NATIONAL BANKSHARES INC 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations $ in thousands, except per share data   The purpose of this discussion and analysis is to provide information about the financial condition and results of operations of the Company.  Please refer to the financial statements and other information included in this report as well as the Company’s 2022 Form 10-K for an understanding of the following discussion and analysis. References in the following discussion and analysis to “we” or “us” refer to the Company unless the context indicates that the reference is to the Bank.   Cautionary Statement Regarding Forward-Looking Statements   We make forward-looking statements in this Form 10-Q that are subject to significant risks and uncertainties.  These forward-looking statements include statements regarding our profitability, liquidity, allowance for credit losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals, and are based upon management’s views and assumptions as of the date of this report.  The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, effects of or changes in:   ● interest rates,   ● national and local economic conditions,   ● monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Consumer Financial Protection Bureau and the Federal Deposit Insurance Corporation, and the impact of any policies or programs implemented pursuant to financial reform legislation,   ● unanticipated increases in the level of unemployment in the Company’s market,   ● the quality or composition of the loan and/or investment portfolios,   ● the sufficiency of the Company’s allowance for credit losses,   ● demand for loan products,   ● deposit flows, including impact on liquidity   ● competition,   ● demand for financial services in the Company’s market,   ● the real estate market conditions in the Company’s market,   ● laws, regulations and policies impacting financial institutions,   ● adverse developments in the financial industry generally, such as the recent bank failures, responsive measures to mitigate and manage such developments, related supervisory and regulatory actions and costs, and related impacts on customer behavior,   ● technological risks and developments, and cyber-threats, attacks or events,   ● the Company’s technology initiatives,   ● geopolitical conditions, including acts or threats of terrorism and/or military conflicts, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts,   ● the occurrence of significant natural disasters, including severe weather conditions, floods, health related issues, and other catastrophic events,   ● the Company's ability to identify, attract, and retain experienced management, relationship managers, and support personnel, particularly in a competitive labor environment,   ● performance by the Company’s counterparties or vendors,   ● applicable accounting principles, policies and guidelines, and   ● the impact of public health events, including the adverse impact on our business and operations and on our customers. These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report. This discussion and analysis should be read in conjunction with the description of our “Risk Factors” in Item 1A of the most recently filed Form 10-K.   Overview   NBI is a financial holding company that was organized in 1986 under the laws of Virginia and is registered under the Bank Holding Company Act of 1956. NBI common stock is listed on the Nasdaq Capital Market and is traded under the symbol “NKSH.” NBI has two wholly-owned subsidiaries; the National Bank of Blacksburg and National Bankshares Financial Services, Inc. NBB is a community bank and does business as National Bank from 24 office locations and three loan production offices. NBB is the source of nearly all of the Company’s revenue. NBFS does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future.   33 Table of Contents     The Company is pleased to announce plans for a new branch in Roanoke, Virginia, expected to open in 2024. The full service branch will expand our already successful loan production office and enhance our service in the Roanoke Valley.   Critical Accounting Policies   The Company’s consolidated financial statements are prepared in accordance with GAAP. The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. Although the economics of the Company’s transactions may not change, the timing of events that would impact the transactions could change. Critical accounting policies are most important to the portrayal of the Company’s financial condition or results of operations and require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. If conditions occur that differ from our assumptions, depending upon the severity of such differences, the Company’s financial condition or results of operations may be materially impacted. The Company designated as critical those policies governing the allowance for credit losses, goodwill and the pension plan. The Company evaluates its critical accounting estimates and assumptions on an ongoing basis and updates them as needed. Please refer to the Company’s 2022 Form 10-K, Note 1: Summary of Significant Accounting Policies for information on these and other accounting policies. For information on the Company’s policies on the ACLL beginning with adoption of CECL on January 1, 2023, please refer to Note 1: General.   Cybersecurity   The Company considers cybersecurity risk to be one of the greatest risks to its business. We have deployed a multi-faceted approach to limit the risk and impact of unauthorized access to customer accounts and to information relevant to customer accounts. We use digital technology safeguards, internal policies and procedures, and employee training to reduce the exposure of our systems to cyber-intrusions. The Company also requires assurances from key vendors regarding their cybersecurity. We control functionalities of online and mobile banking to reduce risk. We do not offer online account openings or loan originations. We do not permit customers to submit address changes through online banking, and we limit the dollar amount of online banking transfers to other banks. We require a special vetting process for commercial customers who wish to originate ACH transfers and for customers who submit wire requests through online banking.           Further, the Company has a program to identify, mitigate and manage its cybersecurity risks.  The program includes penetration testing and vulnerability assessment, technological defenses such as antivirus software, patch management, firewall management, email and web protections, an intrusion prevention system, a cybersecurity insurance policy which covers some but not all losses arising from cybersecurity breaches, as well as ongoing employee training.  