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Item 2. Management’s Discussion and Analysis

2021-08-13 compared with 2021-05-10 · 313 added, 192 removed, 283 unchanged (64% of the section changed)

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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.

Operating results for the three and six months ended June 30, 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

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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.

Refer to Note 2 - Business Combinations, in the Notes to Consolidated Financial Statements, for further detail on the accounting policy for business combinations, fair values of assets and liabilities assumed, assumptions used in determining the fair values of assets and liabilities and the resulting goodwill.

Our primary financial goal is to maximize the Company’s earnings to increase long-term shareholder value.

We monitor three key financial performance measures to determine our success in realizing this goal:

1) return on average assets (ROAA), 2) return on average equity (ROAE), and 3) net income per share (EPS).

Return on average assets (“ROAA”) for the second quarter of 2021 was 0.03% compared to 1.07% realized in the same period in the prior year.

ROAA excluding the impact of merger expenses (a non-GAAP financial measure) would have been 1.02% for the second quarter of 2021.

ROAA for the six months ended June 30, 2021 was 0.24% compared to 0.93% realized in the same period in the prior year.

ROAA excluding the impact of merger expenses (a non-GAAP financial measure) would have been 0.93% for the six months ended June 30, 2021, equaling the ROAA for the prior comparable period.

Return on average equity (“ROAE”) for the second quarter of 2021 was 0.37% compared to 10.64% realized in same period in the prior year.

ROAE excluding the impact of merger expenses (a non-GAAP financial measure) would have been 11.89% for the second quarter of 2021.

ROAE for the six months ended June 30, 2021 was 2.76% compared to 8.98% realized in same period in the prior year.

ROAE excluding the impact of merger expenses (a non-GAAP financial measure) would have been 10.66% for the six months ended June 30, 2021, exceeding the ROAE from the comparable period in the prior year.

The Company incurred $5.9 million in merger expenses during the second quarter of 2021 related to the combination with Fauquier, which closed on April 1, 2021.

Of this total, $2.2 million was incurred for system deconversion, termination and conversion fees, $1.5 million was accrued for the change-of-control payment for Marc Bogan resulting from his resignation, $1.1 million related to buyer investment banker fees, $510 thousand was associated with valuation and integration professional fees, $269 thousand related to other personnel expenses, $235 thousand was incurred for regulatory and shareholder expenses, and $150 thousand was recognized for legal expenses.

This pre-tax expense of $5.9 million represents $1.11 per diluted share for the second quarter of 2021.

The Company incurred $6.2 million in merger expenses during the six months ended June 30, 2021.

First quarter expenses of $278 thousand related primarily to professional fees.

Net income per share was $0.03 for the second quarter of 2021, compared to $0.77 for the second quarter in the prior year.

Net income per share, excluding merger expenses (a non-GAAP financial measure), would have been $0.89 in the current quarter, exceeding the net income per share of the comparable prior period.

Net income per share was $0.41 for the first half of 2021, compared to $1.29 for the same period in the prior year.

Net income per share, excluding merger expenses (a non-GAAP financial measure), would have been $1.33 for the first half of 2021, exceeding the net income per share of the comparable prior period.

We also manage our capital levels through growth, quarterly cash dividends, periodic stock dividends and share repurchases, when prudent, while maintaining a strong capital position.

Refer to the Results of Operations, Non-GAAP Presentation section, later in this Management’s Discussion and Analysis for more discussion on these financial performance measures.

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.

Continuing cases of COVID-19, including the emergence of variants of the COVID-19 virus, continue to be a public health concern in the Company’s markets.

While more than 50% of adults in the U.S.

and in Virginia are fully vaccinated against COVID-19, the rate of vaccinations appears to have peaked during the second quarter of 2021, and the Delta variant has shown that there remains a threat of a resurgence of cases.

There have been encouraging signs of strength in the economic recovery, including growth in consumer spending and improvement in the labor market, but many businesses continue to face difficulty in hiring desirable employees and meeting consumer demand, and certain portions of the global supply chain remain challenged by shortages and delays that first occurred due to the initial COVID-19 outbreak.

There remains uncertainty about the pace of economic recovery, including uncertainty related to the labor market, inflation and fiscal and monetary policy responses from the federal government.

There remains a risk that consumers and borrowers who have been supported during the pandemic by government stimulus measures may not return to employment and may not be able to repay debts as agreed following the cessation of government stimulus programs, including expanded unemployment benefits.

