Franklin Financial Services Corp: Form 10-Q for the period ended Sep 30, 2023

Management’s Discussion and Analysis of Results of Operations and Financial Condition

For the First Nine Months Ended September 30, 2023 and 2022

Forward Looking Statements

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words such as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in the rates of inflation and the effects of inflation, changes in interest rates, ongoing disruption in the financial services industry caused by the bank failures and continuing uncertainty of various banks, changes in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors. We caution readers not to place undue reliance on these forward-looking statements. They only reflect management’s analysis as of this date. The Corporation does not revise or update these forward-looking statements to reflect events or changed circumstances.

Critical Accounting Policies

Management has identified critical accounting policies for the Corporation. These policies are particularly sensitive, requiring significant judgements, estimates and assumptions to be made by Management.

On January 1, 2023, the Corporation adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended, which replaces the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (CECL) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit commitments not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with Topic 842 on leases.

The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost, and unfunded credit exposures. Results for reporting periods beginning after January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with the previously applicable incurred loss methodology.

The Corporation has determined this accounting policy to be critical to the results of operations. A summary of the adoption of the new ASU follows:

Investment Securities – Management classifies its debt securities at the time of purchase as available for sale (AFS) or held to maturity (HTM). At September 30, 2023 and December 31, 2022, all debt securities were classified as available for sale, meaning that the Corporation intends to hold them for an indefinite period of time, but not necessarily to maturity. Available for sale debt securities are stated at estimated fair value, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments of interest income through call date or maturity. The related unrealized gains and losses are reported as other comprehensive income or loss, net of tax, until realized.

With the adoption of CECL on January 1, 2023, the previous concept of other-than-temporary impairment for AFS securities has been eliminated. Under CECL, credit losses on AFS debt securities are recognized in (Allowance for Credit Losses) ACL for investments, through the provision for credit losses, rather than through a direct write-down of the security. In evaluating AFS securities for credit losses, Management considers factors such as delinquency, guarantees, invest grade rating, and specific conditions related to a specific security or industry. If an impaired debt security is sold, any previous ACL on that security is charged-off and any incremental loss will be recognized through earnings. Any improvement in expected credit losses will be recognized by reducing the ACL.

For HTM securities an estimate of current expected credit loss must be established at the time of purchase with changes in estimated credit loss recognized in the ACL through the provision for credit losses.

Prior to January 1, 2023, declines in the fair value of securities was recorded under the other-than-temporary impairment concept more fully described in the Corporation’s report on Form 10-K as of December 31, 2022.

Realized securities gains and losses are computed using the specific identification method. Gains or losses on the disposition of debt investment securities are recorded on the trade date, based on the net proceeds and the adjusted carrying amount of the specific security sold. Equity investments are carried at fair value with changes in fair value recognized in net income.

Allowance for Credit Losses – Loans

The ACL for loans is established through provisions for credit losses charged against income. Loans deemed to be uncollectible are charged against the ACL, and subsequent recoveries, if any, are credited to the ACL.

The ACL for loans is an estimate of the losses expected to be realized over the life of the loan portfolio. The ACL is determined for two distinct categories of loans: 1) loans evaluated individually for expected credit losses (specific reserve), and 2) loans evaluated collectively for expected credit losses (pooled reserve). Management’s periodic evaluation of the adequacy of the ACL for loans is based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ actual or perceived financial and managerial strengths, and other relevant factors. This evaluation is inherently subjective, as it requires material assumptions and estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.

Loans evaluated individually for credit losses are primarily commercial purpose loans that do not share similar characteristics with those loans evaluated in the pool. These loans may exhibit performance characteristics where it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. All commercial purpose loans greater than $250 thousand and rated Substandard (7), Doubtful (8) or on nonaccrual status may be considered for individual evaluation. Impairment is measured on a loan-by-loan basis by one of the following methods: the fair value of the collateral if the loan is collateral dependent, the present value of expected future cash flows discounted at the loan’s effective interest rate or the loan’s obtainable market price. Commercial purpose loans with a balance less than $250 thousand, and consumer purpose loans are not evaluated individually for a specific reserve but are included in the pooled reserve calculation. Loans that are evaluated for a specific reserve, but not needing a specific reserve are not included in the pooled reserve calculation.

The Corporation has elected to exclude accrued interest receivable from the measurement of the ACL. When a loan is placed on nonaccrual status, any outstanding accrued interest is reversed against income. In addition, ASC 326 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities management does not intend to sell or believes that it is more likely than not they will be required to sell.

The pooled reserve represents the ACL for pools of homogenous loans, not evaluated individually. The pooled reserve is calculated using a quantitative and qualitative component for the loan pools.

The following inputs are used to calculate the quantitative component for the pool:

Segregating loans into homogeneous pools by the FRB Call Code which is primarily a collateral-based and secondarily a purpose-based segmentation.

The average remaining life of each pool is calculated using the weighted average remaining maturity method (WARM). The WARM method produces an estimated remaining balance by pool, by year, until maturity.

Using third party data, the Bank determines a reasonable and supportable economic forecast that it believes is likely to exist for the next four quarters.

A historical credit loss rate is calculated for each pool, using the average historical loss, by FRB Call Code, for a peer group of Pennsylvania community banks over the last eight quarters. The historical loss rate is calculated over a historical period the Bank believes best represents a period that will be similar to the next four quarters.

