MID PENN BANCORP INC 10-Q

ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is Management’s Discussion and Analysis of Consolidated Financial Condition as of March 31, 2021, compared to year-end 2020, and the Results of Operations for the three months ended March 31, 2021, compared to the same periods in 2020. For comparative purposes, the March 31, 2020 and December 31, 2020 balances have been reclassified when, and if necessary, to conform to the 2021 presentation. Such reclassifications had no impact on net income or shareholders’ equity. This discussion should be read in conjunction with the financial tables, statistics, and the audited financial statements and notes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2020 (the “2020 Annual Report”). The results of operations for interim periods are not necessarily indicative of operating results expected for the full year. Caution About Forward-Looking Statements Forward-looking statements involve risks, uncertainties and assumptions. Although Mid Penn generally does not make forward-looking statements unless Mid Penn’s management believes its management has a reasonable basis for doing so, Mid Penn cannot guarantee the accuracy of any forward-looking statements. Actual results may differ materially from those expressed in any forward-looking statements due to a number of uncertainties and risks, including the risks described in this Quarterly Report on Form 10-Q, the 2020 Annual Report, and other unforeseen risks. You should not put undue reliance on any forward-looking statements. These statements speak only as of the date of this Quarterly Report on Form 10-Q, even if subsequently made available by us on Mid Penn’s website or otherwise, and Mid Penn undertakes no obligation to update or revise these statements to reflect events or circumstances occurring after the date of this Quarterly Report on Form 10-Q. Certain of the matters discussed in this document and in documents incorporated by reference herein, including matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Mid Penn to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. The words “expect”, “anticipates”, “intend”, “plan”, “believe”, “estimate”, and similar expressions are intended to identify such forward-looking statements. Mid Penn’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation: • the effects of potentially slowing or volatile future economic conditions on Mid Penn and its customers; • governmental monetary and fiscal policies, as well as legislative and regulatory changes; • future actions or inactions of the federal or state governments, including a failure to increase the government debt limit or a prolonged shutdown of the federal government, or a federal or state government-mandated shutdowns of significant segments of the economy; • business or economic disruptions from national or global epidemic or pandemic events, including those from the ongoing COVID-19 pandemic; • an increase in the Pennsylvania Bank Shares Tax to which Mid Penn Bank’s capital stock is currently subject, or imposition of any additional taxes on Mid Penn or Mid Penn Bank; • changes in the capitalization of the Corporation, including the impacts of any capital and liquidity requirements imposed by regulatory pronouncements and rules; • the effect of changes in accounting policies and practices, as may be adopted by the supervisory agencies, as well as the Public Company Accounting Oversight Board, Financial Accounting Standards Board, and other accounting standard setters; • the risks of changes in interest rates and the yield curve on the level and composition of deposits and other funding sources, loan demand and yields, values of loan collateral, securities and yields, and interest rate protection agreements; • the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in Mid Penn’s market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet; • the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; • technological changes and changes to data security systems including those with third-party information technology providers; • our ability to implement business strategies, including our acquisition strategy; • our ability to implement organic branch, product and service expansion strategies; • our current and future acquisition strategies may not be successful in locating or acquiring advantageous targets at favorable prices; • our ability to successfully integrate any banks, companies, assets, liabilities, customers, systems and management personnel we acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames; • potential goodwill impairment charges, future impairment charges and fluctuations in the fair values of reporting units or of assets in the event projected financial results are not achieved within expected time frames; • our ability to attract and retain qualified management and personnel; • our ability to maintain the value and image of our brand and protect our intellectual property rights; • results of regulatory examination and supervision processes; • our ability to maintain compliance with the exchange rules of The NASDAQ Stock Market LLC; • the failure of assumptions underlying the establishment of reserves for loan and lease losses and estimations of values of collateral and various financial assets and liabilities; • acts of war or terrorism; disruptions due to flooding, severe weather, or other natural disasters or Acts of God; and • volatility in the securities markets. The above list of factors that may affect future performance is illustrative, but by no means exhaustive. Accordingly, all forward-looking statements should be evaluated with this understanding of inherent uncertainty. 43 MID PENN BANCORP, INC. Critical Accounting Estimates Mid Penn’s consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) and conform to general practices within the banking industry. Application of these principles involves significant judgments and estimates by management that have a material impact on the carrying value of certain assets and liabilities. The judgments and estimates that we used are also based on historical experiences and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and estimates that we have made, actual results could differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of our operations. Management of the Corporation considers the accounting judgments relating to the allowance, the evaluation of the Corporation’s investment securities for other-than-temporary impairment, the valuation of the Corporation’s goodwill and other merger-related intangible assets for impairment, and the valuation of assets acquired and liabilities assumed in business combinations, to be the accounting areas that require the most subjective and complex judgments. The allowance represents management’s estimate of probable incurred credit losses inherent in the loan and lease portfolio. Determining the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Throughout the remainder of this report, the terms “loan” or “loans” refers to both loans and leases. Valuations for the investment portfolio are determined using quoted market prices, where available. If quoted market prices are not available, investment valuation is based on pricing models, quotes for similar investment securities, and observable yield curves and spreads. In addition to securities valuation, management must assess whether there are any declines in value below the carrying value of the investments that should be considered other than temporary or require an adjustment in carrying value and recognition of the loss in the consolidated statement of income. Certain intangible assets generated in connection with acquisitions are periodically assessed for impairment. Goodwill is tested annually for impairment, and if certain events occur which indicate goodwill might be impaired between annual tests, goodwill must be tested when such events occur. In making this assessment, Mid Penn considers a number of factors including operating results, business plans, economic projections, anticipated future cash flows, current market data, stock price, etc. Similarly, the amortized basis of the core deposit intangible asset and trade name intangible are periodically assessed for impairment. There are inherent uncertainties related to these factors and Mid Penn’s judgment in applying them to the analysis of core deposit intangible, trade name intangible, and goodwill impairment. Changes in economic and operating conditions could result in goodwill or core deposit intangible or trade name intangible impairment in future periods. Valuations of assets acquired and liabilities assumed in business combinations are measured at fair value as of the acquisition date. In many cases, determining the fair value of the assets acquired and liabilities assumed requires Mid Penn to estimate cash flows expected to result from these assets and liabilities and to discount these