The cost of these measures was $64 for the three months ended September 30, 2023 and $95 for the three months ended September 30, 2022. For the nine months ended September 30, 2023 and September 30, 2022, the expense was $192 and $282 respectively. These costs are included in various categories of noninterest expense. However, it is not possible to fully eliminate exposure. The potential for financial and reputational losses due to cyber-breaches is increased by the possibility of human error, unknown system susceptibilities, and the rising sophistication of cyber-criminals to attack systems, disable safeguards and gain access to accounts and related information. We maintain insurance for these risks but insurance policies are subject to exceptions, exclusions and terms whose applications have not been widely interpreted in litigation. Accordingly, insurance can provide less than complete protection against the losses that result from cybersecurity breaches and pursuing recovery from insurers can result in significant expense. In addition, some risks such as reputational damage and loss of customer goodwill, which can result from cybersecurity breaches, cannot be insured against.   Non-GAAP Financial Measures   This report refers to certain financial measures that are computed under a basis other than GAAP (“non-GAAP”). The Company uses certain non-GAAP financial measures to provide meaningful supplemental information regarding the Company’s operational performance and to enhance investors’ overall understanding of such financial performance. The methodology for determining these non-GAP measures may differ among companies and are supplementary to our financial condition, results of operations and cash flows computed in accordance with GAAP. Details on non-GAAP measures follow.   34 Table of Contents     Adjusted Return on Average Assets and Adjusted Return on Average Equity The adjusted return on average assets and adjusted return on average equity are measures of profitability, calculated by annualizing net income and dividing by average year-to-date assets or equity, respectively. Larger nonrecurring income or expenses are not annualized, in order to reduce distortion within the ratios. The tables below present the reconciliation of adjusted annualized net income, which is not a measurement under GAAP, for the three and nine month periods ended September 30, 2023 and 2022.       Three Months Ended September 30,       2023     2022   Annualized Net Income                 Net income (GAAP)   $ 3,074     $ 6,162   Less: items deemed by management to be non-recurring:                 Provision recovery, net of tax of $84 for the period ended September 30, 2023     (317 )     -   Total non-recurring items     (317 )     -   Adjusted net income   $ 2,757     $ 6,162   Adjusted net income, annualized   $ 10,938     $ 24,447   Add: total non-recurring items     317       -   Annualized net income for ratio calculation (non-GAAP)   $ 11,255     $ 24,447   Return on average assets (GAAP)     0.77 %     1.41 % Adjusted return on average assets (non-GAAP)     0.71 %     1.41 % Return on average equity (GAAP)     9.63 %     17.61 % Adjusted return on average equity (non-GAAP)     8.89 %     17.61 %       Nine Months Ended September 30,       2023     2022   Annualized Net Income                 Net income (GAAP)   $ 11,506     $ 16,622   Less: items deemed by management to be non-recurring:                 Partnership income net of tax of ($44) and ($77) for the periods ended September 30, 2023 and 2022, respectively (1)     (164 )     (290 ) Loss on sale of securities, net of tax of $700     2,632       -   Provision recovery, net of tax of $82     (307 )     -   Proxy contest-related expense, net of tax of $161 (2)     607       -   Gain on sale of investment, net of tax of ($624)     (2,347 )     -   Gain on BOLI settlement (3)     (1,037 )     -   Total non-recurring items     (616 )     (290 ) Adjusted net income   $ 10,890     $ 16,332   Adjusted net income, annualized   $ 14,560     $ 21,836   Add: total non-recurring items     616       290   Annualized net income for ratio calculation (non-GAAP)   $ 15,176     $ 22,126   Return on average assets (GAAP)     0.95 %     1.29 % Adjusted return on average assets (non-GAAP)     0.94 %     1.29 % Return on average equity (GAAP)     12.13 %     14.11 % Adjusted return on average equity (non-GAAP)     11.97 %     14.04 %     (1) Partnership income is included in other income in the Consolidated Statements of Income.   (2) Proxy contest-related expense is included in professional services in the Consolidated Statements of Income.   (3) Gain on BOLI investment is included in BOLI income in the Consolidated Statements of Income.   35 Table of Contents     Net Interest Margin The Company uses the net interest margin to measure profit on interest generating activities, as a percentage of total interest-earning assets. The Company’s net interest margin is calculated on a fully taxable equivalent (“FTE”) basis. The portion of interest income that is nontaxable is grossed up to the tax equivalent by adding the tax benefit based on a tax rate of 21%. Annualized FTE net interest income is divided by total average earning assets to calculate the net interest margin. The following tables present the reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, for the periods indicated.       Three Months Ended September 30,       2023     2022   Net Interest Income, FTE                 Total interest income (GAAP)   $ 14,679     $ 13,155   FTE adjustment     229       232   Total interest income (non-GAAP)     14,908       13,387   Total interest expense (GAAP)     6,039       753   Net interest income, FTE (non-GAAP)   $ 8,869     $ 12,634   Average balance of interest-earning assets   $ 1,581,042     $ 1,697,254   Net interest margin     2.23 %     2.95 %       Nine Months Ended September 30,     Twelve Months Ended       2023     2022     December 31, 2022   Net Interest Income, FTE                         Total interest income (GAAP)   $ 43,320     $ 36,127     $ 50,109   FTE adjustment     648       689       919   Total interest income (non-GAAP)     43,968       36,816       51,028   Total interest expense (GAAP)     14,517       2,055       3,083   Net interest income, FTE (non-GAAP)   $ 29,451     $ 34,761     $ 47,945   Average balance of interest-earning assets   $ 1,605,202     $ 1,665,680     $ 1,667,191   Net interest margin     2.45 %     2.79 %     2.88 %   Further detail on the net interest margin is provided under the Net Interest Income discussion.   