QNB CORP. 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS QNB Corp. is a bank holding company headquartered in Quakertown, Pennsylvania. QNB Corp., through its wholly-owned subsidiary, the Bank, has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. Due to its limited geographic area, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services. The consolidated entity is referred to herein as “QNB” or the “Company”. Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars. FORWARD-LOOKING STATEMENTS In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference. Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, and including the risk factors identified in Item 1A of QNB’s 2020 Form 10-K, could affect the future financial results of QNB Corp. and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following: • Volatility in interest rates and shape of the yield curve; • Credit risk; • Liquidity risk; • Operating, legal and regulatory risks; • Economic, political and competitive forces affecting QNB’s business; • The effects of unforeseen external events, including acts of terrorism, natural disasters, and pandemics, including the COVID-19 Pandemic; and • The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful. QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment 36 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS securities, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Other-Than-Temporary Investment Security Impairment Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, it indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities that do not have readily-determinable fair values, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced and a corresponding charge to earnings is recognized. There were no other-than-temporary impairment charges recorded during the quarter ended March 31, 2021 and 2020, respectively. The Company follows accounting guidance related to the recognition and presentation of other-than-temporary impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. There were no credit-related other-than-temporary impairment charges in the quarter ended March 31, 2021 or 2020, respectively. Allowance for Loan Losses The determination of the allowance for loan losses involves a higher degree of judgment and complexity than the Company’s other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management. The allowance for loan losses is based on management’s continual review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral or present value of future estimated cash flows. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, delinquency and loss experience, as well as other qualitative factors such as current economic trends. Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of collection. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of 37 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Foreclosed Assets Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets. Stock-Based Compensation QNB sponsors stock-based compensation plans, administered by a Board committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation . Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimates the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature. Income Taxes QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes . Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term. RESULTS OF OPERATIONS - OVERVIEW QNB reported net income for the first quarter of 2021 of $5,050,000, or $1.42 per share on a diluted basis, compared to net income of $220,000, or $0.06 per share on a diluted basis, for the same period in 2020. The Bank contributed $4,038,000 to net income for the first quarter of 2021 compared to $2,316,000 for the first quarter of 2020; and the holding company contributed $1,012,000 to net income to the first quarter of 2021 compared to a net loss of $2,096,000 for the first quarter of 2020. The results at the holding company are due primarily to the change in the fair value of the equity portfolio during the quarters. Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 1.40% and 15.70%, respectively, for the quarter ended March 31, 2021 compared with 0.07% and 0.73%, respectively, for the quarter ended March 30, 2020. Total assets as of March 31, 2021 were $1,570,519,000, compared with $1,440,229,000 at December 31, 2020. Loans receivable at March 31, 2021 were $945,645,000, compared with $920,042,000 at December 31, 2020, an increase of $25,603,000, or 2.8%, with commercial lending as the largest contributor to the growth. QNB participates in the Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”). In 2020, the Bank originated $82,475,000 in PPP loans, enabling 660 businesses to maintain their payrolls and stay in operation. Of this first round of funding, 365 loans have been forgiven in full and $37,293,000 in balances have been forgiven. The Bank originated 251 PPP loans, or $30,706,000 during the second round of funding which started in January 2021. Excluding PPP loans net of deferred fees, loans receivable at March 31, 2021 would have increased $22,926,000, or 2.7%, since year-end 2020. Total deposits of $1,341,616,000 at March 31, 2021 increased $113,549,000, or 9.2%, compared with total deposits of $1,228,067,000 at December 31, 2020. Most of the PPP loans proceeds were deposited to deposit accounts at the Bank. 38 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results for the three months ended March 31, 2021 include the following significant components: • Net interest income increased $1,354,000, or 14.8%, to $10,517,000 for the three months ended March 31, 2021. • Net interest margin on a tax-equivalent basis decreased eleven basis points for the quarter to 3.07%. • QNB recorded $275,000 in provision for loan losses for the three months ended March 31, 2021, compared with $500,000 for the same period in 2020. • Non-interest income increased $4,975,000, to $3,404,000 for the three months ended March 31, 2021 compared with the same period in 2020. Excluding realized and unrealized gains (losses) on equity securities, non-interest income increased $600,000, or 43.8%, to $1,969,000 for the three months ended March 31, 2021 compared with the same period in 2020. • Non-interest expense increased $45,000, or 0.6%, to $7,323,000 for the three months ended March 31, 2021 compared to the same period in 2020. • Total non-performing loans were $13,266,000, or 1.40% of loans receivable at March 31, 