The historical peer credit loss rate is applied to each WARM bucket though the initial four quarter forecast period.

At the end of the forecast period, the credit loss rate applied to each WARM bucket reverts to the peer group historical loss rate for the respective pool.

Collectively these estimated losses represent the quantitative component of the pooled reserve.

The qualitative component for the pool utilizes a risk matrix comprised of eight risk factors and assigns a risk level to each factor. The risk factors consider changes in: lending policy, procedures and practice; economic conditions; nature and volume of loans; experience of lending team; volume of past due loans; quality of the loan review system; concentrations of credit; and other external factors. The risk factors are weighted to reflect Management’s estimate of how the factor affects potential losses. The risk levels within each factor are measured in basis points and range from minimal risk to very high risk and are determined independently for commercial loans, residential mortgage loans and consumer loans.

The ACL for pooled loans is the sum of the quantitative and qualitative loss estimates.

Allowance for Credit Losses – Unfunded Commitments

The ACL for unfunded commitments is recorded in other liabilities on the consolidated balance sheet. The ACL represents management’s estimate of expected losses from unfunded commitments and is determined by estimating future usage of the commitments, based on historical usage. The estimated loss is calculated in a manner similar to that used for the ACL for loans, previously described. The ACL is increased or decreased through the provision for credit losses.

There were no other changes to the critical accounting policies disclosed in the 2022 Annual Report on Form 10-K in regards to application or related judgments and estimates used. Please refer to Item 7 of the Corporation’s 2022 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Summary

Franklin Financial Services Corporation reported consolidated earnings of $3.9 million ($0.88 per diluted share) for the third quarter of 2023 compared to $4.6 million ($1.05 per diluted share) for the same period in 2022. Year-to-date 2023 net income was $10.1 million ($2.31 per diluted share) compared to $11.2 million ($2.52 per diluted share) for the same nine-month period in 2022, a decrease of 9.7%.

A summary of operating results for the third quarter and year-to-date 2023 are as follows:

Net income for the third quarter of 2023 was $3.9 million ($0.88 per diluted share) compared to $3.0 million ($0.68 per diluted share) for the second quarter of 2023 (an increase of 22.9%), and $4.6 million ($1.05 per diluted share) for the third quarter of 2022 (a decrease of 16.7%).

For the third quarter of 2023, the provision for credit losses was $875 thousand compared to $524 thousand for the second quarter of 2023 and $0 for the third quarter of 2022.

Net income year-to-date for 2023 was $10.1 million ($2.31 per diluted share) compared to $11.2 million ($2.52 per diluted share) for the same period in 2022, a decrease of 9.7%. As compared to the prior year-to-date results, 2023 was affected by a loss of $1.1 million on securities sales, a lease termination expense of $495 thousand and an increase of $1.9 million in the provision for credit losses.

Total net loans increased 5.4% from the end of the second quarter of 2023 and 14.9% from December 31, 2022.

Total deposits increased 3.6% from the end of the second quarter of 2023, and 1.0% from December 31, 2022. Borrowings from the Federal Reserve and FHLB totaled $110.0 million at September 30, 2023.

For the year-to-date period, Return on Average Assets (ROA) was 0.78%, Return on Average Equity (ROE) was 11.25% and the Net Interest Margin (NIM) was 3.33%, compared to ROA of 0.83%, ROE of 11.12% and NIM of 2.96% for the same period in 2022.

On October 19, 2023, the Board of Directors declared a $0.32 per share regular quarterly cash dividend for the fourth quarter of 2023 to be paid on November 22, 2023 to shareholders of record at the close of business on November 3, 2023.

Key performance ratios as of, or for the three months ended September 30, 2023 and 2022 and the year ended December 31, 2022 are listed below:

(Dollars in thousands, except per share)

*Year-to-date annualized

(1) See the section titled “GAAP versus Non-GAAP Presentation” that follows.

GAAP versus non-GAAP Presentations – The Corporation supplements its traditional GAAP measurements with certain non-GAAP measurements to evaluate its performance and to eliminate the effect of intangible assets. By eliminating intangible assets (Goodwill), the Corporation believes it presents a measurement that is comparable to companies that have no intangible assets or to companies that have eliminated intangible assets in similar calculations. However, not all companies may use the same calculation method for each measurement. The non-GAAP measurements are not intended to be used as a substitute for the related GAAP measurements. Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, our reported results prepared in accordance with GAAP. In the event of such a disclosure or release, the Securities and Exchange Commission’s Regulation G requires: (i) the presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP and (ii) a reconciliation of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure calculated and presented in accordance with GAAP. The following table shows the calculation of the non-GAAP measurements as of, or for the first nine months ended September 30, 2023 and 2022 and the year ended December 31, 2022.

(Dollars in thousands, except per share)

Net Interest Income

The largest source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. Demand deposits enhance net interest income because they are noninterest-bearing deposits. For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation’s 21% Federal statutory rate.

Comparison of the three months ended September 30, 2023 to the three months ended September 30, 2022:

Tax equivalent net interest income decreased $441 thousand to $14.0 million in the third quarter of 2023 compared to $14.4 million for the same period in 2022. The balance sheet volume change decreased tax-equivalent net interest income $1.1 million, which was partially offset by an increase of $637 thousand due to interest rate changes.