cash flows at appropriate rates of interest, which require the utilization of significant estimates and judgment in accounting for the acquisition. Results of Operations Overview Net income available to common shareholders was $9,312,000 or $1.11 per common share basic and $1.10 per common share diluted, for the quarter ended March 31, 2021, compared to net income of $3,818,000 or $0.45 per common share basic and diluted for the quarter ended March 31, 2020. Net income as a percent of average assets (return on average assets, or “ROA”) and net income as a percentage of shareholders' equity (return on average equity, or “ROE”) were as follows (calculated and reported on an annualized basis): Three Months Ended March 31, 2021 2020 Return on average assets 1.19 % 0.68 % Return on average equity 14.58 % 6.43 % Net Interest Income/Funding Sources Net interest income, Mid Penn’s primary source of revenue, is the amount by which interest income on loans and investments exceeds interest incurred on deposits and borrowings. The amount of net interest income is affected by changes in interest rates and changes in the volume and mix of interest-sensitive assets and liabilities. Net interest income and corresponding yields are presented in the analysis below on a taxable-equivalent basis. Income from tax-exempt assets, primarily loans to or securities issued by state and local governments, is adjusted by an amount equivalent to the federal income taxes which would have been paid if the income received on these assets was taxable at the statutory rate of 21 percent for the three months ended March 31, 2021 and 2020. 44 MID PENN BANCORP, INC. The following tables include average balances, amounts, and rates of interest income and expense, interest rate spread, and net interest margin for the three months ended March 31, 2021 and 2020. Average Balances, Income and Interest Rates on a Taxable Equivalent Basis For the Three Months Ended (Dollars in thousands) March 31, 2021 March 31, 2020 Average Average Average Average Balance Interest Rates Balance Interest Rates ASSETS: Interest Bearing Balances $ 1,401 $ 2 0.58 % $ 4,488 $ 15 1.34 % Investment Securities: Taxable 78,456 385 1.99 % 133,502 740 2.23 % Tax-Exempt 54,937 351 (a) 2.59 % 42,765 280 (a) 2.63 % Total Securities 133,393 736 2.24 % 176,267 1,020 2.33 % Federal Funds Sold 314,181 79 0.10 % 122,635 390 1.28 % Loans and Leases, Net 2,531,917 28,406 (b) 4.55 % 1,771,444 22,341 (b) 5.07 % Restricted Investment in Bank Stocks 7,052 95 5.46 % 4,660 84 7.25 % Total Earning Assets 2,987,944 29,318 3.98 % 2,079,494 23,850 4.61 % Cash and Due from Banks 34,040 30,580 Other Assets 164,266 147,924 Total Assets $ 3,186,250 $ 2,257,998 LIABILITIES & SHAREHOLDERS' EQUITY: Interest-bearing Demand $ 602,015 $ 578 0.39 % $ 455,685 $ 1,172 1.03 % Money Market 743,994 778 0.42 % 502,925 1,597 1.28 % Savings 197,873 64 0.13 % 175,924 120 0.27 % Time 413,673 1,546 1.52 % 480,316 2,491 2.09 % Total Interest-bearing Deposits 1,957,555 2,966 0.61 % 1,614,850 5,380 1.34 % Short-term Borrowings 203,518 174 0.35 % — — 0.00 % Long-term Debt 75,062 204 1.10 % 28,780 252 3.52 % Subordinated Debt 44,583 499 4.54 % 29,048 402 5.57 % Total Interest-bearing Liabilities 2,280,718 3,843 0.68 % 1,672,678 6,034 1.45 % Noninterest-bearing Demand 623,058 320,524 Other Liabilities 23,462 25,927 Shareholders' Equity 259,012 238,869 Total Liabilities & Shareholders' Equity $ 3,186,250 $ 2,257,998 Net Interest Income (taxable equivalent basis) $ 25,475 $ 17,816 Taxable Equivalent Adjustment (150 ) (151 ) Net Interest Income $ 25,325 $ 17,665 Total Yield on Earning Assets 3.98 % 4.61 % Rate on Supporting Liabilities 0.68 % 1.45 % Average Interest Spread 3.30 % 3.16 % Net Interest Margin 3.46 % 3.45 % (a) Includes tax-equivalent adjustments (calculated using statutory rates of 21 percent) of $74,000 and $59,000 for the three months ended March 31, 2021 and 2020, respectively, resulting from tax-free municipal securities in the investment portfolio. (b) Includes tax-equivalent adjustments (calculated using statutory rates of 21 percent) of $76,000 and $92,000 for the three months ended March 31, 2021 and 2020, respectively, resulting from tax-free municipal loans in the commercial loan portfolio. 45 MID PENN BANCORP, INC. Three months ended March 31, 2021 vs. March 31, 2020 (Dollars in thousands on a Taxable Equivalent Basis) Increase (decrease) Volume Rate Net INTEREST INCOME: Interest Bearing Balances $ (10 ) $ (3 ) $ (13 ) Investment Securities: Taxable (303 ) (52 ) (355 ) Tax-Exempt 79 (8 ) 71 Total Securities (224 ) (60 ) (284 ) Federal Funds Sold 604 (915 ) (311 ) Loans and Leases, Net 9,511 (3,446 ) 6,065 Restricted Investment Bank Stocks 43 (32 ) 11 Total Interest Income 9,924 (4,456 ) 5,468 INTEREST EXPENSE: Interest Bearing Deposits: Interest Bearing Demand 373 (967 ) (594 ) Money Market 759 (1,578 ) (819 ) Savings 15 (71 ) (56 ) Time (343 ) (602 ) (945 ) Total Interest Bearing Deposits 804 (3,218 ) (2,414 ) Short-term Borrowings 174 - 174 Long-term Debt 402 (450 ) (48 ) Subordinated Debt 213 (116 ) 97 Total Interest Expense 1,593 (3,784 ) (2,191 ) NET INTEREST INCOME $ 8,331 $ (672 ) $ 7,659 Taxable-equivalent net interest income was $25,475,000 for the three months ended March 31, 2021, an increase of $7,659,000 or 43 percent compared to the three months ended March 31, 2020. The year-over-year increase included the recognition of $5,037,000 of PPP loan processing fees generated as a result of Mid Penn’s participation in the PPP program (similar fees were not recognized during the first quarter of 2020 as PPP loan funding did not begin until the second quarter of 2020). These PPP fees are recognized into interest income over the term of the respective loan, or sooner if the loans are forgiven by the SBA, or the borrowers otherwise pay down principal prior to a loan’s stated maturity. Also contributing to the net interest income increase were the interest and fees from core loan growth since March 31, 2020, and the reduced interest expense due to the lower cost of deposits in the first quarter of 2021 compared to the same period in 2020. Mid Penn’s tax-equivalent net interest margin for the three months ended March 31, 2021 was 3.46 percent and comparable to the 3.45 percent net interest margin for the three months ended March 31, 2020. The yield on interest-earning assets decreased from 4.61 percent for the first quarter of 2020 to 3.98 percent for the first quarter of 2021. Though the quarterly average balance of interest-earning assets increased year over year, the yields on interest-earning assets declined due to both the reduction in rates, as well as the significant average balance of PPP loans outstanding in the first quarter of 2021, which earn interest at a rate of 1 percent while outstanding. The decrease in the yield on interest-earning assets was substantially offset by a favorable decrease in the cost of funds, as the total cost of deposits for the three months ended March 31, 2021 favorably decreased to 0.61 percent compared to 1.34 percent for the three months ended March 31, 2020. The reduction in the cost of funds reflects both the aforementioned growth in noninterest-bearing deposits, and deposit rate decreases, many of which resulted in response to market rate cuts from the COVID-19 pandemic. Although the effective interest rate impact on earning assets and funding sources can be reasonably estimated at current interest rate levels, the interest-bearing product and pricing options selected by customers, and the future mix of the loan, investment, and deposit products in the Bank's portfolios, may significantly change the estimates used in Mid Penn’s asset and liability management and related interest rate risk simulation models. In addition, our net interest income may be impacted by further interest rate actions of the Federal Reserve’s Federal Open Market Committee (“FOMC”). 