2021, compared to $14,109,000, or 1.53% of loans receivable at December 31, 2020. Loans on non-accrual status were $8,887,000 at March 31, 2021 compared with $9,640,000 at December 31, 2020. Net loan recoveries for the three months ended March 31, 2021 were $14,000, compared with $53,000 in charge-offs for the same period in 2020. These items, as well as others, are explained more thoroughly in the next sections. NET INTEREST INCOME QNB earns its net income primarily through the Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. Management seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors. The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three-month periods ended March 31, 2021 and 2020. For the Three Months Ended March 31, 2021 2020 Total interest income $ 11,731 $ 11,331 Total interest expense 1,214 2,168 Net interest income 10,517 9,163 Tax-equivalent adjustment 162 176 Net interest income (fully taxable-equivalent) $ 10,679 $ 9,339 Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank (Fed) and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest-bearing deposits. For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared. The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company. 39 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis) Three Months Ended March 31, 2021 March 31, 2020 Average Average Average Average Balance Rate Interest Balance Rate Interest Assets Investment securities (AFS & Equity): U.S. Government agencies $ 70,229 1.02 % $ 178 $ 56,163 1.86 % $ 261 State and municipal 93,723 2.59 608 54,445 3.43 467 Mortgage-backed and CMOs 262,937 1.30 856 217,020 2.07 1,125 Pooled trust preferred securities 84 2.51 1 85 4.15 1 Corporate debt securities 7,158 3.72 67 8,007 3.65 73 Equities 13,159 3.26 106 11,352 3.26 92 Total investment securities 447,290 1.62 1,816 347,072 2.33 2,019 Loans: Commercial real estate 530,672 4.34 5,680 478,146 4.76 5,661 Residential real estate 88,506 3.50 775 69,858 3.95 690 Home equity loans 58,738 3.47 502 64,222 4.18 667 Commercial and industrial 228,337 5.00 2,814 165,171 4.87 2,000 Consumer loans 5,333 4.91 65 6,440 5.57 89 Tax-exempt loans 25,075 3.57 221 38,003 3.60 341 Total loans, net of unearned income* 936,661 4.35 10,057 821,840 4.62 9,448 Other earning assets 28,562 0.29 20 11,461 1.41 40 Total earning assets 1,412,513 3.41 11,893 1,180,373 3.92 11,507 Cash and due from banks 26,844 13,769 Allowance for loan losses (10,935 ) (9,951 ) Other assets 38,098 37,296 Total assets $ 1,466,520 $ 1,221,487 Liabilities and Shareholders' Equity Interest-bearing deposits: Interest-bearing demand $ 281,728 0.21 % 148 $ 226,307 0.41 % 231 Municipals 112,550 0.32 90 105,725 1.33 349 Money market 105,556 0.31 82 79,567 0.74 147 Savings 354,018 0.33 290 251,445 0.59 368 Time 103,783 1.09 279 118,921 1.56 463 Time of $100,000 or more 84,887 1.10 231 113,231 1.78 501 Total interest-bearing deposits 1,042,522 0.44 1,120 895,196 0.93 2,059 Short-term borrowings 58,086 0.39 55 47,683 0.78 92 Long-term debt 10,000 1.57 39 4,231 1.57 17 Total interest-bearing liabilities 1,110,608 0.44 1,214 947,110 0.92 2,168 Non-interest-bearing deposits 216,293 142,398 Other liabilities 9,146 10,295 Shareholders' equity 130,473 121,684 Total liabilities and shareholders' equity $ 1,466,520 $ 1,221,487 Net interest rate spread 2.97 % 3.00 % Margin/net interest income 3.07 % $ 10,679 3.18 % $ 9,339 Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21 percent for three months ended March 31, 2021 and 2020. Non-accrual loans are included in earning assets. * Includes loans held-for-sale 40 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume. For the Three Months Ended March 31, 2021 compared to March 31, 2020 Total Due to change in: Change Volume Rate Interest income: Investment securities (AFS & Equity): U.S. Government agencies $ (83 ) $ 64 $ (147 ) State and municipal 141 337 (196 ) Mortgage-backed and CMOs (269 ) 238 (507 ) Pooled trust preferred securities — — — Corporate debt securities (6 ) (7 ) 1 Equities 14 14 — Total Investment securities (AFS & Equity) (203 ) 646 (849 ) Loans: Commercial real estate 19 569 (550 ) Residential real estate 85 184 (99 ) Home equity loans (165 ) (62 ) (103 ) Commercial and industrial 814 742 72 Consumer loans (24 ) (15 ) (9 ) Tax-exempt loans (120 ) (118 ) (2 ) Total Loans 609 1,300 (691 ) Other earning assets (20 ) 59 (79 ) Total interest income 386 2,005 (1,619 ) Interest expense: Interest-bearing deposits: Interest-bearing demand (83 ) 54 (137 ) Municipals (259 ) 19 (278 ) Money market (65 ) 47 (112 ) Savings (78 ) 145 (223 ) Time (184 ) (62 ) (122 ) Time of $100,000 or more (270 ) (128 ) (142 ) Total interest-bearing deposits (939 ) 75 (1,014 ) Short-term borrowings (37 ) 19 (56 ) Long-term debt 22 22 — Total interest expense (954 ) 116 (1,070 ) Net interest income $ 1,340 $ 1,889 $ (549 ) Net Interest Income and Net Interest Margin – Quarterly Comparison Average earning assets for the first quarter of 2021 were $1,412,513,000, an increase of $232,140,000, or 19.7%, from the first quarter of 2020, with average loans increasing $114,821,000, or 14.0%, and average investment securities increasing $100,218,000, or 28.9%, over the same period. Excess cash from deposit growth was deployed to the securities portfolio, which earns a better yield than Fed Funds or deposits at the Federal Reserve Bank. Average loans as a percent of average earning assets were 66.3% for the first quarter of 2021, compared with 69.6% for the first quarter of 2020. On the funding side, average deposits increased $221,221,000, or 21.3%, to $1,258,815,000 for the first quarter of 2021 primarily due to growth in non-interest-bearing and interest-bearing demand, money market and savings deposits. Customers continue to reinvest funds into more liquid accounts. Average short-term borrowed funds for the first quarter of 2021 increased $10,403,000, to $58,086,000, which consisted entirely of average commercial repurchase 41 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS agreements during the first quarter of 202 1 . For the same period in 20 20 , borrowings consisted of average commercial repurchase agreements of $ 40 , 695, 000 and average overnight borrowings of $ 6,988 ,000 . The net interest margin for the first quarter of 2021 decreased 11 basis points to 3.07% from 3.18% at the same period in 2020. While competition for quality loans in our local market continues to exert pressure on the net interest