Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and notes thereto for the years ended December 31, 2022 and 2021, which are included in Item 8 of Part II of this annual report.
Overview
First United Corporation is a bank holding company that, through the Bank and its non-bank subsidiaries, provides an array of financial products and services primarily to customers in four Western Maryland counties and four Northeastern West Virginia counties. Its principal operating subsidiary is the Bank, which consists of a community banking network of 26 branch offices located throughout its market areas. Our primary sources of revenue are interest income earned from our loan and investment securities portfolios and fees earned from financial services provided to customers.
Consolidated net income for the year ended December 31, 2022 was $25.0 million compared to $19.8 million in 2021. The year-over-year increase was primarily due to a $5.1 million increase in net interest income resulting from a $4.2 million increase in interest income and a decrease in interest expense of $0.9 million. Net gains were down $1.1 million in 2022 when compared to 2021 as management made the strategic decision to book the higher rate mortgage loans in 2022 as opposed to selling them to the secondary market. Other income declined in 2022 due to a decrease of $0.4 million in trust and brokerage income and a decrease of $1.4 million due to an insurance reimbursement received in 2021. These declines were slightly offset by an increase of $0.2 million in service charges and debit card income. Provision expense was up $0.2 million as compared to 2021. Salaries and benefits increased by $2.1 million when compared to 2021 due to a lower reduction of loan origination costs of $1.0 million and a $1.1 million increase due to performance related pay and the competitive employment environment. Other changes year-over-year included increased other real estate owned (“OREO”) expenses of $1.5 million in 2022 due to gains on sale of OREO booked during 2021, other net increases in expenses of $0.8 million and increased income taxes of $1.6 million. Non-interest expense decreased significantly due to our payment of $3.3 million in litigation settlement expenses during the first quarter of 2021 and a $2.4 million prepayment penalty for the early repayment of $70.0 million of FHLB advances recognized in the third quarter of 2021, a reduction of $2.4 million in professional and investor relations expenses primarily related to reimbursement of $0.7 in litigation expenses, a reduction of $0.4 million in investor relations costs and a $1.3 million reduction in legal fees. Charitable contributions also declined by $0.9 million primarily due to the decision to make a $1.0 million contribution in 2021 to fund the newly created First United Community Dreams Foundation (the “Foundation”).
The provision for loan losses was a credit of $0.6 million for the year ended December 31, 2022 and a credit of $0.8 million for the year December 31, 2021. Net charge-offs of $0.7 million were recorded for the year ended December 31, 2022, compared to net recoveries of $0.3 million for 2021. The ratio of the ALL to loans outstanding, including Paycheck Protection Program (“PPP”) loan balances, was 1.14% at December 31, 2022 compared to 1.38% at December 31, 2021. The ratio of ALL to loans outstanding, excluding PPP loan balances of $0.4 million and $7.7 million, was 1.14% and 1.39% at December 31, 2022 and 2021, respectively, non-GAAP.
Other operating income, including net gains on sales of mortgage loans and sales of investment securities, decreased by approximately $2.7 million when compared to 2021. This decrease was partially due to a $1.4 million insurance reimbursement that was received in 2021 and a decrease in net gains from the sale of residential mortgage loans of $1.1 million as refinance activity slowed considerably and due to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. These decreases were partially offset by a net increase in service charge, debit card and other income of $0.2 million.
Other operating expenses decreased $4.6 million compared to the year ended December 31, 2021. Salaries and benefits increased by $2.1 million compared to 2021 due to a lower reduction of loan origination costs of $1.0 million and a $1.1 million increase due to performance related pay and the competitive employment environment. Other changes year-over-year included increased OREO expenses of $1.5 million in 2022 due to gains on sale of OREO booked during 2021 and other net increases in expenses of $0.8 million. Non-interest expense decreased significantly due to our payment of $3.3 million in litigation settlement expenses during the first quarter of 2021 and a $2.4 million prepayment penalty for the early repayment of $70.0 million of FHLB advances recognized in the third quarter of 2021, a reduction of $2.4 million
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in professional and investor relations expenses primarily related to reimbursement of $0.7 in litigation expenses, a reduction of $0.4 million in investor relations costs and a $1.3 million reduction in legal fees. Charitable contributions also declined by $0.9 million primarily due to the funding of the Foundation at the end of 2021.
Outstanding loans of $1.3 billion at December 31, 2022 reflected a growth of $125.8 million during 2022. Since December 31, 2021, commercial real estate loans increased by $84.5 million and acquisition and development loans decreased by $57.5 million due primarily to the payoff of one large credit early in the third quarter. Commercial and industrial loans increased by $64.4 million for the year, primarily in new floor plan business, new commercial clients and continued expansion of existing client relationships. Residential mortgage loans increased $39.7 million related to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. The consumer loan portfolio decreased by $5.4 million due to amortization and payoffs of the existing portfolio slightly offset by new production.
Net interest income, on a non-GAAP, fully-taxable equivalent (“FTE”) basis, increased by $5.1 million. Interest income increased by $4.2 million and interest expense decreased by $0.9 million. The yield on earning assets increased 22 basis points to 3.85% in 2022 compared to 3.63% in 2021 in correlation with an increase in average earning assets as well as the rising interest rate environment and new loans booked at higher rates. Interest expense on deposits decreased by $0.2 million while the average balance of deposits increased by $26.1 million and interest on long-term borrowings decreased by $0.7 million related to the prepayment of $70.0 million of FHLB advances in the third quarter of 2021. The decreased interest expense resulted in an overall decrease of 7 basis points on the cost of interest-bearing liabilities. We anticipate increased margin pressure in 2023 due to increasing deposit pricing demands in our market areas. The net interest margin for the year ended December 31, 2022 was 3.56% compared to 3.28% for the year ended December 31, 2021.
Comparing the year ended December 31, 2022 with the year ended December 31, 2021, interest income increased by $4.2 million. Interest and fees on loans increased by $1.5 million and investment income increased by $2.4 million. Excess cash balances during 2022 were invested at the Fed Funds rate, which also positively affected interest income for the year ended December 31, 2022 when compared to 2021. Increases in loan interest income stemmed from the growth of core loans in 2022. The rate earned on the loan portfolio remained stable when comparing the year ended December 31, 2022 to the year ended December 31, 2021.
Total deposits at December 31, 2022 increased by $101.4 million when compared to deposits at December 31, 2021. Non-interest-bearing deposits increased by $5.0 million. Interest bearing demand deposits increased by $99.5 million and traditional savings accounts increased by $14.1 million. The increase in interest bearing demand deposits was attributable to an increase in municipality funding into a higher yielding indexed product. Money market balances increased by $25.4 million. Time deposits decreased by $42.7 million related to maturing balances moving to more liquid accounts, or brokerage investment accounts, due to the rising deposit rates as well as municipal funds moving to higher yielding State funding alternatives.
The decrease in interest expense for 2022 was driven by a decrease in interest rates of 7 basis points, which offset the increase in average balances of $26.1 million on interest bearing deposits, and a $46.4 million decline in average balances on long term borrowings related to the prepayment of $70.0 million in FHLB advances in the third quarter of 2021. This decrease in average long-term borrowings help offset the increase in yields of 190 basis points on interest paid on borrowings during 2022. Proactive efforts to reduce the cost of funds by further reductions to rates on deposit accounts throughout 2021, the runoff of balances in the time deposits, including brokered deposits, and the expiration of empowered rates on money market accounts continued throughout early 2022.