46 MID PENN BANCORP, INC. Provision for Loan Losses The provision for loan and lease losses is the expense necessary to maintain the allowance at a level adequate to absorb management’s estimate of probable losses in the loan and lease portfolio. Mid Penn’s provision for loan and lease losses is based upon management’s monthly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans and leases, analyze delinquencies, ascertain loan and lease growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets Mid Penn serves. Mid Penn has maintained the allowance in accordance with Mid Penn’s assessment process, which takes into consideration, among other relevant factors, the risk characteristics of the loan portfolio, the growth in the loan portfolio during the first three months of 2021, economic and external factor changes, and shifting collateral values from December 31, 2020 to March 31, 2021. The provision for loan losses was $1,000,000 for the three months ended March 31, 2021, an increase of 82 percent compared to the provision for loan losses of $550,000 for the three months ended March 31, 2020. The allowance for loan losses and the related provision reflect Mid Penn’s continued application of the incurred loss method for estimating credit losses as Mid Penn is not yet required to adopt the current expected credit loss (“CECL”) accounting standard. The year-over-year increase in the loan loss reserves and the provision was primarily the result of (i) providing for core loan growth during the three months ended March 31, 2021, and (ii) an increase in qualitative factors related to economic and external conditions when compared to prior periods, with such changes driven by the possibility for ongoing financial implications from the COVID-19 pandemic on Mid Penn’s customers and market area. Mid Penn’s allowance and other asset quality measures did not reflect any new impaired assets or specific reserve allocations related to the early impact of the COVID-19 pandemic, though Bank management is continuously and closely monitoring and evaluating the impact of the COVID-19 situation on the portfolio. Noninterest Income For the three months ended March 31, 2021, noninterest income totaled $4,712,000, an increase of $1,778,000 or 61 percent, compared to noninterest income of $2,934,000 for the three months ended March 31, 2020. The following components of noninterest income showed significant changes: (Dollars in Thousands) Three Months Ended March 31, 2021 2020 $ Variance % Variance Mortgage banking income $ 2,379 $ 1,182 $ 1,197 101 % Income from fiduciary and wealth management activities 556 384 172 45 % Service charges on deposits 152 205 (53 ) -26 % ATM debit card interchange income 568 416 152 37 % Net gain on sales of investment securities — 132 (132 ) -100 % Other income 791 372 419 113 % Mortgage banking income was $2,379,000 for the three months ended March 31, 2021, an increase of $1,197,000 or more than double the mortgage banking income of $1,182,000 recorded during the three months ended March 31, 2020. Mid Penn significantly increased residential mortgage originations (both purchase and refinance activity) and secondary-market loan sales and gains when comparing the first quarter of 2021 to the same period last year as mortgage interest rates declined and remained low in the twelve months since March 31, 2020, resulting in significantly increased mortgage loan production for both home purchasing and refinancing activity. Income from fiduciary and wealth management activities was $556,000 for the three months ended March 31, 2021, an increase of $172,000 or 45 percent, compared to fiduciary income of $384,000 for the same period in 2020. These additional revenues were attributed to growth in trust assets under management and increased sales of retail investment products. ATM debit card interchange income was $568,000 for the three months ended March 31, 2021, an increase of $152,000 or 37 percent compared to interchange income of $416,000 for the three months ended March 31, 2020. The increase resulted from increasing card-based transaction usage across our expanding checking account customer base. Mid Penn recorded no net gains on sales of investment securities during the three months ended March 31, 2021, compared to net gains on sales of securities of $132,000 for the three months ended March 31, 2020. Sale volume and gains vary from quarter to quarter based upon market conditions, as well as related yield curve and valuation changes, and asset/liability and interest rate risk management activities. Service charges on deposits were $152,000 during the three months ended March 31, 2021, reflecting a decrease of $53,000 or 26 percent when compared to the same period in 2020. The decrease is primarily due to less overdraft activity and less overdraft fees being charged to deposit customers. Other income was $791,000 for the three months ended March 31, 2021, an increase of $419,000 compared to other income of $372,000 for the three months ended March 31, 2020. The increase in other income was primarily driven by higher volumes of fee-based income, including fees from execution of new loan-level swap, wire transfer fees, letter of credit fees, and credit card program referrals and royalties. 47 MID PENN BANCORP, INC. Noninterest Expense For the three months ended March 31, 2021, noninterest expense totaled $17,558,000, an increase of $1,977,000 or 13 percent, compared to noninterest expense of $15,581,000 for the three months ended March 31, 2020. The changes were primarily a result of the following components of noninterest expense, which had significant variances when comparing results for periods ending in 2021 versus the corresponding period in 2020: (Dollars in Thousands) Three Months Ended March 31, 2021 2020 $ Variance % Variance Salaries and employee benefits $ 9,598 $ 8,281 $ 1,317 16 % Software licensing and utilization 1,445 1,221 224 18 % Pennsylvania bank shares tax expense 300 405 (105 ) -26 % FDIC Assessment 470 312 158 51 % Legal and professional fees 426 352 74 21 % Charitable contributions qualifying for state tax credits 270 35 235 671 % Mortgage banking profit-sharing expense 120 — 120 100 % Marketing and advertising expense 135 204 (69 ) -34 % Intangible amortization 281 323 (42 ) -13 % Salaries and employee benefits were $9,598,000 for the three months ended March 31, 2021, an increase of $1,317,000 or 16 percent, versus the same period in 2020, with the increase primarily attributable to increased mortgage commissions expense commensurate with the significant increases in loan originations and secondary market sales success of the mortgage banking group. Software licensing and utilization costs were $1,445,000 for the three months ended March 31, 2021, an increase of $224,000 or 18 percent compared to $1,221,000 for the three months ended March 31, 2020. This increase reflects the additional costs from both transaction volume-based charges, and licensing fees related to the addition of new staff added since March 31, 2020, as well as costs associated with ensuring secure connectivity for an increased volume of employees working remotely in response to the COVID-19 restrictions. Additionally, Mid Penn continued to invest in upgrades to internal systems, networks, storage capabilities, cybersecurity management, and data security mechanisms to enhance data management and security capabilities responsive to both the larger company profile and the increasing complexity of information technology management. FDIC Assessment expense was $470,000 for the three months ended March 31, 2021, an increase of $158,000 or 51 percent compared to $312,000 for the three months ended March 31, 2020. The increased FDIC assessment aligns with the growth of the average assets of the Bank on which the assessment is based, when comparing the first quarter of 2021 to the same period in 2020. Community and charitable contributions qualifying for State tax credits totaled $270,000 for the three months ended March 31, 2021, compared to similar program contributions of $35,000 for the three months ended March 31, 2020. This variance reflects the timing of certain tax-credit-qualifying donations made to participants within Pennsylvania’s Department of Community and Economic Development (“DCED”) Educational Improvement Tax Credit Program (“EITC”), and to moderate-to-low income housing projects in the DCED’s Neighborhood Assistance Program (“NAP”) which have been approved by the Commonwealth of Pennsylvania. These EITC and NAP contributions generated tax credits totaling $206,000 and $33,000 during the periods ended March 31, 2021 and 2020, respectively, to be applied to Mid Penn’s Pennsylvania bank shares tax liability. These contributions and programs are also key elements of Mid Penn’s Community Reinvestment Act compliance activities. Pennsylvania bank shares tax expense was $300,000 for the three months ended March 31, 2021, a decrease of $105,000 or 26 percent compared to $405,000 for the three months ended March 31, 2020. The decrease in shares tax expense generally reflects the aforementioned larger dollar volume of EITC and NAP donations made in the first quarter of 2021 which qualified for PA shares tax credits. Mortgage banking profit-sharing expense totaled $120,000 and related to payments to third-party principals commensurate with the success within the Southeastern Pennsylvania mortgage banking group at Mid Penn for the three months ended March 31, 2021. Similar expenses were not recognized during the same period of 2020 as the group did not generate sufficient earnings to qualify for profit-sharing during the three months ended March 31, 2020. Marketing and advertising expense was $135,000 for the three months ended March 31, 2021, a decrease of $69,000 or 34 percent compared to $204,000 during the same period in 2020. As a result of the ongoing pandemic, in-person customer events and related marketing promotions were significantly reduced during the first quarter of 2021 when compared to the same period last year. Intangible amortization decreased from $323,000 during the three months ended March 31, 2020 to $281,000 during the three months ended March 31, 2021, as the core deposit intangible (“CDI”) amortization from the 2018 acquisitions of both (i) the Scottdale Bank and Trust (“Scottdale”) on January 8, 2018, and (ii) First Priority Bancorp (“First Priority”) on July 31, 2018 continues to decrease as the CDI is amortized using the sum-of-the-years digits method over a ten year term (which results in decreasing expense recognized in each year following the respective acquisition). 