Management continues to carefully monitor the pandemic and its impact on the Company’s markets, customers and employees, and believes that the pandemic continues to present risks of elevated loan losses, sustained net interest margin compression and falling demand for loans; however, at this time management cannot determine the ultimate impact of the pandemic on the results of operations of the Company.

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.

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.

During the year ended December 31, 2020, we provided an additional $1.6 million for loan losses primarily by downgrading the qualitative economic factors within the ALLL model in light of the effects of COVID-19 on the economy.

As of June 30, 2021, credit deterioration since the onset of the COVID-19 pandemic has so far not been experienced to the extent previously anticipated, and therefore, during the second quarter of 2021, we released a portion of these added reserves through a reversal of provision for loan losses.

The Company continues to maintain reserves for loan losses at June 30, 2021 related to the pandemic and believe that our allowance for loan losses will be adequate to absorb probable losses that are inherent in our loan portfolio.

If loan losses ultimately are not realized to the extent of the reserves provided for during the pandemic, our allowance for loan losses may be reduced in future periods through further reversals of provision for loan losses, which could benefit our results of operations for any such future period.

However, if there are further challenges to the economic recovery, including a resurgence in COVID-19 cases or the emergence of variants of the COVID-19 virus that threaten to disrupt economic activity, additional provision for loan losses may be required in future periods.

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.

In accordance with guidance from regulators, the Company is working 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 194 deferrals on outstanding loan balances of $59.7 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.

As of June 30, 2021, $57.7 million in loan balances, or 96.6% of the total loan deferments approved, have returned to normal payment schedules and are now current, leaving a remaining balance of deferments of $2.0 million.

Of this remaining balance, $1.9 million, or 92.8%, are 100% government-guaranteed loans for which the deferrals were approved by the United States Department of Agriculture;

and $144 thousand, or 7.2%, 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”).

In accordance with interagency guidance issued in March 2020 and the CARES Act, 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.

In total, the Company, including Virginia National Bank and The Fauquier Bank, funded $207.5 million in PPP loans, with average origination fees of 3.9%, assisting many nonprofits and local businesses through this program.

As of June 30, 2021, 66.9% of the total dollars of PPP loans had been forgiven by the SBA, with $68.8 million outstanding.

Loans funded through the PPP are fully guaranteed by the U.S.

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.

The Company believes that it performed the required due diligence pursuant to the established SBA criteria;

nonetheless, if a determination is 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.

Capital and Liquidity

As of March 31, 2021, capital ratios of the Company were in excess of regulatory requirements.

As of June 30, 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.

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.

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.

The Company’s goodwill was recognized in connection with the acquisition of Fauquier in 2021 and Sturman Wealth Management in 2016.

The Company reviews the carrying value of goodwill at least annually or more frequently if certain impairment indicators exists.

In testing goodwill for impairment, the Company may first consider qualitative factors to determine whether the existence of events or circumstances lead to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.

If, after assessing the events and circumstance, the Company concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the no further testing is required and the goodwill of the reporting unit is not impaired.

If the Company elects to bypass the qualitative assessment or if the conclusion is that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the fair value of the reporting unit is compared with its carrying value to determine whether an impairment exists.

As of June 30, 2021, the goodwill on the balance sheet was not deemed to be impaired.

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

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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.

The only significant changes in the Company’s application of critical accounting policies since December 31, 2020 relates to loans acquired in a business combination, as follows.

Loans acquired in a business combination :

Acquired Loans are classified as either i) purchased credit-impaired (PCI) loans or ii) purchased performing loans and are recorded at fair value on the date of acquisition.

PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments.

When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status.

The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.

On a quarterly basis, we evaluate our estimate of cash flows expected to be collected on PCI loans.

Estimates of cash flows for PCI loans require significant judgment.

Subsequent decreases to the expected cash flows will generally result in a provision for loan losses resulting in an increase to the allowance for loan losses.

Subsequent significant increases in cash flows may result in a reversal of post-acquisition provision for loan losses or a transfer from nonaccretable difference to accretable yield that increases interest income over the remaining life of the loan or pool(s) of loans.

Disposals of loans, which may include sale of loans to third parties, receipt of payments in full or in part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.

PCI loans are not classified nonperforming loans by the Company at the time they are acquired, regardless of whether they had been classified as nonperforming by the previous holder of such loans, and they will not be classified as nonperforming so long as, at quarterly re-estimation periods, we believe we will fully collect the new carrying value of the pools of loans.