margin, the decline in interest rates starting in March 2020 resulted in significantly lower bond yields and prepayments and calls of existing higher-yielding, seasoned investments. The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis increased $386,000, or 3.4%, to $11,893,000 for the first quarter of 2021; total interest expense decreased $954,000, or 44.0%, to $1,214,000. Decreases in rates on earning assets were offset by $744,000 of net deferred origination fees and costs recorded as income on forgiven PPP loans. All categories of interest-bearing deposits experienced lower rates in the first quarter of 2021 compared to first quarter of 2020. The yield on earning assets on a tax-equivalent basis decreased 51 basis points from 3.92% for the first quarter of 2020, to 3.41% for the first quarter of 2021. The cost of interest-bearing liabilities was 0.44% for the first quarter ended March 31, 2021, compared with 0.92% for the same period in 2020. Interest income on investment securities (available-for-sale and equity) decreased $203,000 when comparing the quarters ended March 31, 2021 and 2020. The average yield on the investment portfolio was 1.62% for the first quarter of 2021 compared with 2.33% for the first quarter of 2020. Income on U.S. Government agency securities decreased $83,000 as the rate decreased 84 basis points, partially offset by an increase in average balances of $14,066,000. Interest income on municipal securities, which are primarily tax-exempt, increased due to a $39,278,000 increase in average balances, partially offset by an 84 basis-point decrease in rates. Proceeds from matured, called securities and proceeds from deposits were invested back into the U.S. Government agency, municipal and mortgage-backed securities portfolios. Typically, QNB purchases municipal bonds with 10-20-year maturities and may have call dates between 2-10 years. Interest income on mortgage-backed securities and CMOs decreased $269,000 due to a 77-basis point decline in yield partially offset by a $45,917,000 increase in average balances. This portfolio generally provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested as interest rates increase. Since most of these securities were purchased at a premium, any prepayments result in a shorter amortization period of this premium and therefore a reduction in income. Income on loans increased $609,000 to $10,057,000 when comparing the first quarters of 2021 and 2020, with a 14.0% growth in average balances contributing an increase in interest income of $1,300,000. The yield on loans, at 4.35%, was 27 basis points lower than the first quarter of 2020, contributing to a $691,000 decrease in interest income. Falling interest rates as well as competitive pressures compressed the yields on new loans being originated. The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans increased $19,000 when comparing the first quarters of 2021 and 2020, primarily due to increased average balances of $52,526,000, or 11.0%, offset in part by a 42-basis point decrease in rate from 4.76% in 2020 to 4.34% in 2021. Income on commercial and industrial loans increased $814,000 when comparing the first quarters of 2021 and 2020. The average yield on these loans increased 13 basis points to 5.00% resulting in an increase in income of $72,000; average balances increased $63,166,000, to $228,337,000 for the first quarter of 2021 resulting in an $742,000 increase in interest income. Many of the loans in this category are indexed to the prime interest rate, which decreased a total of 150 basis points in March 2020. Included in this category are the PPP loans which contributed $70,516,000 of the net volume increase. The PPP loans yield one percent to the customer, however QNB received origination fees from the SBA ranging from a flat fee of $2,500 to one to five basis points. The accretion of SBA origination fees is accelerated upon forgiveness of the loan. The yield on PPP loans was 6.57% for the first quarter of 2021. 42 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tax- exempt loan income was $ 221 ,000 for the first quarter of 2021 , a de crease of $ 120 ,000 , or 35.2% , from the same period in 2020 . Average balances de creased $ 12 , 928 ,000, or 34.0 %, to $ 25 , 075 ,000 for the first quarter of 2021 , resulting in a de crease of $ 118 ,000 in income. The yield on municipal loans de creased three basis points, to 3.57 % for the first quarter of 2021 , compared with the same period in 2020 , resulting in a de crease of $ 2 , 000 in interest income. The decrease in volume during 2021 was a result of municipal loans being refinanced as bonds. QNB desires to be the “local consumer lender of choice”, focusing its retail lending efforts on product offerings and marketing and promotion. Interest income on residential mortgage loans secured by first lien 1-4 family increased $85,000 when comparing the first quarter of 2021 to the same period in 2020. Average residential mortgage loan balances increased by $18,648,000, or 26.7%, to $88,506,000 for the first quarter of 2021 compared to the same period in 2020, which contributed a $184,000 increase in interest income. However, the average yield on the portfolio decreased 45 basis points to 3.50% for the first quarter of 2021, which resulted in a $99,000 decrease. QNB chose to retain certain mortgage loans instead of selling them in the secondary market, as the yield on our originated mortgages was higher than comparable mortgage backed securities. Average home equity loans decreased by $5,484,000, or 8.5%, to $58,738,000 and the average yield decreased 71 basis points to 3.47% resulting in a combined decrease in interest income of $165,000. The yield on the consumer portfolio decreased 66 basis points to 4.91% for the first quarter of 2021 and there was a $1,107,000 decrease in average balances resulting in a combined $24,000 decrease in interest income. Earning assets are funded by deposits and borrowed funds. Interest expense decreased $954,000, when comparing the first quarter of 2021 to the same period in 2020. The growth in average deposits continues to be centered in accounts with greater liquidity, such as non-interest and interest-bearing demand deposits. Average non-interest-bearing demand accounts increased $73,895,000, or 51.9%, to $216,293,000 for the first quarter of 2021. Average interest-bearing demand accounts increased $55,421,000, or 24.5%, to $281,728,000 for the first quarter of 2021. Interest expense on interest-bearing demand accounts decreased $83,000 to $148,000 for the same period, as the average rate paid decreased 20 basis points to 0.21% for the first quarter 2021. Included in this category is QNB-Rewards checking, a higher-rate checking account product that pays 1.00% on balances up to $25,000 and 0.20% for balances over $25,000. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 check card purchase transactions post and clear per statement cycle. For the first quarter of 2021, the average balance in this product was $89,966,000 and the related interest expense was $79,000 for an average yield of 0.36%. In comparison, the average balance of the QNB-Rewards accounts for the first quarter of 2020 was $65,926,000 and the related interest expense was $98,000 for an average yield of 0.60%. This product also generates fee income through the use of the check card. Interest expense on municipal interest-bearing demand accounts decreased $259,000 to $90,000 for the first quarter of 2021. The average interest rate paid on municipal interest-bearing demand accounts decreased 101 basis points to 0.32% for the first quarter of 2021 and average balances increased $6,825,000, or 6.5%, to $112,550,000. Many of these accounts are indexed to the Federal funds rate with rate floors between 0.25% and 0.50%; therefore the 150-basis point decrease in the Federal funds rate in March 2020, affected the yield of these deposits. Municipal deposits are seasonal in nature and are received during the second and third quarters as tax receipts are collected and are withdrawn over the course of the year. Average money market accounts increased $25,989,000, or 32.7%, to $105,556,000 for the first quarter of 2021 compared with the same period in 2020. Interest expense on money market accounts decreased $65,000 to $82,000, and the average interest rate paid on money market accounts decreased 43 basis points to 0.31% for the first quarter of 2021. Most of the balances in this category are in a product that pays a tiered rate based on account balances. Interest expense on savings accounts decreased $78,000 when comparing the first quarter of 2021 to the first quarter of 2020. The average interest rate paid on savings accounts decreased 26 basis points to 0.33% for the first quarter of 2021. When comparing these same periods, average savings accounts increased $102,573,000, or 40.8%, to $354,018 for the first quarter of 2021 primarily due to increases in the e-Savings product. QNB’s online e-Savings product is the largest category of savings deposits, with average balances for the first quarter of 2021 of $263,038,000 compared to $179,741,000 in the same period of 2020. The average yield paid on these accounts was 0.40% for the first quarter of 2021 and 0.75% for the same period in 2020. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category and average balances in these types of savings accounts increased $19,276,000 when comparing the first quarter of 2021 average to the same period in 2020. Many of the Bank’s maturing time deposits throughout 2020 and into 2021 were deposited to these liquid interest-bearing accounts. Interest expense on time deposits totaled $510,000 for the first quarter of 2021 compared to $964,000 in 2020. Average total time deposits decreased $43,482,000 to $188,670,000 for the first quarter of 2021. As with fixed-rate loans and investment securities, these deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment, 43 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS however, the maturity and repricing characteristics of time deposits tend to be shorter. The average rate paid on total time deposits de creased 57 basis points from 1. 6 7 % to 1. 10 % when comparing the first quarter of 2020 to the same period in 2021 . Approximately $108,426,000, or 60%, of time deposits at March 31, 2021 will mature over the next 12 months. The average rate paid on these time deposits is approximately 0.80%. The yield on the time deposit portfolio may change slightly in the next quarter as short-term time deposits reprice. However, given the short-term nature of these deposits, interest expense may increase if short-term time deposit rates were to increase suddenly or if customers select higher paying time deposits. Short-term borrowings are primarily comprised of sweep accounts structured as repurchase agreements with our commercial customers and overnight FHLB borrowings. Interest expense on short-term borrowings decreased $37,000 for the first quarter of 2021 to $55,000 when compared to the same period in 2020. When comparing these same periods, average balances increased $10,403,000 to $58,086,000, net of a decrease in average FHLB borrowings of $6,988,000 offset by an increase in average repurchase agreement balances of $17,391,000, with a combined 39-basis point decrease in rate. During 2020, QNB borrowed long-term debt of $10,000,000 to lock in borrowing at a low yield. PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. The determination of an appropriate level for the allowance for loan losses is based upon an analysis of the risks inherent in QNB’s loan portfolio. Management, in determining the allowance for loan losses, makes significant estimates and assumptions. Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s estimates of the allowance for loan losses and actual results could differ. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Actual loan losses, net of recoveries, serve to reduce the allowance. Management closely monitors the quality of its loan portfolio and performs a quarterly analysis of the appropriateness of the allowance for loan losses. This analysis considers several relevant factors including specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit. Based on this analysis, QNB recorded $275,000 in provision for loan losses in the three months ended March 31, 2021, compared with $500,000 for the same period in 2020. QNB's allowance for loan losses of $11,115,000 represents 1.18% of loans receivable at March 31, 2021 compared with an allowance for loan losses of $10,826,000, or 1.18% of loans receivable, at December 31, 2020, and $10,334,000, or 1.26% of loans receivable at March 31, 2020. Management believes the allowance for loan losses at March 31, 2021 is adequate as of that date based on its analysis of known and inherent losses in the portfolio. Excluding PPP loans, the allowance level stated as a percent of loans receivable at March 31, 2021 and at December 31, 2020 was 1.27%. Net recoveries were $14,000 for the three months ended March 31, 2021 compared to net charge-offs of $53,000 for the same period in 2020. Charge-offs of approximately $32,000 during the three months ended March 31, 2021 consisted of overdraft charge-offs of $9,000 and student loans of $23,000. These were offset by $46,000 in recoveries comprising $29,000 in repayments from borrowers of previously charged-off credits, and $17,000 related to overdraft recoveries. Annualized net recoveries as a percentage of average loans receivable were 0.01% for the three months ended March 31, 2021 compared with annualized net charge-offs as a percentage of average loans receivable of 0.03% for the same period in 2020. 