36 Table of Contents     Efficiency Ratio The efficiency ratio is computed by dividing noninterest expense by the sum of FTE net interest income and noninterest income, excluding certain items the Company’s management deems unusual or non-recurring. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. The components of the efficiency ratio calculation for the periods indicated are summarized in the following table.       Three Months Ended September 30,       2023     2022   Noninterest expense (GAAP)   $ 7,465     $ 6,736   Total Income for Efficiency Ratio                 Noninterest income (GAAP)     2,115       2,140   Net interest income, FTE (non-GAAP)     8,869       12,634   Total income for efficiency ratio (non-GAAP)   $ 10,984     $ 14,774   Efficiency ratio     67.96 %     45.59 %       Nine Months Ended September 30,     Twelve Months Ended       2023     2022     December 31, 2022   Noninterest Expense for Efficiency Ratio                         Noninterest expense (GAAP)   $ 22,686     $ 19,660     $ 26,958   Less: proxy contest-related expense     (768 )     -       -   Noninterest expense for efficiency ratio (non-GAAP)   $ 21,918     $ 19,660     $ 26,958   Total Income for Efficiency Ratio                         Noninterest income (GAAP)   $ 7,105     $ 6,543     $ 12,401   Less: Loss on sale of securities     3,332       -       -   Less: Gain on sale of investment     (2,971 )     -       (3,823 ) Less: Gain on BOLI settlement     (1,037 )     -       -   Noninterest income (non-GAAP)     6,429       6,543       8,578   Net interest income, FTE (non-GAAP)     29,451       34,761       47,945   Total income for efficiency ratio (non-GAAP)   $ 35,880     $ 41,304     $ 56,523   Efficiency ratio     61.09 %     47.60 %     47.69 %   37 Table of Contents     Performance Summary   The following tables presents the Company’s key performance indicators for the three and nine month periods ended September 30, 2023 and September 30, 2022 and the year ended December 31, 2022.       Three Months Ended September 30,       2023     2022   Net Income   $ 3,074     $ 6,162   Return on average assets     0.77 %     1.41 % Adjusted return on average assets (1)     0.71 %     1.41 % Return on average equity     9.63 %     17.61 % Adjusted return on average equity (1) (2)     8.89 %     17.61 % Basic diluted earnings per share (2)   $ 0.52     $ 1.03   Fully diluted earnings per share (2) (4)   $ 0.52     $ 1.03   Net interest margin (1)     2.23 %     2.95 % Efficiency ratio (1)     67.96 %     45.59 %       Nine Months Ended September 30, 2023     Nine Months Ended September 30, 2022     Twelve Months Ended December 31, 2022   Net Income   $ 11,506     $ 16,622       25,932   Return on average assets     0.95 %     1.29 %     1.52 % Adjusted return on average assets (1)     0.94 %     1.29 %     1.52 % Return on average equity     12.13 %     14.11 %     17.81 % Adjusted return on average equity (1) (3)     11.97 %     14.04 %     17.81 % Basic earnings per share (3)   $ 1.95     $ 2.77     $ 4.33   Fully diluted earnings per share (3) (4)   $ 1.95     $ 2.77     $ 4.33   Net interest margin (1)     2.45 %     2.79 %     2.88 % Efficiency ratio (1)     61.09 %     47.60 %     47.69 %   (1) See “Non-GAAP Financial Measures” above. (2) During the three months ended September 30, 2022, the Company repurchased 23,500 shares under its publicly announced stock repurchase plan. The repurchase reduced stockholders equity by $795. (3) During the nine months ended September 30, 2022, the Company repurchased 106,662 shares under its publicly announced stock repurchase plan. The repurchase reduced stockholders equity by $3,724. (4) During the second quarter of 2023, the Company granted 2,052 of restricted stock awards with a one year vesting period.   Net income for the three and nine month periods ended September 30, 2023 decreased when compared with the three and nine month periods ended September 30, 2022. Results for 2023 reflected the impact of the Federal Reserve’s interest rate increases as well as key noninterest income and expense items that are discussed below. Results for the year ended December 31, 2022 included pre-tax income of $3,823 from the sale of a private equity investment.   38 Table of Contents     Net Interest Income   The following tables show interest‑earning assets and interest‑bearing liabilities, the interest earned or paid, the average yield or rate on the daily average balance outstanding, net interest income and net yield on average interest‑earning assets for the periods indicated.         Three Months Ended September 30,       2023     2022       Average Balance     Interest     Average Yield/Rate     Average Balance     Interest     Average Yield/Rate   Interest-earning assets:                                                 Loans (1)(2)(4)(5)   $ 843,546     $ 9,924       4.67 %   $ 849,929     $ 8,900       4.15 % Taxable securities (6)(7)     640,578       4,084       2.53 %     683,490       3,425       1.99 % Nontaxable securities (1)(6)     64,415       461       2.84 %     74,670       556       2.95 % Interest-bearing deposits     32,503       439       5.36 %     89,165       506       2.25 % Total interest-earning assets   $ 1,581,042     $ 14,908       3.74 %   $ 1,697,254     $ 13,387       3.13 % Interest-bearing liabilities:                                                 Interest-bearing demand deposits   $ 799,772     $ 4,358       2.16 %   $ 936,368     $ 686       0.29 % Savings deposits     192,702       226       0.47 %     217,637       36       0.07 % Time deposits     163,476       1,452       3.52 %     78,198       31       0.16 % Borrowings     207       3       5.75 %     -       -       -   Total interest-bearing liabilities   $ 1,156,157     $ 6,039       2.07 %   $ 1,232,203     $ 753       0.24 % Net interest income and interest rate spread           $ 8,869       1.67 %           $ 12,634       2.89 % Net yield on average interest‑earning assets                     2.23 %                     2.95 %       Nine Months Ended September 30,       2023     2022       Average Balance     Interest     Average Yield/Rate     Average Balance     Interest     Average Yield/Rate   Interest-earning assets:                                                 Loans (1)(3)(4)(5)   $ 850,543     $ 29,068       4.57 %   $ 829,133     $ 25,484       4.11 % Taxable securities (6)(7)     657,575       12,268       2.49 %     