The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the Acquired Loans’ contractual cash flows.

Purchased performing loans are recorded at fair value, including a credit discount.

The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans.

There is no allowance for loan losses established at the acquisition date for purchased performing loans.

A provision for loan losses may be required for any deterioration in these loans in future periods.

FINANCIAL CONDITION

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.

The total assets of the Company as of June 30, 2021 were $1.8 billion.

This is a $998.7 million, or 117.7%, increase from the $848.4 million total assets reported at December 31, 2020 and a $1.0 billion, or 131.0%, increase from the $799.6 million reported at June 30, 2020.

These increases were substantially due to the acquisition of Fauquier, which became effective April 1, 2021.

Interest-bearing deposits in other banks

The Company had $177.8 million of interest-bearing deposits in other banks as of June 30, 2021, compared to zero as of December 31, 2020 and June 30, 2020, as the current balance included accounts held by Fauquier, primarily at the Federal Reserve Bank of Richmond.

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.

The Company had overnight federal funds sold of $106.6 million as of June 30, 2021, compared to $26.6 million as of December 31, 2020 and $24.8 million as of June 30, 2020.

Any excess funds are sold on a daily basis in the federal funds market.

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The EBA eliminates the potential of concentration risk that comes with depositing excess balances with one or multiple correspondent banks.

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.

The Company’s investment securities portfolio as of June 30, 2021 totaled $271.2 million, an increase of $94.1 million compared with the $177.1 million reported at December 31, 2020 and an increase of $166.7 million from the $104.5 million reported at June 30, 2020.

The increases are primarily due to the inclusion of the investment securities portfolio of Fauquier upon effective date of the merger as of April 1, 2021.

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.

At June 30, 2021 and December 31, 2020, the investment securities holdings represented 14.7% and 20.9% of the Company’s total assets, respectively.

The Company’s investment securities portfolio included restricted securities totaling $4.3 million as of June 30, 2021, compared to $3.0 million as of December 31, 2020 and $1.7 million as of June 30, 2020.

These securities represent stock in the FRB, the Federal Home Loan Bank of Atlanta (“FHLB”), CBB Financial Corporation, the holding company for Community Bankers Bank, and stock in an SBA loan fund.

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.

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

At June 30, 2021, the unrestricted securities portfolio totaled $267.0 million.

The following table summarizes the Company's available for sale securities by type as of June 30, 2021, December 31, 2020, and June 30, 2020 (dollars in thousands):

June 30, 2021

December 31, 2020

March 31, 2020

June 30, 2020

Government agencies

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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

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

The portfolio strategies include seeking industry, loan size, and loan type diversification to minimize credit exposure and originating loans in markets with which the Company is familiar.

The predominant market area for the loans shown below includes the cities of Charlottesville, Winchester and Richmond, the counties of Albemarle, Fauquier, Prince William and Frederick, and areas in the Commonwealth of Virginia that are within a 75-mile radius of any office of the Company.

As of June 30, 2021, total loans were $1.2 billion, compared to $609.4 million as of December 31, 2020 and $632.4 million at June 30, 2020.

Loans as a percentage of total assets at June 30, 2021 were 63.1%, compared to 79.1% as of June 30, 2020.

Loans as a percentage of deposits at June 30, 2021 were 71.6%, compared to 88.5% as of June 30, 2020.

The following table summarizes the Company's loan portfolio by type of loan as of June 30, 2021, December 31, 2020, and June 30, 2020 (dollars in thousands):

June 30, 2021

December 31, 2020

March 31, 2020

Commercial and industrial

Real estate - commercial

Real estate - residential mortgage

Real estate - construction

Consumer loans

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.

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.

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.

June 30, 2020

Real estate construction and land

1-4 family residential mortgages

Commercial mortgages

Loan balances increased $556.8 million, or 91.4%, since December 31, 2020 and increased $533.8 million, or 84.4%, from June 30, 2020.

The increases are primarily due to the inclusion of Fauquier’s loans of $602.6 million, net of the fair value mark, as of the effective date of the merger of April 1, 2021, for which the carrying amount as of June 30, 2021 amounts to $537.5 million.

The increase from the same period in the prior year was offset by the decline in PPP loans of $18.1 million due to loan forgiveness.

As of June 30, 2021, 67% of the total dollars of PPP loans had been forgiven by the SBA, with $68.8 million outstanding.

Non-accrual loans totaled $17 thousand at June 30, 2021, compared to the $8 thousand and $11 thousand reported at December 31, 2020 and June 30, 2020, respectively.