48 MID PENN BANCORP, INC. Income Taxes The provision for income taxes was $2,167,000 during the three months ended March 31, 2021, an increase of $1,517,000 or more than twice the income tax provision recorded for the same period in 2020. The first quarter 2021 provision for income taxes reflects a Federal effective tax rate of 18.1 percent compared to a Federal effective tax rate of 14.5 percent for the three months ended March 31, 2020. The increase in the effective tax rate reflects both (i) higher pre-tax income when compared to the first three months of 2020, and (ii) less tax-exempt interest recognized due to less tax-exempt securities being held in the investment security portfolio when compared to the prior year. In addition to federal taxes, for the three months ended March 31, 2021 and 2020, the income tax provision includes $92,000 and $30,000, respectively, of state income taxes that Mid Penn pays to the states of New Jersey, Maryland, and Delaware for revenues sourced in those respective states. Generally, Mid Penn’s effective tax rate is below the federal statutory rate due to earnings on tax-exempt loans, investments, and earnings from the cash surrender value of life insurance, as well as the impact of federal income tax credits, including those awarded from Mid Penn’s low-income housing investments. The realization of Mid Penn’s deferred tax assets is dependent on future earnings. Mid Penn currently anticipates that future earnings will be adequate to fully realize the currently recorded deferred tax assets. Financial Condition Overview Mid Penn’s total assets were $3,382,038,000 as of March 31, 2021, reflecting an increase of $383,090,000 or 13 percent compared to total assets of $2,998,948,000 as of December 31, 2020. Included in total assets as of March 31, 2021 are $590,035,000 of Paycheck Protection Program (“PPP”) loans, net of deferred fees, with this total being comprised of (i) $335,589,000 of PPP 2021 loans, net of deferred fees, originated during the first quarter of 2021; and (ii) $254,446,000 of PPP 2020 loans, net of deferred fees, originated during 2020 which, as of March 31, 2021, were still outstanding as the “SBA” had not yet completed the loan forgiveness and repayment processing. Comparatively, as of December 31, 2020, Mid Penn had $388,313,000 of PPP 2020 loans outstanding, net of deferred fees. Mid Penn has been a significant participating lender under the PPP. Total core banking loans (total loans excluding both the PPP loans outstanding, and residential mortgage loans held for sale) increased by $60,473,000 since year-end 2020 and totaled $2,056,201,000 as of March 31, 2021, representing an annualized growth rate of over 12 percent. Deposit growth since year-end 2020 through March 31, 2021 totaled $192,247,000 representing an annual deposit growth rate of over 31 percent, including an increase of $140,493,000 in noninterest-bearing deposits including proceeds deposited from PPP loan funding. Also, during the first quarter of 2021, the Bank obtained $182,136,000 of additional funding from the Federal Reserve through the Paycheck Protection Program Liquidity Facility (“PPPLF”), with such funding used to support the PPP 2021 loan production. Under the PPPLF, the Federal Reserve supplies financing to the Bank at a rate of 35 basis points (0.35%) for a term and amount determined based on the principal amount of PPP loans fully and specifically pledged as collateral in support of the PPPLF borrowings. Draws of PPPLF funds must be repaid to the Federal Reserve immediately after the specific PPP loans collateralizing the related draws are repaid to the Bank. Loans Total loans at March 31, 2021 were $2,646,236,000 compared to $2,384,041,000 at December 31, 2020, an increase of $262,195,000 or 11 percent since year-end 2020. The loan growth since December 31, 2020 reflects an increase of $60,473,000 in non-PPP core banking loans, primarily in commercial real estate credits, and commercial and industrial financing loans. Additionally, much of the growth is attributable to a net increase in the balance of PPP loans outstanding, net of deferred fees, of $201,722,000 since December 31, 2020 comprised of 2021 PPP originations less 2020 PPP loan paydowns. Mid Penn classifies PPP loans in its commercial and industrial loan pool. (Dollars in thousands) March 31, 2021 December 31, 2020 Amount % Amount % Commercial and industrial $ 964,045 36.4 % $ 752,354 31.6 % Commercial real estate 1,135,660 42.9 % 1,099,656 46.1 % Commercial real estate - construction 264,945 10.0 % 248,913 10.4 % Residential mortgage 197,788 7.5 % 201,841 8.5 % Home equity 75,423 2.9 % 74,224 3.1 % Consumer 8,375 0.3 % 7,053 0.5 % $ 2,646,236 100.0 % $ 2,384,041 100.0 % 49 MID PENN BANCORP, INC. Credit Quality, Credit Risk, and Allowance for Loan and Lease Losses The allowance for loan losses and the related provision reflect Mid Penn’s continued application of the incurred loss method for estimating credit losses, as Mid Penn is not required to adopt the current expected credit loss (“CECL”) accounting standard until January 1, 2023. Mid Penn’s allowance and other asset quality measures did not reflect any new impaired assets or specific reserve allocations related to the early impact of the COVID-19 pandemic, though Bank management is continuously and closely monitoring and evaluating the impact of the COVID-19 situation on the portfolio. Also, PPP loans, which are included in the commercial and industrial classification, are fully guaranteed by the Small Business Administration, and, as such, no allowance for loan losses was recorded against the $590,035,000 balance of PPP loans outstanding (net of related deferred PPP fees) as of March 31, 2021. For the three months ended March 31, 2021, Mid Penn had net loan charge-offs of $791,000 compared to net charge-offs of $51,000 during the same period in 2020, with the increase in the first quarter of 2021 related to the workout of two larger nonperforming loans late in the quarter. None of the charge offs during the three months ended March 31, 2021 or 2020 were a result of the COVID-19 pandemic. Loans charged off during the first three months of 2021 totaled $865,000 and included three commercial and industrial loans for $859,000, one residential mortgage loan for $3,000, one consumer loan for $1,000, and $2,000 in deposit account charge-offs. Mid Penn may need to make future adjustments to the allowance and the provision for loan and lease losses if economic conditions or loan credit quality differs substantially from the assumptions used in making Mid Penn’s evaluation of the level of the allowance for loan losses as compared to the balance of outstanding loans. Changes in the allowance for the three months ended March 31, 2021 and 2020 are summarized as follows: (Dollars in thousands) Three Months Ended March 31, 2021 2020 Balance, beginning of period $ 13,382 $ 9,515 Loans charged off during period (865 ) (58 ) Recoveries of loans previously charged off 74 7 Net charge-offs (791 ) (51 ) Provision for loan and lease losses 1,000 550 Balance, end of period $ 13,591 $ 10,014 Ratio of net loan charge-offs to average loans outstanding, annualized 0.13 % 0.01 % Ratio of allowance for loan losses to net loans at end of period 0.51 % 0.56 % Decreases in the ratio of allowance for loan losses to net loans since December reflect the increase in outstanding loans due to Mid Penn’s participation in the PPP program during the three months ended March 31, 2021. The allowance for loan and lease losses as a percentage of loans, excluding PPP loans which are guaranteed by the SBA and have no associated allowance, was 0.66 percent as of March 31, 2021 and 0.67 percent as of December 31, 2020. Other than as described herein, including the disclosures in previous sections regarding the continued impact of the COVID-19 pandemic, Mid Penn does not believe there are any trends or events at this time that are reasonably expected to have a material impact on future results of operations, liquidity, or capital resources. Based on known information, Mid Penn believes that the effects of current and past economic conditions and other unfavorable business conditions, including those related to COVID-19, may eventually impact some borrowers’ abilities to comply with their repayment terms. Accordingly, Mid Penn has adjusted its qualitative factors for economic and external conditions as part of its general component determination primarily in response to the economic conditions resulting from the pandemic. Mid Penn continues to monitor closely the financial strength of borrowers and the economic conditions impacting them, including those with a higher risk of impacts from the COVID-19 pandemic. Mid Penn does not ordinarily engage in practices which may be used to artificially shield certain borrowers from the negative economic or business cycle effects that may compromise their ability to repay. Mid Penn does not normally structure construction loans with interest reserve components. Mid Penn has not in the past performed any commercial real estate or other type of loan workouts whereby an existing loan was restructured into multiple new loans. Also, Mid Penn does not extend loans at maturity solely due to the existence of guarantees, without recognizing the credit as impaired. While the existence of a guarantee may be a mitigating factor in determining the proper level of allowance once impairment has been identified, the guarantee does not affect the impairment analysis. 