bearing liabilities, primarily deposits and borrowings. When interest rates change, the yields we earn on our interest-earning assets and the rates we pay on our interest-bearing liabilities do not necessarily move in tandem with each other because of the difference between their maturities and repricing characteristics and this can negatively impact net interest income.
Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but such changes could also affect the average duration of our mortgage portfolio, investment securities and other interest-earning assets.
Our goal is to structure our asset/liability composition to maximize net interest income while managing interest rate risk so as to minimize the adverse impact of changes in interest rates on net interest income and capital in either a rising or declining interest rate environment. Profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact our earnings because the interest rates of the underlying assets and liabilities do not change at the same speed, to the same extent or on the same basis.
Interest rate risk is monitored through the use of three complementary modeling tools: static gap analysis, earnings simulation modeling, and economic value simulation (net present value estimation). Each of these models measures changes in a variety of interest rate scenarios. While each of the interest rate risk models has limitations, taken together they represent a reasonably comprehensive view of the magnitude of our interest rate risk, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap, which measures aggregate repricing values, is less utilized because it only measures the magnitude of the timing differences and does not address repricing lags, market influences, or management actions. Earnings simulation and economic value models, which more effectively measure the cash flow and optionality impacts, are utilized by management on a regular basis and are discussed further below. From the various model results and our expectations regarding future interest rate movements, the national, regional and local economies, and other financial and business risk factors, we quantify the overall magnitude of interest sensitivity risk and then determine appropriate strategies and practices governing asset growth and pricing, funding sources and pricing, and off-balance sheet commitments.
Earnings Simulation Analysis
We use net interest income simulations which measure the short-term earnings exposure from changes in market rates of interest. The model calculates an earnings estimate based on current and projected balances and rates, incorporating our current financial position with assumptions regarding future business to calculate net interest income under varying hypothetical rate scenarios. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analyses, such as the static gap analysis.
Assumptions used in the model are derived from historical trends and management’s outlook. The model assumes a static balance sheet with cash flows reinvested in similar instruments to maintain the balance sheet levels and current composition. Actual cash flows and repricing characteristics for our balance sheet instruments are input to the model. The model incorporates market-based assumptions regarding the impact of changing interest rates on the prepayment rate of certain assets and liabilities. Because these assumptions are inherently uncertain, actual results may differ from simulated results.
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Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates in both a "shocked" instantaneous parallel move and a "steepening" move of rates. Interest rates on different asset and liability accounts move differently when the federal funds rate changes and such assumptions are reflected in the different rate scenarios. The model does not take into account any future actions that management may take to mitigate the impact of interest rate changes, and it is our strategy to proactively change the volume and mix of our balance sheet in order to mitigate our interest rate risk.
The following table presents the estimated net interest income sensitivity over a 12-month horizon for the specified rate change levels presented. This change in interest rates assumes parallel shifts in the yield curve and does not take into account changes in the slope of the yield curve. Further, the estimations are based upon the Company's balance sheet as of period end and is not comparing future results to prior results, but rather comparing hypothetical future results under differing rate scenarios.
Percentage change in Net Interest Income (1)
Change in Interest Rates (in basis points) December 31, 2025 December 31, 2024
+ 400 6.3% 2.3%
+ 300 5.7% 2.8%
+ 200 4.6% 3.3%
+ 100 3.5% 4.3%
- 100 (2.1)% (0.1)%
- 200 (4.0)% (0.8)%
- 300 (5.2)% (1.4)%
- 400 (7.6)% (2.3)%
(1) - The percentage change represents the projected net interest income for 12 months on a static balance sheet in a stable rate environment as compared to the projected net interest income in the various rate scenarios with immediate and parallel shocks applied to the yield curve.
During the last four months of 2024, the FOMC decreased short term rates 100 basis points with a target federal funds rate of 4.25% - 4.50% at December 31, 2024. Further, during the last four months of 2025, the FOMC again decreased short term rates another 75 basis points with a target federal funds rate of 3.50%-3.75% at December 31, 2025. As evidenced by our results for 2024 and 2025, the Company has reacted quickly to interest rate cuts by the FOMC and thus reduced the Company's total cost of deposits, thereby increasing net interest income. As of December 31, 2025, assuming no change in the shape of the yield curve, the Company is reflecting an asset sensitive position. Given the decline in the short term rates from December 31, 2024 to December 31, 2025, the declining rate scenarios for the current year reflect the impact of deposit accounts approaching or reaching minimum rate levels.
The shape of the yield curve also has a significant impact on the earnings of financial institutions, including the Company. Generally speaking, when the yield curve is flat or inverted over time, banks experience a decrease in net interest income. Conversely, a positively sloping yield curve over time is generally favorable for financial institutions. Any additional flattening or inversion of the yield curve could have a material negative impact on the Company.
The Company continues to actively manage interest rate risk through the addition of variable rate assets and the pricing of interest bearing deposits. The model results demonstrated in the above table are based on the immediate shock of each of the various rate scenarios and assume a consistent future slope (or lack thereof) of the yield curve (i.e. a parallel shift of the yield curve) in both a rising and falling rate scenario.
As previously noted, these assumptions are inherently uncertain, and actual results may differ from simulated results. Further, the interest rate simulation models do not take into consideration growth, changes in balance sheet mix or composition, or other strategies that management would employee in either a rising or a falling rate scenario.
Economic Value Simulation
Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the
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balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet and assumes a static average life of deposits in all interest rate scenarios.
The following table presents the estimated change in net economic value for the specified change levels presented. This change in interest rates assumes parallel shifts in the yield curve and does not take into account changes in the slope of the yield curve.
Percentage change in Economic Value of Equity (1)
Change in Interest Rates (in basis points) December 31, 2025 December 31, 2024
+ 400 (4.2)% (3.0)%
+ 300 (2.7)% (2.0)%
+ 200 (1.6)% (1.3)%
+ 100 (0.1)% 0.2%
- 100 (1.5)% (1.2)%
- 200 (5.3)% (5.1)%
- 300 (11.0)% (11.8)%
- 400 (21.0)% (21.0)%
(1) - The percentage change represents our economic value of equity in a stable rate environment as compared to the economic value of equity in the various rate scenarios with immediate and parallel shocks applied to the yield curve.
As of December 31, 2025, the Company's EVE variability has remained relatively consistent across rate levels compared to 2024. Portions of the Company's deposits are nearing their modeled floor rates and therefore reflect a negative projected change in value for the more pronounced rate declines. Refer also to the discussion above under Earnings Simulation Analysis.
Impact of Inflation and Changing Prices
Our financial statements included in Item 8 “Financial Statements and Supplementary Data” of this Report have been prepared in accordance with GAAP, which requires the financial position and operating results to be measured principally in terms of historic dollars without considering the change in the relative purchasing power of money over time due to inflation.
Nearly all of the Company’s assets and liabilities are monetary in nature, and as such, changes in interest rates (as discussed above) generally affect the financial condition of the Company to a greater degree than changes in the rate of inflation. Although interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Inflation affects the Company’s results of operations mainly through increased operating costs, and the impact of inflation on banks in general is normally not as significant as its influence on those businesses that have large investments in plant and inventories. We review pricing of our products and services, as well as our controllable operating and labor costs in light of current and expected costs due to inflation, to mitigate the inflationary impact on financial performance to the extent possible.
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