The Company had loans in its portfolio totaling $2.8 million, $137 thousand and $1.1 million, as of June 30, 2021, December 31, 2020 and June 30, 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 June 30, 2021 includes three government-guaranteed loans in the amount $1.7 million and 54 federally insured student loans totaling $572 thousand.

This past due total only includes four non-insured student loans that are 90 days or more past due and still accruing interesting, amounting to $52 thousand.

At June 30, 2021, the Company had loans classified as impaired loans in the amount of $1.1 million, a decline compared to $1.3 million at December 31, 2020 and $2.1 million at June 30, 2020.

Based on regulatory guidance on student lending, the Company has classified 57 of its Purchased Student Loans as TDRs for a total of $1.0 million as of June 30, 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.

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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.

The Company utilizes a loss migration model, which 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

ended September 30, 2020 , December 31, 2020 or March 31, 2021 .

No additional downgrades of such factors were taken during the quarter ended September 30, 2020, December 31, 2020 or March 31, 2021.

As of June 30, 2021, credit deterioration since the onset of the pandemic has so far not been experienced to the extent previously anticipated and therefore, during the second quarter of 2021, we released a portion of these added reserves through a reversal of provision for loan losses.

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.

It is possible that asset quality metrics could decline in the future if there are further challenges to the economic recovery, including a resurgence in COVID-19 cases or the emergence of variants of the COVID-19 virus.

The relationship of the ALLL to total loans appears below (dollars in thousands):

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Allowance as a percent of period-end loans

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.

The ALLL as a percentage of loans was 0.47% as of June 30, 2021, 0.90% as of December 31, 2020, and 0.78% as of June 30, 2020.

The percentage decrease as compared to year-end and the same period in the prior year relate to the elimination of Fauquier’s ALLL as the Acquired Loans were recorded at fair value.

The ALLL as a percentage of loans, excluding the impact of Acquired Loans and the fair value mark (a non-GAAP financial measure), would have been 0.88% as of June 30, 2021.

The ALLL as a percentage of loans, excluding PPP loans (a non-GAAP financial measure), would have been 0.51% as of June 30, 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):

Provisions for loan losses totaling $210 thousand and $1.1 million were recorded in the six months ended June 30, 2021 and 2020, respectively.

The following is a summary of the changes in the ALLL for the six months ended June 30, 2021 and 2020 (dollars in thousands):

Allowance for loan losses, January 1

Provision for loan losses

Allowance for loan losses, March 31

Allowance for loan losses, June 30

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 5 of the Notes to Consolidated Financial Statements.

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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.

Management believes the ALLL was adequately provided for as of June 30, 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.

The Company’s premises and equipment, net of depreciation, as of June 30, 2021 totaled $25.4 million compared to $5.2 million as of December 31, 2020 and $5.7 million as of June 30, 2020, with the increases due to the inclusion of Fauquier’s land and buildings at fair value effective April 1, 2021.

Premises and equipment are stated at cost less accumulated depreciation.

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Upon disposition, assets and related accumulated depreciation are removed from the books, and any resulting gain or loss is charged to income.

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.

As of June 30, 2021 , the Company occupied sixteen full-service banking facilities throughout Albemarle, Fauquier and Prince William counties and the cities of Charlottesville and Winchester, 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.

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 half of 2021 .

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.

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.

TFB Wealth Management is located at 10 Courthouse Square, Warrenton, Virginia.

Both the Arlington Boulevard facility in Charlottesville and the People Place facility in Albemarle County also contain office space that is currently under lease to tenants.

As of June 30, 2021, the Company has recorded $8.4 million of right-of-use assets and $7.8 million of lease liabilities, in accordance with Accounting Standards Update 2016-02 “Leases” (Topic 842).

As of December 31, 2020, $3.5 million of right-of-use assets and $3.6 million of lease liabilities were included on the balance sheet.

The increase is due to the inclusion of Fauquier’s leases effective April 1, 2021, at fair value.

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.

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.

These deposits have been provided predominantly by individuals, businesses and charitable organizations in the Charlottesville, Albemarle, Fauquier, Prince William, Richmond and Winchester areas.

Total deposits as of June 30, 2021 were $1.6 billion, an increase of $898.7 million compared to the balances of $730.8 million at December 31, 2020, and an increase of $915.2 million compared to the $714.2 million total as of June 30, 2020.