Estimates and Critical Accounting Policies
This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. (See Note 1 to the Consolidated Financial Statements.) On an on-going basis, management evaluates estimates and bases
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those estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company identifies the following critical accounting policies may affect our more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.
Allowance for Loan Losses
One of our most important accounting policies is that related to the monitoring of the loan portfolio. A variety of estimates impact the carrying value of the loan portfolio and resulting interest income, including the calculation of the ALL, the valuation of underlying collateral, and the timing of loan charge-offs. The ALL is established and maintained at a level that is adequate to cover losses resulting from the inability of borrowers to make required payments on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio, current and historical trends in delinquencies and charge-offs, and changes in the size and composition of the loan portfolio. The analysis also requires consideration of the economic climate and direction, changes in lending rates, political conditions, legislation impacting the banking industry and economic conditions specific to Western Maryland and Northeastern West Virginia. Because the calculation of the ALL relies on management’s estimates and judgments relating to inherently uncertain events, actual results may differ from management’s estimates.
The ALL is also discussed below in Item 7 under the heading “Allowance for Loan Losses” and in Note 6 to the Consolidated Financial Statements.
Liquidity Sources
As of December 31, 2022, the Corporation had approximately $140.0 million in unsecured lines of credit with its correspondent banks, $9.6 million available through a secured line of credit with the Federal Reserve Discount Window, and approximately $195.3 million of secured borrowings with the FHLB. Additionally, the Corporation has access to the brokered certificates of deposit market.
Capital
The Corporation’s and the Bank’s capital ratios are strong, and both institutions are considered to be well-capitalized by applicable regulatory measures
Adoption of New Accounting Standards and Effects of New Accounting Pronouncements
Note 1 to the Consolidated Financial Statements discusses new accounting pronouncements that, when adopted, could affect our future consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME REVIEW
Net Interest Income
Net interest income is our largest source of operating revenue. Net interest income is the difference between the interest that we earn on our interest-earning assets and the interest expense we incur on our interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to an FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate. This is a non-GAAP disclosure and it is not materially different than the corresponding GAAP disclosure.
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The table below summarizes net interest income for 2022 and 2021.
GAAP
Non-GAAP - FTE
(Dollars in thousands)
2022
2021
2022
2021
Interest income
$
62,422
$
58,256
$
63,362
$
59,195
Interest expense
4,789
5,714
4,789
5,714
Net interest income
$
57,633
$
52,542
$
58,573
$
53,481
Net interest margin %
3.50%
3.22%
3.56%
3.28%
Net interest income, on a non-GAAP, FTE basis, increased by $5.1 million (9.5%) during the year ended December 31, 2022 when compared to the year ended December 31, 2021, driven by a $4.2 million (7.0%) increase in interest income and a decrease in interest expense of $0.9 million (16.2%). The decrease in interest expense resulted from proactive efforts to reduce the cost of funds by further reductions in rates on deposit accounts throughout 2021, the runoff of balances in the time deposits, including brokered deposits, and the expiration of empowered rates on money market accounts. The net interest margin, on an FTE basis, increased to 3.56% for the year ended December 31, 2022 from 3.28% for the year ended December 31, 2021.
Comparing the year ended December 31, 2022 with the year ended December 31, 2021, interest income increased by $4.2 million . Interest and fees on loans increased by $1.5 million investment income increased by of $2.4 million. The increase in interest on loans was primarily due to an increase of $49.4 million in average loan balance in 2022 compared to 2021. The rate earned on the loan portfolio remained stable when comparing the year ended December 31, 2022 to the year ended December 31, 2021. The increase in investment income was due to the increase in average balances of $77.7 million for the year ended December 31, 2022 compared to the year ended December 31, 2021 as well as an increase in interest yield of 23 basis points.
The decrease in interest expense for 2022 was driven by a decrease of $46.4 million in average balances on long term borrowings related to the prepayment of $70.0 million in FHLB advances in the third quarter of 2021. The decrease of $0.7 million in interest expense on long-term borrowing was partially offset by the 190 basis point increase in rate paid on borrowings for the year ended December 31, 2022 compared to 2021. Average rates paid on deposit accounts decreased slightly in 2022 compared to 2021, which was offset by the growth of $26.1 million in interest-bearing deposits during the year.
As shown below, the composition of total interest income between 2022 and 2021 remained relatively stable.
% of Total Interest Income
2022
2021
Interest and fees on loans
87%
91%
Interest on investment securities
12%
8%
Other
1%
1%
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The following table sets forth the average balances, net interest income and expense, and average yields and rates for our interest-earning assets and interest-bearing liabilities for 2022 and 2021:
Distribution of Assets, Liabilities and Shareholders’ Equity
Interest Rates and Interest Differential – Tax Equivalent Basis
For the Years Ended December 31
2022
2021
(Dollars in thousands)
Average
Balance
Interest
Average
Yield/
Rate
Average
Balance
Interest
Average
Yield/
Rate
Assets
Loans
$
1,223,388
$
54,513
4.46
%
$
1,173,966
$
53,040
4.52
%
Investment Securities:
Taxable
348,516
6,252
1.79
%
272,305
3,912
1.44
%
Non taxable
26,952
1,981
7.35
%
25,463
1,928
7.57
%
Total
375,468
8,233
2.19
%
297,768
5,840
1.96
%
Federal funds sold
44,207
555
1.26
%
150,556
178
0.12
%
Interest-bearing deposits with other banks
3,061
24
0.78
%
4,040
2
0.05
%
Other interest earning assets
1,027
37
3.60
%
2,969
135
4.55
%
Total earning assets
1,647,151
63,362
3.85
%
1,629,299
59,195
3.63
%
Allowance for loan losses
(15,568)
(16,825)
Non-earning assets
170,128
152,674
Total Assets
$
1,801,711
$
1,765,148
Liabilities and Shareholders’ Equity
Interest-bearing demand deposits
$
301,183
$
855
0.28
%
$
214,510
$
553
0.26
%
Interest-bearing money markets
312,978
1,256
0.40
%
341,677
436
0.13
%
Savings deposits
250,624
154
0.06
%
223,114
81
0.04
%
Time deposits
138,865
961
0.69
%
198,280
2,403
1.21
%
Short-term borrowings
63,182
112
0.18
%
57,697
86
0.15
%
Long-term borrowings
30,929
1,451
4.69
%
77,340
2,155
2.79
%
Total interest-bearing
liabilities
1,097,761
4,789
0.44
%
1,112,618
5,714
0.51
%
Non-interest-bearing deposits
533,096
491,967
Other liabilities
33,169
28,013
Shareholders’ Equity
137,685
132,550
Total Liabilities and Shareholders’ Equity
$
1,801,711
$
1,765,148
Net interest income and spread
$
58,573
3.41
%
$
53,481
3.12
%
Net interest margin
3.56
%
3.28
%
Notes:
(1) The above table reflects the average rates earned or paid stated on an FTE basis assuming a tax rate of 21% for 2022 and 2021. Non-GAAP interest income on an FTE basis for the years ended December 31, 2022 and 2021 were $940, and $939, respectively.