662,824       8,847       1.78 % Nontaxable securities (1)(6)     65,649       1,425       2.90 %     75,806       1,728       3.05 % Interest-bearing deposits     31,435       1,207       5.13 %     97,917       757       1.03 % Total interest-earning assets   $ 1,605,202     $ 43,968       3.66 %   $ 1,665,680     $ 36,816       2.96 % Interest-bearing liabilities:                                                 Interest-bearing demand deposits   $ 834,575     $ 10,846       1.74 %   $ 911,926     $ 1,839       0.27 % Savings deposits     200,170       506       0.34 %     216,691       111       0.07 % Time deposits     131,398       2,865       2.92 %     79,981       105       0.18 % Borrowings     8,287       300       4.84 %     -       -       -   Total interest-bearing liabilities   $ 1,174,430     $ 14,517       1.65 %   $ 1,208,598     $ 2,055       0.23 % Net interest income and interest rate spread           $ 29,451       2.01 %           $ 34,761       2.73 % Net yield on average interest‑earning assets                     2.45 %                     2.79 %   (1) Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 21%. (2) Included in interest income are loan fees of $56 and $82 for the three months ended September 30, 2023 and 2022, respectively. (3) Included interest income are loan fees of $162 and $195 for the nine months ended September 30, 2023 and 2022, respectively. (4) Nonaccrual loans are included in average balances for yield computations. (5) Includes loans held for sale. (6) Daily averages are shown at amortized cost. (7) Includes restricted stock.   39 Table of Contents     The 525 basis point increase in the Federal Reserve’s benchmark interest rate between March 2022 and July 2023 expanded the yield on earning assets when the three months and nine month periods ended September 30, 2023 and September 30, 202 are compared. Many of the Company’s loans are adjustable with repricing dates in the future. If rates remain at the current level or increase, repricing will continue to contribute to improved interest income. The rapidity and magnitude of the Federal Reserve’s rate increases stimulated competition for deposits that resulted in higher cost of funds and compressed net interest margin when results for 2023 are compared with 2022. The Company continuously monitors its deposit base and funding costs. Further information on the Company’s funds management and deposit strategy is discussed under the Deposits section below.   Noninterest Income       Three Months Ended September 30,               2023     2022     Percent Change Service charges on deposits   $ 642     $ 661       (2.87 ) % Other service charges and fees     151       51       196.08 % Credit and debit card fees, net     395       448       (11.83 ) % Trust income     505       492       2.64 % BOLI income     253       239       5.86 % Gain on sale of mortgage loans     22       40       (45.00 ) % Other income     147       209       (29.67 ) % Total noninterest income   $ 2,115     $ 2,140       (1.17 ) %       Nine Months Ended September 30,               2023     2022     Percent Change Service charges on deposits   $ 1,871     $ 1,826       2.46 % Other service charges and fees     253       157       61.15 % Credit and debit card fees, net     1,276       1,423       (10.33 ) % Trust income     1,431       1,374       4.15 % BOLI income     1,771       718       146.66 % Gain on sale of mortgage loans     93       136       (31.62 ) % Gain on sale of investment     2,971       -       100.00 % Other income     771       909       (15.18 ) % Loss on sale of securities     (3,332 )     -       (100.00 ) % Total noninterest income   $ 7,105     $ 6,543       8.59 %   Noninterest income decreased slightly when the three months ended September 30, 2023 are compared with the three months ended September 30, 2022, but increased when the nine month periods are compared. Information on key drivers follows. Service charges on deposits include fees for non-sufficient funds and overdrafts. During the third quarter of 2023, the Company modified its policy to exempt from charge small overdrafts on deposit accounts, and small items that overdraw deposit accounts. The policy change is intended to address recent industry-wide regulatory comments and build goodwill with the Company’s deposit base. The increase from 2022 in other service charges and fees reflected a loan transaction-related fee recorded during the three months ended September 30, 2023. Lower volume in both credit and debit card activity and in mortgage origination decreased the related income, when results for 2023 are compared with those of 2022. During the second quarter of 2023, the Company recognized a gain on the sale of its VISA Class B securities, as well as a gain of $1,037 included in BOLI income above from the settlement of a policy. The Company also recorded a loss on the sale of securities during the second quarter. The sale of securities is discussed in more detail under the Securities section below.   40 Table of Contents     Noninterest Expense       Three Months Ended September 30,               2023     2022     Percent Change Salaries and employee benefits   $ 4,462     $ 4,144       7.67 % Occupancy, furniture and fixtures     547       476       14.92 % Data processing and ATM     978       774       26.36 % FDIC assessment     190       114       66.67 % Net costs of other real estate owned     14       68       (79.41 ) % Franchise taxes     339       375       (9.60 ) % Professional services     251       254       (1.18 ) % Other operating expenses     684       531       28.81 % Total noninterest expense   $ 7,465     $ 6,736       10.82 %       Nine Months Ended September 30,               2023     2022     Percent Change Salaries and employee benefits   $ 13,361     $ 12,133       10.12 % Occupancy, furniture and fixtures     1,500       1,432       4.75 % Data processing and ATM     2,730       2,354       15.97 % FDIC assessment     561       336       66.96 % Net costs of other real estate owned     29       78       (62.82 ) % Franchise taxes     1,072       1,108       (3.25 ) % Professional services     1,555       693       124.39 % Other operating expenses     1,878       1,526       23.07 % Total noninterest expense   $ 22,686     $ 19,660       15.39 %   Noninterest expense increased when the three and nine months ended September 30, 2023 are compared with the same periods of 2022. Information on key drivers follows. The Company increased its base compensation during 2022 in order to attract and retain talent, which is reflected in 2023 salaries and employee benefits expense. Occupancy, furniture and fixtures expense includes annual increases to lease expense based upon inflation measures and also higher depreciation and utilities expense. Data processing and ATM expense reflects support for new products and investment in new technology. FDIC insurance expense increased due to an increase in the FDIC’s general assessment rate from 2022 to 2023. Professional services include legal and other expenses for the Company’s response to a threatened proxy contest from an activist shareholder during 2023, which amounted to $768 for the nine months ended September 30, 2023. The Company does not anticipate any further material expense for this matter. Pension non-service cost, which is included in other operating expense, increased $87 and $261, respectively, when three and nine month periods ended September 30, 2023 and September 30, 2022 are compared. The expense is determined by actuarial calculations.   