The following table presents average balances, tax-equivalent (T/E) interest income, and yields earned or rates paid on the assets or liabilities. Loans are classified by type of collateral and residential loans include commercial purpose loans and nonaccrual loans are included in the average loan balance used to calculate the yield. All nontaxable interest income has been adjusted to a tax-equivalent basis using a tax rate of 21%.

(Dollars in thousands)

Provision for Credit Losses

For the third quarter of 2023, the provision for credit losses was $875 thousand allocated between the provision for loans of $866 thousand and the provision for unfunded commitments of $9 thousand. The provision for loan loss expense for the third quarter of 2022 was $0. The ACL ratio for loans was 1.29% at September 30, 2023 compared to 1.35% at December 31, 2022. The ACL for unfunded commitments was $2.0 million compared to $1.5 million at December 31, 2022. For more information refer to the Loan Quality and Allowance for Credit Losses discussion in the Financial Condition section.

Noninterest Income

For the third quarter of 2023, noninterest income increased $350 thousand from the same period in 2022. Investment and trust income increased from asset management fees. Debit card income increased but was offset by a decrease in gains on sale of loans as the volume of mortgages sold decreased. The increase in other income was due in part to a state sales tax refund of $107 thousand.

The following table presents a comparison of noninterest expense for the three months ended September 30, 2023 and 2022:

(Dollars in thousands)

Noninterest Expense

Noninterest expense for the third quarter of 2023 was flat compared to the same period in 2022. Data processing costs increased due to the timing of several annual invoices. Other expenses increased due to small increases across multiple line items.

The following table presents a comparison of noninterest expense for the three months ended September 30, 2023 and 2022:

(Dollars in thousands)

37

Provision for Income Taxes

For the third quarter of 2023, the Corporation recorded a Federal income tax expense of $788 thousand compared to $895 thousand for the same quarter in 2022. The effective tax rate for the third quarter of 2023 was 17.0% compared to 16.2% for the same period in 2022. The federal statutory tax rate is 21% for 2023 and 2022.

Comparison of the nine months ended September 30, 2023 to the nine months ended September 30, 2022:

Tax equivalent net interest income increased $2.5 million to $40.6 million in the first nine months of 2023 compared to $38.0 million for the same period in 2022. A change in rates contributed $4.1 million to the increase which was offset by a balance sheet volume change of $1.6 million.

The following table presents average balances, tax-equivalent (T/E) interest income, and yields earned or rates paid on the assets or liabilities. Loans are classified by type of collateral and residential loans include commercial purpose loans and nonaccrual loans are included in the average loan balance used to calculate the yield. All nontaxable interest income has been adjusted to a tax-equivalent basis using a tax rate of 21%.

(Dollars in thousands)

38

Provision for Credit Losses

For the first nine months of 2023, the provision for credit losses was $1.9 million allocated between the provision for loans of $1.9 million and the provision for unfunded commitments of $79 thousand. The provision for loan loss expense for the first nine months of 2022 was $0. The ACL ratio for loans was 1.29% at September 30, 2023 compared to 1.35% at December 31, 2022. The ACL for unfunded commitments was $2.0 million compared to $1.5 million at December 31, 2022. For more information refer to the Loan Quality and Allowance for Credit Losses discussion in the Financial Condition section.

Noninterest Income

For the first nine months of 2023, noninterest income decreased $873 thousand from the same period in 2022. Debit card income increased but was offset by a decrease in gains on sale of loans as the volume of mortgages sold decreased. Losses on the sale of investment securities of $1.1 million were taken as part of a portfolio restructuring.

The following table presents a comparison of noninterest income for the nine months ended September 30, 2023 and 2022:

(Dollars in thousands)

Noninterest Expense

Noninterest expense for the first nine months of 2023 increased $1.4 million compared to the same period in 2022. Salary expense increased primarily due to a highly competitive labor market, while net occupancy increased from costs associated with the new headquarters and operations center that was put in service in July 2022. A lease termination expense was recorded in the second quarter of 2023 for $495 thousand. The lease termination was a long-term real estate lease held for a new community banking office that will not be constructed.

The following table presents a comparison of noninterest expense for the first nine months ended September 30, 2023 and 2022:

(Dollars in thousands)

Provision for Income Taxes

For the first nine months of 2023, the Corporation recorded a Federal income tax expense of $1.6 million compared to $1.9 million for the same period in 2022. The effective tax rate for the first nine months of 2023 was 13.5% and reflects the benefit of a $280 thousand tax credit recorded during the first nine months of 2023. Without the tax credit, the effective rate would have been 15.9% compared to 14.5% for the first nine months of 2022. The federal statutory tax rate is 21% for 2023 and 2022.

Financial Condition

Cash and Cash Equivalents:

Cash and cash equivalents totaled $74.0 million at September 30, 2023, an increase of $9.1 million from the prior year-end balance of $64.9 million. Short-term interest-earning deposits are held primarily at the Federal Reserve ($53.4 million).