(2) The average balances of non-accrual loans for the years ended December 31, 2022 and 2021, which were reported in the average loan balances for these years, were $2,120 and $6,041, respectively.
(3) Net interest margin is calculated as net interest income divided by average earning assets.
(4) The average yields on investments are based on amortized cost.
The following table sets forth an analysis of volume and rate changes in interest income and interest expense of our average interest-earning assets and average interest-bearing liabilities for 2022 and 2021. This table distinguishes between the changes related to average outstanding balances (changes in volume created by holding the interest rate constant) and the changes related to average interest rates (changes in interest income or expense attributed to average rates created by holding the outstanding balance constant).
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Interest Variance Analysis (1)
2022 Compared to 2021
(In thousands and tax equivalent basis)
Volume
Rate
Net
Interest Income:
Loans
$
2,234
$
(761)
$
1,473
Taxable Investments
1,097
1,243
2,340
Non-taxable Investments
113
(60)
53
Federal funds sold
(128)
505
377
Interest-bearing deposits
—
22
22
Other interest earning assets
(88)
(10)
(98)
Total interest income
3,228
939
4,167
Interest Expense:
Interest-bearing demand deposits
225
77
302
Interest-bearing money markets
(37)
857
820
Savings deposits
11
62
73
Time deposits
(719)
(723)
(1,442)
Short-term borrowings
8
18
26
Long-term borrowings
(1,295)
591
(704)
Total interest expense
(1,807)
882
(925)
Net interest income
$
5,035
$
57
$
5,092
Note:
(1) The change in interest income/expense due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Provision for Loan Losses
The provision for loan losses was a credit of $0.6 million for the year ended December 31, 2022 and a credit of $0.8 million for the year ended December 31, 2021. Net charge-offs of $0.7 million were recorded for the year ended December 31, 2022, compared to net recoveries of $0.3 million for 2021. The ratio of the ALL to loans outstanding was 1.14% at December 31, 2022 compared to 1.38% at December 31, 2021. The ALL reflects a level commensurate with the risk inherent in our loan portfolio.
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Other Operating Income
The following table shows the major components of other operating income for the past two years, exclusive of net gains, and the percentage changes during these years:
(Dollars in thousands)
2022
2021
% Change
Service charges on deposit accounts
$
1,981
$
1,771
11.86%
Other service charges
925
909
1.76%
Trust department income
8,244
8,650
(4.69)%
Debit card income
3,958
3,644
8.62%
Bank owned life insurance
1,196
1,176
1.70%
Brokerage commissions
1,049
1,082
(3.05)%
Insurance reimbursement
—
1,375
(100.00)%
Other income
525
912
(42.43)%
Total other operating income
$
17,878
$
19,519
(8.41)%
Other operating income, exclusive of gains, decreased $1.6 million during the year ended December 31, 2022 when compared to the same period of 2021. The decrease was primarily a result of a decrease of $1.4 million in insurance reimbursements and a $0.4 million decrease in trust income in 2022 when compared to 2021. These decreases were partially offset by increased debit card income of $0.3 million for the year ended December 31, 2022 when compared to 2021 due to growth in deposit relationships and increased customer usage of our electronic services and increased service charge income of $0.2 million in 2022 when compared to 2021. Other income decreased $0.4 million.
Net gains of $0.2 million and $1.2 million were reported through other income for the years ended December 31, 2022 and 2021, respectively. The $1.1 million decrease in gains for 2022 was primarily attributable to the decrease in gains on the sale of mortgage loans to the secondary market of $1.1 million due to refinancing activity occurring at a slower pace than the pace experienced in 2021 and due to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio.
Other Operating Expense
The following table compares the major components of other operating expense for 2022 and 2021:
(Dollars in thousands)
2022
2021
% Change
Salaries and employee benefits
$
24,130
$
22,061
9.38%
FDIC premiums
636
772
(17.62)%
Equipment
4,163
3,898
6.80%
Occupancy
2,906
2,775
4.72%
Data processing
3,444
3,204
7.49%
Marketing
543
535
1.50%
Professional services
1,538
3,528
(56.41)%
Contract labor
618
638
(3.13)%
Line rentals
482
737
(34.60)%
Total OREO expenses/(income), net
590
(945)
(162.43)%
Investor relations
300
676
(55.62)%
Settlement expense
—
3,300
(100.00)%
FHLB prepayment expense
—
2,368
(100.00)%
Contributions
288
1,220
(76.39)%
Other expenses
3,507
3,032
15.67%
Total other operating expense
$
43,145
$
47,799
(9.74)%
Other operating expenses decreased $4.6 million for the year ended December 31, 2022 when compared to 2021. Salaries and benefits increased by $2.1 million when compared to 2021 due to a lower reduction of loan origination costs of $1.0 million and a $1.1 million increase due to performance related pay and the competitive employment environment.
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Other changes year-over-year included increased OREO expenses of $1.5 million in 2022 due to gains on sale of OREO booked during 2021 and other net increases in expenses of $0.8 million. Non-interest expense decreased significantly due to our payment of $3.3 million in litigation settlement expenses during the first quarter of 2021 and a $2.4 million prepayment penalty for the early repayment of $70.0 million of FHLB advances recognized in the third quarter of 2021, a reduction of $2.4 million in professional and investor relations expenses primarily related to reimbursement of $0.7 in litigation expenses, a reduction of $0.4 million in investor relations costs and a $1.3 million reduction in legal fees. Charitable contributions also declined by $0.9 million primarily due to the funding of the Foundation at the end of 2021.
Applicable Income Taxes
We recognized a tax expense of $8.1 million in 2022, compared to a tax expense of $6.5 million in 2021. See the discussion under “Income Taxes” in Note 14 to the Consolidated Financial Statements presented elsewhere in this annual report for a detailed analysis of our deferred tax assets and liabilities. Our effective tax rate was 24.5% in 2022 and 24.9% in 2021. The decrease in the tax rate for 2022 was primarily due to the increase in tax credits related to a new 2021 investment in a low-income housing tax credit that began to provide tax benefits in 2022 and will continue to provide benefits in the coming years.
At December 31, 2022, the Corporation had Maryland Net Operating Losses (“NOLs”) of $41.0 million for which a deferred tax asset of $2.7 million has been recorded. There was also a Maryland state interest expense carryforward of $3.1 million, for which a deferred tax asset of $0.2 million has been recorded. There has been and continues to be a full valuation allowance on these NOLs and interest expense deferred tax assets, based on management’s belief that it is more likely than not that these NOLs will not be realized prior to the expiration of their carry-forward periods because the Corporation will not generate sufficient taxable income in the future to fully utilize the NOLs. The valuation allowance was $2.9 million and $3.0 million at December 31, 2022 and 2021, respectively.
We have concluded that no valuation allowance is deemed necessary for our remaining federal and state deferred tax assets at December 31, 2022, as it is more likely than not that they will be realized based on the expected reversal of deferred tax liabilities, the generation of future income sufficient to realize the deferred tax assets as they reverse, and the ability to implement tax planning strategies to prevent the expiration of any carry-forward periods.