The primary reason for the increases in the periodic comparisons is the inclusion of Fauquier’s deposits of $817.7 million, at fair value, effective upon the merger date of April 1, 2021, as well as increased balances in PPP customer accounts.

Deposit accounts

(dollars in thousands)

March 31, 2021

June 30, 2021

December 31, 2020

March 31, 2020

June 30, 2020

No cost and low cost deposits:

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Total deposit account balances

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

represented 87.5 % of total deposit accounts at March 31, 2021 .

Noninterest-bearing demand deposits on June 30, 2021 were $449.5 million, representing 27.6% of total deposits.

Interest-bearing transaction, money market, and savings accounts totaled $1.0 billion, and represented 61.9% of total deposits at June 30, 2021.

Collectively, noninterest-bearing and interest-bearing transaction and money market accounts represented 89.5% of total deposit accounts at June 30, 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.

ICS ® deposit balances of $29.2 million and $121.7 million are included in the interest checking accounts and the money market and savings deposit accounts balances, respectively, in the table above, as of June 30, 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.

The remaining 10.5% and 13.6% of total deposits consisted of certificates of deposit and other time deposit accounts totaling $171.0 million and $99.1 million at June 30, 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.

CDARS TM deposits totaled $8.8 million as of June 30, 2021 and $ 8.5 million as of December 31, 2020, all of which were reciprocal balances for the Company’s customers.

Short-term borrowings, consisting primarily of FHLB advances and federal funds purchased, are additional sources of funds for the Company.

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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.

As of June 30, 2021 and December 31, 2020, the Company had $43.0 million and $30 million in outstanding balances from FHLB advances, respectively.

As of June 30, 2020, the Company had no outstanding balances from FHLB advances.

Additional borrowing arrangements maintained by the Company include formal federal funds lines with five major regional correspondent banks and the Federal Reserve discount window.

The Company had no outstanding balances on these lines or facilities as of June 30, 2021, December 31, 2020 or June 30, 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):

The following table displays the changes in shareholders' equity for the Company from December 31, 2020 to June 30, 2021 (dollars in thousands):

Equity, December 31, 2020

Acquisition of Fauquier Bankshares, Inc.

Other comprehensive loss

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Equity increase due to expensing of restricted stock

Equity, March 31, 2021

Equity, June 30, 2021

The Basel III capital rules require banks and bank holding companies to comply with the following minimum capital ratios:

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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.

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 :

The Company’s Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios were 1 2.96 %, 1 2.96 %, 1 3.47 % and 7.66 %, respectively, as of June 30, 2021 , thus exceeding the minimum requirements.

The Bank’s Tier 1, common equity Tier 1, total capital to risk-weighted asset s, and leverage ratios were 1 3.26 %, 1 3.26 %, 1 3.77 % and 7.86 %, respectively, as of June 30, 2021 , also exceeding the minimum requirements.

As of June 30, 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%;

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They include:

Performance measures exclude nonrecurring merger expenses, which were incurred in connection with change-in-control, severance, due diligence, legal, and other professional fees associated with the 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.

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.

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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.

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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.

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.

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.

The ALLL as a percentage of loans, excluding the impact of acquired loans and the related fair value mark, excluded the fair value of Acquired Loans from Fauquier.

Management believes that the exclusion of the Acquired Loans provides users of the Company’s financial information a presentation of the Company’s ALLL percentage that is representative of its ongoing operations.

The ALLL 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 ALLL percentage that is representative of its ongoing operations.

Tangible book value per share excludes the impact of the balances of goodwill and other intangibles.

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Reconcilement of Non-GAAP Measures:

Three Months Ended

As of or for the Three Months Ended

For the Six Months Ended

Performance measures

Return on average assets ("ROAA")

Impact of merger expenses, net of tax

ROAA, excluding merger expenses (non-GAAP)

Return on average equity ("ROAE")

Impact of merger expenses, net of tax

ROAE, excluding merger expenses (non-GAAP)

Impact of merger expenses, net of tax

Net income, excluding merger expenses (non-GAAP)

Net income per share, basic and diluted

Impact of merger expenses, net of tax

Net income per share, excluding merger expenses (non-GAAP), basic and diluted

Fully tax-equivalent measures

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Net interest margin (FTE)

Performance measures

Return on average assets

Impact of merger expenses

Operating return on average assets (non-GAAP)

Return on average equity

Impact of merger expenses

Operating return on average equity (non-GAAP)

Other financial measures

ALLL to total loans

Impact of acquired loans and fair value mark

ALLL to total loans, excluding acquired loans and

fair value mark (non-GAAP)

ALLL to total loans

Impact of PPP loans

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Book value per share

Impact of intangibles

Impact of intangible assets

Tangible book value per share (non-GAAP)

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 income for the three months ended June 30, 2021 was $147 thousand, a $1.9 million or 93.0% decrease compared to net income reported for the three months ended June 30, 2020.