Investment Securities:

AFS Securities: At September 30, 2023, the AFS securities portfolio had an amortized cost of $525.5 million, a decrease of $22.8 million from the prior year-end, and had a fair value of $458.3 million, a decrease of $28.6 million from the prior year-end. The Bank sold $41.2 million of securities taking advantage of higher market interest rates while restructuring the AFS portfolio. The AFS portfolio had a net unrealized loss of $67.3 million at September 30, 2023 compared to a net unrealized loss of $61.5 million at the prior year-end. This change was due to an increase in long-term interest rates over the period despite the Bank realizing $1.1 million of losses during the year due to restructuring of the portfolio. The AFS portfolio averaged $457.2 million with a tax-equivalized yield of 3.64% for the three months ended September 30, 2023. This compares to an average of $514.0 million and a tax-equivalized yield of 2.62% for the same period in 2022. The weighted average life of the AFS portfolio is 5.1 years and the effective duration is 4.57%.

The AFS portfolio held $83.7 million, or 16% of the total portfolio, of securities issued by the U.S. Treasury and another $147.1 million, or 28% of the total portfolio, of mortgage and asset-backed securities issued by a U.S. Government Agency or a government sponsored entity and securitized by pools of residential mortgages and other loan assets.

Municipal bond holdings in the AFS portfolio were $161.7 million, or 31% of the total portfolio. The municipal bond holdings are well diversified geographically (154 issuers) and are comprised primarily of general obligation bonds (68%). Many municipal bonds have credit enhancements in the form of private bond insurance or other credit support. The largest geographic municipal bond exposures are in the states of Texas (15%), California (13%), Pennsylvania (12%), and Michigan (10%). The average rating of the municipal holdings from Moody’s is AA. No securities in the portfolio are rated below investment grade.

The corporate bond holdings in the AFS portfolio were $26.3 million, or 5% of the total portfolio, comprised predominantly of 46 fixed rate community bank issued subordinated notes totaling $22.1 million. All of the subordinated notes are unrated. The Bank monitors the credit of the issuers of the subordinated notes on a quarterly basis. The remaining corporate bond holdings consist of five trust preferred securities and are investment grade rated.

The non-agency mortgage and asset-backed securities portfolio was $106.8 million, or 20% of the total portfolio, at September 30, 2023, an increase of $36.0 million from the prior year-end. The majority of these securities, $84.7 million, are investment grade rated while the remaining $22.1 million of securities in this portfolio are unrated. Many of the securities in this portfolio have credit enhancements in the form of subordination and overcollateralization.

Impairment in the AFS securities portfolio, measured by gross unrealized losses, were $67.3 million at September 30, 2023 compared to $61.5 million at December 31, 2022. The Bank believes it will be able to collect all interest and principal due on impaired securities and the decline in fair value below amortized cost is due to changing interest rates and not due to credit related factors; therefore, the Bank has no allowance for credit loss for these investments. The Bank does not have the intent to sell and does not believe it will more likely than not be required to sell, any of these securities prior to a recovery of their fair value to amortized cost.

Restricted Stock at Cost: The Bank held $2.3 million of restricted stock at September 30, 2023. Except for $30 thousand, this investment represents stock in FHLB Pittsburgh. The Bank is required to hold this stock to be a member of FHLB and it is carried at cost of $100 per share. The level of FHLB stock held is determined by FHLB and is comprised of a minimum membership amount plus a variable activity amount. FHLB stock is evaluated for impairment primarily based on an assessment of the ultimate recoverability of its cost. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasury that can be used to support its operations. There is not a public market for FHLB stock and the benefits of FHLB membership (e.g., liquidity and low-cost funding) add value to the stock beyond purely financial measures. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment.

See Note 4 of the accompanying financial statements for additional information on Investment Securities.

Loans:

Residential real estate: This category is comprised of consumer purpose loans secured by residential real estate and to a lesser extent, commercial purpose loans secured by residential real estate. The consumer purpose category represents traditional residential mortgage loans and home equity products (primarily junior liens and lines of credit). Commercial purpose loans in this category represent loans made for various business needs but are secured with residential real estate. In addition to the real estate collateral, it is possible that additional security is provided by personal guarantees or UCC filings. These loans are underwritten as commercial loans and are not originated to be sold.

Total residential real estate loans increased by $40.9 million over year-end 2022. For the first nine months of 2023, the Bank originated $10.7 million of mortgages held for sale and sold $10.2 million through third party brokerage agreements. The Bank does not originate or hold any loans that would be considered sub-prime or Alt-A and does not generally originate mortgages outside of its primary market area.

Residential real estate construction: This category contains loans for the vertical construction of 1-4 family residential properties. The largest component of this category represents loans to residential real estate developers ($11.3 million), while loans for individuals to construct personal residences totaled $9.8 million at September 30, 2023. The Bank’s exposure to residential construction loans is concentrated primarily in south central Pennsylvania. Real estate construction loans, including residential real estate and land development loans, occasionally provide an interest reserve in order to assist the developer during the development stage when minimal cash flow is generated. All real estate construction loans are underwritten in the same manner, regardless of the use of an interest reserve.

Commercial real estate (CRE): This category includes commercial, industrial, farm and agricultural loans and land development loans, where real estate serves as the primary collateral for the loans. Total commercial real estate loans increased to $671.2 million from $566.7 million at the end of 2022. The largest sectors (by collateral) in the commercial real estate category are: apartment buildings ($112.2 million), office buildings ($82.9 million), hotels & motels ($81.6 million), shopping centers ($69.3 million), and development land ($54.6 million). Within the office building portfolio, approximately 27.4% of total office building exposure is to owner occupied properties. The majority of the Bank’s hotel exposure is located along the Interstate 81 (I-81) corridor through south-central Pennsylvania. The portfolio is comprised of properties operating under 12 flagged brands and 3 independent operators.