Income Tax   The Company’s effective tax rate was 16.72% and 18.43% for the three month periods ended September 30, 2023 and 2022, respectively. For the nine months ended September 30, 2023 and 2022, the Company’s effective tax rate was 15.47% and 17.95%, respectively. The Company’s effective tax rate is lower than the statutory rate of 21% due to investments in tax-advantaged loans and securities, and in 2023, the gain from settlement of a BOLI policy.   41 Table of Contents     Asset Quality   Key indicators of the Company’s asset quality are presented in the following table.       September 30, 2023     September 30, 2022     December 31, 2022   Nonaccrual loans   $ 2,981     $ 2,888     $ 2,847   Loans past due 90 days or more, and still accruing     31       48       8   Other real estate owned     662       907       662   ACLL to loans net of unearned income and deferred fees and costs     1.20 %     0.96 %     0.96 % Net charge-off ratio     0.00 %     0.03 %     0.02 % Ratio of nonperforming assets to loans, net of unearned income and deferred fees and costs, plus other real estate owned     0.43 %     0.44 %     0.41 % Ratio of ACLL to nonperforming loans     341.53 %     284.18 %     288.90 %   The Company adopted the CECL model on January 1, 2023, resulting in an increase to the Allowance for Credit Losses for Loans (“ACLL”) of $2,342, from $8,225 at December 31, 2022. For information on the Company’s policies on the ACLL, please refer to Note 1: General of this Form 10-Q. For information on the Company’s application of previous GAAP in determining the allowance for loan losses, please refer to the Company’s 2022 Form 10-K, Note 1: Summary of Significant Accounting Policies. The Company’s risk analysis under the CECL model at September 30, 2023 determined an ACLL of $10,181, or 1.20% of loans net of unearned income and deferred fees and costs. This compares with an allowance of $8,225 as of December 31, 2022, or 0.96% of loans. The allowance for loan losses at September 30, 2022 was $8,207 or 0.96% of loans. To determine the appropriate level of the ACLL, the Company considers credit risk for individually evaluated loans and for groups of loans evaluated collectively.   Individually Evaluated Loans Individually evaluated loans were $10,658 as of September 30, 2023, an increase from $3,032 as of December 31, 2022. The increase was due to a change in the way that the Company identifies individually evaluated loans under CECL. Please refer to Note 1: General for information on the Company’s identification of individually evaluated loans. As of September 30, 2023, one individually evaluated loan was collateral dependent but was adequately collateralized and did not result in an individual allocation. The remaining individually evaluated loans were measured using the DCF method, resulting in an allocation of $875.   Collectively Evaluated Loans Collectively evaluated loans totaled $838,759, with an ACLL of $9,306 as of September 30, 2023. At December 31, 2022, collectively evaluated loans totaled $850,161, with an allowance of $8,225. Collectively evaluated loans are divided into pools based upon risk characteristics. Utilizing historical loss information, the Company calculates a probability of default and loss given default for each pool, which is adjusted for a reasonable and supportable forecast. Loan pools are allocated additional loss estimates based upon the Company’s analysis of qualitative factors including economic measures, asset quality indicators, loan characteristics, and changes to internal Company policies and management.   Reasonable and Supportable Forecast To estimate cash flows, the Company adjusted its historical loss information with a forecast of the national unemployment rate. The forecast applied at September 30, 2023 projects that unemployment will rise over the next 12 months, which increases the loss estimate. The Company determined that 12 months represents a reasonable and supportable forecast period as of September 30, 2023, and set a period of 12 months to revert to historical losses on a straight-line basis.   Qualitative Factors: Economic The Company sources economic data pertinent to its market from the most recently available publications, including business and personal bankruptcy filings, the residential vacancy rate and the inventory of new and existing homes. Higher bankruptcy filings indicate heightened credit risk and increase the ACLL, while lower bankruptcy filings have a beneficial impact on credit risk. Compared with data available at December 31, 2022, business and personal bankruptcy filings increased. Residential vacancy rates and housing inventory impact the Company’s residential construction customers and the consumer real estate market. Higher levels increase credit risk. The residential vacancy rate available at September 30, 2023 improved from the data incorporated into the December 31, 2022 calculation, resulting in a lower allocation. Housing data available as of September 30, 2023 showed higher inventory than at December 31, 2022, resulting in a higher allocation.   42 Table of Contents     Qualitative Factors: Asset Quality Indicators Accruing past due loans are analyzed at the class level and compared with previous levels. Increases in past due loans indicate heightened credit risk. Accruing loans past due 30-89 days were 0.14% of total loans at September 30, 2023, a decrease from 0.16% at December 31, 2022.   