FINANCIAL INSTITUTIONS INC 10-Q

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2023. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein. FORWARD LOOKING INFORMATION Statements and financial analysis contained in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others: • statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (the “Parent” or “FII”) and its subsidiaries (collectively, the “Company,” “we,” “our” or “us”); and • statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “continue,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects” or similar expressions. These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2023 (the “Form 10-K”), including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such material differences include, but are not limited to: • Fluctuations in market interest rates may affect our interest margins and income, demand for our products, defaults on loans, loan prepayments and the fair value of our financial instruments; • Environmental, social and governance matters, and any related reporting obligations may impact our business; • If we experience greater credit losses than anticipated, earnings may be adversely impacted; • We are subject to risks and losses resulting from fraudulent activities that could adversely impact our financial performance and results of operations; • Geographic concentration in our loan portfolio may unfavorably impact our operations; • Our commercial business and mortgage loans increase our exposure to credit risks; • Our indirect and consumer lending involves risk elements in addition to normal credit risk; • Lack of seasoning in portions of our loan portfolio could increase risk of credit defaults in the future; • We accept deposits that do not have a fixed term, and which may be withdrawn by the customer at any time for any reason; • We are subject to environmental liability risk associated with our lending activities; • We operate in a highly competitive industry and market area; • Legal and regulatory proceedings and related matters, such as the action brought by a class of consumers against us as described in Part I, Item 3, “Legal Proceedings,” could adversely affect us and the banking industry in general; • Any future FDIC insurance premium increases may adversely affect our earnings; • We are highly regulated, and any adverse regulatory action may result in additional costs, loss of business opportunities, and reputational damage; • We are subject to the CRA and fair lending laws, and failure to comply with these laws could lead to material penalties; • The policies of the Federal Reserve have a significant impact on our earnings; • Our investment advisory and wealth management operations are subject to risk related to the regulation of the financial services industry and market volatility; • We make certain assumptions and estimates in preparing our financial statements that may prove to be incorrect, which could significantly impact the results of our operations, cash flows and financial condition, and we are subject to new or changing accounting rules and interpretations, and the failure by us to correctly interpret or apply these evolving rules and interpretations could have a material adverse effect; • The value of our goodwill and other intangible assets may decline in the future; • We may be unable to successfully implement our growth strategies, including the integration and successful management of newly acquired businesses; • The introduction of new products and services may subject us to increased regulation and regulatory scrutiny and may affect our reputation; • Acquisitions may disrupt our business and dilute shareholder value; • Our tax strategies and the value of our deferred tax assets and liabilities could adversely affect our operating results and regulatory capital ratios; 45 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS • Liquidity is essential to our businesses; • We rely on dividends from our subsidiaries for most of our revenue; • If our risk management framework does not effectively identify or mitigate our risks, we could suffer losses; • We face competition in staying current with technological changes and banking alternatives to compete and meet customer demands; • We rely on other companies to provide key components of our business infrastructure; • A breach in security of our or third-party information systems, including the occurrence of a cyber incident or a deficiency in cybersecurity, or a failure by us to comply with New York State cybersecurity regulations, may subject us to liability, result in a loss of customer business or damage our brand image; • The soundness of other financial institutions could adversely affect us; • We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all; • We may not pay or may reduce the dividends on our common stock; • We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could dilute our current shareholders or negatively affect the value of our common stock; • Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect; • The market price of our common stock may fluctuate significantly in response to a number of factors; • We may not be able to attract and retain skilled people; • We use financial models for business planning purposes that may not adequately predict future results; • We depend on the accuracy and completeness of information about or from customers and counterparties; • Our business may be adversely affected by conditions in the financial markets and economic conditions generally, including macroeconomic pressures such as inflation, supply chain issues, and geopolitical risks associated with international conflict; and • Severe weather, natural disasters, public health emergencies and pandemics, acts of war or terrorism, and other external events could significantly impact our business. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in the Annual Report on Form 10-K for the year ended December 31, 2023. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. GENERAL The Parent is a financial holding company headquartered in New York State, providing diversified financial services through its operating subsidiaries, Five Star Bank (the “Bank”) and Courier Capital, LLC (“Courier Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly owned New York-chartered banking subsidiary, the Bank. The Bank also has commercial loan production offices in Ellicott City (Baltimore), Maryland, and Syracuse, New York, serving the Mid-Atlantic and Central New York regions. Our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, and the Capital District of New York. Effective January 1, 2024, we exited the Pennsylvania automobile market to align our focus more fully around our core Upstate New York market. Courier Capital provides customized investment advice, wealth management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans. On April 1, 2024, the Company announced and closed the sale of the assets of its wholly owned subsidiary, SDN Insurance Agency, LLC (“SDN”), which provided a broad range of insurance services to personal and business clients, to NFP Property & Casualty Services, Inc. (“NFP”), a subsidiary of NFP Corp. The sale generated $27 million in proceeds, or a pre-tax gain of $13.5 million, after selling costs. The all-cash transaction value represented approximately four times our 2023 insurance revenue. Following the sale of the assets of SDN, we changed the name of the entity to Five Star Advisors LLC and expect to utilize it to serve as a conduit to refer insurance business to NFP. Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, prior to the sale of the assets of SDN, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on the results of our operations and financial condition. 46 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking and other financial needs of individuals, municipalities and businesses of the communities surrounding our primary service area. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad-based banking relationships. Our core customers are primarily small- to medium-sized businesses, individuals and community organizations who prefer to build banking and wealth management relationships with a community bank that combines high quality, competitively priced products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities. A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit, loan, and wealth management products typically found at larger banks, our highly experienced management team and our strategically located banking centers. We prioritize customer acquisition through cost-effective, high-demand digital, virtual and physical channels, while maintaining a community bank distinctiveness relative to larger banks and digital-only neobanks. We leverage the retail branch network and customer contact center to build trust and credibility, provide personal financial education and advice, offer convenience, and bridge digital and physical channels. Our enhanced digital capabilities complement a continued focus on a consistent customer experience and engagement across physical and virtual channels, including using branches to create deeper engagement and relationships with customers, balancing customer engagement with efficiency opportunities (e.g., framing outreach to the customer contact center to teach customers how to use digital channels, in addition to addressing the reason for the call), and maintaining and expanding our customer reach digitally, physically or virtually. By employing digital channels across our current products and services, we deepen existing relationships and enter new geographies or market segments that would otherwise be prohibitively expensive targets using traditional approaches. Deepening our existing digital capabilities allows us to capitalize on a shift in customer preferences away from physical branches, while launching opportunities with non-bank entities through BaaS. We have evolved to meet changing customer needs by offering complementary physical, digital and virtual channels. We focus on technology to provide solutions that fit our customers’ preferences for transacting business with us. Branches are staffed by certified personal bankers who are trained to meet a broad array of customer needs. Our digital banking capabilities, interactive teller machine (“ITM”) functionality and Customer Contact Center provide additional self-serve and phone options through which customer needs are met effectively. Our BaaS business offers banking capabilities to non-bank financial service providers and other FinTechs, allowing them to provide banking services to their end users. With the help of the Bank’s partners, we can offer banking services and products beyond our traditional footprint, creating new fee-based revenue opportunities through service, interchange and other fees, coupled with cost effective deposit gathering opportunities. We are primarily focused on five key BaaS client types where we see strong opportunity: business-to-business, where we help FinTechs innovate solutions while creating new market opportunities and efficiencies; affinity groups, where we help empower traditionally under-banked communities with expanded financial services access; sustainable finance, where we meet customer-led environmental demands by partnering with early movers in the green banking space; cannabis-related businesses, where we can tap into the multi-billion dollar cannabis market by leveraging regulatory and risk experience for sustained operations; and wealth management, which enables wealth managers to meet accelerating client demand for banking services. We will continue to explore market expansion opportunities that complement current market areas as opportunities arise. Our primary focus will be on increasing the Bank’s market share within existing markets, while taking advantage of potential growth opportunities within our noninterest income lines of business by acquiring businesses that can be incorporated into existing operations. We believe our capital position remains strong enough to support an active merger and acquisition strategy and the expansion of our core financial service businesses. Consequently, we continue to explore acquisition opportunities in these activities. When evaluating acquisition opportunities, we will balance the potential for earnings accretion with maintaining adequate capital levels, which could result in our common stock being the predominant form of consideration and/or the need for us to raise capital. Conversations with potential strategic partners occur on a regular basis. The evaluation of any potential opportunity will favor a transaction that complements our core competencies and strategic intent, with a lesser emphasis being placed on geographic location or size. Additionally, we remain committed to maintaining a diversified revenue stream. Our senior management team has experience in acquisitions and post-acquisition integration of operations and is prepared to act promptly should a potential opportunity arise but will remain disciplined with its approach. We believe this experience positions us to successfully acquire and integrate additional financial services and banking businesses. Cannabis Banking The Marijuana Regulation and Taxation Act was signed into law on March 31, 2021, legalizing the possession and sale of recreational marijuana in New York State for adults aged 21 or older and the state has issued adult-use cannabis cultivation, processing and retail dispensary licenses. We have implemented a program to provide financial products and services to legal cannabis-related businesses and partner with other financial institutions who provide such services. 