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GAAP and Non-GAAP measures
The following tables sets forth certain selected financial data for the years ended December 31, 2022 and 2021 and is qualified in its entirety by the detailed information and unaudited financial statements, including the notes thereto, included elsewhere in this annual report.
For the year ended
December 31,
2022
2021
Per Share Data
Basic net income per common share (1) - as reported
$
3.77
$
2.95
Basic net income per common share (1) - non-GAAP
3.77
3.54
Diluted net income per common share (1) - as reported
$
3.76
$
2.95
Diluted net income per common share (1) - non-GAAP
3.76
3.54
Significant Ratios:
Return on Average Assets (a) (1) - as reported
1.39
%
1.12
%
Settlement, FHLB and contribution expenses, and insurance reimbursement income, net of income tax effect
—
0.23
Adjusted Return on Average Assets (a) (1) (non-GAAP)
1.39
%
1.35
%
Return on Average Equity (a) (1) - as reported
18.19
%
14.92
%
Settlement, FHLB and contribution expenses, and insurance reimbursement income, net of income tax effect
—
2.90
Adjusted Return on Average Equity (a) (1) (non-GAAP)
18.19
%
17.82
%
(1) See reconciliation of this non-GAAP financial measure provided elsewhere herein associated with settlement, FHLB and contribution expenses, and insurance reimbursement incurred during 2021.
Year Ended
2022
2021
(in thousands, except for per share amount)
Net income - as reported
$
25,048
$
19,770
Adjustments:
Settlement expense
—
3,300
FHLB penalty
—
2,368
Charitable contribution
—
1,000
Insurance reimbursement
—
(1,375)
Income tax effect of adjustment
—
(1,227)
Adjusted net income (non-GAAP)
$
25,048
$
23,836
Basic earnings per share - as reported
$
3.77
$
2.95
Adjustments:
Settlement expense
—
0.47
FHLB penalty
—
0.35
Charitable contribution
—
0.15
Insurance reimbursement
—
(0.20)
Income tax effect of adjustment
—
(0.18)
Adjusted basic earnings per share (non-GAAP)
$
3.77
$
3.54
Diluted earnings per share - as reported
$
3.76
$
2.95
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CONSOLIDATED BALANCE SHEET REVIEW
Overview
Total assets at December 31, 2022 increased by $118.3 million since December 31, 2021. During 2022, cash and interest-bearing deposits in other banks decreased by $41.4 million, the investment portfolio increased by $18.5 million and gross loans increased by $125.8 million. Management made strategic decisions to deploy excess cash balances in 2022. Cash was utilized to purchase a $73.3 million in securities in 2022. OREO balances increased by $0.3 million due to foreclosure activity in 2022. Other assets, including deferred taxes, premises and equipment, and accrued interest receivable, increased by $3.4 million. Total liabilities increased by $101.4 million since December 31, 2021. Non-interest bearing deposits increased by $5.0 million. Interest bearing demand deposits increased by $99.5 million and traditional savings accounts increased by $14.1 million. The increase in interest bearing demand deposits was attributable to an increase in municipality funding into a higher yielding indexed product. Money market balances increased by $25.4 million. Time deposits decreased by $42.7 million related to maturing balances moving to more liquid accounts, or broker investment accounts, due to the rising deposit rates as well as municipal funds moving to higher yielding State funding alternatives. Total shareholders’ equity increased by $9.9 million during the year ended December 31, 2022, as net income of $25.0 million and the issuance of $0.7 million of new shares of common stock was offset by other comprehensive losses of $11.7 million and the payment of $4.2 million in dividends.
As indicated below, the total interest-earning asset mix remained relatively constant at December 31, 2022 as compared to December 31, 2021. The mix for each year is illustrated below.
Year End Percentage
of Total Assets
2022
2021
Cash and cash equivalents
4%
7%
Net loans
68%
66%
Investments
20%
20%
The year-end total liability mix has remained consistent during the two-year period as illustrated below.
Year End Percentage
of Total Liabilities
2022
2021
Total deposits
93%
93%
Total borrowings
6%
6%
Loan Portfolio
The Bank is actively engaged in originating loans to customers primarily in Allegany County, Frederick County, Garrett County, and Washington County in Maryland, and in Berkeley County, Mineral County, Monongalia County, and Harrison County in West Virginia; and the surrounding regions of West Virginia and Pennsylvania. We have policies and procedures designed to mitigate credit risk and to maintain the quality of our loan portfolio. These policies include underwriting standards for new credits as well as continuous monitoring and reporting policies for asset quality and the adequacy of the ALL. These policies, coupled with ongoing training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the type of the loan, and the experience of the lending officer.
Commercial loans are collateralized primarily by real estate and, to a lesser extent, equipment and vehicles. Unsecured commercial loans represent an insignificant portion of total commercial loans. Residential mortgage loans are collateralized by the related property. Generally, a residential mortgage loan exceeding a specified internal loan-to-value ratio requires private mortgage insurance. Installment loans are typically collateralized, with loan-to-value ratios which are established based on the financial condition of the borrower. We also have made unsecured consumer loans to qualified
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borrowers meeting our underwriting standards. Additional information about our loans and underwriting policies can be found in Item 1 of Part I of this annual report under the heading “Banking Products and Services”.
The following table sets forth the composition of our loan portfolio. Historically, our policy has been to make the majority of our loan commitments in our market areas. We had no foreign loans in our portfolio as of December 31 for any of the years presented.
Summary of Loan Portfolio
The following table presents the composition of our loan portfolio as of December 31 for the past two years:
(In millions)
2022
2021
Commercial real estate
$
458.8
$
374.3
Acquisition and development
70.6
128.1
Commercial and industrial *
245.4
181.0
Residential mortgage
444.4
404.7
Consumer
60.3
65.6
Total Loans
$
1,279.5
$
1,153.7
*Includes PPP loans of $0.4 million and $7.7 million at December 31, 2022 and December 31, 2021, respectively.
Outstanding loans of $1.3 billion at December 31, 2022 reflected an increase of $125.8 million during 2022. Since December 31, 2021, commercial real estate loans increased by $84.5 million and acquisition and development loans decreased by $57.5 million due primarily to the payoff of one large credit early in the third quarter. Commercial and industrial loans increased by $64.4 million for the year, primarily in new floor plan business, new commercial clients and continued expansion of existing client relationships. Residential mortgage loans increased $39.7 million related to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. The consumer loan portfolio decreased by $5.3 million due to amortization and payoffs of the existing portfolio slightly offset by new production.
Commercial loan production for the year ended December 31, 2022 was approximately $374.2 million, with $53.3 million originated during the fourth quarter. At December 31, 2022, unfunded, committed commercial construction loans totaled approximately $27.8 million. Commercial amortization and payoffs were approximately $282.7 million through December 31, 2022.
Consumer mortgage loan production was approximately $91.8 million through December 31, 2022. The pipeline of in-house, portfolio loans as of December 31, 2022, consisted of $7.5 million. The residential mortgage production level slowed in the fourth quarter of 2022 due to the increasing interest rates that occurred in 2022.