Qualitative Factors: Other Considerations The Company considers other factors that impact credit risk, including the interest rate environment, the competitive, legal and regulatory environments, changes in lending policies and loan review, changes in lending management, and high risk loans. The interest rate environment impacts variable rate loans. The Federal Reserve’s aggressive interest rate increases beginning in March 2022 have increased payments on certain adjustable rate loans, which may increase credit risk. The Company allocates additional reserve each time the Federal Reserve increases rates. After the rate increase has been in effect for one year, the allocation may be removed under the assumption that the impact of the change has become integrated to the portfolio. For the calculation as of September 30, 2023, the Company removed allocations for interest rate increases that occurred between March and September 2022. The competitive, legal and regulatory environments were evaluated for changes that would affect credit risk. Higher competition for loans increases credit risk, while lower competition decreases credit risk. Competition remained at similar levels to those at December 31, 2022. The legal and regulatory environments also remain in a similar posture to December 31, 2022. Lending policies, loan review procedures and management’s experience influence credit risk. Except for the adoption of CECL, policies and procedures remain similar to those at December 31, 2022. The Company added an allocation for the retirement of a long term credit administration manager. Levels of high risk loans are considered in the determination of the level of the ACLL. A decrease in the level of high risk loans within a class decreases the required allocation for the loan class, and an increase in the level of high risk loans within a class increases the required allocation for the loan class. Total high risk loans increased from the level at December 31, 2022, resulting in an increased allocation.   Unallocated Surplus The unallocated surplus as of September 30, 2023 is $485, or 5.00% in excess of the calculated requirement. The unallocated surplus at December 31, 2022 was $179, or 2.23% in excess of the calculated requirement. The surplus provides some mitigation of current economic uncertainty that may impact credit risk.   Conclusion The calculation of the appropriate level for the ACLL incorporates analysis of multiple factors and requires management’s prudent and informed judgment. The Company augmented the calculated requirement with an unallocated surplus. Based on analysis of historical indicators, asset quality and economic factors, management believes the level of ACLL is reasonable for the credit risk in the loan portfolio as of September 30, 2023.   (Recovery of) Provision for Credit Losses   The calculation of the ACLL resulted in a recovery of previously recognized provision of $401 for the three month period ended September 30, 2023, compared with a provision of $252 for the three month period ended September 30, 2022. The recovery for the nine month period ended September 30, 2023 was $389, compared with provision of $696 for the nine months ended September 30, 2022. The recovery in 2023 reflected reversal of allocations for interest rate increases taken in 2022, forecast projections for lower unemployment than that forecasted at December 31, 2022, a slight decrease in total loans, and changes in factors detailed in “Asset Quality” above.   Loan Modifications   In the ordinary course of business the Company modifies loan terms on a case-by-case basis for a variety of reasons. Modifications may include rate reductions, payment extensions of varying lengths of time, a change in amortization term or method or other arrangements. Modifications to consumer loans generally involve short-term payment extensions to accommodate specific, temporary circumstances. Modifications to commercial loans may include, but are not limited to, changes in interest rate, maturity, amortization and financial covenants. The Company reviews modifications to determine whether the borrower is experiencing financial difficulty, including indicators of default, bankruptcy, going concern, insufficient projected cash flows and inability to obtain financing from other sources. If a modification is made to a borrower experiencing financial difficulty, the loan’s risk rating is downgraded to special mention or classified, resulting in individual evaluation for the ACL. During the nine months ended September 30, 2023, the Company modified one loan totaling $6,396 for a borrower who was experiencing financial difficulty. The loan was individually evaluated for the ACLL as of September 30, 2023.   43 Table of Contents     Modifications for Borrowers Who Were Not Experiencing Financial Difficulty During the three and nine month periods ended September 30, 2023 and 2022, the Company modified loans in the normal course of business for borrowers who were not experiencing financial difficulty. During the three months ended September 30, 2023, the Company modified 186 loans totaling $23,054. During the nine months ended September 30, 2023, the Company modified 581 loans totaling $65,089. During the three months ended September 30, 2022, the Company provided 187 modifications to loans totaling $27,389. For the nine months ended September 30, 2022, the Company provided 652 modifications to loans totaling $101,347.   Other Real Estate Owned   As of September 30, 2023, OREO of $662 is comprised of one construction property. One loan secured by real estate of $7 was in process of foreclosure, which may increase OREO in future quarters. It is not possible to accurately predict the future total of OREO because property sold at foreclosure may be acquired by third parties and OREO properties are regularly marketed and sold. The Company continues to monitor risk levels within the loan portfolio. If the Company’s market experiences an economic downturn, real estate values could decline and foreclosure activity could increase. A decline in value may result in loss recognition for OREO, while an increase in foreclosures may increase the number of OREO properties.   Key Assets and Liabilities   NBI’s key assets and liabilities and their change from December 31, 2022 are shown in the following table.       