Net income per diluted share was $0.03 for the quarter ended June 30, 2021 compared to $0.77 per diluted share for the same quarter in the prior year.

The entirety of the decrease in net income for the three months ended June 30, 2021, when compared to the same period of 2020, was attributable to $5.9 million in pre-tax ($4.6 million after-tax) merger expenses incurred in the second quarter of 2021.

Excluding merger costs, the Company would have posted net income of $0.89 per diluted share (a non-GAAP financial measure).

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

$ 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.

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 income (FTE) for the three months ended June 30, 2021 was $13.2 million, a $7.4 million or 128.8% increase compared to net interest income (FTE) of $5.8 million for the three months ended June 30, 2020.

Net interest income (FTE) increased primarily due to the inclusion of Fauquier’s net interest income (FTE) for the current quarter, as the merger was effective April 1, 2021.

Net interest income (FTE) was also positively impacted by the decrease in rates paid on deposit accounts, which decreased interest expense by $431 thousand, offset by the increased volume of deposits, which increased interest expense by $547 thousand.

The increased volume of loans, also a result of the merger with Fauquier, increasing from an average of $618.1 million in the second quarter of 2020 to $1.2 billion in the second quarter of 2021, positively impacted interest income by $6.4 million.

The higher average yield earned on loans, increasing from 4.01% to 4.30% for the periods noted, positively impacted interest income by $500 thousand.

In addition, the fair value accretion on loans acquired positively impacted net interest income by 16 basis points during the three months ended June 30, 2021.

The increase in volume of securities held, increasing from an average balance of $68.7 million for the second quarter of 2020 to $270.2 million for the second quarter of 2021, positively impacted net interest income by $865 thousand, while the decline in yield earned on such securities decreased from 2.15% to 1.68% for the periods noted, negatively impacted net interest income by $97 thousand.

Net interest income (FTE) for the six months ended June 30, 2021 was $19.2 million, an $8.1 million or 72.2% increase compared to net interest income (FTE) of $11.2 million for the six months ended June 30, 2020 Net interest income (FTE) increased primarily due to the inclusion of Fauquier’s net interest income (FTE) for the first half of the current year as the merger was effective April 1, 2021.

Net interest income (FTE) was also positively impacted by the decrease in rates paid on deposit accounts, which decreased interest expense by $1.2 million, offset partially by the increased volume of deposits, which increased interest expense by $938 thousand.

The increased volume of loans, also a result of the merger with Fauquier, increasing from an average of $577.0 million in the six months ended June 30, 2020 to $910.0 million in the six months ended June 30, 2021, positively impacted interest income by $6.9 million.

The increase in volume of securities held, increasing from an average balance of $91.5 million for the six months ended June 30, 2020 to $222.0 million for the six months ended June 30, 2021, positively impacted net interest income by $1.2 million, while the decline in yield earned on such securities decreased from 2.18% to 1.65% for the periods noted, negatively impacted net interest income by $335 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.

The net interest margin (FTE) of 3.05% for the three months ended June 30, 2021 was 7 basis points lower than the 3.12% for the three months ended June 30, 2020.

The net interest margin (FTE) of 3.00% for the six months ended June 30, 2021 was 16 basis points lower than the 3.16% for the six months ended June 30, 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).

Interest expense increased $224 thousand for the three months ended June 30, 2021 compared to the same period in the prior year, due to increased volume of deposits from the Fauquier merger, as average interest-bearing deposits increased $681.8 million for the period noted, negatively impacting interest expense by $547 thousand, offset by lower rates paid on deposits, positively impacting interest expense by $431 thousand.

The rate paid on interest-bearing deposits averaged 30 basis points in the three months ended June 30, 2021, compared to 62 basis points for the three months ended June 30, 2020.

Average balances of borrowed funds, from FHLB advances, increased from zero in the three months ended June 30, 2020 to $43.0 million in the three months ended June 30, 2021, causing an increase in interest expense on borrowed funds of $59 thousand.