47 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Offering financial products and services to the cannabis industry presents a unique set of regulatory risks due to the conflict between state and federal laws, as marijuana remains illegal at the federal level. In January 2018, the U.S. Department of Justice (the “DOJ”) rescinded the “Cole Memo” and related memoranda which characterized the enforcement of the Controlled Substances Act against persons and entities complying with state regulatory systems permitting the use, manufacture and sale of medical marijuana as an inefficient use of their prosecutorial resources and discretion. The impact of the DOJ ’ s rescission of the Cole Memo and related memoranda is unclear, but in the future may result in increased enforcement actions against the regulated cannabis industry generally. More recently, the United States Attorney General has indicated that the DOJ, under his leadership, does not intend to pursue cases against parties who comply with the laws in states which have legalized and are effectively regulating marijuana. However, enforcement policies and practices may be highly variable between political administrations. In addition, federal prosecutors have significant discretion and there can be no assurance that the federal prosecutor for any district in which we operate will not choose to strictly enforce the federal laws governing cannabis. In the future, enforcement actions may be taken against cannabis-related businesses or financial services providers that are viewed as aiding and abetting such activities. The Financial Crimes Enforcement Network (“FinCEN”) published guidelines in 2014 for financial institutions servicing state-legal cannabis businesses. These guidelines were issued for the explicit purpose so “that financial institutions can provide services to marijuana-related businesses in a manner consistent with their obligations to know their customers and to report possible criminal activity.” The Bank has and will continue to follow this and other FinCEN guidance in the areas of cannabis banking. EXECUTIVE OVERVIEW Summary of 2024 Second Quarter Results Net income increased $11.3 million to $25.6 million for the second quarter of 2024 compared to $14.4 million for the second quarter of 2023. Net income available to common shareholders for the second quarter of 2024 was $25.3 million, or $1.62 per diluted share, compared with $14.0 million, or $0.91 per diluted share, for the second quarter of 2023. Return on average common equity was 23.51% and return on average assets was 1.68% for the second quarter of 2024 compared to 13.64% and 0.95%, respectively, for the second quarter of 2023. Second quarter 2024 results benefited from a pre-tax gain of $13.5 million, after selling costs, associated with the sale of the assets of SDN on April 1, 2024. First quarter 2024 results were negatively impacted by our deposit-related fraud event, for which we recorded an $18.4 million pre-tax loss that was recorded in deposit-related charged-off items and approximately $660 thousand of related professional services expenses related to legal expenses. In the second quarter of 2024, we recorded a small recovery of $143 thousand and incurred approximately $371 thousand of professional services expenses related to the deposit-related fraud event which included legal expenses as well as expenses associated with the engagement of a third party to support our internal review and advise on best practices for fraud prevention and detection. We continue to aggressively pursue our legal rights and seek any and all recovery avenues to minimize the loss. Net interest income totaled $41.2 million in the second quarter of 2024, a decrease of $1.1 million compared to $42.3 million in the second quarter of 2023. Average interest-earning assets for the second quarter of 2024 were $74.0 million higher than the second quarter of 2023 due to a $107.2 million increase in average loans and a $41.2 million increase in the average balance of Federal Reserve interest-earning cash, partially offset by a $74.4 million decrease in average investment securities. Average interest-bearing liabilities for the second quarter of 2024 were $113.6 million higher than the second quarter of 2023 due to a $376.6 million increase in average savings and money market account deposits, partially offset by a $154.5 million decrease in average borrowings, a $107.5 million decrease in average interest-bearing demand deposits and a $927 thousand decrease in average time deposits. Net interest margin was 2.87% for the second quarter of 2024 compared to 2.99% in the second quarter of 2023, primarily due to higher funding costs amid the continued high interest rate environment, partially offset by an increase in the average yield on interest-earning assets. The provision for credit losses was $2.0 million in the second quarter of 2024 compared to a provision for credit losses of $3.2 million in the second quarter of 2023. The provision for credit losses for the second quarter of 2024 was primarily driven by a combination of factors, including a modest increase in consumer indirect delinquencies during the period, which increased the qualitative factor for that portfolio, partially offset by improvement in forecasted losses. Net charge-offs during the recent quarter were $1.1 million, representing 0.10% of average loans on an annualized basis, compared to $636 thousand, or an annualized 0.06% of average loans, in the second quarter of 2023. See the “Allowance for Credit Losses – Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion regarding the provision for credit losses and net charge-offs. Noninterest income totaled $24.0 million in the second quarter of 2024, compared to $11.5 million in the second quarter of 2023. Noninterest income for the second quarter of 2024 included the gain of $13.5 million from the sale of the assets of SDN, recorded in net gain (loss) on other assets, which resulted in a decrease of insurance income of $1.3 million. Also contributing to the increase in noninterest income for the second quarter of 2024 were increases of $407 thousand in company owned life insurance income, due to the higher crediting rate and associated impact to cash surrender value related to the surrender and redeploy strategy executed in the fourth quarter of 2023, $334 thousand of income from investments in limited partnerships, and $362 thousand in other income. These increases were partially offset by decreases of $326 thousand in income from derivative instruments, net, and $244 thousand in service charges on deposits. 48 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Noninterest expense totaled $33.0 million in the second quarter of 2024, compared to $33.8 million in the second quarter of 2023. The decrease in noninterest expense for the second quarter of 2024 was primarily attributable to a decrease in salaries and employee benefits expense of $2.0 million as a result of the sale of the assets of SDN and the previously disclosed fourth quarter 2023 leadership and organizational changes, which reduced salaries and wages expense, partially offset by increases in computer and data processing expense of $592 thousand, due in part to investments in data efficiency and marketing technology, $521 thousand of professional services expense, due to legal and consulting expenses related to the deposit fraud-related event, and $374 thousand of other expenses. The regulatory Tier 1 Capital Ratio and Total Risk-Based Capital Ratio were 10.36%, and 12.65%, respectively, at June 30, 2024. See the “Liquidity and Capital Management” section of this Management’s Discussion and Analysis for further discussion regarding regulatory capital and the Basel III capital rules. RESULTS OF OPERATIONS Net Interest Income and Net Interest Margin Net interest income is our primary source of revenue, comprising approximately 63% and 70% of revenue during the three and six months ended June 30, 2024, respectively. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of interest-earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies. We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest-earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and shareholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis. The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis (dollars in thousands): Three months ended June 30, Six months ended June 30, 2024 2023 2024 2023 Interest income per consolidated statements of income $ 78,788 $ 71,115 $ 157,201 $ 134,886 Adjustment to fully taxable equivalent basis 81 113 167 234 Interest income adjusted to a fully taxable equivalent basis 78,869 71,228 157,368 135,120 Interest expense per consolidated statements of income 37,595 28,778 75,926 50,734 Net interest income on a taxable equivalent basis $ 41,274 $ 42,450 $ 81,442 $ 84,386 Analysis of Net Interest Income for the Three Months Ended June 30, 2024 and 2023 Net interest income on a taxable equivalent basis for the three months ended June 30, 2024, was $41.3 million, a decrease of $1.2 million versus the comparable quarter last year of $42.5 million. The decrease in net interest income was primarily due to higher funding costs amid the current high interest rate environment. Our net interest margin for the second quarter of 2024 was 2.87%, 12-basis points lower than 2.99% for the same period in 2023 due to higher funding costs as a result of the continued high interest rate environment, partially offset by an increase in the average yield on interest-earning assets. For the second quarter of 2024, the average yield on average interest earning assets of 5.50% was 48-basis points higher than the second quarter of 2023 of 5.02% primarily due to an increase in market interest rates. Average loan yields increased 47-basis points during the second quarter of 2024 to 6.40% from 5.93% for the second quarter of 2023. The average yield on investment securities increased 28-basis points during the second quarter of 2024 to 2.17% from 1.89% for the second quarter of 2023. Overall, the average interest rate changes increased interest income by $5.8 million and volume variance increased interest income by $1.8 million during the second quarter of 2024, which collectively drove a favorable variance of $7.6 million. 