50 MID PENN BANCORP, INC. The following table presents the change in nonperforming asset categories as of March 31, 2021 , December 31, 2020 , and March 31 , 2020 . (Dollars in thousands) March 31, 2021 December 31, 2020 March 31, 2020 Nonperforming Assets: Nonaccrual loans $ 6,220 $ 15,047 $ 10,670 Accruing troubled debt restructured loans 457 463 484 Total nonperforming loans 6,677 15,510 11,154 Foreclosed real estate 154 134 1,718 Total non-performing assets 6,831 15,644 12,872 Accruing loans 90 days or more past due — — — Total risk elements $ 6,831 $ 15,644 $ 12,872 Nonperforming loans as a % of total loans outstanding 0.25 % 0.65 % 0.62 % Nonperforming assets as a % of total loans outstanding and other real estate 0.26 % 0.66 % 0.72 % Ratio of allowance for loan losses to nonperforming loans 203.55 % 86.28 % 89.78 % In the table above, troubled debt restructured loans that are no longer accruing interest are included in nonaccrual loans. Total nonperforming assets were $6,831,000 at March 31, 2021, a substantial decrease compared to nonperforming assets of $15,644,000 at December 31, 2020 and $12,872,000 at March 31, 2020. The decrease in nonperforming assets was primarily the result of the successful workout of two nonaccrual commercial relationships totaling $9,123,000: • Management determined that an acquired commercial loan relationship with three loans totaling $7,354,000 (reclassified to nonaccrual status in 2019) would likely involve a long-term workout period and substantial legal and other collection costs in order for the Bank to execute its rights on the commercial real estate collateral. As part of its collection efforts, management identified a third party willing to purchase the Bank’s loans and rights for a $604,000 discount from the recorded balance. Management opted for this solution to both expedite the workout of the relationship, and eliminate the high and extended legal and collection costs associated with the long-term workout. • Additionally, during the first quarter of 2021, as part of the workout plan related to one commercial loan relationship consisting of five loans totaling $1,769,000 (reclassified to nonaccrual status in 2020), management capitalized on a strong offer from a qualified buyer on property collateralizing the loans, thereby avoiding a likely costly, long-term bankruptcy and foreclosed real estate situation. The proceeds of the sale of the collateral were applied to the existing loans and management agreed to a partial charge-off of $255,000 provided the borrower could pay the remaining deficiency. As a result, one loan within this relationship totaling $143,000 was refinanced and remains on nonaccrual status as of March 31, 2021. None of the nonperforming assets were impaired as a result of the COVID-19 pandemic, as the conditions resulting in the respective asset’s impairment preceded the pandemic. However, as Mid Penn pursues full collection of these assets, the timing or extent of resolution may ultimately be impacted if the pandemic persists. One loan relationship which accounts for $2,312,000 of the nonperforming loan balance as of March 31, 2021 is discussed in more detail below. The contractual outstanding principal balance of this loan relationship was comprised of two loans acquired in 2018. These loans were transferred from accrual to nonaccrual status during the second quarter of 2020. These loans are collateralized primarily by commercial real estate, and, given that the fair value of the remaining collateral exceeds the outstanding principal balance, no specific allowance allocation has been currently assigned to this relationship. Management expects to recover the remaining outstanding balance through the sale of real estate collateral pledged in support of the loans. The increase in foreclosed real estate from $134,000 at December 31, 2020 to $154,000 at March 31, 2021 was driven by the transfer of three small loans among two borrowers totaling $20,000 from nonaccrual status to foreclosed real estate during the first quarter of 2021. 51 MID PENN BANCORP, INC. Mid Penn assesses a specific allocation for both commercial loans and commercial real estate loans prior to writing down or charging off the loan. Once the write down is taken, the remaining balance remains a nonperforming loan with the original terms and interest rate intact and is not treated as a restructured credit. The following table provides additional analysis of partially charged-off loans. (Dollars in thousands) March 31, 2021 December 31, 2020 Period ending total loans outstanding $ 2,646,236 $ 2,384,041 Allowance for loan and lease losses 13,591 13,382 Total Nonperforming loans 6,677 15,510 Nonperforming and impaired loans with partial charge-offs 665 836 Ratio of nonperforming loans with partial charge-offs to total loans 0.03 % 0.04 % Ratio of nonperforming loans with partial charge-offs to total nonperforming loans 9.96 % 5.39 % Coverage ratio net of nonperforming loans with partial charge-offs 226.06 % 91.20 % Ratio of total allowance to total loans less nonperforming loans with partial charge-offs 0.51 % 0.56 % Mid Penn considers a commercial loan or commercial real estate loan to be impaired when it becomes 90 days or more past due and not well-secured or otherwise not probable for collection. This methodology assumes the borrower cannot or will not continue to make additional payments. At that time the loan would be considered collateral dependent as the discounted cash flow method indicates no operating income is available for evaluating the collateral position; therefore, most impaired loans are deemed to be collateral dependent. Mid Penn evaluates loans for charge-off on a monthly basis. Policies that govern the recommendation for charge-off are unique to the type of loan being considered. Commercial loans rated as nonaccrual or lower will first have a collateral evaluation completed in accordance with the guidance on impaired loans. Once the collateral evaluation has been completed, a specific allocation of allowance is made based upon the results of the evaluation. The balance remains a nonperforming loan with the original terms and interest rate intact (not restructured). In the event the loan is unsecured, the loan would have been charged-off at the recognition of impairment. Commercial real estate loans rated as impaired will also have an initial collateral evaluation completed in accordance with the guidance on impaired loans. An updated real estate valuation is ordered and the collateral evaluation is modified to reflect any variation in value. A specific allocation of allowance is made for any anticipated collateral shortfall. The balance remains a nonperforming loan with the original terms and interest rate intact (not restructured). The process of charge-off for residential mortgage loans begins upon a loan becoming delinquent for 90 days and not in the process of collection. The existing appraisal is reviewed and a lien search is obtained to determine lien position and any instances of intervening liens. A new appraisal of the property will be ordered if deemed necessary by management and a collateral evaluation is completed. The loan will then be charged down to the value indicated in the evaluation. Consumer loans are recommended for charge-off after reaching delinquency of 90 days and the loan is not well-secured or otherwise not probable for collection. The collateral shortfall of the consumer loan is recommended for charge-off at this point. As noted above, Mid Penn assesses a specific allocation for both commercial loans and commercial real estate loans. The balance remains a nonperforming loan with the original terms and interest rate intact (not restructured). In addition, Mid Penn takes a preemptive step when any commercial