SB FINANCIAL GROUP, INC. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statement Regarding Forward-Looking Information This Quarterly Report on Form 10-Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains certain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance. Examples of forward-looking statements include: (a) projections of income or expense, earnings per share, the payment or non-payment of dividends, capital structure and other financial items; (b) statements of plans and objectives of the Company or our management or Board of Directors, including those relating to products or services; (c) statements of future economic performance; (d) statements regarding future customer attraction or retention; and (e) statements of assumptions underlying such statements. Words such as “anticipates”, “believes”, “plans”, “intends”, “expects”, “projects”, “estimates”, “should”, “may”, “would be”, “will allow”, “will likely result”, “will continue”, “will remain”, or other similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying those statements. Forward-looking statements are based on management’s expectations and are subject to a number of risks and uncertainties. Although management believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those expressed or implied in such statements. Risks and uncertainties that could cause actual results to differ materially include, without limitation, risks and uncertainties inherent in the national and regional banking industry including impacts from the COVID-19 pandemic on local, national and global economic conditions as well as the various governmental responses to the COVID-19 pandemic, including stimulus packages and programs; potential litigation or other risks related to participation in the U.S. Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”); changes in economic conditions in the market areas in which the Company and its subsidiaries operate; changes in policies by regulatory agencies; the transition away from LIBOR as a reference rate for financial contracts; operating risks; changes in accounting standards and policies; changes in tax laws; fluctuations in interest rates; demand for loans in the market areas in which the Company and its subsidiaries operate; increases in FDIC insurance premiums; changes in the competitive environment; losses of significant customers; geopolitical events; and the loss of key personnel. Additional detailed information concerning a number of important factors which could cause actual results to differ materially from the forward-looking statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations is available in the Company’s filings with the Securities and Exchange Commission, including the risks identified under the heading “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as supplemented by the risk factors included under the heading “Item 1A. Risk Factors” of Part II of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2021. Undue reliance should not be placed on the forward-looking statements, which speak only as of the date hereof. Except as may be required by law, the Company undertakes no obligation to update any forward-looking statement to reflect unanticipated events or circumstances after the date on which the statement is made. Overview of SB Financial SB Financial Group, Inc. (“SB Financial” or the “Company”) is an Ohio corporation and a financial holding company registered with the Federal Reserve Board. SB Financial’s wholly-owned subsidiary, The State Bank and Trust Company (“State Bank”), is an Ohio-chartered bank engaged in commercial banking. Rurban Statutory Trust II (“RST II”) was established in August 2005. In September 2005, RST II completed a pooled private offering of 10,000 Trust Preferred Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to SB Financial in exchange for junior subordinated debentures of SB Financial with terms substantially similar to the Trust Preferred Securities. The sole assets of RST II are the junior subordinated debentures, and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by SB Financial of the obligations of RST II. RFCBC, Inc. (“RFCBC”) is an Ohio corporation and wholly-owned subsidiary of SB Financial that was incorporated in August 2004. RFCBC operates as a loan subsidiary in servicing and working out problem loans. State Bank Insurance, LLC (“SBI”) is an Ohio corporation and a wholly-owned subsidiary of State Bank incorporated in June of 2010. SBI is an insurance company that engages in the sale of insurance products to retail and commercial customers of State Bank. SBFG Title, LLC (“Title”) is an Ohio corporation that was formed in March 2019. SBFG Title engages in the sale of title insurance services. SB Captive, Inc. (“Captive”) is a Nevada corporation that was formed in March 2019. SB Captive pools insurance risk among like sized banking institutions. Unless the context indicates otherwise, all references herein to “we”, “us”, “our”, or the “Company” refer to SB Financial and its consolidated subsidiaries. 33 Critical Accounting Policies Note 1 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020 describes the significant accounting policies used in the development and presentation of the Company’s financial statements. The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company’s financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, and/or complex. Allowance for Loan Losses - The allowance for loan losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in underwriting activities, loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management’s estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs. The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate. Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the subjective nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are also factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company’s evaluation of imprecise risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. To the extent that actual results differ from management’s estimates, additional loan loss provisions may be required that could adversely impact earnings for future periods. Goodwill and Other Intangibles - The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required. Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line or accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. A decrease in earnings resulting from these or other factors could lead to an impairment of goodwill that could adversely impact earnings for future periods. 34 Three Months Ended September 30, 2021 compared to Three Months Ended September 30, 2020 Net Income: Net income for the third quarter of 2021 was $4.1 million compared to net income of $5.3 million for the third quarter of 2020, a decrease of 21.8 percent. Earnings per diluted share (EPS) of $0.58 were down 15.9 percent from EPS of $0.69 for the third quarter of 2020. Net income for the third quarter of 2021 was positively impacted by the recapture of the Company’s temporary mortgage servicing rights impairment of $0.25 million. The 2020 third quarter was also positively impacted by mortgage servicing rights recapture of $0.33 million. The Consolidated Appropriations Act, 2021, which was signed into law on December 27, 2020, provided additional PPP funding of $284.5 billion and the establishment of PPP Second Draw Loans under the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Relief Act”.) The Company continued its participation in the CARES Act pandemic response through the PPP lending initiative. During the quarter ended September 30, 2021, the Company processed forgiveness (loans paid by off by the SBA) of $24.6 million. PPP loans outstanding at September 30, 2021 totaled $10.2 million, with $0.4 million remaining from Phase I and $9.8 million remaining from Phase II. Provision for Loan Losses: The third quarter provision for loan losses was $0.3 million, compared to $1.8 million for the year-ago quarter. The total reserve level of $13.8 million is up over 17 percent from the prior year. The Company had recoveries of $0.2 million for the quarter compared to net charge-offs of $0.02 million for the year-ago quarter. Total delinquent loans ended the quarter at $3.0 million, or 0.35 percent of total loans, which is down $3.0 million from the prior year. Asset Quality Review – For the Period Ended ($ in thousands) Sep. 30, 2021 Sep. 30, 2020 Net chargeoffs (recoveries) – QTD/YTD ($206)/($188 ) $21/$662 Nonaccruing loans 3,188 6,409 Accruing Trouble Debt Restructures 805 789 Nonaccruing and restructured loans 3,993 7,198 OREO / OAO 1,601 76 Nonperforming assets 5,594 7,274 Nonperforming assets/Total assets 0.42 % 0.60 % Allowance for loan losses/Total loans 1.63 % 1.33 % Allowance for loan losses/Nonperforming loans 351.5 % 163.8 % Consolidated Revenue: Total revenue, consisting of net interest income and noninterest income, was $16.7 million for the third quarter of 2021, a decrease of $3.0 million, or 15.3 percent, from the $19.7 million generated during the third quarter of 2020. Net interest income (“NII”) was $10.0 million for the third quarter of 2021, which was up $0.8 million from the prior year third quarter’s $9.3 million. Included in NII was $1.1 million in fees and interest from PPP loans compared to $0.6 million for the prior year quarter. The Company’s earning assets increased $163.3 million, coupled with a 44 basis point decrease in the yield on earning assets. The net interest margin (FTE) for the third quarter of 2021 was 3.21 percent compared to 3.41 percent for the third quarter of 2020. Funding costs for interest bearing liabilities for the third quarter of 2021 were 0.44 percent compared to 0.75 percent for the prior year third quarter. Noninterest income was $6.6 million for the third quarter of 2021, which was down $3.8 million from the prior year third quarter’s $10.4 million. In addition to the mortgage revenue detailed below, wealth management revenue was $1.0 million. Recapture of mortgage servicing rights impairment increased noninterest income by $0.25 million in the quarter. Our title agency contributed revenue of $0.5 million in the third quarter of 2021. Noninterest income as a percentage of average assets for the third quarter of 2021 was 1.99 percent compared to 3.42 percent for the prior year third quarter. 35 State Bank originated $153.1 million of mortgage loans for the third quarter of 2021, of which $123.1 million of loans were sold with the remainder of loans held for investment. This compares to $200.2 million originated for the third quarter of 2020, of which $166.2 million of loans were sold with the remainder of loans held for investment. These third quarter 2021 originations and subsequent sales resulted in $3.9 million of gains, down $4.1 million from the gains for the third quarter of 2020. Net mortgage banking revenue was $4.1 million for the third quarter of 2021 compared to $7.9 million for the third quarter of 2020. The 2021 third quarter included a $0.25 million recapture of mortgage servicing rights compared to a $0.33 million recapture for the third quarter of 2020. Consolidated Noninterest Expense: Noninterest expense for the third quarter of 2021 was $11.3 million, which was even compared to the $11.3 million in the prior-year third quarter. The third quarter of 2021 included lower commission and incentives on mortgage sales and title volume, which was offset by higher data processing and professional fee expense due to expanded implementation of technology