49 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Average interest-earning assets were $5.77 billion for the second quarter of 2024 compared to $5.69 billion for the second quarter of 2023, an increase of $74.0 million, or 1%, from the comparable quarter last year, with average loans up $107.2 million from $4.33 billion for the second quarter of 2023 to $4.44 billion for the second quarter of 2024, and a $41.2 million increase in average Federal Reserve interest-earning cash, partially offset by a decrease in average securities of $74.4 million from $1.27 billion for the second quarter of 2023 to $1.19 billion for the second quarter of 2024. Average loans comprised 77% of average interest-earning assets during the second quarter of 2024 compared to 76% during the second quarter of 2023. The increase in average loans was primarily due to organic growth in commercial mortgages. Loans generally have significantly higher yields compared to other interest-earning assets and, as such, have a more positive effect on the net interest margin. The average yield on average loans was 6.40% for the second quarter of 2024, an increase of 47-basis points compared to 5.93% for the comparable quarter in 2023 due to the impact of the higher market interest rates. Interest rate changes on average loans increased interest income by $4.9 million, and an increase in the volume of average loans resulted in a $1.7 million increase. Average investment securities represented 21% of average interest-earning assets during the second quarter of 2024 compared to 22% during the second quarter of 2023. The decrease in average investment securities was primarily due to repayment and maturities of investment securities, and the use of cash to fund loan originations, including the sale of approximately $54 million in lower yielding available-for-sale agency mortgage-backed securities in the fourth quarter of 2023. For the second quarter of 2024, the average cost of average interest-bearing liabilities of 3.32% was 72-basis points higher than the second quarter of 2023 and the average cost of interest-bearing deposits of 3.29% was 89-basis points higher than the second quarter of 2023 due to the continued repricing of deposits at higher interest rates. The average cost of total borrowings decreased 69-basis points to 3.83% in the second quarter of 2024, compared to 4.52% in the second quarter of 2023. The reduction in the cost of total borrowings was driven by a wholesale mix shift, lower level of outstanding balances, and the benefit of the Bank’s cash flow hedging program. Average interest-bearing liabilities were $4.55 billion for the second quarter of 2024, compared to $4.43 billion for the second quarter of 2023, an increase of $113.6 million, or 3%, driven by increases in average balances of interest-bearing deposits. On average, interest-bearing deposits grew $268.2 million from $4.02 billion for the second quarter of 2023 to $4.28 billion for the current quarter while noninterest-bearing demand deposits (a principal component of net free funds) decreased $78.9 million to $950.8 million for the second quarter of 2024. The increase in average interest-bearing deposits was due to growth in non-public deposits, public deposits, and reciprocal deposits, partially offset by a decrease in brokered deposits. For further discussion of our reciprocal and brokered deposits, refer to the “Funding Activities – Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate changes resulted in a $9.1 million increase in interest expense, and volume changes resulted in a $1.9 million increase in interest expense during the second quarter of 2024. Total average borrowings decreased to $264.8 million, down $154.5 million from the second quarter of 2023. A decrease in average interest rates on short term borrowings decreased interest expense by $2.2 million during the second quarter of 2024. Analysis of Net Interest Income for the Six Months Ended June 30, 2024 and 2023 Net interest income on a taxable equivalent basis for the six months ended June 30, 2024, was $81.4 million, a decrease of $2.9 million versus the comparable period in 2023 of $84.4 million. The decrease in net interest income was primarily due to higher funding costs amid the current high interest rate environment. Our net interest margin for the six months ended June 30, 2024 was 2.83%, 21-basis points lower than 3.04% for the same period in 2023 due to higher funding costs as a result of the continued high interest rate environment, partially offset by an increase in the average yield on interest-earning assets. For the six months ended June 30, 2024, the average yield on average interest earning assets of 5.47% was 60-basis points higher than the six months ended June 30, 2023 of 4.87%. The average yield on loans increased 59-basis points during the six months ended June 30, 2024, to 6.37% from 5.78% for the comparable period last year. The average yield on investment securities increased 24-basis points to 2.13% for the six months ended June 30, 2024 compared to 1.89% for the six months ended June 30, 2023. Overall, the impact of the interest rate increases in 2023 and 2024 has a positive impact on yields, increasing interest income by $14.3 million, while volume variances in average interest-earning assets and average interest-bearing liabilities increased net interest income by $7.9 million during the six months ended June 30, 2024. Average interest-earning assets were $5.79 billion for the six months ended June 30, 2024 compared to $5.59 billion for the six months ended June 30, 2023, an increase of $195.9 million, or 3.50%, with average loans up $224.3 million from $4.23 billion for the six months ended June 30, 2023 to $4.45 billion for the six months ended June 30, 2024, and a $67.9 million increase in average Federal Reserve interest-earning cash, partially offset by a decrease in average investment securities of $96.4 million from $1.29 billion for the six months ended June 30, 2023 to $1.19 billion for the six months ended June 30, 2024. Average investment securities represented 20.6% of average interest-earning assets during the six months ended June 30, 2024 compared to 23.0% during the six months ended June 30, 2023. Loans comprised 76.9% of average interest-earning assets during the six months ended June 30, 2024 compared to 75.6% during the six months ended June 30, 2023. The increase in average loans was primarily due to organic growth in commercial mortgages. Loans generally have significantly higher yields compared to other interest-earning assets and, as such, have a more positive effect on the net interest margin. Higher interest rates on loans increased interest income by $12.6 million, and an increase in the volume of average loans resulted in a $7.3 million increase in interest income. 50 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS For the six months ended June 30, 2024, the average cost of average interest-bearing liabilities of 3.33% was 96-basis points higher than the average cost of 2.37% for the six months ended June 30, 2023, with the average cost of average interest-bearing deposits of 3.29% increasing 109-basis points from 2.20% for the six months ended June 30, 2023 due to the higher interest rate environment that began in 2023 and continued into 2024. Average interest-bearing liabilities of $4.58 billion in the six months ended June 30, 2024 were $270.0 million, or 6.3%, higher than the six months ended June 30, 2023. The increase was driven by an increase in average interest-bearing deposits, partially offset by a decrease in total average borrowings. Total average borrowings decreased to $284.5 million, down $55.4 million from the six months ended June 30, 2023. On average, interest-bearing deposits increased $325.4 million from $3.97 billion for the six months ended June 30, 2023 to $4.30 billion for the current period, while noninterest-bearing demand deposits (a principal component of net free funds) decreased $90.5 million to $956.7 million for the six months ended June 30, 2024. The increase in average deposits was primarily due to growth in non-public and reciprocal deposits, partially offset by a decrease in brokered and public deposits. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities – Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate changes resulted in a $22.4 million increase in interest expense and volume changes contributed $4.6 million during the six months ended June 30, 2024, primarily due to the higher interest rate environment. 51 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS The following tables set forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (dollars in thousands). Average balances were derived from daily balances. Three months ended June 30, 2024 2023 Average Balance Interest Average Rate (3) Average Balance Interest Average Rate (3) Interest-earning assets: Federal funds sold and interest-earning deposits $ 134,123 $ 1,711 5.13 % $ 92,954 $ 1,186 5.12 % Investment securities (1) : Taxable 1,141,604 6,100 2.14 1,190,177 5,451 1.83 Tax-exempt (2) 53,204 382 2.86 79,004 539 2.73 Total investment securities 1,194,808 6,482 2.17 1,269,181 5,990 1.89 Loans: Commercial business 704,272 13,269 7.58 710,145 12,701 7.17 Commercial mortgage 2,059,382 34,949 6.83 1,911,729 30,827 6.47 Residential real estate loans 648,099 6,576 4.06 598,638 5,447 3.64 Residential real estate lines 75,575 1,466 7.80 76,191 1,371 7.22 Consumer indirect 905,056 13,675 6.08 1,011,338 13,272 5.26 Other consumer 44,552 741 6.69 21,686 434 8.02 Total loans (4) 4,436,936 70,676 6.40 4,329,727 64,052 5.93 Total interest-earning assets 5,765,867 78,869 5.50 5,691,862 71,228 5.02 Less: Allowance for credit losses (44,638 ) (49,183 ) Other noninterest-earning assets 432,200 410,579 Total assets $ 6,153,429 $ 6,053,258 Interest-bearing liabilities: Deposits: Interest-bearing demand $ 741,006 $ 2,178 1.18 % $ 848,552 $ 1,636 0.77 % Savings and money market 2,036,772 15,232 3.01 1,660,148 8,283 2.00 Time deposits 1,505,665 17,663 4.72 1,506,592 14,135 3.76 Total interest-bearing deposits 4,283,443 35,073 3.29 4,015,292 24,054 2.40 Short-term borrowings 140,110 958 2.75 294,923 3,159 4.30 Long-term borrowings 124,640 1,564 5.02 124,329 1,565 5.04 Total borrowings 264,750 2,522 3.83 419,252 4,724 4.52 Total interest-bearing liabilities 4,548,193 37,595 3.32 4,434,544 28,778 2.60 Noninterest-bearing demand deposits 950,819 1,029,681 Other noninterest-bearing liabilities 204,917 159,781 Shareholders’ equity 449,500 429,252 Total liabilities and shareholders’ equity $ 6,153,429 $ 6,053,258 Net interest income (tax-equivalent) $ 41,274 $ 42,450 Interest rate spread 2.18 % 2.42 % Net earning assets $ 1,217,674 $ 1,257,318 Net interest margin (tax-equivalent) 2.87 % 2.99 % Ratio of average interest-earning assets to average interest-bearing liabilities 126.77 % 128.35 % (1) Investment securities are shown at amortized cost. (2) The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a federal income tax rate of 21%. (3) Annualized. (4) Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Net deferred loan fees (costs) included in interest income were as follows (in thousands): 52 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Three months ended June 30, 2024 2023 Commercial business $ (9 ) $ (3 ) Commercial mortgage 535 598 Residential real estate loans (384 ) (397 ) Residential real estate lines (109 ) (102 ) Consumer indirect (900 ) (1,067 ) Other consumer 11 5 Total $ (856 ) $ (966 ) Six months ended June 30, 2024 2023 Average Balance Interest Average Rate (3) Average Balance Interest Average Rate (3) Interest-earning assets: Federal funds sold and interest-earning deposits $ 146,099 $ 3,696 5.09 % $ 78,214 $ 1,802 4.65 % Investment securities (1) : Taxable 1,133,485 11,868 2.09 1,202,822 11,052 1.84 Tax-exempt (2) 55,416 794 2.86 82,432 1,116 2.71 Total investment securities 1,188,901 12,662 2.13 1,285,254 12,168 1.89 Loans: Commercial business 713,496 26,868 7.57 690,360 23,933 6.99 Commercial mortgage 2,044,612 69,249 6.81 1,828,807 57,227 6.31 Residential real estate loans 648,510 13,052 4.03 594,217 10,693 3.60 Residential real estate lines 75,986 2,957 7.83 76,408 2,674 7.06 Consumer indirect 919,718 27,387 5.99 1,017,814 25,796 5.11 Other consumer 48,043 1,497 6.26 18,439 827 9.04 Total loans (4) 4,450,365 141,010 6.37 4,226,045 121,150 5.78 Total interest-earning assets 5,785,365 157,368 5.47 5,589,513 135,120 4.87 Less: Allowance for credit losses (48,086 ) (47,933 ) Other noninterest-earning assets 452,315 407,521 Total assets $ 6,189,594 $ 5,949,101 Interest-bearing liabilities: Deposits: Interest-bearing demand $ 745,259 $ 4,254 1.15 % $ 864,235 $ 3,035 0.71 % Savings and money market 2,059,294 31,180 3.04 