Virginia National Bankshares Corp 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the unaudited consolidated financial statements, and notes thereto, of Virginia National Bankshares Corporation (the “Company”) included in this report and the audited consolidated financial statements, and notes thereto, of the Company included in the Company’s Form 10-K for the year ended December 31, 2020. Operating results for the three months ended March 31, 2021 are not necessarily indicative of the results for the year ending December 31, 2021 or any future period. FORWARD-LOOKING STATEMENTS AND FACTORS THAT COULD AFFECT FUTURE RESULTS Certain statements contained or incorporated by reference in this quarterly report on Form 10-Q may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, without limitation, statements with respect to the Company’s operations, performance, future strategy and goals, and are often characterized by use of qualified words such as “expect,” “believe,” “estimate,” “project,” “anticipate,” “intend,” “will,” “should,” or words of similar meaning or other statements concerning the opinions or judgement of the Company and its management about future events. While Company management believes such statements to be reasonable, future events and predictions are subject to circumstances that are not within the control of the Company and its management. Actual results may differ materially from those included in the forward-looking statements due to a number of factors, including, without limitation, the effects of and changes in: general economic and market conditions, including the effects of declines in real estate values, an increase in unemployment levels and general economic contraction as a result of COVID-19 or other pandemics; fluctuations in interest rates, deposits, loan demand, and asset quality; assumptions that underlie the Company’s allowance for loan losses (“ALLL”); the potential adverse effects of unusual and infrequently occurring events, such as weather-related disasters, terrorist acts or public health events (e.g., COVID-19 or other pandemics), and of governmental and societal responses thereto; the performance of vendors or other parties with which the Company does business; competition; technology; changes in laws, regulations and guidance; changes in accounting principles or guidelines; performance of assets under management; expected revenue synergies and cost savings from the recently completed merger with Fauquier Bankshares, Inc. (“Fauquier”) may not be fully realized or realized within the expected timeframe; the businesses of the Company and Fauquier may not be integrated successfully or such integration may be more difficult, time-consuming or costly than expected; revenues following the merger may be lower than expected; customer and employee relationships and business operations may be disrupted by the merger; and other factors impacting financial services businesses. Many of these factors and additional risks and uncertainties are described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020 and other reports filed from time to time by the Company with the Securities and Exchange Commission (“SEC”). These statements speak only as of the date made, and the Company does not undertake to update any forward-looking statements to reflect changes or events that may occur after this release. MERGER WITH FAUQUIER BANKSHARES, INC., AND THE FAUQUIER BANK On April 1, 2021, the Company completed its merger with Fauquier. The merger of Fauquier with and into the Company (the “Merger”) was effected pursuant to the terms and conditions of the Agreement and Plan of Reorganization, dated as of September 30, 2020, between the Company and Fauquier, and a related Plan of Merger (together, the “Merger Agreement”). Immediately after the Merger, The Fauquier Bank, Fauquier’s wholly-owned bank subsidiary, merged with and into Virginia National Bank (the “Bank”), the Company’s wholly-owned bank subsidiary. Pursuant to the Merger Agreement, former holders of shares of Fauquier common stock received 0.675 shares of the Company’s common stock for each share of Fauquier common stock held immediately prior to the Merger, with cash paid in lieu of fractional shares. Each share of common stock of the Company outstanding immediately prior to the Merger remained outstanding and was unaffected by the Merger. The Company’s balance sheet and results of operations as of and for the period ended March 31, 2021 do not include the impact of Fauquier’s financial position and results of operations for the first quarter of 2021. At March 31, 2021, Fauquier had total assets of $911.3 million, net loans of $616.4 million and total deposits of $817.5 million. 33 IMPACT OF COVID-19 The COVID-19 pandemic has caused, and will likely continue to cause, economic and social disruption, significantly affecting many industries, including many of our clients. Significant uncertainty exists regarding the magnitude of the impact and duration of this pandemic. Following are brief descriptions of areas within our Company that have been or may be impacted. Financial Condition and Results of Operations The Company’s consolidated financial statements include estimates and assumptions made by management which affect the reported amounts of assets and liabilities, including the level of the ALLL that is established. The ALLL calculation and resulting provision for loan losses are impacted by changes in economic conditions. As of March 31, 2020 and June 30, 2020, the Company downgraded the economic qualitative factors within its ALLL model in light of the effects of COVID-19 on the economy. No additional downgrades of such factors were taken during the quarter ended September 30, 2020, December 31, 2020 or March 31, 2021. If economic conditions improve or worsen, the Company could experience further changes in the required ALLL. It is possible that asset quality metrics could decline in the future if the effects of COVID-19 are sustained. While most industries have been adversely impacted by COVID-19, the Company has exposures on its balance sheet as of March 31, 2021 in the following categories of loans that are considered to have higher risk of significant impact: • Travel accommodations (hotels/motels/B&B) – $16.6 million, or 3.0% of loans • Retail trade - $12.3 million, or 2.2% of loans • Restaurants - $7.5 million, or 1.4% of loans • Wholesale trade - $7.3 million, or 1.3% of loans • Arts, entertainment and recreation - $6.5 million, or 1.2% of loans, and • Caterers - $5.8 million, or 1.1% of loans Note that the loan balances and percentages above do not include Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loans made to entities within such categories. Interest income could be