solutions. Income Taxes: Income taxes for the third quarter of 2021 were $1.0 million (effective rate of 19.8 percent) compared to $1.3 million (effective rate of 19.8 percent) for the third quarter of 2020. Nine Months Ended September 30, 2021 compared to Nine Months Ended September 30, 2020 Net Income : Net income for the nine months ended September 30, 2021 was $14.9 million compared to net income of $9.6 million for the first nine months of 2020, an increase of $5.4 million or 56 percent. EPS for the period of $2.08 were up 66 percent from EPS of $1.25 for the prior year nine-month period. Provision for Loan Losses : The provision for loan losses for the nine months ended September 30, 2021 was $1.1 million compared to $3.7 million for the prior year nine months. The Company had recoveries of $0.2 million for the first nine months of 2021 compared to net charge offs of $0.7 million for the prior year nine-month period. Consolidated Revenue : Total revenue, consisting of net interest income and noninterest income, was $52.9 million for the first nine months of 2021, an increase of $5.0 million, or 10.4 percent, from the $47.9 million generated during the prior year nine-month period. Net interest income was $28.8 million, which is up $2.1 million or 8.0 percent from net interest income of $26.7 million for the prior year nine months. The Company’s earning assets increased $188.4 million, and had a 64 basis point decrease in the yield on earning assets for the nine months of 2021. The net interest margin (FTE) for the first nine months of 2021 was 3.12 percent compared to 3.41 percent for the nine months of 2020. Funding costs for interest bearing liabilities for the nine months of 2021 were 0.46 percent compared to 0.91 percent for the prior year nine months. Noninterest income was $24.1 million for the nine months ended September 30, 2021, which is up $2.9 million or 13.7 percent from noninterest income of $21.2 million for the prior year nine months. In addition to the mortgage revenue detailed below, gains from the sale of non-mortgage loans was $0.1 million, compared to $0.3 million for the same period in 2020. For the nine months ended September 30, 2021, the Company had mortgage servicing rights recapture of $2.9 million compared to mortgage servicing rights impairment in the nine months of 2020 of $3.0 million. State Bank originated $473.8 million of mortgage loans during the first nine months of 2021, of which $378.9 million of loans were sold with the remainder of loans held for investment. These levels compare to $525.2 million of loans originated and $455.3 million of loans sold for the prior nine month period, or declines of 9.8 and 16.8 percent, respectively. Consolidated Noninterest Expense: Noninterest expense for the nine months ended September 30, 2021 was $33.2 million, which is up $0.8 million or 2.6 percent compared to the $32.4 million from the prior year nine month period. The increase in noninterest expenses compared to the prior year was due to increases in staffing, benefit costs and higher investments in technology. The prior year period included $1.2 million in one-time expenses related to the Edon acquisition. 36 Income Taxes: Income taxes for the nine months ended September 30, 2021 were $3.7 million (effective rate of 19.8 percent) compared to $2.2 million (effective rate of 18.6 percent) for the nine months ended September 30, 2020. Changes in Financial Condition Total assets at September 30, 2021 were $1.33 billion, an increase of $71.9 million or 5.7 percent since December 31, 2020. Total loans, net of unearned income, were $846.5 million as of September 30, 2021, down $26.2 million or 3.0 percent, from year-end. PPP loan balances of $10.2 million were included in our total loans at September 30, 2021. Total deposits at September 30, 2021 were $1.11 billion, an increase of $62.6 million or 6.0 percent since 2020 year end. Borrowed funds (consisting of FHLB advances, REPOs, Trust Preferred Securities and subordinated debt) totaled $56.1 million at September 30, 2021. This is up from year-end 2020 when borrowed funds totaled $47.1 million due to an increase in REPOs and the subordinated debt. Total equity for the Company of $144.3 million now stands at 10.9 percent of total assets compared to the December 31, 2020 level of $142.9 million and 11.4 percent of total assets. The allowance for loan loss of $13.8 million is up $1.2 million from the December 2020 year end level. Capital Resources As of September 30, 2021, based on the computations for the FFIEC 041 Consolidated Reports of Condition and Income filed by State Bank with the Federal Reserve, State Bank was classified as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, State Bank must maintain capital ratios as set forth in the table below. There are no conditions or events since September 30, 2021 that management believes have changed State Bank’s capital classification. State Bank’s actual capital levels and ratios as of September 30, 2021 and December 31, 2020 are presented in the following table. Capital levels are presented for State Bank only as the Company is exempt from quarterly reporting on capital levels at the holding company level: To Be Well Capitalized Under For Capital Adequacy Prompt Corrective Action Actual Purposes Procedures ($ in thousands) Amount Ratio Amount Ratio Amount Ratio As of September 30, 2021 Tier I Capital to average assets $ 129,714 9.98 % $ 52,014 4.0 % $ 65,017 5.0 % Tier I Common equity capital to risk-weighted assets 129,714 13.23 % 44,134 4.5 % 63,749 6.5 % Tier I Capital to risk-weighted assets 129,714 13.23 % 58,845 6.0 % 78,460 8.0 % Total Risk-based capital to risk-weighted assets 141,992 14.48 % 78,460 8.0 % 98,075 10.0 % As of December 31, 2020 Tier I Capital to average assets $ 119,480 9.94 % $ 48,099 4.0 % $ 60,123 5.0 % Tier I Common equity capital to risk-weighted assets 119,480 12.91 % 41,651 4.5 % 60,162 6.5 % Tier I Capital to risk-weighted assets 119,480 12.91 % 55,534 6.0 % 74,046 8.0 % Total Risk-based capital to risk-weighted assets 131,062 14.16 % 74,046 8.0 % 92,557 10.0 % New regulatory capital requirements commonly referred to as “Basel III” were fully phased in as of January 1, 2019 and are reflected in the September 30, 2021 capital table above. Management opted out of the accumulated other comprehensive income treatment under the new requirements and, as such, unrealized gains and losses from available-for-sale securities will continue to be excluded from State Bank’s regulatory capital. 