44 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Non-performing assets were $ 13 , 266 ,000 at March 31, 2021 compared to $ 1 4 , 109 ,000 as of December 31, 2020 and $ 1 5 , 861 ,000 at March 31 , 2020 . Total non-performing loans, which represent loans on non-accrual status, loans past due 90 days or more and still accruing interest and restructured loans, were 1.40 % of loans receivable at March 31, 2021 compared with 1.53 % of loans receivable at December 31, 2020 and 1 . 93 % of loans receivable at March 31 , 2020 . In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. At March 31, 2021 , $ 4,809 ,000, or approximately 54 % of the loans classified as non-accrual are current or past due less than 30 days. Commercial l oans classified as substandard or doubtful totaled $ 21 , 935 ,000, a de crease of $258 , 000, or 1.2 %, from the $ 22 , 193 ,000 reported at December 31, 2020 and a n in crease of $ 6,762 , 000, or 44.6 % , from the $1 5 , 173 ,000 reported at March 31 , 2020 . The increase in classified loans since March 2020 is due to the downgrade of three large credit s, partially offset by repayments on existing substandard loans. QNB had no loans past due 90 days or more and still accruing interest at March 31, 2021, December 31, 2020, or March 31, 2020. Total loans 30 days or more past due, which includes non-accrual loans by actual number of days delinquent, represented 0.60% of loans receivable at March 31, 2021 compared with 0.62% at December 31, 2020 and 1.32% at March 31, 2020. Troubled debt restructured loans, not classified as non-accrual loans or loans past due 90 days or more and accruing, were $4,379,000 at March 31, 2021, compared with $4,469,000 at December 31, 2020, and $4,727,000 at March 31, 2020. There were no newly identified troubled debt restructurings during the three months ended March 31, 2021. QNB had no other real estate owned or repossessed assets at March 31, 2021, December 31, 2020, or March 31, 2020. A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent. 45 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality: March 31, December 31, March 31, 2021 2020 2020 Non-accrual loans $ 8,887 $ 9,640 $ 11,134 Loans past due 90 days or more and still accruing interest — — — Troubled debt restructured loans (not already included above) 4,379 4,469 4,727 Total non-performing loans 13,266 14,109 15,861 Total non-performing assets $ 13,266 $ 14,109 $ 15,861 Total loans (excluding loans held-for-sale): Average total loans (YTD) $ 932,617 $ 868,461 $ 821,695 Total loans 945,645 920,042 821,283 Allowance for loan losses 11,115 10,826 10,334 Allowance for loan losses to: Non-performing loans 83.79 % 76.73 % 65.15 % Total loans (excluding held-for-sale) 1.18 % 1.18 % 1.26 % Average total loans (excluding held-for-sale) 1.19 % 1.25 % 1.26 % Non-performing loans / total loans (excluding held-for-sale) 1.40 % 1.53 % 1.93 % Non-performing assets / total assets 0.84 % 0.98 % 1.29 % An analysis of net loan charge-offs for the three months ended March 31, 2021 compared to 2020 is as follows: For the Three Months Ended March 31, 2021 2020 Net charge-offs $ (14 ) $ 53 Net annualized charge-offs to: Total loans (0.01 %) 0.03 % Average total loans excluding held-for-sale (0.01 %) 0.03 % Allowance for loan losses (0.51 %) 2.06 % 46 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS At March 31, 2021 and December 31, 2020, the recorded investment in loans for which impairment has been identified totaled $13,616,000 and $14,516,000 of which $5,682,000 and $6,432,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $7,934,000 and $8,084,000 at March 31, 2021 and December 31, 2020, respectively, and the related allowance for loan losses associated with these loans was $2,849,000 and $3,050,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans. NON-INTEREST INCOME Non-Interest Income Comparison For the Three Months Ended March 31, Change from prior year 2021 2020 Amount Percent Net gain on sales of investment securities $ 342 $ — $ 342 #DIV/0 ! Unrealized gain (loss) on investment equity securities 1,096 (2,940 ) 4,036 N/M Fees for services to customers 299 411 (112 ) (27.3 ) ATM and debit card 593 488 105 21.5 Retail brokerage and advisory 167 113 54 47.8 Bank-owned life insurance 263 68 195 286.8 Merchant 104 91 13 14.3 Net gain on sale of loans 352 81 271 N/M Other 188 117 71 60.7 Total $ 3,404 $ (1,571 ) $ 4,975 -316.7 % Quarter to Quarter Comparison Total non-interest income for the first quarter of 2021 was $3,404,000, an increase of $4,975,000, compared to a loss of $1,571,000 for the first quarter of 2020. Excluding net realized and unrealized gains (losses) on equity securities for both periods, total non-interest income was $1,969,000 and $1,369,000 for the quarters ended March 31, 2021 and 2020, respectively, an increase of $600,000 or 43.8%. During the first quarter of 2021, unrealized gains of $1,096,000 were recorded compared to unrealized losses of $2,940,000 in the same period of 2020. The unrealized gains and losses for the three months ended March 31, 2021 and 2020 resulted from the change in the fair value of the equities portfolio, the performance of which was consistent with the overall performance of the U.S. stock market for the periods. The equities portfolio comprises blue-chip large-capitalized stocks, providing a taxable equivalent dividend yield of 3.16%. The estimated cumulative contribution (realized and unrealized net gains (losses), plus dividends) of the equity portfolio to earnings per share from January 1, 2011 through March 31, 2021 is $2.14 per diluted share. Details of the equity portfolio’s contribution to net income is detailed in the following table. 