reduced due to the economic impact of COVID-19. In accordance with guidance from regulators, we worked with borrowers who were adversely affected by COVID-19 to defer principal only, or principal and interest. While interest will continue to accrue to income, in accordance with accounting principles generally accepted in the United States (“GAAP”), if the Company ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively affected. Since the beginning of the pandemic, the Company has accommodated 193 deferrals on outstanding loan balances of $59.0 million (of which 131 deferrals on outstanding loan balances of $1.8 million were related to student loans). As of March 31, 2021, $57.5 million in loan balances, or 97.4% of the total loan deferments approved, have returned to normal payment schedules and are now current, leaving a remaining balance of deferments of $1.5 million. Of this remaining balance, $1.2 million, or 77.3%, are 100% government-guaranteed loans for which the deferrals were approved by the United States Department of Agriculture; and $349 thousand, or 22.7%, are student loans, which are private student loans not subject to potential federal forgiveness. In accordance with interagency guidance issued in March 2020, these short-term deferrals are not considered troubled debt restructurings (“TDRs”). Primarily within the second quarter of 2020 and the first quarter of 2021, the Company devoted significant resources to accept PPP applications, a program designed to provide a direct incentive for small businesses to keep employees on their payroll. In total, the Company has closed 924 loans representing $123.1 million in funding, with average origination fees of 3.9%, assisting many nonprofits and local businesses through this program. As of March 31, 2021, 43% of the total dollars of PPP loans had been forgiven by the SBA, with $70.2 million outstanding. Loans funded through the PPP are fully guaranteed by the U.S. government. The Company performed the required due diligence pursuant to the established SBA criteria; nonetheless, if a determination was made that certain loans did not meet the criteria established for the program, the Company may be required to establish additional ALLL through provision for loan loss expense which will negatively impact net income. Throughout the onset of this pandemic, the Company has maintained its high standards of credit quality on organic loan funding to limit credit risk exposure. Capital and Liquidity As of March 31, 2021, capital ratios of the Company were in excess of regulatory requirements. While currently included in the category of “well capitalized” by bank regulators, a prolonged economic recession could adversely impact reported and regulatory capital ratios. 34 The Company maintains access to multiple sources of liquidity. Management has also revisited its capital and liquidity stress tests, as well as capital and liquidity contingency plans to validate how the Company can react effectively to the economic downturn caused by this pandemic and to gauge the amount of SBA PPP loans the Company c ould and should accept. Goodwill As of March 31, 2021, the goodwill on our balance sheet was not deemed to be impaired. However, management may determine that goodwill is required to be evaluated for impairment in the future due to the presence of a triggering event, which may have a negative impact on the Company’s results of operations. Operations, Processes, Controls and Business Continuity Plan The Company reacted quickly to the COVID-19 pandemic. We began internal social distancing in mid-March of 2020, as well as distancing from the public by keeping our drive-thru services available, and encouraging customers to conduct transactions at ATMs, through online banking and/or the mobile app. The Company also increased consumer and business mobile deposit limits to encourage customers to make deposits remotely from the safety of their home or business. The Company implemented a schedule whereby most staff members are working remotely at any given time, allowing the remaining essential staff to create more distance between each other within the offices. We temporarily increased the number of staff in the client service center to assist more customers by telephone and encourage them to utilize online and mobile banking. The client service center was also temporarily moved to a larger location to allow for appropriate social distancing. In addition, the Company enhanced disinfecting procedures to include hospital-grade cleaning solution and foggers, increased the frequency of cleaning and issued personal protective equipment, including N-95 and disposable face masks, face shields, sneeze guards, gloves and thermometers, to employees, along with specific instructions for use, to enhance their safety. We also installed disinfecting protective strips to high touch areas and placed free-standing air filter machines throughout our facilities. We purchased COVID-19 instant test kits that we have on-site, ready to be deployed when needed, and we provided antibody testing options to all employees. Management provides frequent email communications and social media updates regarding COVID-19, helpful tips and status of Company initiatives, as well as warning customers of potential scams during this pandemic. Beginning mid-July of 2020, the Company took steps to resume normal branch activities with specific guidelines in place to continue protecting our customers and employees. The Company’s preparedness resulted in minimal impact to the Company’s operations as a result of COVID-19. Business continuity planning allowed for successful deployment of most of our employees to work in a remote environment. No material operational or internal control risks have been identified to date, and the Company has enhanced fraud-related controls. APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES The accounting and reporting policies followed by the Company conform, in all material respects, to GAAP and to general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Company bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates. The Company considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s consolidated financial statements. The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations. For additional information regarding critical accounting policies, refer to the Application of Critical Accounting Policies and Critical Accounting Estimates section under Item 7 in the Company’s 2020 Form 10-K. There have been no significant changes in the Company’s application of critical accounting policies since December 31, 2020. 