loan or commercial real estate loan becomes classified under its internal classification system. A preliminary collateral evaluation in accordance with the guidance on impaired loans is prepared using the existing collateral information in the loan file. This process allows Mid Penn to review both the credit and documentation files to determine the status of the information needed to make a collateral evaluation. This collateral evaluation is preliminary, but allows Mid Penn to determine if any potential collateral shortfalls exist. Larger groups of small-balance loans, such as residential mortgages and consumer installment loans are collectively evaluated for impairment. Accordingly, individual consumer and residential loans are not separately identified for impairment disclosures unless such loans are the subject of a restructuring agreement. Mid Penn’s rating system assumes any loans classified as substandard nonaccrual to be impaired, and most of these loans are considered collateral dependent; therefore, most of Mid Penn’s impaired loans, whether reporting a specific allocation or not, are considered collateral dependent. It is Mid Penn’s policy to obtain updated third-party valuations on all impaired loans collateralized by real estate as soon as practically possible following the credit being classified as substandard nonaccrual. Prior to receipt of the updated real estate valuation Mid Penn will use any existing real estate valuation to determine any potential allowance issues; however, no allowance recommendation will be made until such time Mid Penn is in receipt of the updated valuation. The Asset Recovery department employs an electronic tracking system to monitor the receipt of and need for updated appraisals. To date, there have been no material time lapses noted with the above processes. 52 MID PENN BANCORP, INC. In some instances, Mid Penn is not holding real estate as collateral and is relying on business assets (personal property) for repayment. In these circumstances a collateral inspection is performed by Mid Penn personnel to determine an estimated value. The value is based on net book value, as provided by the financial statements, and discounted accordingly based on determinations made by management. Occasionally, Mid Penn will employ an outside service to provide a fair estimate of value based on auction or private sales. Management reviews the estimates of these third parties and discounts them accordingly based on management’s judgment, if deemed necessary. For impaired loans with no valuation allowance required, Mid Penn’s practice of obtaining independent third-party market valuations on the subject property as soon as practically possible of being placed on nonaccrual status sometimes indicates that the loan to value ratio is sufficient to obviate the need for a specific allocation in spite of significant deterioration in real estate values in Mid Penn’s primary market area. These circumstances are determined on a case-by-case analysis of the impaired loans. Mid Penn actively monitors the values of collateral on impaired loans. This monitoring may require the modification of collateral values over time or changing circumstances by some factor, either positive or negative, from the original values. All collateral values will be assessed by management at least every 12 months for possible revaluation by an independent third party. Mid Penn had loans with an aggregate balance of $6,677,000 which were deemed by management to be impaired at March 31, 2021, including $1,717,000 in loans acquired with credit deterioration in connection with the closing of the Phoenix acquisition in 2015 and the Scottdale and First Priority acquisitions in 2018. Of the $4,959,000 of impaired loan relationships excluding the loans acquired with credit deterioration, $368,000 were commercial and industrial relationships, $1,469,000 were commercial real estate relationships, $2,334,000 were home equity relationships, $758,000 were residential relationships, and $30,000 were commercial real estate – construction relationships. There were specific loan loss reserve allocations of $263,000 against $874,000 of commercial real estate loan relationships and $68,000 of specific loan loss reserve allocations against $225,000 of commercial and industrial loan relationships. Management currently believes that the specific reserves are adequate to cover probable future losses related to these relationships. The allowance is a reserve established in the form of a provision expense for loan and lease losses and is reduced by loan charge-offs net of recoveries. In conjunction with an internal loan review function that operates independently of the lending function, management monitors the loan portfolio to identify risk on a monthly basis so that an appropriate allowance is maintained. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance to the Board of Directors, indicating any changes in the allowance since the last review. In making the evaluation, management considers the results of recent regulatory examinations, which typically include a review of the allowance as an integral part of the examination process. As part of the examination process, federal or state regulatory agencies may require Mid Penn to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management. In establishing the allowance, management evaluates on a quantitative basis individual classified loans and nonaccrual loans, and determines an aggregate reserve for those loans based on that review. In addition, an allowance for the remainder of the loan and lease portfolio is determined based on historical loss experience within certain components of the portfolio. These allocations may be modified if current conditions indicate that loan and lease losses may differ from historical experience. In addition, a portion of the allowance is established for losses inherent in the loan and lease portfolio which have not been identified by the quantitative processes described above. This determination inherently involves a higher degree of subjectivity, and considers risk factors that may not have yet manifested themselves in historical loss experience. These factors include: • changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments (and the potential adverse impacts on the economy from the COVID-19 pandemic); • changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans; • changes in the value of underlying collateral for collateral-dependent loans; • changes in the experience, ability, and depth of lending management and other relevant staff; • changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses; • changes in the quality of the institution's loan review system; • changes in the nature and volume of the portfolio and in the terms of loans; • the effect of other external factors such as competition, legal and regulatory requirements, governmental restrictions impacting business activity as a result of the COVID-19 pandemic, and other factors beyond the control of Mid Penn which could affect the level of estimated credit losses in the institution's existing portfolio; and • the existence and effect of any concentrations of credit and changes in the level of such concentrations. 53 MID PENN BANCORP, INC. While the allowance is maintained at a level believed to be adequate by management to provide for probable losses inherent in the loan and lease portfolio, determination of the allowance is inherently subjective, as it requires estimates, all of which may be susceptible to significant change. The unallocated component of the allowance for loan and lease losses covers several considerations that are not specifically measurable through either the specific or general components. For example, we believe that we could face increasing credit risks and uncertainties, not yet reflected in recent historical losses or qualitative factor assessments and underlying data and evaluations, associated with unpredictable changes in economic growth or business conditions in our markets or for certain industries in which we have commercial loan borrowers, or unanticipated stresses to the values of real estate held as collateral, including the prospective unknown impacts of the persisting COVID-19 pandemic. Any or all of these additional issues can adversely affect our borrowers’ ability to timely repay their loans. Additionally, we have experienced continued strong commercial loan growth, including growth in newer markets where we have less of a loss history. Also, the unallocated component allocation recognizes the inherent imprecision in our allowance for loan and lease loss methodology, or any alternative methodology, for estimating specific and general loan losses, including the unpredictable timing and amounts of charge-offs, the fact that historical loss averages don’t necessarily correlate to future loss trends, and unexpected changes to specific-credit or general portfolio future cash