37 LIQUIDITY Liquidity relates primarily to the Company’s ability to fund loan demand, meet deposit customers’ withdrawal requirements and provide for operating expenses. Assets used to satisfy these needs consist of cash and due from banks, federal funds sold, interest-earning deposits in other financial institutions, securities available-for-sale and loans held for sale. These assets are commonly referred to as liquid assets. Liquid assets were $399.8 million at September 30, 2021, compared to $303.2 million at December 31, 2020. Liquidity risk arises from the possibility that the Company may not be able to meet the Company’s financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Board of Directors of the Company has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates the Asset/Liability Committee (“ALCO”) as the body responsible for meeting these objectives. The ALCO reviews liquidity regularly and evaluates significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company’s Chief Financial Officer and Asset Liability Manager. The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolio of $652.8 million at September 30, 2021 and $608.4 million at December 31, 2020, which can and has been used to collateralize borrowings, is an additional source of liquidity. Management believes the Company’s current liquidity level, without these borrowings, is sufficient to meet its liquidity needs. At September 30, 2021, all eligible commercial real estate, first mortgage residential and multi-family mortgage loans were pledged under an FHLB blanket lien. The cash flow statements for the periods presented provide an indication of the Company’s sources and uses of cash, as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A discussion of the cash flow statements for the nine months ended September 30, 2021 and 2020 follows. The Company experienced positive cash flows from operating activities for the nine months ended September 30, 2021 and September 30, 2020. Net cash provided by operating activities was $6.0 million for the nine months ended September 30, 2021 and $5.4 million for the nine months ended September 30, 2020. Highlights for the current year include $378.9 million in proceeds from the sale of loans, which is down $76.4 million from the prior year. Originations of loans held for sale was a use of cash of $371.5 million, which is down from the prior year by $76.1 million. For the nine months ended September 30, 2021, there was a gain on sale of loans of $14.2 million, and depreciation and amortization of $1.6 million. The Company experienced negative cash flows from investing activities for the nine months ended September 30, 2021 and September 30, 2020. Net cash used in investing activities was $77.9 million for the nine months ended September 30, 2021 and $54.1 million for the nine months ended September 30, 2020. Highlights for the current year include purchases of available-for-sale securities of $138.5 million. These cash payments were offset by $34.6 million in proceeds from maturities and sales of securities, which is down $37.0 million from the prior year nine-month period. The Company experienced a $24.7 million decrease in loans, which is down $69.5 million from the prior year nine-month period. The Company experienced positive cash flows from financing activities for the nine months ended September 30, 2021 and September 30, 2020. Net cash provided by financing activities was $69.2 million for the nine months ended September 30, 2021 and $116.3 million for the nine months ended September 30, 2020. Highlights for the current period include a $133.7 million increase in transaction deposits for the nine months ended September 30, 2021, which is down $6.0 million from the prior year. Certificates of deposit decreased by $71.0 million in the current year compared to $16.9 million for the prior year nine-month period. The issuance of subordinated debt during the quarter provided for $19.5 million in proceeds net of debt issuance costs. 38 ALCO uses an economic value of equity (“EVE”) analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of the Company’s assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The likelihood of a significant decrease in rates as of September 30, 2021 and December 31, 2020 was considered unlikely given the current interest rate environment and therefore, only the minus 100 basis point rate change was included in this analysis as of September 30, 2021 and only the minus 100 basis point rate change was included in this analysis as of December 31, 2020. The results of this analysis are reflected in the following tables for September 30, 2021 and December 31, 2020. Economic Value of Equity September 30, 2021 ($ in thousands) Change in rates $ Amount $ Change % Change +400 basis points $ 248,503 $ 36,771 17.37 % +300 basis points 242,622 30,890 14.59 % +200 basis points 235,142 23,410 11.06 % +100 basis points 225,417 13,685 6.46 % Base Case 211,732 — — -100 basis points 186,649 (25,083 ) -11.85 % Economic Value of Equity December 31, 2020 ($ in thousands) Change in rates $ Amount $ Change % Change +400 basis points $ 243,779 $ 61,586 33.80 % +300 basis points 231,590 49,397 27.11 % +200 basis points 217,936 35,743 19.62 % +100 basis points 202,260 20,067 11.01 % Base Case 182,193 — — -100 basis points 154,509 (27,684 ) -15.19 % Off-Balance-Sheet Borrowing Arrangements: Significant additional off-balance-sheet liquidity is available in the form of FHLB advances and unused federal funds lines from correspondent banks. Management expects the risk of changes in off-balance-sheet arrangements to be immaterial to earnings. The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolios in the total amount of $652.8 million were pledged to meet FHLB collateralization requirements as of September 30, 2021. Based on the current collateralization requirements of the FHLB, the Company had approximately $105.2 million of additional borrowing capacity at September 30, 2021. The Company also had $161.0 million in unpledged securities available to pledge for additional borrowings. The Company’s contractual obligations as of September 30, 2021 were comprised of long-term debt obligations, other debt obligations, operating lease obligations and other long-term liabilities. Long-term debt obligations were comprised of FHLB Advances of $5.5 million, Trust Preferred Securities of $10.3 million, and Subordinated debt, net of issuance costs, of $19.5 million. Total time deposits at September 30, 2021 were $158.5 million, of which $62.8 million mature beyond one year. In addition, as of September 30, 2021, the Company had commitments to sell mortgage loans totaling $52.0 million. The Company believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If the Company requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnati and other financial institutions are available. 39 ASSET LIABILITY MANAGEMENT Asset liability management involves developing, executing and monitoring strategies to maintain appropriate liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on current and future earnings. The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and securities available for sale) which are primarily funded by interest-bearing liabilities (deposits and borrowings). With the exception of specific loans which are originated and held for sale, all of the financial instruments of the Company are for other than trading purposes. All of the Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. In addition, the Company has limited exposure to commodity prices related to agricultural loans. The impact of changes in foreign exchange rates and commodity prices on interest rates are assumed to be insignificant. The Company’s financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Interest rate risk is the Company’s primary market risk exposure; to a lesser extent, liquidity risk also impacts market risk exposure. Interest rate risk is the exposure of a banking institution’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the Company’s safety and soundness. Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization’s quantitative level of exposure. When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risks at prudent levels of consistency and continuity. Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity and asset quality (when appropriate). The Federal Reserve Board together with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Company adopted a Joint Agency Policy Statement on interest rate risk effective June 26, 1996. The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in prior Federal Reserve guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of director and senior management oversight and a comprehensive risk management process that effectively identifies, measures and controls interest rate risk. Financial institutions derive their income primarily from the excess of interest collected over interest paid. The rates of interest an institution earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, an institution is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. For example, assume that an institution’s assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise by the time the short-term liabilities must be refinanced, the increase in the institution’s interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution’s profits could decrease on existing assets because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate-sensitive assets are funded by longer-term, fixed-rate liabilities in a declining rate environment. There are several ways an institution can manage interest rate risk including: 1) matching repricing periods for new assets and liabilities, for example, by shortening or lengthening terms of new loans, investments, or liabilities; 2) selling existing assets or repaying certain liabilities; and 3) hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change interest rate risk. Interest rate swaps, futures contracts, options on futures contracts, and other such derivative financial instruments can be used for this purpose. Because these instruments are sensitive to interest rate changes, they require management’s expertise to be effective. The Company does not currently utilize any derivative financial instruments to manage interest rate risk. As market conditions warrant, the Company may implement various interest rate risk management strategies, including the use of derivative financial instruments. 40 Item 3. Quantitative and Qualitative Disclosures about Market Risk Management believes there has been no material change in the Company’s market risk from the information contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) for the year ended December 31, 2020.