35 FINANCIAL CONDITION Total assets The total assets of the Company as of March 31, 2021 were $918.4 million. This is a $70.0 million, or 8.2%, increase from the $848.4 million total assets reported at December 31, 2020 and a $201.3 million, or 28.1%, increase from the $717.1 million reported at March 31, 2020. The year-over-year increase was funded by a $169.0 million increase in deposits. Federal funds sold The Company had overnight federal funds sold of $77.1 million as of March 31, 2021, compared to $26.6 million as of December 31, 2020 and $12.3 million as of March 31, 2020. Any excess funds are sold on a daily basis in the federal funds market. The Company intends to maintain sufficient liquidity at all times to meet its funding commitments. The Company continues to participate in the Excess Balance Account (“EBA”) of the Federal Reserve Bank of Richmond (“FRB”). The EBA is a limited-purpose account at the FRB for the maintenance of excess cash balances held by financial institutions. The EBA eliminates the potential of concentration risk that comes with depositing excess balances with one or multiple correspondent banks. Securities The Company’s investment securities portfolio as of March 31, 2021 totaled $175.7 million, a decrease of $1.4 million compared with the $177.1 million reported at December 31, 2020 and an increase of $71.9 million from the $103.8 million reported at March 31, 2020. Management proactively manages the mix of earning assets and cost of funds to maximize the earning capacity of the Company. At March 31, 2021 and December 31, 2020, the investment securities holdings represented 19.1% and 20.9% of the Company’s total assets, respectively. The Company’s investment securities portfolio included restricted securities totaling $2.7 million as of March 31, 2021, compared to $3.0 million as of December 31, 2020 and $1.7 million as of March 31, 2020. These securities represent stock in the FRB, the Federal Home Loan Bank of Atlanta (“FHLB”), and CBB Financial Corporation, the holding company for Community Bankers Bank. The level of FRB and FHLB stock that the Company is required to hold is determined in accordance with membership guidelines provided by the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the FHLB, respectively. Stock ownership in the bank holding company for Community Bankers’ Bank provides the Company with several benefits that are not available to non-shareholder correspondent banks. None of these restricted securities are traded on the open market and can only be redeemed by the respective issuer. At March 31, 2021, the unrestricted securities portfolio totaled $173.1 million. The following table summarizes the Company's available for sale securities by type as of March 31, 2021, December 31, 2020, and March 31, 2020 (dollars in thousands): March 31, 2021 December 31, 2020 March 31, 2020 Percent Percent Percent Balance of Total Balance of Total Balance of Total U.S. Government agencies $ 32,561 18.8 % $ 25,305 14.5 % $ 13,013 12.8 % Mortgage-backed securities/CMOs 72,328 41.8 % 78,100 44.9 % 67,394 66.0 % Municipal bonds 68,199 39.4 % 70,681 40.6 % 21,647 21.2 % Total available for sale securities $ 173,088 100.0 % $ 174,086 100.0 % $ 102,054 100.0 % The securities are held primarily for earnings, liquidity, and asset/liability management purposes and are reviewed quarterly for possible other-than-temporary impairments. During this review, management analyzes the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer, and the Company’s intent and ability to hold the security to recovery or maturity. These factors are analyzed for each individual security. Loan portfolio A management objective is to grow loan balances while maintaining the asset quality of the loan portfolio. The Company seeks to achieve this objective by maintaining rigorous underwriting standards coupled with regular evaluation of the creditworthiness of, and the designation of lending limits for, each borrowing relationship. The portfolio strategies include seeking industry, loan size, and loan type diversification to minimize credit exposure and originating loans in markets with 36 which the Company is familiar. The predominant market area for the loans shown below includes Charlottesville, Albemarle County, Winchester, Frederick County , Richmond and area s in the Commonwealth of Virginia that are within a 75-mile radius of any office of the Company . As of March 31, 2021, total loans were $621.1 million, compared to $609.4 million as of December 31, 2020 and $554.0 million at March 31, 2020. Loans as a percentage of total assets at March 31, 2021 were 67.6%, compared to 77.3% as of March 31, 2020. Loans as a percentage of deposits at March 31, 2021 were 77.2%, compared to 87.2% as of March 31, 2020. The following table summarizes the Company's loan portfolio by type of loan as of March 31, 2021, December 31, 2020, and March 31, 2020 (dollars in thousands): March 31, 2021 December 31, 2020 March 31, 2020 Balance Percent of Total Balance Percent of Total Balance Percent of Total Commercial and industrial $ 130,388 21.0 % $ 118,688 19.5 % $ 79,997 14.4 % Real estate - commercial 280,215 45.1 % 282,781 46.4 % 259,277 46.8 % Real estate - residential mortgage 129,221 20.8 % 127,294 20.9 % 121,601 22.0 % Real estate - construction 26,254 4.2 % 22,509 3.7 % 25,105 4.5 % Consumer loans 54,990 8.9 % 58,134 9.5 % 67,979 12.3 % Total loans $ 621,068 100.0 % $ 609,406 100.0 % $ 553,959 100.0 % Loan balances increased $11.7 million, or 1.9%, since December 31, 2020 and increased $67.1 million, or 12.1%, from March 31, 2020. The increases are largely due to the origination of PPP loans of $86.9 million in 2020, as well as $36.2 million during the first quarter of 2021. As of March 31, 2021, 43% of the total dollars of PPP loans had been forgiven by the SBA, with $70.2 million outstanding. The purchase of loans is considered a secondary strategy, which allows the Company to supplement organic loan growth. Balances in purchased loans were $113.7 million as of March 31, 2020 and have declined $26.6 million compared to $87.1 million as of March 31, 2021 Balances outstanding in purchased loans as of March 31, 2021 were comprised of: • Student loans totaling $35.7 million. The Company purchased two student loan packages in 2015, a third tranche in the fourth quarter of 2016, and a fourth tranche in the fourth quarter of 2017. Along with the purchase of these four packages of student loans, the Company purchased surety bonds to fully insure this portion of the Company’s consumer portfolio. However, during June 2018, ReliaMax Surety, the insurance company which issued the surety bonds, was placed into liquidation due to insolvency. Loss claims were filed for loans in default as of July 27, 2018, when the surety bonds were terminated, and the Company received payment in the fourth quarter