Also included in CRE are real estate construction loans totaling $120.0 million. At September 30, 2023, the Bank had $52.3 million in real estate construction loans funded with an interest reserve and capitalized $1.2 million of interest in 2023 from these reserves on active projects for commercial construction. Real estate construction loans are monitored on a regular basis by either an independent third-party inspector or the assigned loan officer depending on loan amount or complexity of the project. This monitoring process includes at a minimum, the submission of invoices and American Institute of Architects (AIA) documents (depending on the complexity of the project) detailing costs incurred by the borrower, on-site inspections, and a signature by the assigned loan officer for disbursement of funds.

Commercial: This category includes commercial, industrial, farm, agricultural, and municipal loans. Commercial loans increased $13.5 million to $249.1 million at September 30, 2023, compared to $235.6 million at the end of 2022. At September 30, 2023, the balance of PPP loans was $68 thousand, down from $179 thousand at year-end. At September 30, 2023, the Bank had approximately $117.1 million in tax-free loans. The largest sectors (by industry) in the commercial category are: public administration ($45.3 million), utilities ($41.3 million), real estate rental and leasing ($25.9 million), manufacturing ($23.2 million) and retail trade ($19.1 million).

Participations: The Bank may supplement its own commercial loan production by purchasing loan participations. These participations are primarily located in south-central Pennsylvania. At September 30, 2023, the outstanding commercial participations were $86.2 million, or 8.6%, of commercial purpose loans and 7.1% of total gross loans compared to $70.6 million at December 31, 2022, or 8.0%, of commercial purpose loans and 6.7% of total gross loans. The Bank’s total exposure (including outstanding balances and unfunded commitments) to purchased participations is $122.4 million, compared to $90.0 million at December 31, 2022. The commercial loan participations are comprised of $23.0 million of Commercial loans and $63.2 million of CRE loans, reported in the respective loan class.

Consumer loans: This category had a balance of $6.4 million at September 30, 2023, compared to $6.2 million at prior year-end and is comprised primarily of installment loans and personal lines of credit.

The following table presents a summary of loans outstanding, by class as of:

(Dollars in thousands)

Loan Quality:

Management monitors loan performance on a monthly basis and performs a quarterly evaluation of the adequacy of the Allowance for Credit Loss for loans (ACL). The Bank begins enhanced monitoring of all loans rated 6–OAEM or worse and obtains a new appraisal or asset valuation for any loans placed on nonaccrual and rated 7 - Substandard or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the ACL, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows. Management monitors the adequacy of the ACL on an ongoing basis and reports its adequacy quarterly to the Board Enterprise Risk Management Committee of the Board of Directors. Management believes the ACL at September 30, 2023 is adequate.

Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list totaled $10.4 million at September 30, 2023 compared to $11.6 million at December 31, 2022. The watch list includes both performing and nonperforming loans. Included in the watchlist total are $213 thousand of nonaccrual loans. The credit composition of the watch list (loans rated 6, 7, or 8), by primary collateral is shown in Note 6 of the accompanying financial statements.

Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank. See Note 6 in the accompanying financial statements for a table that presents the aging of payments in the loan portfolio.

Nonaccruing loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more past due, nonaccrual loans, or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7-Substandard.

The Bank’s Loan Management Committee reviews these loans and risk ratings on a quarterly basis in order to proactively identify and manage problem loans. In addition, a committee meets monthly to discuss possible workout strategies for all credits rated 7-Substandard or worse. Management also tracks other commercial loan risk measurements including high loan to value loans, concentrations, participations and policy exceptions and reports these to the Board Enterprise Risk Management Committee of the Board of Directors. The Bank also uses an external loan review consultant to assist with internal loan review with a goal of reviewing up to 80% of commercial loans each year. The FDIC defines certain supervisory loan-to-value lending limits. The Bank’s internal loan–to-value limits are all equal to or have a lower loan-to-value limit than the supervisory limits. However, in certain instances, the Bank may make a loan that exceeds the supervisory loan-to-value limit. At September 30, 2023, the Bank had loans of $14.2 million (7.6% of total risk-based capital) that exceeded the supervisory limit, compared to 7.2% at year-end 2022.

Loan quality, as measured by nonaccrual loans, had a balance of $213 thousand at September 30, 2023 compared to $120 thousand at December 31, 2022 and the nonperforming loan to total loans ratio was 0.02% at September 30, 2023 compared to 0.01% and December 31, 2022. Loans past due 90-days or more, but still accruing, totaled $14 thousand at September 30, 2023.

In addition to monitoring nonaccrual loans, the Bank also closely monitors loans to borrowers experiencing financial difficulty when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement.

Modifications to borrowers experiencing financial difficulty may include interest rate reductions, principal or interest forgiveness, forbearances, term extensions, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral.

Allowance for Credit Losses:

Allowance for Credit Losses – Loans

The ACL for loans is established through provisions for credit losses charged against income. Loans deemed to be uncollectible are charged against the ACL, and subsequent recoveries, if any, are credited to the ACL.