Average balances of junior subordinated debt, increased from zero in the three months ended June 30, 2020 to $3.3 million in the three months ended June 30, 2021, causing an increase in interest expense on borrowed funds of $49 thousand.

Interest expense decreased $272 thousand for the six months ended June 30, 2021 compared to the same period in the prior year, due primarily to the lower rates paid on deposits, positively impacting interest expense by $1.2 million, offset by the increased volume of deposits from the Fauquier merger, as average interest-bearing deposits increased $373.5 million for the period noted, negatively impacting interest expense by $794 thousand.

The rate paid on interest-bearing deposits averaged 36 basis points in the six months ended June 30, 2021 , compared to 83 basis points for the six months ended June 30, 2020 .

Average balances of borrowed funds, from FHLB advances, increased from zero in the six months ended June 30, 2020 to $36.60 million in the six months ended June 30, 2021 , causing an increase in interest expense on borrowed funds of $95 thousand.

Average balances of junior subordinated debt, increased from zero in the six months ended June 30, 2020 to $1.3 million in the six months ended June 30, 2021 , causing an increase in interest expense on borrowed funds of $49 thousand.

The following tables detail the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest-bearing liabilities, for the three and six months ended June 30, 2021 and 2020.

These tables also include rate/volume analyses for these same periods (dollars in thousands).

Consolidated Average Balance Sheet and Analysis of Net Interest Income

For the three months ended

March 31, 2021

March 31, 2020

June 30, 2021

June 30, 2020

Change in Interest Income/ Expense

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Fed Funds Sold

Other interest-bearing deposits

Total Earning Assets

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Total Interest-Bearing Deposits

Other borrowed funds

Short term borrowings

Junior subordinated debt

Total Interest-Bearing Liabilities

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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.

Consolidated Average Balance Sheet and Analysis of Net Interest Income

For the Six Months Ended

June 30, 2021

June 30, 2020

Change in Interest Income/ Expense

Change Due to :

(dollars in thousands)

Interest Earning Assets:

Taxable Securities

Tax Exempt Securities (1)

Total Securities (1)

Fed Funds Sold

Other interest-bearing deposits

Total Earning Assets

Allowance for Loan Losses

Total Non-Earning Assets

LIABILITIES AND SHAREHOLDERS' EQUITY

Interest Bearing Liabilities:

Interest Bearing Deposits:

Interest Checking

Money Market and Savings Deposits

Time Deposits

Total Interest-Bearing Deposits

Short term borrowings

Junior subordinated debt

Total Interest-Bearing Liabilities

Non-Interest-Bearing Liabilities:

Demand deposits

Other liabilities

Total Liabilities

Shareholders' Equity

Total Liabilities & Shareholders' Equity

Net Interest Income (FTE)

Interest Rate Spread 2

Interest Expense as a Percentage of Average Earning Assets

Net Interest Margin (FTE) 3

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.

Interest spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities.

Net interest margin (FTE) is net interest income expressed as a percentage of average earning assets.

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.

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.

A recovery of loan losses of $141 thousand was recognized during the three months ended June 30, 2021 compared to a provision for loan losses of $378 thousand recognized during the three months ended June 30, 2020, and a provision for loan losses of $210 thousand was recognized during the six months ended June 30, 2021, compared to $1.1 million recognized during the six months ended June 30, 2020.

During the first two quarters of 2020, the Company increased the economic qualitative factors in the ALLL calculation due to the deterioration in the economic outlook resulting from the impact of COVID-19.

During the second quarter of 2021, the Company released of a portion of the reserves that were added during 2020 since the credit deterioration has so far not been experienced to the extent previously anticipated.

The period-end ALLL as a percentage of assets was 0.47% as of June 30, 2021, 0.90% as of December 31, 2020 and 0.78% as of June 30, 2020.

The percentage decrease as compared to the prior year end and the same period in the prior year was due to the addition of purchased loans upon the acquisition of Fauquier, and the elimination of their ALLL as the loans were acquired and booked at fair value.

The ALLL as of June 30, 2021, excluding the impact of the Acquired Loans and the fair value mark, would have been 0.88%.

Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to Non-GAAP ALLL.

Further discussion of management’s assessment of the ALLL is provided earlier in the report and in Note 5 – 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.

In management’s opinion, the allowance was adequately provided for at June 30, 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;

We have downgraded, then upgraded slightly, 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):

The components of noninterest income for the three months ended June 30, 2021 and 2020 are shown below (dollars in thousands):

For the three months ended

10 unchanged sentences

Total noninterest income

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.