of 2019 on the balance of the claims approved by the liquidator. Also, in 2020 the Company realized a partial recovery of unearned insurance premiums related to the loss of insurance on the student loan portfolio in the amount of $401 thousand. The Company expects to receive the balance of unearned premiums of approximately $400 thousand. Student loans continue to be profitable for the Company. • Loans guaranteed by a U.S. government agency (“government guaranteed”) totaling $29.0 million, inclusive of premium. During the fourth quarter of 2016, the Company began augmenting the commercial and industrial portfolio with government guaranteed loans which represent the portion of loans that are 100% guaranteed by either the United States Department of Agriculture or the SBA; the originating institution holds the unguaranteed portion of each loan and services it. These government guaranteed portions of loans are typically purchased at a premium. In the event of early prepayment, the Company may need to write off any unamortized premium. • Mortgage loans totaling $16.1 million, inclusive of premium. In each of the fourth quarters of 2019 and 2018, the Company purchased a package of 1-to-4 family residential mortgages. Each of the adjustable rate loans purchased were individually underwritten by the Company prior to the closing of the purchases. The collateral on these loans is located primarily on the East Coast of the United States. The balance in purchased mortgage loans declined $13.6 million, or 45.8%, from March 31, 2020 to March 31, 2021, due to significant payoffs during this low rate environment. 37 • Syndicated loans totaling $6.4 million. Syndicated loans represent shared national credits in leveraged lending transactions and are included in the commercial and industrial portfolio. The Company has developed policies to limit overall credit exposure to the syndicated market, as well as limits by industry and amount per borrower. Management proactively manages shared national credits and has opportunistically increased or decreased exposure over time. Management will continue to evaluate loan purchase transactions to strengthen earnings, diversify the loan portfolio and supplement organic loan growth. Loan quality Non-accrual loans totaled $5 thousand at March 31, 2021, compared to the $8 thousand and $273 thousand reported at December 31, 2020 and March 31, 2020, respectively. The March 31, 2020 non-accrual balance included a loan which was foreclosed upon during the second quarter of 2020, with the Company being made whole on the loan with the proceeds from a third-party bidder without the Company’s taking title to the property. The Company had loans in its portfolio totaling $399 thousand, $137 thousand and $733 thousand, as of March 31, 2021, December 31, 2020 and March 31, 2020, respectively, that were 90 or more days past due, with all such loans still accruing interest as the Company deemed them to be collectible. The balance as of March 31, 2021 consists of one government-guaranteed loan in the amount $382 thousand and one student loan in the amount of $17 thousand. At March 31, 2021, the Company had loans classified as impaired loans in the amount of $1.2 million, a decline compared to $1.3 million at December 31, 2020 and $2.4 million at March 31, 2020. Based on regulatory guidance on student lending, the Company has classified 68 of its purchased student loans as TDRs for a total of $1.1 million as of March 31, 2021. These borrowers that should have been in repayment have requested and been granted payment extensions or reductions exceeding the maximum lifetime allowable payment forbearance of twelve months (36 months lifetime allowance for military service), as permitted under the regulatory guidance, and are therefore considered TDRs. Student loan borrowers are allowed in-school deferments, plus an automatic six-month grace period post in-school status, before repayment is scheduled to begin, and these deferments do not count toward the maximum allowable forbearance. Management has evaluated these loans individually for impairment and included any probable loss in the allowance for loan loss; interest continues to accrue on these TDRs during any deferment and forbearance periods. Management identifies potential problem loans through its periodic loan review process and considers potential problem loans as those loans classified as special mention, substandard, or doubtful. Allowance for loan losses In general, the Company determines the adequacy of its ALLL by considering the risk classification and delinquency status of loans and other factors. Management may also establish specific allowances for loans which management believes require allowances greater than those allocated according to their risk classification. The purpose of the allowance is to provide for losses inherent in the loan portfolio. Since risks to the loan portfolio include general economic trends as well as conditions affecting individual borrowers, the allowance is an estimate. The Company is committed to determining, on an ongoing basis, the adequacy of its ALLL. The Company applies historical loss rates to various pools of loans based on risk rating classifications. In addition, the adequacy of the ALLL is further evaluated by applying estimates of loss that could be attributable to any one of the following eight qualitative factors: 1) Changes in national and local economic conditions, including the condition of various market segments; 2) Changes in the value of underlying collateral; 3) Changes in volume of classified assets, measured as a percentage of capital; 4) Changes in volume of delinquent loans; 5) The existence and effect of any concentrations of credit and changes in the level of such concentrations; 6) Changes in lending policies and procedures, including underwriting standards; 7) Changes in the experience, ability and depth of lending management and staff; and 8) Changes in the level of policy exceptions. As discussed earlier, the Company utilizes a loss migration model. Migration analysis uses loan level attributes to track the movement of loans through various risk classifications in order to estimate the percentage of losses likely in the portfolio. As of March 31, 2020 and June 30, 2020, the Company downgraded the economic qualitative factors within its ALLL model in light of the effects of COVID-19 on the economy. No additional downgrades of such factors were taken during the quarter 38 ended September 30, 2020 , December 31, 2020 or March 31, 2021 . If economic conditions improve or worsen , the Company could experience changes in the required ALLL. It is possible that asset quality metrics could decline in the future if the effects of COVID-19 are sustained. The