The ACL for loans is an estimate of the losses expected to be realized over the life of the loan portfolio. The ACL is determined for two distinct categories of loans: 1) loans evaluated individually for expected credit losses (specific reserve), and 2) loans evaluated collectively for expected credit losses (pooled reserve). Management’s periodic evaluation of the adequacy of the ACL for loans is based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ actual or perceived financial and managerial strengths, and other relevant factors. This evaluation is inherently subjective, as it requires material assumptions and estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on loans evaluated individually.

Loans evaluated individually for credit losses are primarily commercial purpose loans that do not share similar characteristics with those loans evaluated in the pool. These loans may exhibit performance characteristics where it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. All commercial purpose loans greater than $250 thousand and rated Substandard (7), Doubtful (8) or on nonaccrual status may be considered for individual evaluation. Impairment is measured on a loan-by-loan basis by one of the following methods: the fair value of the collateral if the loan is collateral dependent, the present value of expected future cash flows discounted at the loan’s effective interest rate or the loan’s obtainable market price. Commercial purpose loans with a balance less than $250 thousand, and consumer purpose loans are not evaluated individually for a specific reserve but are included in the pooled reserve calculation. Loans that are evaluated for a specific reserve, but not needing a specific reserve are not included in the pooled reserve calculation.

The Corporation has elected to exclude accrued interest receivable from the measurement of the ACL. When a loan is placed on nonaccrual status, any outstanding accrued interest is reversed against income.

The pooled reserve represents the ACL for pools of homogenous loans, not evaluated individually. The pooled reserve is calculated using a quantitative and qualitative component for the loan pools.

The following inputs are used to calculate the quantitative component for the loan pool:

Segregating loans into homogeneous pools by the FRB Call Code which is primarily a collateral-based and secondarily a purpose-based segmentation.

The average remaining life of each pool is calculated using the weighted average remaining maturity method (WARM). The WARM method produces an estimated remaining balance by pool, by year, until maturity.

Using third party data, the Bank determines a reasonable and supportable economic forecast that it believes is likely to exist for the next four quarters.

A historical credit loss rate is calculated for each pool, using the average historical loss, by FRB Call Code, for a peer group of Pennsylvania community banks over the last eight quarters. The historical loss rate is calculated over a historical period the Bank believes best represents a period that will be similar to the next four quarters.

The historical peer credit loss rate is applied to each WARM bucket though the initial four quarter forecast period.

At the end of the forecast period, the credit loss rate applied to each WARM bucket reverts to the peer group historical loss rate for the respective pool.

Collectively these estimated losses represent the quantitative component of the pooled reserve.

The qualitative component for the pool utilizes a risk matrix comprised of eight risk factors and assigns a risk level to each factor. The risk factors give consideration to changes in: lending policy, procedures and practice; economic conditions; nature and volume of loans; experience of lending team; volume of past due loans; quality of the loan review system; concentrations of credit; and other external factors. The risk factors are weighted to reflect Management’s estimate of how the factor affects potential losses. The risk levels within each factor are measured in basis points and range from minimal risk to very high risk and are determined independently for commercial loans, residential mortgage loans and consumer loans.

The ACL for pooled loans is the sum of the quantitative and qualitative loss estimates.

Allowance for Credit Losses – Unfunded Commitments

The ACL for unfunded commitments is recorded in other liabilities on the consolidated balance sheet. The ACL represents management’s estimate of expected losses from unfunded commitments and is determined by estimating future usage of the commitments, based on historical usage. The estimated loss is calculated in a manner similar to that used for the ACL for loans, previously described. The ACL is increased or decreased through the provision for credit losses.

The following table shows the allocation of the allowance for credit losses and other loan performance ratios, by class, as of September 30, 2023 and December 31, 2022:

(Dollars in thousands)

Deposits:

Total deposits increased $16.0 million during the first nine months of 2023 to $1.567 billion. Interest-bearing checking decreased by $30.6 million primarily in municipal deposits and savings decreased by $18.6 million, while the Bank’s Money Management increased $16.3 million. Time deposits increased $52.9 million as customers shifted to higher rate products. The Bank also added $8.6 million of brokered CDs, during the first nine months of 2023.

As of September 30, 2023, the Bank had deposits of $233.5 million placed in the IntraFi Network deposit program ($142.1 million in interest-bearing checking and $91.4 million in money management) and $6.5 million in reciprocal time deposits in the CDARS program included in time deposits. These programs allow the Bank to offer full FDIC coverage to large depositors, but with the convenience to the customer of only having to deal with one bank. The Bank solicits these deposits from within its market and it believes they present no greater risk than any other local deposit. Only reciprocal deposits that exceed 20% of liabilities are considered brokered deposits. At September 30, 2023, the Bank’s reciprocal deposits were 14.0% of total liabilities compared to 12.7% at year-end 2022.

The Bank estimates that approximately 91% of its deposits are FDIC insured or collateralized as of September 30, 2023.