September 30, 2023     December 31, 2022     Percent Change   Interest-bearing deposits   $ 40,353     $ 59,026       (31.64 ) % Securities available for sale, at fair value     591,552       656,852       (9.94 ) % Loans, net     838,794       844,519       (0.68 ) % Total assets     1,591,902       1,677,551       (5.11 ) % Deposits     1,465,000       1,542,725       (5.04 ) %   Average Balances   Year-to-date daily averages for the major balance sheet categories are as follows:   Assets   September 30, 2023     December 31, 2022     Percent Change Interest-bearing deposits   $ 31,435     $ 88,963       (64.67 ) % Securities available for sale, at fair value     627,908       683,183       (8.09 ) % Loans, net     839,764       825,110       1.78 % Total assets     1,614,757       1,705,614       (5.33 ) %                           Liabilities and stockholders ’ equity                         Noninterest-bearing demand deposits   $ 302,568     $ 338,269       (10.55 ) % Interest-bearing demand deposits     834,575       910,989       (8.39 ) % Savings deposits     200,170       216,414       (7.51 ) % Time deposits     131,398       77,686       69.14 % Stockholders’ equity     126,792       145,641       (12.94 ) %   Increased competition resulted in decreased customer deposits and reduced the funds available for the Company to invest in interest bearing deposits. Changes in securities, loans, deposits and stockholders’ equity are discussed below.   44 Table of Contents     Securities       September 30, 2023     December 31, 2022     Percent Change   Amortized cost   $ 702,083     $ 759,917       (7.61 ) % Unrealized loss     (110,531 )     (103,065 )     (7.24 ) % Securities available for sale, at fair value   $ 591,552     $ 656,852       (9.94 ) %   As part of its interest rate risk management, the Company periodically evaluates its position in financial assets. During the first half of 2023, the Company strategically selected and sold securities with an amortized cost of $46,850, realizing a loss of $3,332. The strategy for the sales prioritized enhancement of long-term earnings. Though not a primary objective, proceeds from the sales also bolstered liquidity. There were no sales of securities during 2022. Securities available for sale are presented at fair value as of each reporting date. Most of the Company’s securities were purchased during periods prior to the Federal Reserve’s interest rate increases that began in March of 2022. The fair value of bonds moves inversely to interest rate changes, as well as expectations of interest rate changes. The Company’s Asset Liability Management Committee is closely monitoring interest rate risk on all of the Company’s financial assets and liabilities. At this time, there are no credit risk concerns on securities available for sale and no associated ACL. Please refer to Note 1: General and Note 3: Securities for additional information.   Loans       September 30, 2023     December 31, 2022     Percent Change   Real estate construction   $ 64,181     $ 54,579       17.59 % Consumer real estate     226,671       221,052       2.54 % Commercial real estate     424,765       437,888       (3.00 ) % Commercial non real estate     42,940       57,652       (25.52 ) % Public sector and IDA     51,591       48,074       7.32 % Consumer non real estate     39,269       33,948       15.67 % Less: unearned income and deferred fees and costs     (442 )     (449 )     (1.56 ) % Loans, net of unearned income and deferred fees and costs   $ 848,975     $ 852,744       (0.44 ) %   Loans decreased slightly from December 31, 2022, as higher interest rates decreased demand. The Company is positioned to continue to make every loan that meets its underwriting standards.   Deposits       September 30, 2023     December 31, 2022     Percent Change Noninterest-bearing demand deposits   $ 303,166     $ 327,713       (7.49 ) % Interest-bearing demand deposits     789,148       933,269       (15.44 ) % Saving deposits     184,801       214,114       (13.69 ) % Time deposits     187,885       67,629       177.82 % Total deposits   $ 1,465,000     $ 1,542,725       (5.04 ) %   Competition for deposits began impacting the Company during the latter part of 2022 and has continued during 2023. The Company implemented competitive pricing on CDs, raised offering rates on other deposits and negotiated with depositors to strengthen the deposit base, at costs well below the cost of borrowing. The Company’s depositors within its market area are diverse, including individuals, businesses and municipalities. The Company does not have any brokered deposits. Depositors are insured up to the FDIC maximum of $250 thousand. Municipal deposits, which account for approximately 24% of the Company’s deposits, have additional security from bonds pledged as collateral, in accordance with state regulation. Of the Company’s non-municipal deposits, approximately 20% are uninsured.   45 Table of Contents     Capital Resources       September 30, 2023     December 31, 2022     Percent Change Common stock and additional paid in capital   $ 7,383     $ 7,362       0.29 % Retained earnings     198,394       199,091       (0.35 ) % Accumulated other comprehensive loss     (89,664 )     (83,766 )     (7.04 ) % Total stockholders’ equity   $ 116,113     $ 122,687       (5.36 ) %   The decrease in stockholders’ equity reflects an increase in the unrealized loss on securities available for sale, the adoption of CECL at January 1, 2023, payment of a special one-time cash dividend and the Company’s normal semi-annual dividend, partially offset by net income for the nine months ended September 30, 2023. The Company’s stockholders approved a new equity compensation plan at the annual meeting held in May 2023. Under the plan, part of the June 2023 semi-annual retainer for non-employee directors was paid in a restricted stock grant. The equity compensation plan aims to align decision making with long-term value creation for the Company’s shareholders. The Company qualifies as a small bank holding company under the Federal Reserve’s Small Bank Holding Company Policy Statement, which exempts bank holding companies with less than $3 billion in assets from reporting consolidated regulatory capital ratios and from minimum regulatory capital requirements. NBB is subject to various capital requirements administered by banking agencies, including an additional capital conservation buffer in order to make capital distributions or discretionary bonus payments. Risk-based capital ratios are calculated in compliance with OCC rules based on the Basel III Capital Rules. The Bank’s ratios are well above the required minimums as of September 30, 2023. Risk based capital ratios for NBB are shown in the following tables.       