flows and collateral values which could negatively impact unimpaired portfolio loss factors. Changes from these various other uncertainties and considerations may impact the provisions charged to expense in future periods. Management believes, based on information currently available, that the allowance for loan losses of $13,591,000 is adequate as of March 31, 2021 to cover specifically identifiable loan losses, as well as estimated losses inherent in our portfolio for which certain losses are probable but not specifically identifiable. Liquidity Mid Penn’s objective is to maintain adequate liquidity to meet funding needs at a reasonable cost and to provide contingency plans to meet unanticipated funding needs or a loss of funding sources, while minimizing interest rate risk. Adequate liquidity provides resources for credit needs of borrowers, for depositor withdrawals, and for funding corporate operations. Sources of liquidity are as follows: • a growing core deposit base; • proceeds from the sale or maturity of investment securities; • proceeds from interest-bearing time deposits with other financial institutions; • payments received on loans and mortgage-backed securities; • overnight correspondent bank borrowings on various credit lines; and • borrowing capacity available from the FHLB, the Federal Reserve Discount Window, and other lines of credit currently available to Mid Penn. The major sources of cash received in the first three months of 2021 were from the $192,247,000 net increase in deposits, $182,136,000 net increase in short-term borrowings (from the PPPLF), and $100,621,000 of proceeds from sales of mortgage loans originated for sale. Major uses of cash in the first three months of 2021 were $263,006,000 to fund portfolio loan growth (primarily PPP commercial loans) and $98,578,000 to fund mortgage loans originated for sale. Mid Penn believes its core deposits are generally stable even in periods of changing interest rates. Liquidity is measured and monitored daily, allowing management to better understand and react to balance sheet trends. These measurements indicate that liquidity generally remains stable and exceeds our minimum defined levels of adequacy. Other than the trends of continued competitive pressures and volatile interest rates, and the uncertain impact of the persisting COVID-19 pandemic, there are no known demands, commitments, events, or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way. On at least a quarterly basis, a comprehensive liquidity analysis is reviewed by the Asset Liability Committee and Board of Directors. The analysis provides a summary of the current liquidity measurements, projections, and future liquidity positions given various levels of liquidity stress. Management also maintains a detailed Contingency Funding Plan designed to respond to overall stress in the financial condition of the banking industry or a prospective liquidity problem specific to Mid Penn. Subordinated Debt Subordinated Debt Issued December 2020 On December 22, 2020, Mid Penn Bancorp, Inc. entered into agreements for and sold, at 100% of their principal amount, an aggregate of $12,150,000 of its Subordinated Notes due December 2030 (the “December 2020 Notes”) on a private placement basis to accredited investors. The December 2020 Notes are treated as Tier 2 capital for regulatory capital purposes. 54 MID PENN BANCORP, INC. The December 2020 Notes bear interest at a rate of 4.5% per year for the first five years and then float at the Wall Street Journal’s Prime Rate, provided that the interest rate applicable to the outstanding principal balance during the period the December 2020 Notes are floating will at no time be less than 4.5%. Interest is payable quarterly in arrears on March 31, June 30, September 30 and December 31 of each year, beginning on March 31, 2021. The December 2020 Notes will mature on December 31, 2030 and are redeemable, in whole or in part, without premium or penalty, on any interest payment date on or after December 31, 2025 and prior to December 31, 2030, subject to any required regulatory approvals. Additionally, if ( i ) all or any portion of the December 2020 Notes cease to be deemed Tier 2 Capital, ( ii ) interest on the December 2020 Notes fails to be deductible for United States federal income tax purposes or ( iii ) Mid Penn will be considered an “investment company,” Mid Penn may redeem the December 2020 Notes, in whole but not in part, by giving 10 days’ notice to the holders of the December 2020 Notes. In the event of a redemption described in the previous sentence, Mid Penn will redeem the December 2020 Notes at 100% of the principal amount of the December 2020 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption. Holders of the December 2020 Notes may not accelerate the maturity of the December 2020 Notes, except upon the bankruptcy, insolvency, liquidation, receivership or similar event of Mid Penn or Mid Penn Bank, its principal banking subsidiary. Related parties held $750,000 of the December 2020 Notes as of March 31, 2021 and December 31, 2020. Subordinated Debt Issued March 2020 On March 20, 2020, Mid Penn Bancorp, Inc. entered into agreements with accredited investors who purchased $15,000,000 aggregate principal amount of Mid Penn Subordinated Notes due 2030 (the “March 2020 Notes”). The March 2020 Notes are intended to be treated as Tier 2 capital for regulatory capital purposes. The March 2020 Notes bear interest at a rate of 4.0% per year for the first five years and then float at the Wall Street Journal’s Prime Rate, provided that the interest rate applicable to the outstanding principal balance during the period the March 2020 Notes are floating will at no time be less than 4.25%. Interest is payable semi-annually in arrears on June 30 and December 30 of each year, beginning on June 30, 2020, for the first five years after issuance and will be payable quarterly in arrears thereafter on March 30, June 30, September 30 and December 30. The March 2020 Notes will mature on March 30, 2030 and are redeemable in whole or in part, without premium or penalty, at any time on or after March 30, 2025 and prior to March 30, 2030. Additionally, if all or any portion of the March 2020 Notes cease to be deemed Tier 2 Capital, Mid Penn may redeem, on any interest payment date, all or part of the 2020 Notes. In the event of a redemption described in the previous sentence, Mid Penn will redeem the March 2020 Notes at 100% of the principal amount of the March 2020 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption. Holders of the March 2020 Notes may not accelerate the maturity of the March 2020 Notes, except upon the bankruptcy, insolvency, liquidation, receivership or similar event of Mid Penn or Mid Penn Bank, its principal banking subsidiary. Related parties held $1,700,000 of the March 2020 Notes as of March 31, 2021 and December 31, 2020. Subordinated Debt Issued December 2017 On December 19, 2017, Mid Penn entered into agreements with investors to purchase $10,000,000 aggregate principal amount of its Subordinated Notes due 2028 (the “2017 Notes”). The 2017 Notes are intended to be treated as Tier 2 capital for regulatory capital purposes. The offering closed in December 2017. The 2017 Notes bear interest at a rate of 5.25% per year for the first five years and then float at the Wall Street Journal’s Prime Rate plus 0.50%, provided that the interest rate applicable to the outstanding principal balance will at no time be less than 5.0%. Interest is payable semi-annually in arrears on January 15 and July 15 of each year, beginning on July 15, 2018, for the first five years after issuance and will be payable quarterly in arrears thereafter on January 15, April 15, July 15, and October 15. The 2017 Notes will mature on January 1, 2028 and are redeemable in whole or in part, without premium or penalty, at any time on or after December 21, 2022, and prior to January 1, 2028. Additionally, Mid Penn may redeem the 2017 Notes in whole at any time, or in part from time to time, upon at least 30 days’ notice if: (i) a change or prospective change in law occurs that could prevent Mid Penn from deducting interest payable on the 2017 Notes for U.S. federal income tax purposes; (ii) an event occurs that precludes the 2017 Notes from being recognized as Tier 2 capital for regulatory capital purposes; or (iii) Mid Penn becomes required to register as an investment company under the Investment Company Act of 1940, as amended. In the event of a redemption described in the previous sentence, Mid Penn will redeem the 2017 Notes at 100% of the principal amount of the 2017 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption. Holders of the 2017 Notes may not accelerate the maturity of the 2017 Notes, except upon the bankruptcy, insolvency, liquidation, receivership or similar event of Mid Penn or Mid Penn Bank, its principal banking subsidiary. Related parties held $1,450,000 of the 2017 Notes as of March 31, 2021 and December 31, 2020. Subordinated Debt Issued December 2015 On December 9, 2015, Mid Penn Bancorp, Inc. sold $7,500,000 aggregate principal amount of Subordinated Debt (the “2015 Notes”) due 2025. Given that the 2015 Notes are in the sixth year since issuance, eighty-percent of the principal balance of the notes is treated as Tier 2 capital for regulatory capital purposes as of March 31, 2021. 