relationship of the ALLL to total loans appears below (dollars in thousands): March 31, 2021 December 31, 2020 March 31, 2020 Loans held for investment at period-end $ 621,068 $ 609,406 $ 553,959 Allowance for loan losses $ 5,615 $ 5,455 $ 4,704 Allowance as a percent of period-end loans 0.90 % 0.90 % 0.85 % The ALLL as a percentage of loans was 0.90% as of March 31, 2021 and December 31, 2020, and 0.85% as of March 31, 2020. The percentage increase as compared to a year ago was primarily due to the increase in the necessary allowance on most of the Company’s loans due to worsening economic qualitative factors, as well as impact of the increase in substandard loans, partially offset by the SBA-guaranteed PPP loans not requiring an allowance. The ALLL as a percentage of loans, excluding PPP loans (a non-GAAP financial measure), would have been 1.02% as of March 31, 2021 and 0.98% as of December 31, 2020. Refer to the Reconciliation of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to non-GAAP ALLL as a percentage of loans. Provisions for loan losses totaling $351 thousand and $765 thousand were recorded in the three months ended March 31, 2021 and 2020, respectively. The following is a summary of the changes in the ALLL for the three months ended March 31, 2021 and 2020 (dollars in thousands): 2021 2020 Allowance for loan losses, January 1 $ 5,455 $ 4,209 Charge-offs (241 ) (388 ) Recoveries 50 118 Provision for loan losses 351 765 Allowance for loan losses, March 31 $ 5,615 $ 4,704 For additional insight into management’s approach and methodology in estimating the ALLL, please refer to the earlier discussion of “Allowance for Loan Losses” in Note 4 of the Notes to Consolidated Financial Statements. In addition, Note 4 includes details regarding the rollforward of the allowance by loan portfolio segments. The rollforward tables indicate the activity for loans that are charged-off, amounts received from borrowers as recoveries of previously charged-off loan balances, and the allocation by loan portfolio segment of the provision made during the period. The events that can positively impact the amount of allowance in a given loan segment include any one or all of the following: the recovery of a previously charged-off loan balance; the decline in the amount of classified or delinquent loans in a loan segment from the previous period, which most commonly occurs when these loans are repaid or are foreclosed; or when there are improvements in the ratios used to estimate the probability of loan losses. Improvements to the ratios could include lower historical loss rates, improvements to any of the qualitative factors mentioned above, or reduced loss expectations for individually-classified loans. Management reviews the ALLL on a quarterly basis to ensure it is adequate based upon the calculated probable losses inherent in the portfolio. Management believes the ALLL was adequately provided for as of March 31, 2021 and acknowledges that the ALLL may increase throughout the year as economic conditions may continue to deteriorate for the foreseeable future. Premises and equipment The Company’s premises and equipment, net of depreciation, as of March 31, 2021 totaled $5.1 million compared to $5.2 million as of December 31, 2020 and $6.0 million as of March 31, 2020. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method based on the estimated useful lives of assets. Expenditures for repairs and maintenance are charged to expense as incurred. The costs of major renewals and betterments are capitalized and depreciated over their estimated useful lives. Upon disposition, assets and related accumulated depreciation are removed from the books, and any resulting gain or loss is charged to income. 39 As of March 31, 2021 , the Company occupied five full-service banking facilities in the cities of Charlottesville and Winchester, as well as the count y of Al bemarle in Virginia. The Company also operates a drive-through location at 301 East Water Street, Charlottesville, Virginia. T he Company entered into a lease for branch and office space in Richmond, Virginia during the first quarter of 2020 and anticipates opening the office during the second quarter of 2021 , a bsent delays as a result of COVID-19. The five-story office building at 404 People Place, Charlottesville, Virginia, located in Albemarle County, also serves as the Company’s corporate headquarters, operations center, and offices of both Masonry Capital and Sturman Wealth Advisors. VNB Trust & Estate Services is located at 112 Third Street, SE, Charlottesville, Virginia, which is part of the same leased space that the Company uses to operate the drive-through location at 301 East Water Street, Charlottesville, Virginia. Both the Arlington Boulevard facility in Charlottesville and the People Place facility also contain office space that is currently under lease to tenants. Leases As of March 31, 2021, $3.3 million of right-of-use assets and $3.4 million of lease liabilities are included in Other Assets and Other Liabilities, respectively, in accordance with Accounting Standards Update 2016-02 “Leases” (Topic 842). As of March 31, 2020, $3.4 million of right-of-use assets and lease liabilities were included in Other Assets and Other Liabilities. Right-of-use assets are assets that represent the Company’s right to use, or control the use of, a specified asset for the lease term, offset by the lease liability, which is the Company’s obligation to make lease payments arising from a lease, measured on a discounted basis. Deposits Deposit accounts represent the Company’s primary source of funds and are comprised of demand deposits, interest-bearing checking, money market, and savings accounts as well as time deposits. These deposits have been provided predominantly by individuals, businesses and charitable organizations in the Charlottesville/Albemarle County, Richmond and Winchester areas. Total deposits as of March 31, 2021 were $804.2 million, an increase of $73.4 million compared to the balances of $730.8 million at December 31, 2020, and an increase of $169.1 million compared to the $635.1 million total as of March 31, 2020. The primary reason for the increase since year-end is due to increased balances in PPP customer accounts. Deposit accounts (dollars in thousands) March 31, 2021 December 31, 2020 March 31, 2020 Balance % of Total Deposits Balance % of Total Deposits Balance % of Total Deposits No cost and low cost deposits: Noninterest demand deposits $ 248,212 30.9 % $ 209,772 28.71 % $ 190,618 30.0 % Interest checking accounts 162,218 20.2 % 148,910 20.37 % 124,350 19.6 % Money market and savings deposit accounts 292,886 36.4 % 272,980 37.36 % 218,432 34.4 % Total noninterest and low cost deposit accounts 703,316 