NBB     Regulatory Capital Minimum Ratios     Regulatory Capital Minimum Ratios with Capital Conservation Buffer   Common Equity Tier I Capital Ratio     17.83 %     4.50 %     7.00 % Tier I Capital Ratio     17.83 %     6.00 %     8.50 % Total Capital Ratio     18.79 %     8.00 %     10.50 % Leverage Ratio     11.71 %     4.00 %     4.00 %   Liquidity   Liquidity measures the Company’s ability to meet its financial commitments at a reasonable cost. Demands on the Company’s liquidity include funding additional loan demand and accepting withdrawals of existing deposits. The Company has diverse liquidity sources, including customer and purchased deposits, customer repayments of loan principal and interest, sales, calls and maturities of securities, Federal Reserve discount window borrowing, short-term borrowing, and FHLB advances. Periodically during 2023, the Company accessed FHLB borrowings to reinforce liquidity. The advances were fully repaid, due to the success of the Company’s deposit strategy. As of September 30, 2023, the Company did not have purchased deposits, discount window borrowings or short-term borrowings. The Company considers its security portfolio for typical liquidity needs, within accounting, legal and strategic parameters. Portions of the securities portfolio are pledged to meet state requirements for public funds deposits. Discount window borrowings also require pledged securities. Increased/decreased liquidity from public funds deposits or discount window borrowings results in increased/decreased liquidity from pledging requirements. The Company monitors public funds pledging requirements and unpledged available for sale securities accessible for liquidity needs. Regulatory capital levels determine the Company’s ability to use purchased deposits and the Federal Reserve discount window. As of September 30, 2023, the Company is considered well capitalized and does not have any restrictions on purchased deposits or borrowing ability at the Federal Reserve discount window. As of September 30, 2023, the Company had $301,515 of borrowing capacity from the FHLB and an unsecured federal funds line of credit with an unaffiliated bank of $10,000, with no amounts advanced against those lines. Additionally, the Company had $176,210 of unused capacity at the Federal Reserve Bank discount window. The Company monitors factors that may increase its liquidity needs. Some of these factors include deposit trends, large depositor activity, maturing deposit promotions, interest rate sensitivity, maturity and repricing timing gaps between assets and liabilities, the level of unfunded loan commitments and loan growth. As of September 30, 2023, the Company’s liquidity is sufficient to meet projected trends. To monitor and estimate liquidity levels, the Company performs stress testing under varying assumptions on credit sensitive liabilities and the sources and amounts of balance sheet and external liquidity available to replace outflows. The Company’s Contingency Funding Plan sets forth avenues for rectifying liquidity shortfalls. As of September 30, 2023, the analysis indicated adequate liquidity under the tested scenarios.   46 Table of Contents     The Company utilizes several other strategies to maintain sufficient liquidity. Loan and deposit growth are managed to keep the loan to deposit ratio within the Company’s internally-set target range. As of September 30, 2023, the loan to deposit ratio was 57.95%. The investment strategy takes into consideration the term of the investment, and securities in the available for sale portfolio are laddered based upon projected funding needs.   Off-Balance Sheet Arrangements   In the normal course of business, NBB extends lines of credit and letters of credit to its customers. Depending on their needs, customers may draw upon lines of credit at any time in any amount up to a pre-approved limit. Financial letters of credit guarantee payments to facilitate customer purchases. Performance letters of credit guarantee payment if the customer fails to complete a specific obligation. While it would be possible for customers to fully draw on approved lines of credit and for beneficiaries to call all letters of credit, historically this has not occurred. In the event of a sudden and substantial draw on these lines, the Company would be able to access multiple options, including its lines of credit with correspondents, raising additional deposits, or selling securities available for sale or loans. The Company estimates an ACL on unfunded loan commitments under the CECL model. The Company sells mortgages on the secondary market. Our agreement with the purchaser provides for strict underwriting and documentation requirements. Violation of the representations and warranties of the agreement would entitle the purchaser to recourse provisions. The Company has determined that its risk in this area is not significant because of a low volume of secondary market mortgage loans and high underwriting standards. The Company estimates a potential loss reserve for recourse provisions that is not material as of September 30, 2023. To date, no recourse provisions have been invoked. If funds were needed, the Company would access the same sources as noted above for funding lines and letters of credit. There were no material changes in off-balance sheet arrangements during the nine months ended September 30, 2023.   Contractual Obligations   The Company had no finance lease or purchase obligations and no long-term debt at September 30, 2023.   Item 3.   Quantitative and Qualitative Disclosures About Market Risk   Not applicable.   Item 4.   Controls and Procedures   The Company’s management evaluated, with the participation of the Company’s principal executive officer and principal financial officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e)) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this report. Based on that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective as of September 30, 2023 to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the Company's management, including the Company's principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the three months ended September 30, 2023, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Because of the inherent limitations in all control systems, the Company believes that no system of controls, no matter how well designed and operated, can provide absolute assurance that all control issues have been detected.   47 Table of Contents     Part II Other Information   Item 1.    Legal Proceedings   There are no pending or threatened legal proceedings to which the Company or any of its subsidiaries is a party or to which the property of the Company or any of its subsidiaries is subject that, in the opinion of management, may materially impact the financial condition of the Company.