47 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income (Expense) on Equity Securities For the Year Ended December 31, For the Three Months Ended March 31, 2015 2016 2017 2018 2019 2020 2021 2020 Equity Securities: Tax-equivalent dividends* $ 244 $ 233 $ 249 $ 300 $ 274 $ 392 $ 106 $ 92 Net gain (loss) on sales 691 758 1,557 (79 ) 1,781 585 339 — OTTI (55 ) (192 ) (80 ) N/A N/A N/A N/A N/A Unrealized (loss) gain N/A N/A N/A (336 ) 770 (47 ) 1,096 (2,940 ) Tax-equivalent income before tax 880 799 1,726 (115 ) 2,825 930 1,541 (2,848 ) Tax expense (benefit)* 357 324 700 (33 ) 816 269 445 (823 ) Net income $ 523 $ 475 $ 1,026 $ (82 ) $ 2,009 $ 661 $ 1,096 $ (2,025 ) Earnings per share - basic $ 0.16 $ 0.14 $ 0.30 $ (0.02 ) $ 0.57 $ 0.19 $ 0.31 $ (0.57 ) Earnings per share - diluted $ 0.16 $ 0.14 $ 0.30 $ (0.02 ) $ 0.57 $ 0.19 $ 0.31 $ (0.57 ) Tax-equivalent yield* 3.35 % 3.13 % 3.49 % 3.08 % 3.31 % 3.54 % 3.16 % 3.32 % *Based on Federal tax rates of 34% for the 2015 and 2016 periods and 21% for all 2017, 2018, 2019, 2020 and 2021 periods. QNB originates residential mortgage loans for sale in the secondary market. Net gain on sale of loans increased $271,000 when comparing the two periods. The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination. Proceeds from the sale of residential mortgages were $9,105,000 and $2,498,000 for the first quarters of 2021 and 2020, respectively. Fees for services to customers decreased $112,000 to $299,000 for the first quarter of 2021, due primarily to a decrease in net overdraft income. ATM and debit card income increased $105,000 to $593,000 for the first quarter of 2021, compared to the same period in 2020, due primarily to debit card interchange fee income. QNB provides securities and advisory services under the name QNB Financial Services. Retail brokerage and advisory fees increased for the first quarter of 2021 compared to the same period in 2020. Advisory fees increased $59,000 for the first quarter of 2021 compared with the same period in 2020, while transactional fees declined $5,000 when comparing first quarters of 2021 and 2020. Bank-owned life insurance income includes a life insurance benefit claim of $193,000. Merchant income increased by $13,000 to $104,000 for the first quarter of 2021, compared to the same period in 2020. Other non-interest income increased $71,000, or 60.7%. Other non-interest income includes broker-dealer conversion cost reimbursements of $15,000 and $17,000 in the first quarter of 2021 and 2020, respectively. Mortgage serving income increased $7,000 when comparing the two quarters primarily due to an increase in the fair value of servicing rights. There was an increase in title company income of $37,000 due to the increased volume of mortgage originations and an increase in letter of credit fees of $24,000. 48 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS NON-INTEREST EXPENSE Non-Interest Expense Comparison For the Three Months Ended March 31, Change from prior year 2021 2020 Amount Percent Salaries and employee benefits $ 4,017 $ 4,072 $ (55 ) -1.4 % Net occupancy 618 523 95 18.2 Furniture and equipment 670 675 (5 ) (0.7 ) Marketing 214 322 (108 ) (33.5 ) Third-party services 488 454 34 7.5 Telephone, postage and supplies 198 195 3 1.5 State taxes 273 243 30 12.3 FDIC insurance premiums 171 137 34 24.8 Other 674 657 17 2.6 Total $ 7,323 $ 7,278 $ 45 0.6 % Quarter to Quarter Comparison Total non-interest expense was $7,323,000 for the first quarter of 2021, an increase of $45,000, or 0.6%, compared to the first quarter of 2020. Salaries and benefits comprise the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense decreased $55,000, or 1.4%, to $4,017,000 when comparing the two quarters. Salary expense and related payroll taxes decreased $3,000 to $3,428,000 during the first quarter of 2021 compared to the same period in 2020 due increased loan origination deferred costs of $122,000. Medical and dental premiums, net of employee contributions decreased $77,000 to $281,000 when comparing the two quarters due to a decrease in medical claims. Bonus expense increased $74,000. Net occupancy and furniture and equipment expenses combined increased $90,000, or 7.5%. This is due primarily to increased building repairs and maintenance expense. Marketing expense decreased $108,000, or 33.5%, to $214,000 for the quarter ended March 31, 2021 due to cancellation of events resulting from the COVID-19 pandemic. Third party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, IT services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense increased $34,000 when comparing the two periods, due primarily to decreases in fees paid to outside vendors for support services. State taxes increased $30,000 due to an increase bank shares tax expense. FDIC insurance premiums increased $34,000 due to capital and asset growth. Other non-interest expense increased $17,000, or 2.6%, primarily due to Checkcard expense. INCOME TAXES QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of March 31, 2021, QNB’s net deferred federal tax asset was $1,457,000 and a net deferred state tax liability of $110,000. The primary components of deferred taxes are deferred tax assets of which $2,334,000 relates to the allowance for loan losses. As of December 31, 2020, QNB’s net deferred tax asset was $66,000. The increase in the balance of net deferred tax assets when comparing March 31, 2021 to December 31, 2020 is due to the decrease in unrealized gains on available for sale securities at March 31, 2021 compared to December 31, 2020, contributing to $1,682,000 of the increase. This increase was partially offset by the deferred tax on unrealized gains at March 31, 2021 compared to gains at December 31, 2020 on equity securities, resulting in a decrease of $316,000. The realizability of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets. 49 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Applicable income tax expense was $ 1,273 ,000 for the quarter ended March 31, 2021 , compared to a benefit of $ 406 ,000 for the same period in 20 20 . The effective tax rate for first quarter 2021 was 20.1 %, compared with 218.3 % for the same period in 20 20 . The decrease in the effective tax rate for the quarter ended March 31, 2021 is due to the state income tax benefit at the parent company related to the un realized losses on the equities portfolio and to the proportion of tax-exempt net interest income to income before