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The following table sets forth the maturities, based upon contractual dates, for selected loan categories as of December 31, 2022:
Maturities of Loan Portfolio at December 31, 2022
Fixed Rate Loans
(In thousands)
Maturing
Within
One Year
Maturing After
One Year
But Within
Five Years
Maturing
After
Five Years Within Fifteen Years
Maturing After Fifteen Years
Total
Commercial Real Estate
$
26,050
$
235,702
$
75,591
$
1,001
$
338,344
Acquisition and Development
31,470
11,632
1,915
794
45,811
Commercial and Industrial *
12,456
97,657
45,406
136
155,655
Residential Mortgage
789
35,323
37,225
106,497
179,834
Consumer
1,287
28,696
18,836
2,441
51,260
Total Loans
$
72,052
$
409,010
$
178,973
$
110,869
$
770,904
Variable Rate Loans
(In thousands)
Maturing
Within
One Year
Maturing After
One Year
But Within
Five Years
Maturing
After
Five Years Within Fifteen Years
Maturing After Fifteen Years
Total
Commercial Real Estate
$
7,173
$
14,818
$
65,475
$
33,021
$
120,487
Acquisition and Development
5,376
5,020
7,314
7,075
24,785
Commercial and Industrial *
54,223
21,534
13,943
41
89,741
Residential Mortgage
1,125
1,910
20,123
241,419
264,577
Consumer
3,860
4
64
5,072
9,000
Total Loans
$
71,757
$
43,286
$
106,919
$
286,628
$
508,590
* Commercial and Industrial includes $0.4 million of PPP balances at December 31, 2022
Management monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a required payment is past due. A loan is considered to be past due when a scheduled payment has not been received for 30 days past its contractual due date. For all loan segments, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. All non-accrual loans are considered to be impaired. Interest payments received on non-accrual loans are applied as a reduction of the loan principal balance. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Our policy for recognizing interest income on impaired loans does not differ from our overall policy for interest recognition.
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The following sets forth the amounts of non-accrual, past-due and restructured loans for the past two years:
Risk Elements of Loan Portfolio
At December 31,
(In thousands)
2022
2021
Non-accrual loans:
Commercial real estate
$
145
$
81
Acquisition and development
146
390
Commercial and industrial
—
90
Residential mortgage
3,204
1,901
Total non-accrual loans
$
3,495
$
2,462
Accruing Loans Past Due 90 days or more:
Residential mortgage
282
148
Consumer
25
152
Total accruing loans past due 90 days or more
$
307
$
300
Total non-accrual and past due 90 days or more
$
3,802
$
2,762
Restructured Loans (TDRs):
Performing
$
2,751
$
2,997
Non-accrual (included above)
277
300
Total TDRs
$
3,028
$
3,297
Other Real Estate Owned
$
4,733
$
4,477
Total Non-performing assets
$
8,535
$
7,239
Impaired loans without a valuation allowance
$
6,153
$
5,248
Impaired loans with a valuation allowance
345
480
Total impaired loans
$
6,498
$
5,728
Valuation allowance related to impaired loans
$
26
$
64
Non-accrual loans to total loans (as %)
0.27%
0.21%
Non-performing loans to total loans (as %)
0.30%
0.24%
Non-performing assets to total assets (as %)
0.46%
0.42%
Allowance for loan losses to non-accrual loans (as %)
418.77%
648.05%
Allowance for loan losses to non-performing assets (as %)
171.48%
220.40%
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The following table sets forth the percent applicable by portfolio for non-accrual loans for the past two years:
Non-Accrual Loans as a % of Applicable Portfolio
2022
2021
Commercial real estate
0.0%
0.0%
Acquisition and development
0.2%
0.3%
Commercial and industrial
0.0%
0.0%
Residential mortgage
0.7%
0.5%
Consumer
0.0%
0.0%
We would have recognized $0.2 million in interest income for the year ended December 31, 2022 had our non-accrual loans been current and performing in accordance with their terms. During 2022, we recognized, on a cash basis, $0.2 million of interest income on non-accrual loans that paid off.
Performing loans considered to be impaired (including performing troubled debt restructurings, or TDRs), as defined and identified by management, amounted to $3.0 million at December 31, 2022 and $3.3 million at December 31, 2021. Loans are identified as impaired when, based on current information and events, management determines that we will be unable to collect all amounts due according to contractual terms. These loans consist primarily of acquisition and development loans and CRE loans. The fair values are generally determined based upon independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds. Specific allocations have been made where there is insufficient collateral to repay the loan balance if liquidated and there is no secondary source of repayment available.
The level of performing impaired loans (other than performing TDRs) decreased by $0.3 million during the year ended December 31, 2022. The decrease in allowance for loan losses as a percentage of non-accrual loans was related to the increase in non-accrual loans in 2022 compared to 2021.
A troubled debt restructuring is the restructuring of a loan in which one or more concessions are granted to a borrower who is experiencing financial difficulties. A loan will be classified as a TDR if the Bank restructures the loan’s terms (i.e., interest rate, payment amount, amortization period and/or maturity date) after determining that the borrower is experiencing financial difficulties. A modified loan is considered to be a TDR when the Bank has determined that the borrower is experiencing financial difficulties. The Bank evaluates the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification. To make this determination, the Bank performs a global financial review of the borrower and loan guarantors to assess their current ability to meet their financial obligations.
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The following table presents the details of TDRs by loan class at December 31, 2022 and December 31, 2021:
December 31, 2022
December 31, 2021
(Dollars in thousands)
Number of
Contracts
Recorded
Investment
Number of
Contracts
Recorded
Investment
Performing
Commercial real estate
Non owner-occupied
1
$
100
1
$
106
All other CRE
2
2,018
2
2,178
Acquisition and development
1-4 family residential construction
1
210
1
239
All other A&D
—
—
—
—
Commercial and industrial
—
—
—
—
Residential mortgage
Residential mortgage – term
6
423
6
474
Residential mortgage – home equity
—
—
—
—
Consumer
—
—
—
—
Total performing
10
$
2,751
10
$
2,997
Non-accrual
Commercial real estate
Non owner-occupied
—
$
—
—
$
—
All other CRE
—
—
—
—
Acquisition and development
1-4 family residential construction
—
—
—
—
All other A&D
—
—
—
—
Commercial and industrial
—
—
—
—
Residential mortgage
Residential mortgage – term
2
277
2
300
Residential mortgage – home equity
—
—
—
—
Consumer
—
—
—
—
Total non-accrual
2
277
2
300
Total TDRs
12
$
3,028
12
$
3,297
The level of TDRs decreased by $0.3 million during the year ended December 31, 2022. There were no new loans added to TDRs and one loan already in performing TDRs was re-modified. Net principal payments totaling $0.3 million were received during the same time period.
At December 31, 2022, there were no additional funds committed to be advanced in connection with TDRs. In 2022, interest income not recognized due to rate modifications of TDRs was $55 thousand and interest income recognized on all TDRs was $0.2 million.
Allowance for Loan Losses
The ALL is maintained to absorb probable incurred credit losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.