The following table presents a summary of deposits for the periods ended:

(Dollars in thousands)

Borrowings:

At September 30, 2023, the Bank had $70.0 million borrowed from the Federal Reserve’s Bank Term Funding Program (BTFP) to temporarily support its liquidity position and $40.0 million in short-term borrowing from the Federal Home Loan Bank of Pittsburgh (FHLB). The BTFP borrowing is comprised of $50.0 million with a rate of 4.38% due March 22, 2024, and $20.0 million with a rate of 4.71% due May 10, 2024. At September 30, 2023, the fair value of debt securities pledged for the BTFP was $79.8 million. The FHLB borrowings have a blended rate of 5.80% and are due during the third quarter of 2024.

On August 4, 2020, the Corporation completed the sale of a subordinated debt note offering. The Corporation sold $15.0 million of subordinated debt notes with a maturity date of September 1, 2030. These notes are noncallable for 5 years and carry a fixed interest rate of 5.00% per year for 5 years and then convert to floating rate of SOFR plus 4.93% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The Corporation also sold $5.0 million of subordinated debt notes with a maturity date of September 1, 2035. These notes are noncallable for 10 years and carry a fixed interest rate of 5.25% per year for 10 years and then convert to floating rate of SOFR plus 4.92% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank. The Corporation paid an issuance fee of 2% of the total issue that will be amortized to maturity date of each issue on a pro-rata basis. The proceeds are intended to be used for general corporate purposes.

Shareholders’ Equity:

Total shareholders’ equity increased $572 thousand to $114.8 million as of September 30, 2023 from December 31, 2022. Retained earnings increased $6.0 million in 2023 and accumulated other comprehensive income (AOCI) decreased $4.5 million as the fair value of the investment portfolio decreased during 2023. The increase in retained earnings was from net earnings of $10.1 million partially offset by cash dividends of $4.2 million. The Corporation’s Dividend Reinvestment Plan (DRIP) added $306 thousand in new capital from optional cash contributions and $781 thousand from the reinvestment of quarterly dividends. The Corporation’s dividend payout ratio was 41.45% for the first nine months of 2023 compared to 37.91% for the first nine months of 2022.

As part of its quarterly dividend decision, the Corporation considers current and future income projections, dividend yield, payout ratio, and current and future capital ratios. For the third quarter of 2023, the Corporation paid a $0.32 per share dividend, compared to $0.32 paid in the second quarter of 2023. On October 19, 2023, the Board of Directors declared a $0.32 per share regular quarterly dividend for the fourth quarter of 2023, which will be paid on November 22, 2023.

On December 15, 2022, the Board of Directors authorized the 2022 Repurchase Plan for the repurchase of up to 150,000 shares of the Corporation’s $1.00 par value common stock at market prices in open market or privately negotiated transactions beginning December 22, 2022 and expiring on December 21, 2023. A total of 85,906 shares have been repurchased under the current plan. The Corporation is monitoring the market and intends to repurchase shares when and if the opportunity arises in accordance with applicable law, regulations and plan authorizations.

Capital adequacy for the Bank is currently defined by regulatory agencies through the use of several minimum required ratios. The capital ratios to be considered “well capitalized” are: (1) Common Equity Tier 1 (CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. In addition, a capital conservation buffer of 2.5% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum for each respective capital measurement. The Bank’s capital conservation buffer at September 30, 2023 was 6.28% compared to the regulatory buffer of 2.5%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions and is in addition to the minimum required capital requirements. As of September 30, 2023, the Bank was “well capitalized.”

In 2019, the Community Bank Leverage Ratio (CBLR) was approved by federal banking agencies as an optional capital measure available to Qualifying Community Banking Organizations (QCBO). If a bank qualifies as a QCBO and maintains a CBLR of 9% or greater, the bank would be considered “well-capitalized” for regulatory capital purposes and exempt from complying with the risk-based capital rule described above. The CBLR rule took effect January 1, 2020 and banks could opt-in through an election in the first quarter 2020 regulatory filing. The Bank met the criteria of a QCBO but did not opt-in to the CBLR.

The consolidated asset limit on small bank holding companies is $3.0 billion and a company with assets under that limit is not subject to the consolidated capital rules but may file reports that include capital amounts and ratios. The Corporation has elected to file those reports.

The following table summarizes the regulatory capital requirements and results as of September 30, 2023 and December 31, 2022 for the Corporation and the Bank:

(Dollars in thousands)

(1) Common equity Tier 1 capital / total risk-weighted assets

(2) Tier 1 capital / total risk-weighted assets

(3) Total risk-based capital / total risk-weighted assets

(4) Tier 1 capital / average quarterly assets

Economy

The Corporation’s primary market area includes Franklin, Fulton, Cumberland, Huntingdon, and Dauphin Counties, Pennsylvania and Washington County, Maryland. This area is diverse in demographic and economic makeup. County populations range from a low of approximately 15,000 in Fulton County to over 280,000 in Dauphin County. Unemployment in the Bank’s market area ranged from 1.9% in Washington County, MD to 4.3% in Huntingdon County, as of the end of July 2023. The market area has a diverse economic base and local industries include warehousing, truck & rail shipping centers, light and heavy manufacturers, healthcare, higher education institutions, farming and agriculture, and a varied service sector. The Corporation’s primary market area provides easy access to the major metropolitan markets on the east coast via trucking and rail transportation. Because of this, warehousing and distribution companies continue to find the area attractive. The local economy is not overly dependent on any one industry or business and Management believes that the Bank’s primary market area continues to be well suited for growth.