55 MID PENN BANCORP, INC. The 2015 Notes paid interest at a rate of 5.15% per year for the first five years ending December 31, 2020. Beginning January 1, 2021, the 2015 Notes bear interest at a floating rate based on the Wall Street Journal’s Prime Rate plus 0.50%, provided that the interest rate applicable to the outstanding principal balance will at no time be less than 4.0%. Interest is payable quarterly in arrears on January 1, April 1, July 1 and October 1 of each year, beginning on January 1, 2016. The 2015 Notes will mature on December 9, 2025 and are redeemable in whole or in part, without premium or penalty, at any time on or after December 9, 2020, and prior to December 9, 2025. Additionally, Mid Penn may redeem the 2015 Notes in whole at any time, or in part from time to time, upon at least 30 days’ notice if: ( i ) a change or prospective change in law occurs that could prevent Mid Penn from deducting interest payable on the 2015 Notes for U.S. federal income tax purposes; (ii) an event occurs that precludes the 2015 Notes from being recognized as Tier 2 capital for regulatory capital purposes; or (iii) Mid Penn becomes required to register as an investment company under the Investment Company Act of 1940, as amended, in each case at 100% of the principal amount of the 2015 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption. Holders of the 2015 Notes may not accelerate the maturity of the 2015 Notes, except upon Mid Penn’s or Mid Penn Bank’s bankruptcy, insolvency, liquidation, receivership or similar event. Related parties held $1,930,000 of the 2015 Notes as of March 31, 2021 and December 31, 2020. ASC Subtopic 835-30, Simplifying the Presentation of Debt Issuance Costs , requires that debt issuance costs be reported in the balance sheet as a direct deduction from the face amount of the related liability. The unamortized debt issuance costs associated with the 2015 Notes and the 2017 Notes were collectively $64,000 at March 31, 2021 and $70,000 at December 31, 2020. Subordinated Debt Assumed July 2018 with the First Priority Acquisition On July 31, 2018, Mid Penn completed its acquisition of First Priority and assumed $9,500,000 of Subordinated Notes (the “First Priority Notes”). On December 18, 2020, Mid Penn redeemed the full $9,500,000 of the First Priority Notes promptly following the expiration of the Notes’ noncallable period, and upon receipt of the required regulatory approval. Mid Penn recognized redemption pricing fees of $143,000 which were fully recognized in the fourth quarter of 2020 related to the early redemption as provided in the terms of the First Priority Notes. Regulatory Capital Changes In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The final rules implemented higher minimum capital requirements, added a new common equity Tier 1 capital requirement, and established criteria that instruments must meet to be considered common equity Tier 1 capital, additional Tier 1 capital or Tier 2 capital. Under the new rules, in order to avoid limitations on capital distributions (including dividend payments and certain discretionary bonus payments to executive officers), a banking organization must hold a capital conservation buffer comprised of common equity Tier 1 capital above its minimum risk-based capital requirements, which amount must be greater than 2.5% of total risk-weighted assets. A summary of the payout restrictions based on the capital conservation buffer is as follows: Capital Conservation Buffer (as a % of risk-weighted assets) Maximum Payout (as a % of eligible retained income) > 2.5% No payout limitation applies ≤2.5% and >1.875% 60% ≤1.875% and >1.25% 40% ≤1.25% and >0.625% 20% ≤0.625% 0% The final rules allowed community banks to make a one-time election not to include the additional components of accumulated other comprehensive income (“AOCI”) in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. Mid Penn made the election not to include the additional components of AOCI in regulatory capital. Consistent with the Dodd-Frank Act, the new rules replaced the ratings-based approach to securitization exposures, which is based on external credit ratings, with the simplified supervisory formula approach in order to determine the appropriate risk weights for these exposures. Alternatively, banking organizations may use the existing gross-ups approach to assign securitization exposures to a risk weight category or choose to assign such exposures a 1,250% risk weight. Under the new rules, mortgage servicing assets (“MSAs”) and certain deferred tax assets (“DTAs”) are subject to stricter limitations than those applicable under the current general risk-based capital rule. The new rules also increase the risk weights for past-due loans, certain risk weights and credit conversion factors. Mid Penn has implemented these changes in determining and reporting the regulatory ratios of Mid Penn and the Bank, and has concluded that the new rules do not have a material adverse effect on Mid Penn’s financial condition. 56 MID PENN BANCORP, INC. Capital Resources Shareholders' equity, or capital, is evaluated in relation to total assets and the risk associated with those assets, and the desire to collectively maintain and enhance shareholders’ value, and satisfactorily address regulatory capital requirements. Accordingly, capital management has been, and will continue to be, of paramount importance to the Corporation. Shareholders’ equity increased by $8,348,000 or 3 percent from $255,688,000 as of December 31, 2020 to $264,036,000 as of March 31, 2021. The increase in shareholders’ equity primarily reflects the growth in retained earnings through year-to-date net income, less dividends declared and paid during the first quarter of 2021. Regulatory capital ratios for both Mid Penn and its banking subsidiary exceeded regulatory “well-capitalized” levels at both March 31, 2021 and December 31, 2020. Banks are evaluated for capital adequacy by regulatory supervisory agencies based on the ratio of capital to risk-weighted assets and total assets. The minimum capital to risk-weighted assets requirements, including the capital conservation buffers, which became effective for Mid Penn and the Bank on January 1, 2016 are illustrated below. At March 31, 2021, regulatory capital ratios for both Mid Penn and the Bank met the definition of a “well-capitalized” institution under the regulatory framework for prompt corrective action, and exceeded the minimum capital requirements under Basel III. Mid Penn and Mid Penn Bank maintained the following regulatory capital levels, leverage ratios, and risk-based capital ratios as of March 31, 2021 and December 31, 2020: Capital Adequacy To Be Well-Capitalized (Dollars in thousands) Minimum for Under Prompt Basel III Capital Corrective Actual Adequacy (a) Action Provisions Amount Ratio Amount Ratio Amount Ratio Mid Penn Bancorp, Inc. As of March 31, 2021: Tier 1 Capital (to Average Assets) $ 196,590 6.7 % $ 116,632 4.0 % N/A N/A Common Equity Tier 1 Capital (to Risk Weighted Assets) 196,590 9.7 % 142,410 7.0 % N/A N/A Tier 1 Capital (to Risk Weighted Assets) 196,590 9.7 % 172,926 8.5 % N/A N/A Total Capital (to Risk Weighted Assets) 254,833 12.5 % 213,615 10.5 % N/A N/A Mid Penn Bank As of March 31, 2021: Tier 1 Capital (to Average Assets) $ 227,851 7.8 % $ 116,600 4.0 % $ 145,750 5.0 % Common Equity Tier 1 Capital (to Risk Weighted Assets) 227,851 11.2 % 142,363 7.0 % 132,194 6.5 % Tier 1 Capital (to Risk Weighted Assets) 227,851 11.2 % 172,869 8.5 % 162,701 8.0 % Total Capital (to Risk Weighted Assets) 241,508 11.9 % 213,545 10.5 % 203,376 10.0 % Mid Penn Bancorp, Inc. As of December 31, 2020: Tier 1 Capital (to Average Assets) $ 188,501 6.8 % $ 111,201 4.0 % N/A N/A Common Equity Tier 1 Capital (to Risk Weighted Assets) 188,501 9.6 % 137,351 7.0 % N/A N/A Tier 1 Capital (to Risk Weighted Assets) 188,501 9.6 % 166,783 8.5 % N/A N/A Total Capital (to Risk Weighted Assets) 246,529 12.6 % 206,026 10.5 % N/A N/A Mid Penn Bank As of December 31, 2020: Tier 1 Capital (to Average Assets) $ 218,676 7.9 % $ 111,166 4.0 % $ 138,958 5.0 % Common Equity Tier 1 Capital (to Risk Weighted Assets) 218,676 11.1 % 137,288 7.0 % 127,482 6.5 % Tier 1 Capital (to Risk Weighted Assets) 218,676 11.1 % 166,707 8.5 % 156,901 8.0 % Total Capital (to Risk Weighted Assets) 232,124 11.8 % 205,933 10.5 % 196,126 10.0 % (a) Minimum amounts and ratios include the full phase in of the capital conservation buffer of 2.5 percent required by the Basel III framework. 57 MID PENN BANCORP, INC.