1,662,598 14,839 1.80 Time deposits 1,492,399 34,877 4.70 1,444,705 25,474 3.56 Total interest-bearing deposits 4,296,952 70,311 3.29 3,971,538 43,348 2.20 Short-term borrowings 159,929 2,487 3.13 220,641 4,361 3.99 Long-term borrowings 124,601 3,128 5.02 119,318 3,025 5.07 Total borrowings 284,530 5,615 3.97 339,959 7,386 4.38 Total interest-bearing liabilities 4,581,482 75,926 3.33 4,311,497 50,734 2.37 Noninterest-bearing demand deposits 956,670 1,047,121 Other noninterest-bearing liabilities 199,175 166,858 Shareholders’ equity 452,267 423,625 Total liabilities and shareholders’ equity $ 6,189,594 $ 5,949,101 Net interest income (tax-equivalent) $ 81,442 $ 84,386 Interest rate spread 2.14 % 2.50 % Net earning assets $ 1,203,883 $ 1,278,016 Net interest margin (tax-equivalent) 2.83 % 3.04 % Ratio of average interest-earning assets to average interest-bearing liabilities 126.28 % 129.64 % 53 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS (1) Investment securities are shown at amortized cost. (2) The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21%. (3) Annualized. (4) Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Net deferred loan fees (costs) included in interest income were as follows (in thousands): Six months ended June 30, 2024 2023 Commercial business $ (5 ) $ (4 ) Commercial mortgage 1,148 1,146 Residential real estate loans (742 ) (801 ) Residential real estate lines (192 ) (176 ) Consumer indirect (1,822 ) (2,161 ) Other consumer 21 5 Total $ (1,592 ) $ (1,991 ) 54 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands). No out-of-period adjustments were included in the rate/volume analysis. Three months ended June 30, 2024 vs. 2023 Six months ended June 30, 2024 vs. 2023 Increase (decrease) in: Volume Rate Total Volume Rate Total Interest income: Federal funds sold and interest-earning deposits $ 525 $ — $ 525 $ 1,701 $ 193 $ 1,894 Investment securities: Taxable (229 ) 878 649 (663 ) 1,479 816 Tax-exempt (184 ) 26 (158 ) (384 ) 62 (322 ) Total investment securities (413 ) 904 491 (1,047 ) 1,541 494 Loans: Commercial business (106 ) 674 568 821 2,114 2,935 Commercial mortgage 2,455 1,667 4,122 7,080 4,942 12,022 Residential real estate loans 472 657 1,129 1,028 1,331 2,359 Residential real estate lines (11 ) 106 95 (15 ) 298 283 Consumer indirect (1,481 ) 1,884 403 (2,641 ) 4,232 1,591 Other consumer 391 (84 ) 307 987 (317 ) 670 Total loans 1,720 4,904 6,624 7,260 12,600 19,860 Total interest income 1,832 5,808 7,640 7,914 14,334 22,248 Interest expense: Deposits: Interest-bearing demand (228 ) 770 542 (465 ) 1,684 1,219 Savings and money market 2,172 4,777 6,949 4,170 12,171 16,341 Time deposits (9 ) 3,537 3,528 866 8,537 9,403 Total interest-bearing deposits 1,935 9,084 11,019 4,571 22,392 26,963 Short-term borrowings 31 (2,232 ) (2,201 ) (1,056 ) (818 ) (1,874 ) Long-term borrowings 4 (6 ) (2 ) 133 (30 ) 103 Total borrowings 35 (2,238 ) (2,203 ) (923 ) (848 ) (1,771 ) Total interest expense 1,970 6,846 8,816 3,648 21,544 25,192 Net interest income $ (138 ) $ (1,038 ) $ (1,176 ) $ 4,266 $ (7,210 ) $ (2,944 ) Provision (Benefit) for Credit Losses The provision for credit losses for the three and six months ended June 30, 2024 was a provision of $2.0 million and a benefit of $3.4 million, respectively, compared to provisions for credit losses of $3.2 million and $7.4 million for the corresponding periods in 2023. The provision for credit losses in the second quarter of 2024 was driven by a combination of factors, including a modest increase in consumer indirect delinquencies during the period, which increased the qualitative factors for that portfolio, partially offset by improvement in forecasted losses. Also included in the (benefit) provision for credit losses was a credit loss for unfunded commitments of $43 thousand and $287 thousand for the second quarters of 2024 and 2023, respectively. The benefit for credit losses for the six months ended June 30, 2024 was reflective of the $4.9 million benefit for credit losses – loans for the first quarter of 2024, which was driven by improvement in forecasted losses, positive trends in qualitative factors, including a reduction in consumer indirect loan delinquencies during the period, and a reduction in total period-end loan balances. Also included in the benefit for credit losses for the six months ended June 30, 2024 and 2023 was a credit loss benefit for unfunded commitments of $527 thousand and a credit loss for unfunded commitments of $298 thousand for the six months ended June 30, 2024 and 2023, respectively. See the “Allowance for Credit Losses – Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion. 55 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Noninterest Income The following table details the major categories of noninterest income for the periods presented (in thousands): Three months ended June 30, Six months ended June 30, 2024 2023 2024 2023 Service charges on deposits $ 979 $ 1,223 $ 2,056 $ 2,250 Insurance income 4 1,328 2,138 3,415 Card interchange income 2,008 2,107 3,910 4,046 Investment advisory 2,779 2,819 5,361 5,742 Company owned life insurance 1,360 953 2,658 1,947 Investments in limited partnerships 803 469 1,145 720 Loan servicing 158 114 333 260 Income from derivative instruments, net 377 703 551 1,199 Net gain on sale of loans held for sale 124 122 212 234 Net gain (loss) on other assets 13,508 (7 ) 13,495 32 Net gain on tax credit investments 406 489 31 288 Other 1,508 1,146 3,025 2,257 Total noninterest income $ 24,014 $ 11,466 $ 34,915 $ 22,390 Service charges on deposits decreased $244 thousand, or 20%, to $979 thousand for the second quarter of 2024 compared to $1.2 million for the second quarter of 2023. For the first six months of 2024, service charges on deposits decreased $194 thousand, or 9%, to $2.1 million, compared to $2.3 million for the first six months of 2023. Lower service charges on deposits reflected changes to the Bank’s fee policies that align with trends in community banking. The April 1, 2024 sale of the assets of our insurance subsidiary, SDN, generated a gain of $13.5 million, after selling costs, which was included in net gain (loss) on other assets. The decrease in insurance income for the second quarter of 2024 and the first six months of 2024 was reflective of the sale. Income from company owned life insurance increased $407 thousand, or 43%, to $1.4 million for the second quarter of 2024 compared to $953 thousand for the second quarter of 2023. For the first six months of 2024, income from company owned life insurance increased $711 thousand, or 37%, to $2.7 million compared to $1.9 million for the first six months of 2023. The increase in both periods was primarily due to the higher crediting rate and associated impact to cash surrender value recorded in the linked quarter related to the previously disclosed surrender and redeploy strategy executed in the fourth quarter of 2023. Investments in limited partnerships income increased $334 thousand, or 71%, to $803 thousand for the second quarter of 2024 compared to $469 thousand for the second quarter of 2023. For the first six months of 2024, income from investments in limited partnerships increased $425 thousand, or 59%, to $1.1 million compared to $720 thousand for the first six months of 2023. The income from our investments in limited partnerships fluctuates based on the maturity and performance of the underlying investments. Income from derivative instruments, net decreased $326 thousand, or 46%, to $377 thousand for the second quarter of 2024 compared to $703 thousand for the second quarter of 2023. For the first six months of 2024, income from derivative instruments, net decreased $648 thousand, or 54%, to $551 thousand compared to $1.2 million for the first six months of 2023. Income from derivative instruments, net is based on the number and value of interest rate swap transactions executed during the period combined with the impact of changes in the fair value of borrower-facing trades. 56 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Noninterest Expense The following table details the major categories of noninterest expense for the periods presented (in thousands): Three months ended June 30, Six months ended June 30, 2024 2023 2024 2023 Salaries and employee benefits $ 15,748 $ 17,754 $ 33,088 $ 35,887 Occupancy and equipment 3,448 3,538 7,200 7,268 Professional services 1,794 1,273 4,166 2,768 Computer and data processing 5,342 4,750 10,728 9,441 Supplies and postage 437 473 912 963 FDIC assessments 1,346 1,239 2,641 2,354 Advertising and promotions 440 498 737 812 Amortization of intangibles 114 230 331 464 Restructuring recoveries — (19 ) — (19 ) Deposit-related charged-off items 398 467 19,577 790 Other 3,953 3,579 7,653 6,715 Total noninterest expense $ 33,020 $ 33,782 $ 87,033 $ 67,443 Salaries and employee benefits expense decreased $2.0 million, or 11%, to $15.7 million for the second quarter of 2024 compared to $17.8 million for the second quarter of 2023. For the first six months of 2024, salaries and employee benefits expense decreased $2.8 million, or 8%, to $33.1 million compared to $35.9 million for the first six months of 2023. The decrease in both periods was driven in part by lower salaries and wages in the 2024, as a result of the sale of the assets of SDN, as well as our previously disclosed leadership and organizational changes completed in the fourth quarter of 2023. Professional services expense increased $521 thousand, or 41%, to $1.8 million for the second quarter of 2024 compared to $1.3 million for the second quarter of 2023. For the first six months of 2024, professional services expense increased $1.4 million, or 51%, to $4.2 million compared to $2.8 million for the first six months of 2023. The increases in both periods were primarily due to higher legal expenses in 2024 related to the deposit-related fraud event, including $660 thousand and $371 thousand for the first and second quarters of 2024, respectively. The second quarter of 2024 expenses also included professional expense associated with the engagement of a third party to support the Company’s internal review and advise on best practices for fraud prevention and detection. Computer and data processing expense increased $592 thousand, or 12%, to $5.3 million for the second quarter of 2024 compared to $4.8 million for the second quarter of 2023. For the first six months of 2024, computer and data processing expense increased $1.3 million, or 14%, to $10.7 million compared to $9.4 million for the first six months of 2023. The increase during the 2024 periods was a result of our strategic investments in data efficiency and marketing technology. Deposit-related charged-off items expense for the first six months of 2024 included an $18.2 million loss associated with the deposit-related fraud event, including the $18.4 million recorded in the first quarter of 2024, partially offset by $143 thousand of recoveries recorded in the second quarter of 2024. Other expense increased $374 thousand, or 10%, to $4.0 million for the second quarter of 2024 compared to $3.6 million for the second quarter of 2023. For the first six months of 2024, other expense increased $938 thousand, or 14%, to $7.7 million compared to $6.7 million for the first six months of 2023. The increase for both periods was primarily driven by an increase in New York State capital base franchise tax accrual. Our efficiency ratio for the second quarter of 2024 and the first six months of 2024 was 50.58% and 74.80%, respectively, compared with 62.66% and 63.17% for the second quarter of 2023 and the first six months of 2023, respectively. The lower efficiency ratio for the second quarter of 2024 was primarily due to the $13.5 million pre-tax gain on sale of the assets of our insurance subsidiary. The higher efficiency ratio for the first six months of 2024 was primarily due to the $18.2 million pre-tax loss in deposit-related charged-off items and approximately $1.0 million of legal and consulting expenses, recorded in professional services expense, related to the deposit-related fraud event. The efficiency ratio is calculated by dividing total noninterest expense by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains on investment securities. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease indicates a more efficient allocation of resources. The efficiency ratio, a banking industry financial measure, is not required by GAAP. However, the efficiency ratio is used by management in its assessment of financial performance specifically as it relates to noninterest expense control. Management also believes such information is useful to investors in evaluating Company performance. 57 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Income Taxes For the three and six months ended June 30, 2024, we recorded income tax expense of $4.5 million and $4.9 million, versus $2.4 million and $5.2 million for the same periods in the prior year. The increase in income tax expense for the second quarter of 2024 compared to the second quarter of 2023 is reflective of higher net income, due in part to the gain on the sale of the assets of SDN. In the second quarter of 2024, we recognized federal and state tax benefits related to tax credit investments placed in service and/or amortized during the period resulting in a reduction in income tax expense of $1.3 million, versus $761 thousand for the same period in the prior year. The six months ended June 30, 2024 and 2023 also included related benefits of $2.1 million and $1.3 million, respectively. Our effective tax rate for both the three and six months ended June 30, 2024 was 15.0%, versus 14.4% and 16.4%, respectively, for the same periods in the prior year. Effective tax rates are typically impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities, earnings on company owned life insurance and the impact of tax credit investments. In addition, our effective tax rates for 2024 and 2023 reflect the New York State tax benefit generated by our real estate investment trust. ANALYSIS OF FINANCIAL CONDITION INVESTING ACTIVITIES Investment Securities The following table summarizes the composition of our investment securities portfolio as of the dates indicated (in thousands): Investment Securities Portfolio Composition June 30, 2024 December 31, 2023 Amortized Fair Amortized Fair Cost Value Cost Value Securities available for sale: U.S. Government agency and government-sponsored enterprise securities $ 24,535 $ 21,792 $ 24,535 $ 21,811 Mortgage-backed securities: Agency mortgage-backed securities 1,004,309 847,446 1,013,455 865,594 Non-Agency mortgage-backed securities — 384 — 325 Other debt securities 2,000 2,013 — — Total available for sale securities 1,030,844 871,635 1,037,990 887,730 Securities held to maturity: U.S. Government agency and government-sponsored enterprise securities 16,588 15,949 16,513 15,983 State and political subdivisions 52,811 47,303 68,854 63,782 Mortgage-backed securities 58,875 52,597 62,793 57,265 Total held to maturity securities 128,274 115,849 148,160 137,030 Allowance for credit losses – securities (3 ) (4 ) Total held to maturity securities, net 128,271 148,156 Total investment securities $ 1,159,115 $ 987,484 $ 1,186,146 $ 1,024,760 Our available for sale (“AFS”) investment securities portfolio decreased $7.1 million from December 31, 2023 to June 30, 2024. The AFS portfolio had a net unrealized loss of $159.2 million at June 30, 2024 and $150.3 million at December 31, 2023, respectively. The decrease in the AFS portfolio balance was primarily the result of the purchase of securities for collateral for municipal deposits in the first six months of 2024. Security Yields and Maturities Schedule The following table sets forth certain information regarding the amortized cost (“Cost”), weighted average yields (“Yield”) and contractual maturities of our debt securities portfolio as of June 30, 2024. In this table, Yield is defined as the book yield weighted against the ending book value. Mortgage-backed securities are included in maturity categories based on their stated maturity date. Actual maturities may differ from the contractual maturities presented because borrowers may have the right to call or prepay certain investments. No tax-equivalent adjustments were made to the weighted average yields (dollars in thousands). 58 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Due in one year or less Due from one to five years Due after five years through ten years Due after ten years Total Cost Yield Cost Yield Cost Yield Cost Yield Cost Yield Available for sale debt securities: U.S. Government agencies and government-sponsored enterprises $ — — $ 15,000 1.69 % $ 9,535 1.90 % $ — — $ 24,535 1.77 % Mortgage-backed securities 12 3.39 % 28,722 1.65 % 117,266 2.05 % 858,309 2.09 % 1,004,309 2.08 % Other debt securities — — — — 2,000 8.99 % — — 2,000 8.99 % 12 3.39 % 43,722 1.66 % 128,801 2.14 % 858,309 2.09 % 1,030,844 2.08 % Held to maturity debt securities: U.S. Government agencies and government-sponsored enterprises $ — — $ 10,000 3.00 % $ 6,588 3.49 % $ — — $ 16,588 3.80 % State and political subdivisions 20,915 2.39 % 5,381 2.06 % 5,003 1.62 % 21,512 2.45 % 52,811 2.31 % Mortgage-backed securities — — 4,186 2.55 % 17,227 2.27 % 37,462 2.91 % 58,875 2.70 % 20,915 2.39 % 19,567 3.16 % 28,818 2.43 % 58,974 2.74 % 128,274 2.68 % Total investment securities $ 20,927 2.39 % $ 63,289 2.12 % $ 157,619 2.20 % $ 917,283 2.14 % $ 1,159,118 2.15 % Impairment Assessment For AFS securities in an unrealized loss position, we first assess whether (i) we intend to sell, or (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If either case is affirmative, any previously recognized allowances are charged-off and the security’s amortized cost is written down to fair value through income. If neither case is affirmative, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and any adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income. Adjustments to the allowance are reported in our income statement as a component of credit loss expense. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met. For the three and six months ended June 30, 2024 and 2023, no allowance for credit losses was recognized on AFS securities in an unrealized loss position as management does not believe any of the securities are impaired due to reasons of credit quality. LENDING ACTIVITIES Total loans were $4.461 billion at June 30, 2024, a decrease of $671 thousand from $4.462 billion at December 31, 2023. Commercial loans and consumer loans represented 63% and 37% of total loans as of June 30, 2024, respectively. The composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, is summarized as follows (dollars in thousands): Loan Portfolio Composition June 30, 2024 December 31, 2023 Amount % of Total Amount % of Total Commercial business $ 713,947 16.0 % $ 735,700 16.5 % Commercial mortgage 2,085,870 46.8 2,005,319 44.9 Total commercial 2,799,817 62.8 2,741,019 61.4 Residential real estate loans 647,675 14.5 649,822 14.6 Residential real estate lines 75,510 1.7 77,367 1.7 Consumer indirect 894,596 20.0 948,831 21.3 Other consumer 43,870 1.0 45,100 1.0 Total consumer 1,661,651 37.2 1,721,120 38.6 Total loans 4,461,468 100.0 % 4,462,139 100.0 % Less: Allowance for credit losses – loans 43,952 51,082 Total loans, net $ 4,417,516 $ 4,411,057 59 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Total commercial loans of $2.80 billion, or 63% of total loans at June 30, 2024, were comprised of commercial business loans of $713.9 million, or 16% of total loans, down $21.8 million, or 3%, from December 31, 2023, and commercial mortgage loans of $2.09 billion, or 47% of total loans, up $80.6 million, or 4%, from December 31, 2023. Commercial loans include both owner-occupied and non-owner occupied commercial real estate loans. As of June 30, 2024, commercial real estate (“CRE”) loans made up approximately 65% of total commercial loans, and 41% of total loans, commercial and industrial loans approximated 31% of total commercial loans, and 20% of total loans, and business banking unit loans were approximately 4% of total commercial loans and 3% of total loans. Our CRE committed credit exposure at June 30, 2024 related to approximately 41% multi-family, 18% office, 7% retail, 7% hospitality, 7% industrial property, and 6% home builder. Approximately 70% of our office exposure at June 30, 2024, or 12% of our total CRE exposure, related to Class B or medical office space. More than 90% of our CRE loans have full or limited personal or corporate recourse. Total consumer loans of $1.66 billion, or 37% of total loans at June 30, 2024, decreased $59.5 million from December 31, 2023. Consumer loans at June 30, 2024 were comprised of residential real estate loans and lines of credit of $723.2 million, or 16% of total loans, consumer indirect loans of $894.6 million, or 20% of total loans, and other consumer loans of $43.9 million, or 1% of total loans. During the six months ended June 30, 2024, we originated $114.7 million in indirect automobile loans with a mix of approximately 22% new automobile and 78% used automobile loans. This compares with the $169.0 million in indirect automobile loans with a mix of approximately 26% new automobile and 74% used automobile loans for the six months ended June 30, 2023. Origination volumes and the mix of new and used vehicles financed fluctuate depending on general market conditions. Effective January 1, 2024, we exited the Pennsylvania automobile market to align our focus more fully around our core Upstate New York market, which includes a strong network of approximately 375 new automobile dealers. Loans Held for Sale and Loan Servicing Rights Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate loans and totaled $2.1 million and $1.4 million as of June 30, 2024 and December 31, 2023, respectively. We sell certain qualifying newly originated or refinanced residential real estate loans on the secondary market. Residential real estate loans serviced for others, which are not included in the consolidated statements of financial condition, amounted to $273.5 million and $269.4 million as of June 30, 2024 and December 31, 2023, respectively. 60 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Allowance for Credit Losses – Loans The following table summarizes the activity in the allowance for credit losses – loans for the periods indicated (dollars in thousands). Credit Loss – Loans Analysis Three months ended June 30, Six months ended June 30, 2024 2023 2024 2023 Allowance for credit losses – loans, beginning of period $ 43,075 $ 47,528 $ 51,082 $ 45,413 Net charge-offs (recoveries): Commercial business 7 33 (30 ) (91 ) Commercial mortgage (3 ) 16 (4 ) 14 Residential real estate loans 96 13 100 71 Residential real estate lines — 25 — 41 Consumer indirect 844 300 3,817 2,138 Other consumer 178 249 360 552 Total net charge-offs 1,122 636 4,243 2,725 Provision (benefit) for credit losses – loans 1,999 2,944 (2,887 ) 7,148 Allowance for credit losses – loans, end of period $ 43,952 $ 49,836 $ 43,952 $ 49,836 Net loan charge-offs (recoveries) to average loans: Commercial business 0.00 % 0.02 % (0.01 )% (0.03 )% Commercial mortgage 0.00 % 0.00 % 0.00 % 0.00 % Residential real estate loans 0.06 % 0.01 % 0.03 % 0.02 % Residential real estate lines 0.00 % 0.13 % 0.00 % 0.11 % Consumer indirect 0.38 % 0.12 % 0.83 % 0.42 % Other consumer 1.62 % 4.62 % 1.51 % 6.04 % Total loans 0.10 % 0.06 % 0.19 % 0.13 % Allowance for credit losses – loans to total loans 0.99 % 1.13 % 0.99 % 1.13 % Allowance for credit losses – loans to nonaccrual loans 175 % 503 % 175 % 503 % Allowance for credit losses – loans to non-performing loans 174 % 503 % 174 % 503 % Loans not analyzed for a specific reserve are segmented into “pools” of loans based upon similar risk characteristics. This is referred to as the “pooled loan” component of the allowance for credit losses estimate. The allowance for credit losses for pooled loans estimate is based upon periodic review of the collectability of the loans quantitatively correlating historical loan experience with reasonable and supportable forecasts using forward looking information. Adjustments to the quantitative evaluation may be made for differences in current or expected qualitative risk characteristics such as changes in underwriting standards, delinquency level, regulatory environment, economic condition, Company management and the status of portfolio administration including the Company’s Loan Review function. The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, and other loans deemed appropriate by management, collectively referred to as collateral dependent loans. See Note 4., Loans, of the notes to the consolidated financial statements for further details on collateral dependent loans. Assessing the adequacy of the allowance for credit losses – loans involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing a variety of factors, including the risk profile of our loan products and customers. The adequacy of the allowance for credit losses – loans is subject to ongoing management review. While management evaluates currently available information in establishing the allowance for credit losses – loans, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for credit losses – loans. Such agencies may require the financial institution to increase the allowance based on their judgments about information available to them at the time of their examination. 