Impact of Inflation

The impact of inflation upon financial institutions such as the Corporation differs from its effect upon other commercial enterprises. Unlike many companies, the assets and liabilities of the Corporation are financial in nature. As such, interest rates and changes in interest rates may have a more significant effect on the Corporation’s financial results than on other types of industries. Because of this, the Corporation watches the actions of the Federal Reserve Open Market Committee (FOMC) as it makes decisions about interest rate changes and how such changes affect market rates and the Corporation. Although inflation (and inflation expectations) may affect the interest rate environment, it is not possible to measure with any precision the effect of inflation on the Corporation.

Liquidity

The Corporation must meet the financial needs of the customers that it serves, while providing a satisfactory return on the shareholders’ investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. The Bank regularly reviews its liquidity position by measuring its projected net cash flows (in and out) at a 30 and 90-day interval. The Bank stresses the measurements by assuming a level of deposit out-flows that have not historically been realized. In addition to this forecast, other funding sources are reviewed as a method to provide emergency funding if necessary. The objective of this measurement is to identify the amount of cash that could be raised quickly without the need to liquidate assets. The Bank also stresses its liquidity position utilizing different longer-term scenarios. The varying degrees of stress create pressure on deposit flows in its local market, reduce access to wholesale funding and limit access of funds available through brokered deposit channels. In addition to stressing cash flow, specific liquidity risk indicators are monitored to help identify risk areas. This analysis helps identify and quantify the potential cash surplus/deficit over a variety of time horizons to ensure the Bank has adequate funding resources. Assumptions used for liquidity stress testing are subjective. Should an evolving liquidity situation or business cycle present new data, potential assumption changes will be considered. The Bank believes it can meet all anticipated liquidity demands.

Historically, the Corporation has satisfied its liquidity needs from earnings, repayment of loans and amortizing investment securities, maturing investment securities, loan sales, deposit growth and its ability to access existing lines of credit. All investment securities are classified as available for sale; therefore, securities that are unencumbered ($179.5 million fair value) as collateral for borrowings are an additional source of readily available liquidity, either by selling the security or, more preferably, to provide collateral for additional borrowing. The Bank also has access to other wholesale funding via the brokered CD market.

The FHLB system has always been a major funding source for the Bank. There are no current indicators that lead the Bank to believe the FHLB would discontinue its lending function or restrict the Bank’s ability to borrow. If either of these events would occur, it would have a negative effect on the Bank, and it is unlikely that the Bank could replace the level of FHLB funding in a short time. The Bank has established credit at the Federal Reserve Discount Window and at correspondent banks.

The following table shows the Bank’s available liquidity at September 30, 2023.

(Dollars in thousands)

Off Balance Sheet Commitments

The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation. At September 30, 2023, the ACL-unfunded commitments was $2.0 million compared to $1.5 million at December 31, 2022. The ACL-unfunded commitments is reported in Other Liabilities on the Consolidated Balance Sheet.

(Dollars in thousands)

The Corporation has entered into various contractual obligations to make future payments. These obligations include time deposits, long-term debt, operating leases, deferred compensation and pension payments. These amounts have not changed materially, except as reported, from those reported in the Corporation’s 2022 Annual Report on Form 10-K.

Management believes that any amounts actually drawn upon can be funded in the normal course of operations. The Corporation has no investment in or financial relationship with any unconsolidated entities that are reasonably likely to have a material effect on liquidity.

There were no material changes in the Corporation’s exposure to market risk during the nine months ended September 30, 2023. For more information on market risk refer to the Corporation’s 2022 Annual Report on Form 10-K.

Evaluation of Controls and Procedures

The Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon the evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2023, the Corporation’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in the Corporation’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There were no changes in the Corporation’s internal control over financial reporting during the quarterly period ended September 30, 2023, that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

The management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. The Corporation’s internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

There were no material changes in the Corporation’s risk factors during the three months ended September 30, 2023 except as described below. For more information, refer to the Corporation’s 2022 Annual Report on Form 10-K.

Negative Developments Affecting the Banking Industry, Including Bank Failures or Concerns Regarding Liquidity, Have Eroded Customer Confidence in the Banking System and May Have a Material Adverse Effect on the Corporation.

During March and April 2023, three significant bank failures occurred (Silicon Valley Bank, Signature Bank, and First Republic Bank). This was and continues to be accompanied by financial instability at various additional banks. These bank failures and bank instabilities have created and may continue to create market and other risks, for all financial institutions and banks, including the Corporation. These risks include, but are not limited to:

1. Market risk and loss of confidence in the financial services sector, and/or specific banks;

2. Deterioration of securities and loan portfolios;

3. Deposit volatility and reductions with higher volumes and occurring over shorter periods of time;

4. Increased liquidity demand and utilization of sources of liquidity; and

5. Interest rate volatility and abrupt, sudden and greater than usual rate changes.

These factors individually, or in any combination, could materially and adversely affect:

1. Financial condition;

2. Operations and results thereof; and

3. Stock price.

In addition, the previously mentioned bank failures and instabilities may result in an increase of FDIC deposit insurance premiums and/or result in special FDIC deposit insurance assessments, which also may adversely affect the Corporation’s financial condition, operations, results thereof or stock price.

The Corporation cannot predict the impact, timing or duration of such events.