The ALL is also based on estimates, and actual losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the ALL. The methodology used to determine the adequacy of the ALL is consistent with prior years. An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared. This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment. At December 31, 2022 and 2021, the balance for reserve
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for probable losses on unfunded commitments, included in other liabilities in the consolidated statements of financial condition was $0.1 million.
The ALL was $14.6 million at December 31, 2022 compared to $16.0 million at December 31, 2021, a decrease of 8.3% that resulted primarily from improvements in unemployment rates and a decline in total delinquencies. Net charge-offs of $0.7 million were recorded for 2022, compared to net recoveries of $0.3 million for 2021. The ratio of the ALL to loans outstanding was 1.14% at December 31, 2022 compared to 1.38% at December 31, 2021.
The ratio of net charge-offs to average loans for the year ended December 31, 2022 was an annualized 0.06%, compared to net recoveries to average loans of 0.02% for the year ended December 31, 2021. The increase in net charge-offs was primarily related to increased charge-offs in our consumer loan portfolio. Our special assets team continues to effectively collect on charged-off loans, resulting in ongoing overall low charge-off ratios.
Accruing loans past due 30 days or more decreased to 0.16%, compared to 0.31% at December 31, 2021. Non-accrual loans totaled $3.5 million at December 31, 2022 compared to $2.5 million at December 31, 2021. The increase in non-accrual balances at December 31, 2022 was primarily related to one residential real estate loan of $1.5 million added to non-accrual in 2022. This was partially offset by reductions in principal balance of existing non-accrual loans.
The ALL at December 31, 2022 is adequate to provide for probable losses inherent in our loan portfolio. Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors. Management also applies interest rate risk, collateral value and debt service sensitivity analyses to the CRE loan portfolio and obtains new appraisals on specific loans under defined parameters to assist in the determination of the periodic provision for loan losses.
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The following table presents the activity in the ALL by major loan category for the past two years.
Analysis of Activity in the Allowance for Loan Losses
For the Years Ended December 31,
(In thousands)
2022
2021
Balance, January 1
$
15,955
$
16,486
Charge-offs:
Commercial real estate
—
(14)
Acquisition and development
(20)
(85)
Commercial and industrial
(134)
(2)
Residential mortgage
(46)
(141)
Consumer
(921)
(396)
Total charge-offs
(1,121)
(638)
Recoveries:
Commercial real estate
1
—
Acquisition and development
22
175
Commercial and industrial
93
513
Residential mortgage
184
66
Consumer
145
170
Total recoveries
445
924
Net credit (losses)/recoveries
(676)
286
Credit for loan losses
(643)
(817)
Balance at end of period
$
14,636
$
15,955
Allowance for loan losses to total loans (as %)
1.14%
1.38%
Net (Charge-offs)/Recoveries as a % of Average Applicable Portfolio
2022
2021
Commercial real estate
0.0%
(0.0%)
Acquisition and development
0.0%
0.1%
Commercial and industrial
(0.0%)
0.2%
Residential mortgage
0.0%
(0.0%)
Consumer
(1.3%)
(0.4%)
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The following presents management’s allocation of the ALL by major loan category in comparison to that loan category’s percentage of total loans. Changes in the allocation over time reflect changes in the composition of the loan portfolio risk profile and refinements to the methodology of determining the ALL. Specific allocations in any particular category may be reallocated in the future as needed to reflect current conditions. Accordingly, the entire ALL is considered available to absorb losses in any category.
Allocation of the Allowance for Loan Losses
For the Years Ended December 31,
(In thousands)
2022
% of
Total
Loans
2021
% of
Total
Loans
Commercial real estate
$
6,345
43%
$
6,032
38%
Acquisition and development
979
7%
2,615
16%
Commercial and industrial
2,845
19%
2,460
15%
Residential mortgage
3,160
22%
3,484
22%
Consumer
877
6%
934
6%
Unallocated
430
3%
430
3%
Total
$
14,636
100%
$
15,955
100%
Investment Securities
The following table sets forth the composition of our investment securities portfolio by major category as of the indicated dates:
At December 31,
2022
2021
(In thousands)
Amortized
Cost
Fair
Value
(FV)
FV As
% of
Total
Amortized
Cost
Fair
Value
(FV)
FV As
% of
Total
Securities Available-for-Sale:
U.S. government agencies
$
11,044
$
9,462
8%
$
69,602
$
67,169
23%
Residential mortgage-backed agencies
45,052
37,401
30%
49,630
48,661
17%
Commercial mortgage-backed agencies
37,393
30,732
23%
51,694
50,868
19%
Collateralized mortgage obligations
25,828
21,044
17%
93,018
90,077
31%
Obligations of states and political subdivisions
10,848
10,492
8%
12,439
12,804
4%
Corporate bonds
1,000
887
1%
Collateralized debt obligations
18,664
15,871
13%
18,609
17,192
6%
Total available for sale
$
149,829
$
125,889
100%
$
294,992
$
286,771
100%
Securities Held to Maturity:
U.S. treasuries
$
37,204
$
35,611
18%
$
—
$
—
0%
U.S. government agencies
67,734
54,473
27%
—
—
0%
Residential mortgage-backed agencies
28,624
25,122
12%
30,634
30,847
47%
Commercial mortgage-backed agencies
22,389
17,821
9%
5,456
5,601
9%
Collateralized mortgage obligations
57,085
47,084
23%
—
—
0%
Obligations of states and political subdivisions
22,623
22,969
11%
20,169
28,921
44%
Total held to maturity
$
235,659
$
203,080
100%
$
56,259
$
65,369
100%
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The fair value of investment securities available for sale decreased by $160.9 million since December 31, 2021 due to the transfer of investments from available for sale to held to maturity in the first quarter 2022. At December 31, 2022, the securities classified as available for sale included a net unrealized loss of $24.0 million, which represents the difference between the fair value and the amortized cost of securities in the portfolio
The Corporation reassessed the classification of certain investments and, effective February 1, 2022, the Corporation transferred $139.0 million of callable agencies, obligation of state and political subdivisions, and collateralized mortgage obligations from available for sale to held to maturity securities. The transferred occurred at fair value. The related unrealized loss of $8.4 million included in other comprehensive loss remained in other comprehensive loss, to be amortized out of other comprehensive loss with an offsetting entry to interest income as a yield adjustment over the remaining term of the securities. No gain or loss was recorded at the time of transfer. The transfer of these securities was completed in an effect to mitigate further decline in fair market value value in a rising rate environment. Management’s assessment of the potential included lower yielding bonds and the risk of extension in an up 300 basis point shock.
As discussed in Note 20 to the Consolidated Financial Statements presented elsewhere in this report, we measure fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures . The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity). These Level 3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require.
Approximately $110.0 million of the available-for-sale portfolio was valued using Level 2 pricing and had net unrealized losses of $21.2 million at December 31, 2022. The remaining $15.9 million of the securities available-for-sale represents the entire collateralized debt obligation (“CDO”) portfolio, which was valued using significant unobservable inputs, or Level 3 pricing. The $2.8 million in net unrealized losses associated with the CDO portfolio relates to nine pooled trust preferred securities that comprise the CDO portfolio. Net unrealized losses of $1.7 million represent non-credit related other than temporary impairment (“OTTI”) charges on seven of the securities while $1.1 million of unrealized losses relates to two securities which have had no credit related OTTI.