61 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Net charge-offs of $1.1 million for the second quarter of 2024 represented 0.10% of average loans on an annualized basis compared to net charge-offs of $636 thousand, or 0.06% of average loans for the second quarter of 2023. The allowance for credit losses – loans was $44.0 million at June 30, 2024, compared with $49.8 million at June 30, 2023. The ratio of the allowance for credit losses – loans to total loans was 0.99% at June 30, 2024 and 1.13% at June 30, 2023. The ratio of allowance for credit losses – loans to non-performing loans was 174% at June 30, 2024, reflecting one large commercial loan relationship totaling $13.6 million that was placed on nonaccrual status during the fourth quarter of 2023, compared with 503% at June 30, 2023. The following table sets forth the allocation of the allowance for credit losses – loans by loan category as of the dates indicated (dollars in thousands). The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio. Allowance for Credit Losses – Loans by Loan Category June 30, 2024 December 31, 2023 Percentage Percentage Credit of loans by Credit of loans by Loss category to Loss category to Allowance total loans Allowance total loans Commercial business $ 12,246 16.0 % $ 13,102 16.5 % Commercial mortgage 15,365 46.7 15,858 44.9 Residential real estate loans 4,211 14.5 5,286 14.6 Residential real estate lines 769 1.7 764 1.7 Consumer indirect 10,842 20.1 14,099 21.3 Other consumer 519 1.0 1,973 1.0 Total $ 43,952 100.0 % $ 51,082 100.0 % Non-Performing Assets and Potential Problem Loans The table below summarizes our non-performing assets at the dates indicated (dollars in thousands). Non-Performing Assets June 30, 2024 December 31, 2023 Nonaccrual loans: Commercial business $ 5,680 $ 5,664 Commercial mortgage 10,452 10,563 Residential real estate loans 5,961 6,364 Residential real estate lines 183 221 Consumer indirect 2,897 3,814 Other consumer — 13 Total nonaccrual loans 25,173 26,639 Accruing loans 90 days or more delinquent 36 21 Total non-performing loans 25,209 26,660 Foreclosed assets 63 142 Total non-performing assets $ 25,272 $ 26,802 Nonaccrual loans to total loans 0.56 % 0.60 % Non-performing loans to total loans 0.57 % 0.60 % Non-performing assets to total assets 0.41 % 0.44 % Non-performing assets include non-performing loans and foreclosed assets. Non-performing assets at June 30, 2024 were $25.3 million, a decrease of $1.5 million from the $26.8 million balance at December 31, 2023. The primary component of non-performing assets is non-performing loans, which were $25.2 million or 0.57% of total loans at June 30, 2024 and $26.7 million or 0.60% of total loans at December 31, 2023. Approximately $1.1 million, or 4%, of the $25.2 million in non-performing loans as of June 30, 2024 were current with respect to payment of principal and interest but were classified as non-accruing because repayment in full of principal and/or interest was uncertain. Foreclosed assets consist of real property formerly pledged as collateral for loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. We had $63 thousand and $142 thousand of properties representing foreclosed asset holdings at June 30, 2024 and December 31, 2023, respectively. 62 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes us to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as non-performing at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. We consider loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $21.3 million and $29.9 million in loans that continued to accrue interest which were classified as substandard as of June 30, 2024 and December 31, 2023, respectively. Contractual Loan Maturity Schedule The following table summarizes the contractual maturities of our loan portfolio at June 30, 2024. Loans, net of deferred loan origination costs, include principal amortization and non-accruing loans. Demand loans having no stated schedule of repayment or maturity and overdrafts as reported as due in one year or less (in thousands). Due in less than one year Due from one to five years Due from five to fifteen years Due after fifteen years Total Commercial business $ 153,161 $ 254,266 $ 19,619 $ 286,901 $ 713,947 Commercial mortgage 669,549 1,108,304 306,780 1,237 2,085,870 Residential real estate loans 87,771 245,928 289,966 24,010 647,675 Residential real estate lines 1,382 6,355 26,038 41,735 75,510 Consumer indirect (1) 316,262 578,333 1 — 894,596 Other consumer 7,385 15,951 18,071 2,463 43,870 Total loans $ 1,235,510 $ 2,209,137 $ 660,475 $ 356,346 $ 4,461,468 Loans maturing after one year: With a predetermined interest rate Commercial business $ 107,828 $ 10,267 $ 469 $ 118,564 Commercial mortgage 511,430 140,103 194 651,727 Residential real estate loans 176,165 242,313 21,520 439,998 Residential real estate lines — — — — Consumer indirect (1) 578,333 1 — 578,334 Other consumer 15,951 18,071 2,463 36,485 With a floating or adjustable rate Commercial business 146,438 9,352 286,432 442,222 Commercial mortgage 596,874 166,677 1,043 764,594 Residential real estate loans 69,763 47,653 2,490 119,906 Residential real estate lines 6,355 26,038 41,735 74,128 Consumer indirect (1) — — — — Other consumer — — — — Total loans maturing after one year $ 2,209,137 $ 660,475 $ 356,346 $ 3,225,958 _________ (1) Amounts include prepayment assumptions based on actual historical experience. FUNDING ACTIVITIES Deposits The following table summarizes the composition of our deposits at the dates indicated (dollars in thousands): Deposit Composition June 30, 2024 December 31, 2023 Amount % of Total Amount % of Total Noninterest-bearing demand $ 939,346 18.3 % $ 1,010,614 19.4 % Interest-bearing demand 711,580 13.9 713,158 13.7 Savings and money market 2,007,256 39.1 2,084,444 40.0 Time deposits 1,475,139 28.7 1,404,696 26.9 Total deposits $ 5,133,321 100.0 % $ 5,212,912 100.0 % 63 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS As of June 30, 2024 and December 31, 2023, the aggregate amount of estimated uninsured deposits (deposits in amounts greater than $250 thousand, which is the maximum amount for federal deposit insurance) was $1.83 billion, or 36% of total deposits, and $1.82 billion, or 35% of total deposits, respectively. The portion of our time deposits by account that were in excess of the FDIC insurance limit was $296.3 million and $302.6 million at June 30, 2024 and December 31, 2023, respectively. The maturities of our uninsured time deposits at June 30, 2024 were as follows: $115.1 million in three months or less; $53.9 million between three months and six months; $49.6 million between six months and one year; and $77.8 million over one year. Approximately $980.4 million and $956.3 million of reciprocal and public deposits, characterized as preferred deposits for FDIC call report purposes, were collateralized by government-backed securities as of June 30, 2024 and December 31, 2023, respectively. As of June 30, 2024, estimated uninsured nonpublic deposits were approximately 16% of total deposits. We offer a variety of deposit products designed to attract and retain customers, with the primary focus on building and expanding long-term relationships. At June 30, 2024, total deposits were $5.13 billion, representing a decrease of $79.6 million from December 31, 2023. The decrease was primarily due to a decrease in brokered deposits, partially offset by growth in reciprocal, public, and non-public deposits. Time deposits were approximately 29% and 27% of total deposits at June 30, 2024 and December 31, 2023, respectively. Non-public deposits, the largest component of our funding sources, totaled $3.14 billion and $3.12 billion at June 30, 2024 and December 31, 2023, respectively, and represented 61% and 60% of total deposits as of each date, respectively. We have managed this segment of funding through a strategy of competitive pricing that minimizes the number of customer relationships that have only a single service high-cost deposit account. As an additional source of funding, we offer a variety of public (municipal) deposit products to the towns, villages, counties and school districts within our market area. Public deposits generally range from 20% to 30% of our total deposits. There is a high degree of seasonality in this component of funding because the level of deposits varies with the seasonal cash flows for these public customers. We maintain the necessary levels of short-term liquidity to accommodate the seasonality associated with public deposits. Total public deposits were $1.04 billion and $1.02 billion at June 30, 2024 and December 31, 2023, respectively, and represented 20% of total deposits as of each date. We also participate in reciprocal deposit programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Reciprocal deposits totaled $878.3 million at June 30, 2024, compared to $817.6 million at December 31, 2023, as this product has been an attractive option for customers with more than $250 thousand on deposit desiring FDIC insurance. Reciprocal deposits represented 17% and 16% of total deposits as of each date, respectively. Brokered deposits totaled $75.8 million and $256.8 million at June 30, 2024 and December 31, 2023, respectively, and represented 2% and 5% of total deposits as of each date. As of June 30, 2024 and December 31, 2023, $25.8 million and $206.8 million of interest-bearing demand deposits and $50.0 million of time deposits were brokered deposit accounts. The Bank reduced the outstanding balance of the brokered sweep deposit portfolio by $180 million in April 2024 through the utilization of more cost effective funding sources. Borrowings The Company classifies borrowings as short-term or long-term in accordance with the original terms of the applicable agreement. Outstanding borrowings consisted of the following as of the dates indicated (in thousands): June 30, December 31, 2024 2023 Short-term borrowings: FHLB $ 139,000 $ 107,000 FRB 63,000 78,000 Total short-term borrowings 202,000 185,000 Long-term borrowings: FHLB 50,000 50,000 Subordinated notes, net 74,687 74,532 Total long-term borrowings 124,687 124,532 Total borrowings $ 326,687 $ 309,532 Short-term Borrowings Short-term Federal Home Loan Bank (“FHLB”) borrowings have original maturities of less than one year and include overnight borrowings which we typically utilize to address short term funding needs as they arise. Short-term FHLB borrowings at June 30, 2024 and December 31, 2023 totaled $139.0 million and $107.0 million, respectively. The FHLB borrowings are collateralized by securities from the Company’s investment portfolio and certain qualifying loans. In May 2023, we borrowed $15.0 million under the Federal Reserve Bank (“FRB”) Bank Term funding program at a rate of 4.80%, which matured on May 8, 2024. In December 2023, we borrowed an additional $50 million under the program at an interest rate of 4.89%, which matures on December 13, 2024, and $13.0 million at an interest rate of 4.88%, which matures on December 20, 2024. Short-term borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits. 64 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS As of June 30, 2024, $50.0 million of the short-term borrowings balance was designated as a cash-flow hedge, which became