87.5 % 631,662 86.4 % 533,400 84.0 % Time deposit accounts: Certificates of deposit 92,352 11.4 % 90,615 12.4 % 89,681 14.1 % CDARS deposits 8,492 1.1 % 8,487 1.2 % 12,055 1.9 % Total certificates of deposit and other time deposits 100,844 12.5 % 99,102 13.6 % 101,736 16.0 % Total deposit account balances $ 804,160 100.0 % $ 730,764 100.0 % $ 635,136 100.0 % Noninterest-bearing demand deposits on March 31, 2021 were $248.2 million, representing 30.9% of total deposits. Interest-bearing transaction, money market, and savings accounts totaled $455.1 million, and represented 56.6% of total deposits at March 31, 2021. Collectively, noninterest-bearing and interest-bearing transaction and money market accounts 40 represented 87.5 % of total deposit accounts at March 31, 2021 . These account types are an excellent source of low-cost funding for the Company. The Company also offers insured cash sweep (“ICS ® ”) deposit products. ICS ® deposit balances of $40.6 million and $88.0 million are included in the interest checking accounts and the money market and savings deposit accounts balances, respectively, in the table above, as of March 31, 2021. As of December 31, 2020, ICS ® deposit balances of $28.0 million and $81.1 million are included in the interest checking accounts and the money market and savings deposit account balances, respectively. All ICS accounts consist of reciprocal balances for the Company’s customers. The remaining 12.5% and 13.6% of total deposits consisted of certificates of deposit and other time deposit accounts totaling $100.8 million and $99.1 million at March 31, 2021 and December 31, 2020, respectively. Included in these deposit totals are Certificate of Deposit Account Registry Service CDs, known as CDARS TM , whereby depositors can obtain Federal Deposit Insurance Corporation (“FDIC”) deposit insurance on account balances of up to $50 million. CDARS TM deposits totaled $8.5 million as of March 31, 2021 and December 31, 2020, all of which were reciprocal balances for the Company’s customers. Borrowings Short-term borrowings, consisting primarily of FHLB advances and federal funds purchased, are additional sources of funds for the Company. The level of these borrowings is determined by various factors, including customer demand and the Company's ability to earn a favorable spread on the funds obtained. The Company has a collateral dependent line of credit with the FHLB. As of March 31, 2021 and December 31, 2020, the Company had $30.0 million in outstanding balances from FHLB advances. As of March 31, 2020, the Company had no outstanding balances from FHLB advances. Additional borrowing arrangements maintained by the Company include formal federal funds lines with four major regional correspondent banks and the Federal Reserve discount window. The Company had no outstanding balances on these lines or facilities as of March 31, 2021, December 31, 2020 or March 31, 2020. Shareholders' equity and regulatory capital ratios The following table displays the changes in shareholders' equity for the Company from December 31, 2019 to March 31, 2021 (dollars in thousands): Equity, December 31, 2020 $ 82,598 Net income 1,505 Other comprehensive loss (3,387 ) Cash dividends declared (814 ) Equity increase due to exercise of stock options 15 Equity increase due to expensing of stock options 34 Equity increase due to expensing of restricted stock 61 Equity, March 31, 2021 $ 80,012 The Basel III capital rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter). The Company’s Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios were 14.49%, 14.49%, 15.49% and 9.02%, respectively, as of March 31, 2021, thus exceeding the minimum requirements. The Bank’s Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios were 14.35%, 14.35%, 15.35% and 8.94%, respectively, as of March 31, 2021, also exceeding the minimum requirements. 41 As of March 31, 2021 , the Bank exceeded all of the following minimum capital ratios in order to be considered “well capitalized” under the “prompt corrective action” regulations, as revised : (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%. RESULTS OF OPERATIONS Non-GAAP presentations The Company, in referring to its net income and net interest income, is referring to income computed in accordance with GAAP, unless otherwise noted. Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations also refer to various calculations that are non-GAAP presentations. They include: • Fully taxable-equivalent (“FTE”) adjustments – Net interest margin and efficiency ratios are presented on an FTE basis, consistent with SEC guidance in Industry Guide 3 which states that tax exempt income may be calculated on a tax equivalent basis. This is a non-GAAP presentation. The FTE basis adjusts for the tax-exempt status of net interest income from certain investments using a federal tax rate of 21%, where applicable, to increase tax-exempt interest income to a taxable-equivalent basis. • Net interest margin – Net interest margin (FTE) is calculated as net interest income, computed on an FTE basis, expressed as a percentage of average earning assets. The Company believes this measure to be the preferred industry measurement of net interest margin and that it enhances comparability of net interest margin among peers in the industry. • Efficiency ratio – One of the ratios the Company monitors in its evaluation of operations is the efficiency ratio, which measures the cost to produce one dollar of revenue. The Company computes its efficiency ratio (FTE) by dividing noninterest expense by the sum of net interest income (FTE) and noninterest income. A lower ratio is an indicator of increased operational efficiency. This non-GAAP metric is used to assist investors in understanding how management assesses its ability to generate revenues from its non-funding-related expense base, as well as to align presentation of this financial measure with peers in the industry. The Company believes this measure to be the preferred industry measurement of operational efficiency, which is consistent with FDIC studies. • Performance measures exclude nonrecurring merger expenses, which were incurred in connection with due diligence, legal and other professional fees associated with the proposed merger with Fauquier. Management believes that the exclusion of the significant one-time effect of merger expenses provides users of the Company’s financial information a presentation of the Company’s financial results that is representative of its ongoing operations. In this non-GAAP presentation, the merger expenses incurred is added to the Company’s net income. • The allowance for loan losses as a percentage of loans, excluding PPP loans, measure eliminates the impact of PPP loans. Management believes that the elimination of the impact of PPP loans provides users of the Company’s financial information a presentation of the Company’s allowance for loan loss percentage that is representative of its ongoing operations. • Tangible book value per share excludes the impact of the balances of goodwill and other intangibles. Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, to evaluate use of equity, financial condition and capital strength. Management uses these non-GAAP measures to evaluate the Company’s operating performance on a basis comparable to other financial periods. Net income is discussed in Management’s Discussion and Analysis on a GAAP basis unless noted as “non-GAAP.” 42 The reconcilement below shows how these non-GAAP measures are computed from their respective GAAP measures (dollars in thousands): Reconcilement of Non-GAAP Measures: Three Months Ended March 31, 2021 March 31, 2020 Fully tax-equivalent measures Net interest income $ 5,974 $ 5,375 Fully tax-equivalent adjustment 47 20 Net interest income (FTE) $ 6,021 $ 5,395 Efficiency ratio 68.2 % 64.5 % Fully tax-equivalent adjustment -0.5 % -0.2 % Efficiency ratio (FTE) 67.7 % 64.3 % Net interest margin 2.81 % 3.18 % Fully tax-equivalent adjustment 0.02 % 0.02 % Net interest margin (FTE) 2.83 % 3.20 % Performance measures Return on average assets 0.68 % 0.78 % Impact of merger expenses 0.03 % — Operating return on average assets (non-GAAP) 0.71 % 0.78 % Return on average equity 7.40 % 7.28 % Impact of merger expenses 0.34 % — Operating return on average equity (non-GAAP) 7.74 % 7.28 % Other financial measures ALLL to total loans 0.90 % 0.85 % Impact of PPP loans 0.12 % — ALLL to total loans, excluding PPP loans (non-GAAP) 1.02 % 0.85 % Book value per share $ 29.33 $ 28.23 Impact of intangibles (0.26 ) (0.28 ) Tangible book value per share (non-GAAP) $ 29.07 $ 27.95 Net income Net income for the three months ended March 31, 2021 was $1.5 million, a $101 thousand or 7.2% increase compared to net income reported for the three months ended March 31, 2020. Net income per diluted share was $0.55 for the quarter ended March 31, 2021 compared to $0.52 per diluted share for the same quarter in the prior year. The increase in net income for the three months ended March 31, 2021, when compared to the same period of 2020, was attributable to the combination of: i) a $599 thousand increase in net interest income, primarily due to lower cost of funds; ii) a $414 thousand decrease in provision for loan losses, largely due to a larger provision taken in the first quarter of the prior year driven by deterioration in the economic outlook resulting from the initial onset of COVID-19, iii) a $630 thousand decrease in noninterest income, as explained in the Noninterest income section below; iv) a $238 thousand increase in noninterest expense, as explained in the Noninterest expense section below, and v) a $44 thousand increase in provision for income taxes. Net interest income Net interest income (FTE) for the three months ended March 31, 2021 was $6.0 million, a $626 thousand or 11.6% increase compared to net interest income (FTE) of $5.4 million for the three months ended March 31, 2020. Net interest income (FTE) was positively impacted by the decrease in rates paid on deposit accounts, which decreased interest expense by 43 $ 631 thousand , offset by the increased volume of deposits, which increased interest expense by $ 9 9 thousand . The increased volume of loans, increasing from an average of $ 535.8 million in the first quarter of 20 20 to $ 6 18.9 million in the first quarter of 202 1 , positively impacted interest income by $ 847 thousand ; however, the lower rate earned on loans, declining from 4. 41 % to 3 . 89 % for the periods noted, negatively impacted interest income by $ 780 thousand , nearly offsetting the positive impact of the increase in volume . The increase in volume of securities held, increasing from an average balance of $ 114.2 million for the first quarter of 20 20 to $1 76.1 million for the first quarter of 202 1 , positively impacted net interest income by $32 5 thousand, while the decline in yield earned on such securities decreased from 2. 20 % to 1.74% for the periods noted, negatively impact ed net interest income by $1 8 9 thousand. Net interest margin (FTE) is the ratio of net interest income (FTE) to average earning assets for the period. The level of interest rates, together with the volume and mix of earning assets and interest-bearing liabilities, impact net interest income (FTE) and net interest margin (FTE). The net interest margin (FTE) of 2.83% for the three months ended March 31, 2021 was 37 basis points lower than the 3.20% for the three months ended March 31, 2020. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to non-GAAP net interest margin. Interest expense decreased $496 thousand for the three months ended March 31, 2021 compared to the same period in the prior year, due predominantly to rate decreases. The rate paid on interest-bearing deposits averaged 50 basis points in the three months ended March 31, 2021, compared to 104 basis points for the three months ended March 31, 2020. Average balances of interest-bearing deposits increased from $460.6 million in the three months ended March 31, 2020 to $530.8 million in the three months ended March 31, 2021. Average balances of borrowed funds, from FHLB advances, increased from zero in the three months ended March 31, 2020 to $30.0 million in the three months ended March 31, 2021, causing an increase in interest expense on borrowed funds of $36 thousand. The following table details the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest-bearing liabilities, for the three months ended March 31, 2021 and 2020. This table also includes a rate/volume analysis for these same periods (dollars in thousands). 