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The following table sets forth the contractual or estimated maturities of the components of our investment securities portfolio as of December 31, 2022 and the weighted average yields on a tax-equivalent basis.
Investment Security Maturities, Yields, and Fair Values at December 31, 2022
(In thousands)
Within
1 Year
1 Year
To 5 Years
5 Years
To 10 Years
Over
10 Years
Total
Fair Value
Securities Available-for-Sale:
U.S. government agencies
$
—
$
8,186
$
—
$
1,276
$
9,462
Residential mortgage-backed agencies
—
—
29,653
7,748
37,401
Commercial mortgage-backed agencies
85
24,118
6,529
—
30,732
Collateralized mortgage obligations
—
1,701
12,201
7,142
21,044
Obligations of states and political subdivisions
340
2,832
891
6,429
10,492
Corporate bonds
—
—
887
—
887
Collateralized debt obligations
—
—
—
15,871
15,871
Total available for sale
$
425
$
36,837
$
50,161
$
38,466
$
125,889
Percentage of total
0.34%
29.26%
39.85%
30.56%
100.00%
Weighted average yield
3.82%
2.10%
2.01%
7.99%
3.87%
Held to Maturity:
US Treasuries
$
—
$
35,611
$
—
$
—
$
35,611
U.S. government agencies
—
11,246
26,825
16,403
54,474
Residential mortgage-backed agencies
854
4,120
2,957
17,191
25,122
Commercial mortgage-backed agencies
712
6,977
10,132
—
17,821
Collateralized mortgage obligations
—
9,108
25,514
12,461
47,083
Obligations of states and political subdivisions
—
—
—
22,969
22,969
Total held to maturity
$
1,566
$
67,062
$
65,428
$
69,024
$
203,080
Percentage of total
0.77%
33.02%
32.22%
33.99%
100.00%
Weighted average yield
(0.88)%
2.20%
2.64%
3.50%
2.76%
The weighted average yield was calculated using historical cost balances and does not give effect to changes in fair value. The negative weighted average yield was due to increased paydowns on mortgage-backed securities that impacted their factors and three month conditional prepayment rate. At December 31, 2022, one Tax Increment Funding bond totaling $17.7 million exceeded 10% of shareholders’ equity.
Deposits
The following table sets forth the deposit balances by major category for 2022 and 2021:
Deposit Balances
2022
2021
(In thousands)
Actual Balance
Percent
Actual Balance
Percent
Non-interest-bearing demand deposits
$
506,613
32%
$
501,627
34%
Interest-bearing deposits:
Demand
327,685
21%
228,175
16%
Money Market
365,192
23%
339,748
23%
Savings deposits
250,720
16%
236,595
16%
Time deposits
120,523
8%
163,229
11%
Total Deposits
$
1,570,733
100%
$
1,469,374
100%
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Total deposits at December 31, 2022 increased by $101.4 million when compared to deposits at December 31, 2021. Non-interest-bearing deposits increased by $5.0 million. Interest bearing demand deposits increased by $99.5 million and traditional savings accounts increased by $14.1 million. The increase in interest bearing demand deposits was attributable to an increase in municipality funding into a higher yielding indexed product. Money market balances increased by $25.4 million. Time deposits decreased by $42.7 million related to maturing balances moving to more liquid accounts, or brokerage investment accounts, due to the rising deposit rates as well as municipal funds moving to higher yielding State funding alternatives.
Borrowed Funds
The following shows the composition of our borrowings at December 31:
(In thousands)
2022
2021
Securities sold under agreements to repurchase
$
64,565
$
57,699
Total short-term borrowings
$
64,565
$
57,699
Junior subordinated debentures
$
30,929
$
30,929
Total long-term borrowings
$
30,929
$
30,929
Total borrowings
$
95,494
$
88,628
Average balance (from Table 1)
$
94,111
$
135,037
The following is a summary of short-term borrowings at December 31 with original maturities of less than one year:
(Dollars in thousands)
2022
2021
Securities sold under agreements to repurchase:
Outstanding at end of year
$
64,565
$
57,699
Weighted average interest rate at year end
0.12%
0.15%
Maximum amount outstanding as of any month end
$
75,912
$
72,396
Average amount outstanding
63,182
57,697
Approximate weighted average rate during the year
0.12%
0.15%
Total borrowings increased by $6.9 million, or 7.7%, in 2022 when compared to 2021 due to increased balances in our existing accounts in our Treasury Management product.
Management will continue to closely monitor interest rates within the context of its overall asset-liability management process. See the discussion under the heading “Interest Rate Sensitivity” in this Item 7 for further information on this topic.
At December 31, 2022, we had additional borrowing capacity with the FHLB totaling $195.3 million, an additional $140.0 million of unused lines of credit with various financial institutions, and $9.6 million of an unused secured line of credit with the Federal Reserve Bank. See Note 11 to the Consolidated Financial Statements presented elsewhere in this annual report for further details about our borrowings and additional borrowing capacity, which is incorporated herein by reference.
Off-Balance Sheet Arrangements
In the normal course of business, to meet the financing needs of its customers, the Bank is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, lines of credit, and standby letters of credit. Our exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. The credit risks inherent in loan commitments and letters of credit are essentially the same as those involved in extending loans to customers, and these arrangements are subject to our normal credit policies. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. We generally require collateral or other security to support the financial
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instruments with credit risk. The amount of collateral or other security is determined based on management’s credit evaluation of the counterparty. We evaluate each customer’s creditworthiness on a case-by-case basis.
Loan commitments and letters of credit totaled $253.9 million and $14.3 million, respectively, at December 31, 2022. Management does not believe that any of the foregoing arrangements have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. We are not a party to any other off-balance sheet arrangements. See Note 19 to the Consolidated Financial Statements presented elsewhere in this annual report for additional information on these arrangements.
Capital Resources
We require capital to fund loans, satisfy our obligations under the Bank’s letters of credit, meet the deposit withdraw demands of the Bank’s customers, and satisfy our other monetary obligations. To the extent that deposits are not adequate to fund our capital requirements, we can rely on the funding sources identified below under the heading “Liquidity Management”. At December 31, 2022, the Bank had $140.0 million available through unsecured lines of credit with correspondent banks, $9.6 million available through a secured line of credit with the Federal Reserve Discount Window and approximately $195.3 million available through the FHLB. Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our ability to meet our future capital requirements.
In addition to operational requirements, the Bank and the Corporation are subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators. These regulations are used to evaluate capital adequacy and require an analysis of an institution’s asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit. Detailed information about these capital regulations and their requirements is set forth in the “Supervision and Regulation” section of Item 1 of Part I of this annual report under the heading “Capital Requirements”.
At December 31, 2022, the Corporation’s total risk-based capital ratio was 16.12% and the Bank’s total risk-based capital ratio was 14.37%, both of which were well above the regulatory minimum of 8%. The total risk-based capital ratios of the Corporation and the Bank at December 31, 2021 were 15.89% and 14.97%, respectively. The decrease at the Bank was primarily due to dividend funding to the Corporation.