effective in April 2022, at a fixed rate of 0.787%, $30.0 million was designated as a cash-flow hedge, which became effective in January 2023, at a fixed rate of 3.669%, and $25.0 million was designated as a cash-flow hedge, which became effective in May 2023, at a fixed rate of 3.4615%. We have credit capacity with the FHLB and can borrow through facilities that include amortizing and term advances or repurchase agreements. We had approximately $259.0 million of immediate credit capacity with the FHLB, and approximately $890.7 million in secured borrowing capacity at the FRB discount window as of June 30, 2024. The FHLB and FRB credit capacity are collateralized by securities from our investment portfolio and certain qualifying loans. We had $155.0 million of credit available under unsecured federal funds purchased lines with various banks as of June 30, 2024, with no amounts outstanding. Additionally, we had approximately $92.7 million of unencumbered liquid securities available for pledging at June 30, 2024. The Parent has a revolving line of credit with a commercial bank allowing borrowings up to $20.0 million in total as an additional source of working capital. At June 30, 2024, no amounts have been drawn on the line of credit. Long-term Borrowings As of June 30, 2024 we had a long-term advance payable to FHLB of $50.0 million. The advance matures on January 20, 2026 and bears interest at a fixed rate of 4.05%. FHLB advances are collateralized by securities from our investment portfolio and certain qualifying loans. On October 7, 2020, we completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes to qualified institutional buyers and accredited institutional investors that were subsequently exchanged for subordinated notes with substantially the same terms (the “2020 Notes”) registered under the Securities Act of 1933, as amended. The 2020 Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month SOFR plus 4.265%, payable quarterly until maturity. The 2020 Notes are redeemable by us, in whole or in part, on any interest payment date on or after October 15, 2025, and we may redeem the Notes in whole at any time upon certain other specified events. We used the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank. Proceeds, net of debt issuance costs of $740 thousand, were $34.3 million. The 2020 Notes qualify as Tier 2 capital for regulatory purposes. On April 15, 2015, we issued $40.0 million of subordinated notes (the “2015 Notes”) in a registered public offering. The 2015 Notes bear interest at a fixed rate of 6.0% per year, payable semi-annually, for the first 10 years. From April 15, 2025 to the April 15, 2030 maturity date, the interest rate will reset quarterly to an annual interest rate equal to the then current three-month CME Term SOFR plus 4.20561%. The 2015 Notes are redeemable by us at any quarterly interest payment date beginning on April 15, 2025 to maturity at par, plus accrued and unpaid interest. Proceeds, net of debt issuance costs of $1.1 million, were $38.9 million. The 2015 Notes qualify as Tier 2 capital for regulatory purposes. LIQUIDITY AND CAPITAL MANAGEMENT Liquidity We continue to actively monitor our liquidity profile and funding concentrations in accordance with our Board approved Liquidity Policy. Management is actively monitoring customer activity by way of commercial and consumer line of credit utilization, as well as deposit flows. As of June 30, 2024, all structural liquidity ratios and early warning indicators remain in compliance, with what we believe are ample funding sources available in the event of a stress scenario. The objective of maintaining adequate liquidity is to assure that we meet our financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of matured borrowings, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. We achieve liquidity by maintaining a strong base of both core customer funds and maturing short-term assets; we also rely on our ability to sell or pledge securities and lines-of-credit and our overall ability to access to the financial and capital markets. Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with other banking institutions, the FHLB, the FRB Discount Window, and brokered deposit relationships. The primary source of our non-deposit short-term borrowings is FHLB advances, of which $139.0 million were outstanding at June 30, 2024. In addition to this amount, we have additional collateralized wholesale borrowing capacity of approximately $1.30 billion as of June 30, 2024 from various funding sources which include the FHLB, the FRB and commercial banks that we can use to fund lending activities, liquidity needs, and/or to adjust and manage our asset and liability position. The Parent’s funding requirements consist primarily of dividends to shareholders, debt service, income taxes, operating expenses, funding of non-bank subsidiaries, repurchases of our stock, and acquisitions. The Parent obtains funding to meet obligations from dividends received from the Bank, net taxes collected from subsidiaries included in the federal consolidated tax return, and the issuance of debt and equity securities. In addition, the Parent maintains a revolving line of credit with a commercial bank for an aggregate amount of up to $20.0 million, all of which was available at June 30, 2024. The line of credit has a one-year term and matures in May 2025. Funds drawn would be used for general corporate purposes and backup liquidity. 65 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Cash and cash equivalents were $146.3 million as of June 30, 2024, up $21.9 million from $124.4 million as of December 31, 2023. During the six months ended June 30, 2024, net cash provided by operating activities totaled $48.0 million and the principal source of operating activity cash flow was net income adjusted for noncash income and expense items. Net cash provided by investing activities totaled $46.9 million, which primarily included inflows of $27.0 million for the proceeds from the sale of the assets of SDN, $25.6 million for net proceeds from investment securities, partially offset by outflows of net loan originations of $3.6 million, and $2.1 million of purchases of premises and equipment. Net cash used in financing activities of $73.0 million was primarily attributed to a $79.6 million net decrease in deposits, and $10.4 million in dividend payments, partially offset by a $17.0 million net increase in short-term borrowings. Capital Management We actively manage capital, commensurate with our risk profile, to enhance shareholder value. We also seek to maintain capital levels for the Company and the Bank at amounts in excess of the regulatory “well-capitalized” thresholds. Periodically, we may respond to market conditions by implementing changes to our overall balance sheet positioning to manage our capital position. Banks and financial holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material impact on our consolidated financial statements. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors. Shareholders’ equity was $467.7 million at June 30, 2024, an increase of $12.9 million from $454.8 million at December 31, 2023, primarily due to net income in the first six months of 2024 offset by an increase in accumulated other comprehensive loss of $5.8 million during the six months ended June 30, 2024 due primarily to an increase in net unrealized losses on securities available for sale. The FRB and FDIC have adopted a system using risk-based capital guidelines to evaluate the capital adequacy of banks and bank holding companies on a consolidated basis. As of June 30, 2024, the Company’s capital levels remained characterized as “well-capitalized” under the Basel Committee on Banking Supervision’s (“BCBS”) capital guidelines for U.S. banks. See the “Basel III Capital Rules” section below for further discussion. The following table reflects the ratios and their components (dollars in thousands): June 30, December 31, 2024 2023 Common shareholders’ equity $ 452,509 $ 441,773 Less: Goodwill and other intangible assets 58,458 69,594 Net unrealized loss on investment securities (1) (118,416 ) (111,761 ) Hedging derivative instruments 4,381 3,911 Net periodic pension and postretirement benefits plan adjustments (11,614 ) (11,946 ) Other (125 ) (145 ) Common Equity Tier 1 (“CET1”) Capital 519,825 492,120 Plus: Preferred stock 17,292 17,292 Tier 1 Capital 537,117 509,412 Plus: Qualifying allowance for credit losses 44,143 48,916 Subordinated Notes 74,687 74,532 Total regulatory capital $ 655,947 $ 632,860 Adjusted average total assets (for leverage capital purposes) $ 6,236,167 $ 6,224,339 Total risk-weighted assets $ 5,183,712 $ 5,218,724 Regulatory Capital Ratios Tier 1 Leverage (Tier 1 capital to adjusted average assets) 8.61 % 8.18 % CET1 Capital (CET1 capital to total risk-weighted assets) 10.03 % 9.43 % Tier 1 Capital (Tier 1 capital to total risk-weighted assets) 10.36 % 9.76 % Total Risk-Based Capital (Total regulatory capital to total risk-weighted assets) 12.65 % 12.13 % (1) Includes unrealized gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category. 66 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS We have elected to apply the 2020 Current Expected Credit Losses (“CECL”) transition provision related to the impact of the CECL accounting standard on regulatory capital, as provided by the US banking agencies’ March 2020 interim final rule. Under the 2020 CECL transition provision, the regulatory capital impact of the Day 1 adjustment to the allowance for credit losses (after-tax) upon the January 1, 2020 CECL adoption date has been deferred and has begun to phase into regulatory capital at 25% per year commencing January 1, 2022. For the ongoing impact of CECL, we were allowed to defer the regulatory capital impact of the allowance for credit losses in an amount equal to 25% of the change in the allowance for credit losses (pre-tax) recognized through earnings for each period between January 1, 2020, and December 31, 2021. The cumulative adjustment to the allowance for credit losses between January 1, 2020, and December 31, 2021, also began to phase into regulatory capital at 25% per year commencing January 1, 2022. Basel III Capital Rules Under the Basel III Capital Rules, the current minimum capital ratios, including an additional capital conservation buffer applicable to the Company and the Bank, are: • 7.0% CET1 to risk-weighted assets; • 8.5% Tier 1 capital (that is, CET1 plus Additional Tier 1 capital) to risk-weighted assets; and • 10.5% Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. Banking institutions with a capital conservation buffer below the minimum level will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall. The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to the Company or the Bank. Strict eligibility criteria for regulatory capital instruments were also implemented under the Basel III Capital Rules. As of June 30, 2024, the Company and Bank’s capital levels remained characterized as “well capitalized” under the Basel III rules, including the additional capital conversion buffer. The following table presents actual and required capital ratios as of June 30, 2024 and December 31, 2023 for the Company and the Bank under the Basel III Capital Rules. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, under the Basel III Capital Rules (dollars in thousands): Required to be Minimum Capital Considered Well Actual Required – Basel III Capitalized Amount Ratio Amount Ratio Amount Ratio June 30, 2024 Tier 1 leverage: Company $ 537,117 8.61 % $ 249,447 4.00 % $ 311,808 5.00 % Bank 593,148 9.53 248,896 4.00 311,120 5.00 CET1 capital: Company 519,825 10.03 362,860 7.00 336,941 6.50 Bank 593,148 11.47 362,010 7.00 336,153 6.50 Tier 1 capital: Company 537,117 10.36 440,615 8.50 414,467 8.00 Bank 593,148 11.47 439,584 8.50 413,726 8.00 Total capital: Company 655,947 12.65 544,290 10.50 518,371 10.00 Bank 637,291 12.32 543,016 10.50 517,158 10.00 December 31, 2023 Tier 1 leverage: Company $ 509,412 8.18 % $ 248,974 4.00 % $ 311,217 5.00 % Bank 562,775 9.06 248,385 4.00 310,481 5.00 CET1 capital: Company 492,120 9.43 365,311 7.00 339,217 6.50 Bank 562,775 10.82 364,191 7.00 338,177 6.50 Tier 1 capital: Company 509,412 9.76 443,592 8.50 417,498 8.00 Bank 562,775 10.82 442,232 8.50 416,218 8.00 Total capital: Company 632,860 12.13 547,966 10.50 521,872 10.00 Bank 611,691 11.76 546,286 10.50 520,272 10.00 67 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS Dividend Restrictions In the ordinary course of business, the Company is dependent upon dividends from the Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years. 