44 Consolidated Average Balance Sheet and Analysis of Net Interest Income For the three months ended March 31, 2021 March 31, 2020 Change in Interest Income/ Expense Average Interest Average Average Interest Average Change Due to : 4 Total Balance Income/ Yield/Cost Balance Income/ Yield/Cost Volume Rate Increase/ (dollars in thousands) Expense Expense (Decrease) ASSETS Interest Earning Assets: Securities Taxable Securities $ 142,837 $ 541 1.52 % $ 102,786 $ 533 2.07 % $ 175 $ (167 ) $ 8 Tax Exempt Securities 1 33,234 223 2.68 % 11,425 95 3.33 % 150 (22 ) 128 Total Securities 1 176,071 764 1.74 % 114,211 628 2.20 % 325 (189 ) 136 Total Loans 618,902 5,938 3.89 % 535,832 5,871 4.41 % 847 (780 ) 67 Fed Funds Sold 67,400 12 0.07 % 28,898 85 1.18 % 51 (124 ) (73 ) Total Earning Assets 862,373 6,714 3.16 % 678,941 6,584 3.90 % 1,223 (1,093 ) 130 Less: Allowance for Loan Losses (5,476 ) (4,081 ) Total Non-Earning Assets 45,619 45,520 Total Assets $ 902,516 $ 720,380 LIABILITIES AND SHAREHOLDERS' EQUITY Interest Bearing Liabilities: Interest Bearing Deposits: Interest Checking $ 146,781 $ 26 0.07 % $ 122,719 $ 31 0.10 % 5 $ (10 ) $ (5 ) Money Market and Savings Deposits 284,333 351 0.50 % 228,891 664 1.17 % 133 (446 ) (313 ) Time Deposits 99,692 280 1.14 % 108,941 494 1.82 % (39 ) (175 ) (214 ) Total Interest-Bearing Deposits 530,806 657 0.50 % 460,551 1,189 1.04 % 99 (631 ) (532 ) Other borrowed funds 30,000 36 0.49 % — — — 18 18 36 Total Interest-Bearing Liabilities 560,806 693 0.50 % 460,551 1,189 1.04 % 117 (613 ) (496 ) Non-Interest-Bearing Liabilities: Demand deposits 255,227 177,878 Other liabilities 3,948 4,405 Total Liabilities 819,981 642,834 Shareholders' Equity 82,535 77,546 Total Liabilities & Shareholders' Equity $ 902,516 $ 720,380 Net Interest Income (FTE) $ 6,021 $ 5,395 $ 1,106 $ (480 ) $ 626 Interest Rate Spread 2 2.66 % 2.86 % Interest Expense as a Percentage of Average Earning Assets 0.33 % 0.70 % Net Interest Margin (FTE) 3 2.83 % 3.20 % ( 1) Tax-exempt income for investment securities has been adjusted to a fully tax-equivalent basis (FTE), using a Federal income tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations earlier in this section. (2) Interest spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities. (3) Net interest margin (FTE) is net interest income expressed as a percentage of average earning assets. (4) The impact on the net interest income (FTE) resulting from changes in average balances and average rates is shown for the period indicated. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. 45 Provision for loan losses A provision for loan losses of $351 thousand was recognized during the three months ended March 31, 2021 compared to a provision for loan losses of $765 thousand recognized during the three months ended March 31, 2020, primarily due to the deterioration in the economic outlook resulting from the impact of COVID-19. The period-end ALLL as a percentage of assets was 0.90% as of March 31, 2021 and December 31, 2020 and 0.85% as of March 31, 2020. The percentage increase as compared to the prior year was primarily due to the increase in the necessary allowance on most of the Company’s loans due to worsening economic qualitative factors later in 2020, which was partially offset by the SBA-guaranteed PPP loans not needing an allowance. Further discussion of management’s assessment of the ALLL is provided earlier in the report and in Note 4 – Allowance for Loan Losses, found in the Notes to the Consolidated Financial Statements. In management’s opinion, the allowance was adequately provided for at March 31, 2021. The ALLL calculation, provision for loan losses, asset quality and collateral values may be significantly impacted by deterioration in economic conditions. We have downgraded the qualitative factors pertaining to economic conditions within our ALLL methodology; should economic conditions worsen, we could experience further increases in our required ALLL and record additional provision for loan loss exposure. Noninterest income The components of noninterest income for the three months ended March 31, 2021 and 2020 are shown below (dollars in thousands): For the three months ended Variance March 31, 2021 March 31, 2020 $ % Noninterest income: Wealth management fees $ 329 $ 310 $ 19 6.1 % Advisory and brokerage income 191 178 13 7.3 % Royalty income 5 47 (42 ) -89.4 % Deposit account fees 160 179 (19 ) -10.6 % Debit/credit card and ATM fees 154 157 (3 ) -1.9 % Earnings/increase in value of bank owned life insurance 107 107 0 0.0 % Fees on mortgage sales - 47 (47 ) -100.0 % Gains on sales of securities - 53 (53 ) -100.0 % Loan swap fee income 15 509 (494 ) -97.1 % Other 78 82 (4 ) -4.9 % Total noninterest income $ 1,039 $ 1,669 $ (630 ) -37.7 % Noninterest income for the three months ended March 31, 2021 of $1.0 million was $630 thousand or 37.7% lower than the amount recorded for the three months ended March 31, 2020. Noninterest income fell predominantly due to the decline in loan swap fee income of $494 thousand, as swap arrangements are less attractive to borrowers in the current interest rate environment. Additionally, there were no sales of securities in the first quarter of 2021, compared to gains on sales of securities of $53 thousand for the first quarter of 2021, and there were no fees on mortgage sales earned in the first quarter of the current year due to elimination of the department. 46 Noninterest expense The components of noninterest expense for the three months ended March 31, 2021 and 2020 are shown below (dollars in thousands): For the three months ended Variance March 31, 2021 March 31, 2020 $ % Noninterest expense: Salaries and employee benefits $ 2,402 $ 2,424 $ (22 ) -0.9 % Net occupancy 495 452 43 9.5 % Equipment 116 131 (15 ) -11.5 % ATM, debit and credit card 42 54 (12 ) -22.2 % Bank franchise tax 173 163 10 6.1 % Computer software 167 140 27 19.3 % Data processing 289 328 (39 ) -11.9 % FDIC deposit insurance assessment 63 0 63 N/A Loan expenses 63 91 (28 ) -30.8 % Marketing, advertising and promotion 137 139 (2 ) -1.4 % Merger expenses 278 - 278 N/A Professional fees 177 186 (9 ) -4.8 % Other 379 435 (56 ) -12.9 % Total noninterest expense $ 4,781 $ 4,543 $ 238 5.2 % Noninterest expense for the quarter ended March 31, 2021 of $4.8 million was $238 thousand or 5.2% higher than the quarter ended March 31, 2020. The predominant reason for the increase was that the Company incurred $278 thousand in merger-related expenses during the three months ended March 31, 2021. During the three months ended March 31, 2021, the Company expensed $63 thousand related to FDIC deposit insurance assessment, compared to zero in the first quarter of the prior year. The efficiency ratio (FTE) of 67.7% for the three months ended March 31, 2021 was elevated compared to the 64.3% for the same quarter of 2020, due primarily to the decrease in noninterest income. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to non-GAAP efficiency ratio. Provision for Income Taxes For the three months ended March 31, 2021 and 2020, the Company provided $376 thousand and $332 thousand for Federal income taxes, respectively, resulting in an effective income tax rate of 20.0% and 19.1%, respectively. The effective income tax rates differed from the U.S. statutory rate of 21% primarily due to the effect of tax-exempt income from life insurance policies and municipal bonds, and the effective rate for the three months ended March 31, 2021 was higher than the prior year, as certain merger related expenses are non-deductible for tax purposes. OTHER SIGNIFICANT EVENTS None ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not required 47