At December 31, 2022, the most recent notification from the regulators categorizes the Corporation and the Bank as “well capitalized” under the regulatory framework for prompt corrective action. See Note 4 to the Consolidated Financial Statements presented elsewhere in this annual report for additional information regarding regulatory capital ratios.
Liquidity Management
Liquidity is a financial institution’s capability to meet customer demands for deposit withdrawals while funding all credit-worthy loans. The factors that determine the institution’s liquidity are:
● Reliability and stability of core deposits;
● Cash flow structure and pledging status of investments; and
● Potential for unexpected loan demand.
We actively manage our liquidity position through meetings of a sub-committee of executive management, which looks forward 12 months at 30-day intervals. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. Monthly reviews by management and quarterly reviews by the Asset and Liability Committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds.
It is our policy to manage our affairs so that liquidity needs are fully satisfied through normal Bank operations. That is, the Bank will manage its liquidity to minimize the need to make unplanned sales of assets or to borrow funds
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under emergency conditions. The Bank will use funding sources where the interest cost is relatively insensitive to market changes in the short run (periods of one year or less) to satisfy operating cash needs. The remaining normal funding will come from interest-sensitive liabilities, either deposits or borrowed funds. When the marginal cost of needed wholesale funding is lower than the cost of raising this funding in the retail markets, the Corporation may supplement retail funding with external funding sources such as:
● Unsecured Fed Funds lines of credit with upstream correspondent banks (M&T Bank, Atlantic Community Bankers Bank, Community Bankers Bank, PNC Financial Services, Pacific Coast Banker’s Bank and Zions Bancorp).
● Secured advances with the FHLB of Atlanta, which are collateralized by eligible one to four family residential mortgage loans, home equity lines of credit, commercial real estate loans. Cash and various securities may also be pledged as collateral.
● Secured line of credit with the Federal Reserve Discount Window for use in borrowing funds up to 90 days, using municipal securities as collateral.
● Brokered deposits, including CDs and money market funds, provide a method to generate deposits quickly. These deposits are strictly rate driven but often provide the most cost effective means of funding growth.
● One Way Buy CDARS/ICS funding – a form of brokered deposits that has become a viable supplement to brokered deposits obtained directly.
We have adequate liquidity available to respond to current and anticipated liquidity demands and is not aware of any trends or demands, commitments, events or uncertainties that are likely to materially affect our ability to maintain liquidity at satisfactory levels.
Market Risk and Interest Sensitivity
Our primary market risk is interest rate fluctuation. Interest rate risk results primarily from the traditional banking activities that we engage in, such as gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the difference between the interest earned on our assets and the interest paid on our liabilities. Interest rate sensitivity refers to the degree that earnings will be impacted by changes in the prevailing level of interest rates. Interest rate risk arises from mismatches in the repricing or maturity characteristics between interest-bearing assets and liabilities. Management seeks to minimize fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Management uses interest sensitivity gap analysis and simulation models to measure and manage these risks. The interest rate sensitivity gap analysis assigns each interest-earning asset and interest-bearing liability to a time frame reflecting its next repricing or maturity date. The differences between total interest-sensitive assets and liabilities at each time interval represent the interest sensitivity gap for that interval. A positive gap generally indicates that rising interest rates during a given interval will increase net interest income, as more assets than liabilities will reprice. A negative gap position would benefit us during a period of declining interest rates.
At December 31, 2022, we were asset sensitive.
Our interest rate risk management goals are:
● Ensure that the Board of Directors and senior management will provide effective oversight and ensure that risks are adequately identified, measured, monitored and controlled;
● Enable dynamic measurement and management of interest rate risk;
● Select strategies that optimize our ability to meet our long-range financial goals while maintaining interest rate risk within policy limits established by the Board of Directors;
● Use both income and market value oriented techniques to select strategies that optimize the relationship between risk and return; and
● Establish interest rate risk exposure limits for fluctuation in net interest income (“NII”), net income and economic value of equity.
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In order to manage interest sensitivity risk, management formulates guidelines regarding asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These guidelines are based on management’s outlook regarding future interest rate movements, the state of the regional and national economy, and other financial and business risk factors. Management uses computer simulations to measure the effect on net interest income of various interest rate scenarios. Key assumptions used in the computer simulations include cash flows and maturities of interest rate sensitive assets and liabilities, changes in asset volumes and pricing, and management’s capital plans. This modeling reflects interest rate changes and the related impact on net interest income over specified periods.
We evaluate the effect of a change in interest rates of -300 basis points to +400 basis points on both NII and Net Portfolio Value (“NPV”) / Economic Value of Equity (“EVE”). We concentrate on NII rather than net income as long as NII remains the significant contributor to net income.
NII modeling allows management to view how changes in interest rates will affect the spread between the yield earned on assets and the cost of deposits and borrowed funds. Unlike traditional Gap modeling, NII modeling takes into account the different degree to which installments in the same repricing period will adjust to a change in interest rates. It also allows the use of different assumptions in a falling versus a rising rate environment. The period considered by the NII modeling is the next eight quarters.
NPV / EVE modeling focuses on the change in the market value of equity. NPV / EVE is defined as the market value of assets less the market value of liabilities plus/minus the market value of any off-balance sheet positions. By effectively looking at the present value of all future cash flows on or off the balance sheet, NPV / EVE modeling takes a longer-term view of interest rate risk. This complements the shorter-term view of the NII modeling.
Measures of NII at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.
Based on the simulation analysis performed at December 31, 2022 and 2021, management estimated the following changes in net interest income, assuming the indicated rate changes:
(Dollars in thousands)
2022
2021
+400 basis points
$
1,112
$
4,072
+300 basis points
$
225
$
3,233
+200 basis points
$
173
$
2,315
+100 basis points
$
121
$
1,160
-100 basis points
$
(776)
$
(3,110)
-200 basis points
$
(3,165)
N/A
-300 basis points
$
(7,382)
N/A
This estimate is based on assumptions that may be affected by unforeseeable changes in the general interest rate environment and any number of unforeseeable factors. Rates on different assets and liabilities within a single maturity category adjust to changes in interest rates to varying degrees and over varying periods of time. The relationships between lending rates and rates paid on purchased funds are not constant over time. Management can respond to current or anticipated market conditions by lengthening or shortening the Bank’s sensitivity through loan repricings or changing its funding mix. The rate of growth in interest-free sources of funds will influence the level of interest-sensitive funding sources. In addition, the absolute level of interest rates will affect the volume of earning assets and funding sources. As a result of these limitations, the interest-sensitive gap is only one factor to be considered in estimating the net interest margin.
Impact of Inflation – Our assets and liabilities are primarily monetary in nature, and as such, future changes in prices do not affect the obligations to pay or receive fixed and determinable amounts of money. During inflationary periods, monetary assets lose value in terms of purchasing power and monetary liabilities have corresponding purchasing power gains. The concept of purchasing power is not an adequate indicator of the impact of inflation on financial institutions because it does not incorporate changes in our earnings.
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a smaller reporting company, the Corporation is not required to provide the information contemplated by this item. See Item 7 of Part II of this report under the heading “Market Risk and Interest Sensitivity” for a discussion of the Corporation’s primary market risk.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.