68 Table of Contents ITEM 3. Quantitative and Qualit ative Disclosures About Market Risk Market risk refers to the potential impact on earnings or capital arising from movements in interest rates. The Bank’s market risk management framework has been developed to control both short-term and long-term exposure within Board approved policy limits and is monitored by the Asset-Liability Management Committee and Board of Directors. Quantitative and qualitative disclosures about market risk were presented at December 31, 2023 in Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2023, as filed with the Securities and Exchange Commission on March 13, 2024. The following is an update of the discussion provided therein. Portfolio Composition There was no material change in the composition of assets, deposit liabilities or borrowings from December 31, 2023 to June 30, 2024. See the section titled “Analysis of Financial Condition” in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of asset, deposit and borrowing activity during the period. Net Interest Income at Risk A primary tool used to manage interest rate risk is “rate shock” simulation to measure the rate sensitivity. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income as well as economic value of equity. Net interest income at risk is measured by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of 12 months. The following table sets forth the estimated changes to net interest income over the 12-month period ending June 30, 2025, assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands): Changes in Interest Rate -100 bp +100 bp +200 bp +300 bp Estimated change in net interest income $ (5,472 ) $ 2,718 $ 5,189 $ 7,750 % Change 2.90 % 1.44 % 2.75 % 4.11 % In the rising rate scenarios, the static model results indicate that net interest income is modeled to increase compared to the flat rate scenario over a one-year time frame. This is a combination of an increase across the entire deposit portfolio, which has decreased wholesale borrowings and the higher cost associated with the borrowings. This simulation does not consider balance sheet growth or a change in the balance sheet mix. As intermediate and longer-term assets continue to mature and are replaced at higher yields, net interest income should improve over the longer-term time frame. Model results in the declining rate scenario show a decreasing in net interest income due to a combination of increases in the yield curve, as well as increases in higher yield public and nonpublic deposits, which will reprice downward slower due to market deposit competition. In addition to the changes in interest rate scenarios listed above, other scenarios are typically modeled to measure interest rate risk. These scenarios vary depending on the economic and interest rate environment. Furthermore, given the static balance sheet approach, retained earnings are considered to be reinvested in a noninterest earning asset. The simulation referenced above is based on our assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of future results, does not measure the effect of changing interest rates on noninterest income and is based on many assumptions that, if changed, could cause a different outcome. Economic Value of Equity at Risk The economic (or “fair”) value of financial instruments on our balance sheet will also vary under the interest rate scenarios previously discussed. This variance is measured by simulating changes in our economic value of equity (“EVE”), which is calculated by subtracting the estimated fair value of liabilities from the estimated fair value of assets. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at current replacement rates for each account type, while fair values of non-financial assets and liabilities are assumed to equal book value and do not vary with interest rate fluctuations. An economic value simulation is a static measure for balance sheet accounts at a given point in time, but this measurement can change substantially over time as the characteristics of our balance sheet evolve and as interest rate and yield curve assumptions are updated. 69 Table of Contents The amount of change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including the stated interest rate or spread relative to current market rates or spreads, the likelihood of prepayment, whether the rate is fixed or floating, and the maturity date of the instrument. As a rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical data (back-testing). The analysis that follows presents the estimated EVE resulting from market interest rates prevailing at a given quarter-end (“Pre-Shock Scenario”), and under other interest rate scenarios (each a “Rate Shock Scenario”) represented by immediate, permanent, parallel shifts in interest rates from those observed at June 30, 2024 and December 31, 2023 (dollars in thousands). The analysis additionally presents a measurement of the interest rate sensitivity at June 30, 2024 and December 31, 2023. EVE amounts are computed under each respective Pre-Shock Scenario and Rate Shock Scenario. An increase in the EVE amount is considered favorable, while a decline is considered unfavorable. The following table sets forth the estimated changes to EVE assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands): June 30, 2024 December 31, 2023 Rate Shock Scenario: EVE Change Percentage Change EVE Change Percentage Change Pre-Shock Scenario $ 675,993 $ 627,519 - 100 Basis Points 662,806 $ (13,187 ) -1.95 % 616,940 $ (10,579 ) -1.69 % +100 Basis Points 680,589 4,596 0.68 626,463 (1,056 ) -0.17 + 200 Basis Points 680,804 4,811 0.71 628,434 915 0.15 + 300 Basis Points 681,135 5,142 0.76 628,229 710 0.11 The increase in the Pre-Shock Scenario EVE at June 30, 2024 compared to December 31, 2023 is the result of a combination of increased cash at the federal reserve and the continued effort to grow the Bank’s deposits, which also improved the valuation of the deposits. The sensitivity in the -100-basis point Rate Shock Scenario to EVE grows more negative at June 30, 2024 compared to December 31, 2023. This is a result from the continued deposit mix shift from non-maturity, non-public to time, reciprocal, and municipal deposits. As a result, the shift in mix of deposits becomes less valuable when rates shock downward, most notably in the money market accounts and time deposits in comparison to December 31, 2023, driving slightly more sensitive. ITEM 4. Control s and Procedures Evaluation of Disclosure Controls and Procedures As of June 30, 2024, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b), as adopted by the SEC under the Securities Exchange Act of 1934, as amended (“Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2024 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. 70 Table of Contents PART II. OTHE R INFORMATION ITEM 1. L egal Proceedings From time to time, we are a party to or otherwise involved in legal proceedings arising out of the normal course of business. Regardless of the outcome, litigation can have an adverse impact on us because of prosecution, defense and settlement costs, unfavorable awards, diversion of management resources and other factors. We are party to an action filed against us on May 16, 2017 by Matthew L. Chipego, Charlene Mowry, Constance C. Churchill and Joseph W. Ewing in the Court of Common Pleas in Philadelphia, Pennsylvania. Plaintiffs sought class certification to represent classes of consumers in New York and Pennsylvania along with statutory damages, interest and declaratory relief. The plaintiffs sought to represent a putative class of consumers who are alleged to have obtained direct or indirect financing from us for the purchase of vehicles that we later repossessed. The plaintiffs specifically claim that the notices the Bank sent to defaulting consumers after their vehicles were repossessed did not comply with the relevant portions of the Uniform Commercial Code in New York and Pennsylvania. We dispute and believe we have meritorious defenses against these claims and plan to vigorously defend ourselves. On September 30, 2021, the Court granted plaintiffs’ motion for class certification and certified four different classes (two classes of New York consumers and two classes of Pennsylvania consumers). There are approximately 5,200 members in the New York classes and 300 members in the Pennsylvania classes. On September 26, 2022, the lower Court denied the plaintiffs’ motion for partial summary judgment for most of the relief they seek and found that there were questions of fact as to whether the members of the class had purchased the subject vehicles for “consumer use” within the meaning of the relevant statutes. The Court also denied our motion for partial summary judgment seeking an offset in the form of recoupment reducing any liability that may be imposed against us by the amounts that the borrowers owe for failing to repay their motor vehicle loans, determining that the Court could not enter a judgment on recoupment – which is a set off from liability – without first determining whether there was liability. On October 7, 2022, the Superior Court of Pennsylvania granted our December 20, 2021 Request for an Interlocutory Appeal of the denial of our motion to dismiss the claims brought by New York borrowers for lack of subject matter jurisdiction and lack of standing. In a Memorandum filed on February 13, 2024, the Superior Court affirmed the decision of the lower court, holding that trial court has subject matter jurisdiction over the New York part of this action and that the New York plaintiffs have standing to pursue relief against us. The Superior Court also remanded the case to the lower court for further proceedings, which will include the completion of any remaining discovery and an adjudication of the open claims and defenses that have been asserted in the case. On April 5, 2024, the lower court conducted a Case Management Conference to discuss remaining matters and next steps, and thereafter issued a Scheduling Order setting a deadline of April 19, 2024 for the Company to re-file its motion to compel discovery and motion for re-consideration of the prior striking of its jurisdictional defense and scheduled a pre-trial conference for July 11, 2024. The time for the Company to re-file the aforementioned motions was extended to April 23, 2024, and we timely filed and served them. The case was also re-assigned to another member of the Court of Common Pleas to handle future proceedings. The Court of Common Please denied our aforementioned motions to compel discovery and for re-consideration. The parties are in the process of completing the remaining discovery. During the July 11, 2024 pretrial conference, the Court instructed the parties to engage in further settlement of non-binding mediation discussions and set a September 11, 2024 deadline to file motions in limine and a bench trial to commence on May 5, 2025. Once the lower court has issued a final adjudication, the parties will have an opportunity to appeal adverse rulings in the case. We have not accrued a contingent liability for this matter at this time because, given our defenses, we are unable to conclude whether a liability is probable to occur nor are we able to currently reasonably estimate the amount of potential loss. If we settle these claims or the action is not resolved in our favor, we may suffer reputational damage and incur legal costs, settlements or judgments that exceed the amounts covered by our insurer. We can provide no assurances that our insurer will cover the full legal costs, settlements or judgments we incur. If we are unsuccessful in defending ourselves from these claims or if our insurer does not cover the full amount of legal costs we incur, the result may materially adversely affect our business, results of operations and financial condition.