taxes. FINANCIAL CONDITION ANALYSIS Financial service organizations are challenged to demonstrate they can generate sustainable and consistent earnings growth in a dynamic operating environment. Rate competition for quality loans is anticipated to continue through 2021. It is also anticipated that the rate competition for attracting and retaining deposits may continue in 2021, which could result in a lower net interest margin and a decline in net interest income. QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices. QNB is committed to make credit available to its customers. Total assets at March 31, 2021 were $1,570,519,000 compared with $1,440,229,000 at December 31, 2020. Cash and cash equivalents increased $69,402,000 from $39,331,000 at December 31, 2020 to $108,733,000 at March 31, 2021, due primarily to increases in deposits during the three months ended March 31, 2021. The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio to take advantage of changes in the shape of the yield curve and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio. Loans receivable grew $25,603,000, or 2.8%, with commercial loans increasing $20,445,000, or 2.7%, to $790,255,000 at March 31, 2021, compared with $769,810,000 at year-end 2020. Retail loan balances increased $5,545,000 comparing March 31, 2021 to December 31, 2020. Under the CARES Act, QNB continues to provide solutions to customers experiencing financial hardship caused by the COVID-19 Pandemic. As of March 31, 2021, QNB had modifications to approximately 3.3% of the commercial portfolio, with an outstanding balance of $26,277,000, and modifications to approximately 1.6% of the retail portfolio, with an outstanding balance of $2,453,000, related to the COVID-19 Pandemic. At March 31, 2021, QNB had 546 PPP loans totaling $75,887,000 reported in commercial and industrial loans. In 2020, the Bank originated $82,475,000 in PPP loans, enabling 660 businesses to maintain their payrolls and stay in operation. Of this first round of funding, 365 loans have been forgiven in full and $37,293,000 in balances have been forgiven. The Bank originated 251 PPP loans, or $30,706,000, during the second round of funding which started in January 2021. Second-draw customers made up 205 of these loans, or $28,700,000 and first-draw customers made of the remaining 46 loans, or $2,006,000. Excluding PPP loans net of deferred fees, loans receivable at March 31, 2021 would have increased $22,926,000, or 2.7%, since year-end 2020. Deposits grew $113,549,000, or 9.2%, from December 31, 2020 to March 31, 2021. Non-interest-bearing demand deposits increased $49,273,000, or 24.1%, with balances of $253,857,000 at March 31, 2021 compared with $204,584,000 at year-end 2020. Interest-bearing demand balances, excluding municipal deposits, increased $18,790,000, or 6.7%, to $297,953,000, with increases in all personal checking products and in the business checking product. The $47,397,000 increase in savings and $16,436,000 increase in money markets was partially offset by the decline in time deposits as balances were moved to more liquid accounts. Total time deposits declined $15,092,000 from December 31, 2020 to March 31, 2021. Municipal deposit balances decreased $3,255,000, or 2.8%, to $112,946,000. Municipal deposits can be volatile depending on the timing of deposits and withdrawals, and the cash flow needs of the school districts or municipalities. Municipal deposits increase as tax money is received from the local school districts during second and third quarters and it is anticipated that these funds will flow out for the subsequent twelve months as the schools use the funds for operations. These deposits provide incremental income as they are invested in short-term investment securities but will further reduce the net interest margin as the spread earned is significantly less than the current net interest margin. 50 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Short-term borrowings in creased 10.4 % , from $ 5 8 , 838 ,000 at December 31, 20 20 to $ 64 , 947 ,000 at March 31, 2021 . Commercial sweep accounts in creased $ 6 , 109 ,000, as these funds may be volatile based on businesses’ receipt and disbursement of funds and is offset by business non-interest-bearing demand accounts. There were no o vernight borrowings from FHLB at March 31, 2021 or December 31, 2020 . In 2020, QNB borrowed long-term debt from the FHLB of $10,000,000 to lock in a rate at a low yield. LIQUIDITY Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. Liquidity is provided from asset sources through repayments and maturities of loans and investment securities. The portfolio of investment securities classified as available for sale and QNB's policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Core deposits and cash management repurchase agreements have historically been the most significant funding source for QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area. Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At March 31, 2021, the Bank had a maximum borrowing capacity with the FHLB of approximately $295,895,000, which is net of the $10,000,000 in long-term borrowings and a $350,000 letter of credit. The maximum borrowing depends upon qualifying collateral assets and the Bank’s asset quality and capital adequacy. In addition, the Bank maintains unsecured Federal funds lines with five correspondent banks totaling $101,000,000. At March 31, 2021 there were no outstanding borrowings under these lines. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn. Liquid sources of funds, including cash, available-for-sale and equity investment securities, and loans held-for-sale have increased $101,172,000 since December 31, 2020, totaling $595,568,000 at March 31, 2021. Growth in deposits since year-end 2020 has been used to fund loans, excess cash was invested in debt securities, primarily amortizing securities, and to cover operating expenses. Management expects these liquid sources will be adequate to meet normal fluctuations in loan demand or deposit withdrawals. The investment portfolio is expected to continue to provide sufficient liquidity, as municipal bonds are called or mature and cash flow on mortgage-backed and CMO securities continues to be steady. Approximately $233,868,000 and $220,934,000 of available-for-sale debt securities at March 31, 2021 and December 31, 2020, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. The level of pledged securities corresponds with the municipal deposit and repurchase agreement balances. QNB is a member of the Certificate of Deposit Account Registry Services (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. QNB also has available Insured Cash Sweep (ICS), another program through Promontory Interfinancial Network, LLC, which is a product similar to CDARS, but one that provides liquidity like a money market or savings account. CAPITAL ADEQUACY A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB's shareholders' equity at March 31, 2021 was $131,996,000, or 8.40% of total assets, compared with shareholders' equity of $134,445,000, or 9.33% of total assets, at December 31, 2020. Shareholders’ equity at March 31, 2021 included a negative adjustment of $678,000 compared to a positive adjustment of $5,649,000 at December 31, 2020, related to unrealized holding losses and gains, net of taxes, on investment securities available-for-sale. Without these adjustments, shareholders' equity to total assets would have been 8.44% and 8.98% at March 31, 2021 and December 31, 2020, respectively. Average shareholders' equity and average total assets were $130,473,000 and $1,466,520,000 for the three months ended March 31, 2021, an increase of 7.2% and 20.1%, respectively, from the averages for the three months ended March 31, 2020. The ratio of average total equity to average total assets was 8.90% for the three months ended March 31, 2021 compared to 9.96% for the same period in 2020. Retained earnings at March 31, 2021 were impacted by three months of net income totaling $5,050,000 offset by dividends declared and paid of $1,243,000 for the three-month period. QNB offers a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to 51 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares at a discount. The Plan also allows participants to make additional cash purchases of stoc k . Stock purchases under the Plan contributed $ 207 ,000 to capital during the three months ended March 31, 2021 . The Board of Directors has authorized the repurchase of up to 100,000 shares of QNB common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of March 31, 2021, 70,683 shares have been repurchased since the initial authorization at an average price of $19.79 and a total cost of $1,399,000. QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier 1 capital and Tier 2 capital. Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. The required minimum Common equity Tier 1 capital to risk-weighted assets ratio is 4.5%, the required minimum ratio of Tier 1 capital to risk-weighted assets is 6.0%, the required minimum ratio of Total Capital to risk-weighted assets is 8.0%, and the required minimum Tier 1 leverage ratio is 4.0%. A capital conservation buffer of 2.5% of risk-weighted assets also applies to avoid limitations on certain capital distributions. The following table sets forth consolidated information for QNB: March 31, December 31, Capital Analysis 2021 2020 Regulatory Capital Shareholders' equity $ 131,996 $ 134,445 Net unrealized securities losses, net of tax 678 (5,649 ) Deferred tax assets on net operating loss — — Disallowed intangible assets (8 ) (8 ) Common equity tier I capital 132,666 128,788 Tier I capital 132,666 128,788 Allowable portion: Allowance for loan losses and reserve for unfunded commitments 11,206 10,917 Total regulatory capital $ 143,872 $ 139,705 Risk-weighted assets $ 1,032,611 $ 1,001,561 Quarterly average assets for leverage capital purposes $ 1,466,512 $ 1,419,404 March 31, December 31, Capital Ratios 2021 2020 Common equity tier I capital / risk-weighted assets 12.85 % 12.86 % Tier I capital / risk-weighted assets 12.85 12.86 Total regulatory capital / risk-weighted assets 13.93 13.95 Tier I capital / average assets (leverage ratio) 9.05 9.07 At March 31, 2021, common equity Tier I, Tier I capital, and total regulatory capital ratios were fairly level with December 31, 2020. The Company remains well-capitalized by all applicable regulatory requirements as of March 31, 2021. MARKET RISK MANAGEMENT Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. QNB’s primary market risk exposure is interest rate risk and liquidity risk. QNB’s liquidity position was discussed in a prior section. QNB’s largest source of revenue is net interest income, which is subject to changes in market interest rates. Interest rate risk management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability and Investment Management 52 QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income. QNB uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation considers current balance sheet volumes and the scheduled repricing dates, instrument level optionality, and maturities of assets and liabilities. It incorporates assumptions for growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios. A balance sheet is considered liability sensitive when its liabilities (deposits and borrowings) reprice faster than its earning assets (loans and securities). A liability sensitive balance sheet will produce relatively less net interest income when interest rates rise and more net interest income when they decline. Based on our simulation analysis, management believes QNB’s interest sensitivity position at March 31, 2021 is liability sensitive. Management expects that market interest rates will remain level over the next 12 months, based on the economic environment and policy of the Board of Governors of the Federal Reserve System. The following table shows the estimated impact of changes in interest rates on net interest income as of March 31, 2021 and 2020 assuming instantaneous rate shocks, and consistent levels of assets and liabilities. Net interest income for the subsequent twelve months is projected to decrease when interest rates are higher than current rates. Estimated Change in Net Interest Income Changes in Interest rates March 31, (in basis points) 2021 2020 +300 -2.30 % -0.37 % +200 -0.52 % 0.58 % +100 0.26 % 1.05 % -100 -5.85 % -5.06 % Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel. Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect QNB’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt. QNB is not subject to foreign currency exchange or commodity price risk. At March 31, 2021, QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors. 53 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The information required in response to this item is set forth in Item 2, above.