Noninterest income for the three months ended June 30, 2021 of $2.9 million was $1.3 million or 79.6% higher than the amount recorded for the three months ended June 30, 2020.

Gains on sales of securities declined from the second quarter of the prior year by $590 thousand, as no securities were sold and swap fee income declined $104 thousand, as swap arrangements are not as attractive to borrowers in the current rate environment.

The components of noninterest income for the six months ended June 30, 2021 and 2020 are shown below (dollars in thousands):

For the Six Months Ended

Noninterest income:

Wealth management fees

Advisory and brokerage income

Royalty income

Deposit account fees

Debit/credit card and ATM fees

Earnings/increase in value of bank owned life insurance

Fees on mortgage sales

Gains on sales of securities

Loan swap fee income

Total noninterest income

Noninterest income for the six months ended June 30, 2021 of $4.0 million was $664 thousand or 20.2% higher than the amount recorded for the six months ended June 30, 2020.

Noninterest income increased predominantly due to the inclusion of TFB’s wealth management fees of $647 thousand, advisory and brokerage income of $157 thousand, deposit fees of $258 thousand and debit card income of $418 thousand, which are the same increases as noted above, as the effective date of the merger was April 1, 2021 and therefore, only TFB’s second quarter is included in the year-to-date figures.

Gains on sales of securities declined from the second quarter of the prior year by $643 thousand, as no securities were sold and swap fee income declined $598 thousand, as swap arrangements are not as attractive to borrowers in the current rate environment.

Noninterest expense

The components of noninterest expense for the three months ended March 31, 2021 and 2020 are shown below (dollars in thousands):

The components of noninterest expense for the three months ended June 30, 2021 and 2020 are shown below (dollars in thousands):

For the three months ended

11 unchanged sentences

Professional fees

Core deposit intangible amortization

Total noninterest expense

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.

Noninterest expense for the quarter ended June 30, 2021 of $16.0 million was $11.6 million or 263.1% higher than the quarter ended June 30, 2020.

The predominant reason for the increase was that the Company incurred $5.9 million in merger-related expenses during the three months ended June 30, 2021.

Additionally, the second quarter of 2021 includes the salaries of the employees of the combined company, as the effective date of merger with Fauquier was April 1, 2021.

The components of noninterest expense for the six months ended June 30, 2021 and 2020 are shown below (dollars in thousands):

For the Six Months Ended

Noninterest expense:

Salaries and employee benefits

Net occupancy

ATM, debit and credit card

Bank franchise tax

Computer software

Data processing

FDIC deposit insurance assessment

Loan expenses

Marketing, advertising and promotion

Merger expenses

Professional fees

Core deposit intangible amortization

Total noninterest expense

Noninterest expense for the six months ended June 30, 2021 of $20.8 million was $11.8 million or 132.2% higher than the six months ended June 30, 2020.

The predominant reason for the increase was that the Company incurred $6.2 million in merger-related expenses during the six months ended June 30, 2021.

Additionally, the first half of 2021 includes the salaries of the employees of the combined company, as the effective date of merger with Fauquier was April 1, 2021.

The efficiency ratio (FTE) of 99.1% for the three months ended June 30, 2021 was elevated compared to the 59.5% for the same quarter of 2020, due primarily to the increase in noninterest expense, as described above.

The efficiency ratio (FTE) of 89.5% for the six months ended June 30, 2021 was elevated compared to the 61.8% for the same period of 2020, also due to the increase in noninterest expense, as described above.

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.

For the three months ended June 30, 2021 and 2020, the Company provided $72 thousand and $511 thousand for Federal income taxes, respectively, resulting in an effective income tax rate of 32.9% and 19.7%, respectively.

The effective income tax rate for the three months ended June 30, 2021 was higher than the prior year, as certain merger related expenses are non-deductible for tax purposes.

For the six months ended June 30, 2021 and 2020, the Company provided $448 thousand and $843 thousand for Federal income taxes, respectively, resulting in an effective income tax rate of 21.3% and 19.4%, respectively.

The effective income tax rate for the six months ended June 30, 2021 was higher than the prior year, as certain merger related expenses are non-deductible for tax purposes.

For all periods, the effective income tax rate differed from the U.S.

statutory rate of 21% due to the effect of tax-exempt income from life insurance policies and municipal bonds.

OTHER SIGNIFICANT EVENTS

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK

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What changed 10-Q

Item 2. Management’s Discussion and Analysis