Franklin Financial Services Corp: Form 10-Q for the period ended Jun 30, 2024

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

For the Three and Six Months Ended June 30, 2024 and 2023

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 bank failures and uncertainties involving 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.

There were no changes to the critical accounting policies disclosed in the 2023 Annual Report on Form 10-K in regards to application or related judgments and estimates used as of June 30, 2024. Please refer to Item 7 of the Corporation’s 2023 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Summary

A summary of operating results for Franklin Financial Services Corporation for the three and six months ended June 30, 2024 are as follows:

Net income for the second quarter of 2024 was $3.0 million ($0.66 per diluted share) compared to $3.4 million ($0.77 per diluted share) for the first quarter of 2024 (a decrease of 9.8%) and $3.0 million ($0.68 per diluted share) for the second quarter of 2023.

Net income year-to-date for 2024 was $6.4 million ($1.43 per diluted share) compared to $6.3 million ($1.42 per diluted share) for the same period in 2023

For the second quarter of 2024, the provision for credit losses was $546 thousand compared to $452 thousand for the first quarter of 2024 and $532 thousand for the second quarter of 2023. Year-to-date provision expense was $998 thousand compared to $1.1 million for the same period in 2023.

Total assets were $2.039 billion as of June 30, 2024.

Total net loans increased $61.3 million (4.9%) to $1.301 billion at June 30, 2024 from $1.241 billion at December 31, 2023.

Total deposits increased $48.5 million (3.2%) to $1.586 billion at June 30, 2024 from $1.538 billion at December 31, 2023.

At June 30, 2024, borrowings from the Federal Home Loan Bank of Pittsburgh (FHLB) were $240.0 million and $40.0 million from the Federal Reserve Bank.

Shareholders’ equity increased by $4.7 million, year-to-date, to $136.8 million, and the book value of the Corporation’s common stock increased to $31.01 per share.

For the year-to-date period, Return on Assets (ROA) was 0.63%, Return on Equity (ROE) was 9.71% and the Net Interest Margin (NIM) was 2.94%, compared to an ROA of 0.75%, ROE of 10.56% and NIM of 3.35% for the same period in 2023.

On July 11, 2024, the Board of Directors declared a $0.32 per share regular quarterly cash dividend for the third quarter of 2024 to be paid on August 28, 2024 to shareholders of record at the close of business on August 2, 2024.

Key performance ratios as of, or for the six months ended June 30, 2024 and 2023 and the year ended December 31, 2023 are listed below:

*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 six months ended June 30, 2024 and 2023 and the year ended December 31, 2023.

(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 June 30, 2024 to the three months ended June 30, 2023:

Tax equivalent net interest income increased $1.0 million to $14.5 million in the second quarter of 2024 compared to $13.5 million for the same period in 2023. Tax-equivalent net interest income increased $433 thousand from balance sheet volume changes and $567 thousand from 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 second quarter of 2024, the provision for credit losses on loans was $560 thousand and the provision for unfunded commitments was a reversal of $14 thousand, resulting in a total provision for credit loss expense of $546 thousand. The loan provision expense was due primarily to growth in the loan portfolio as the historical credit loss rate and the qualitative loss factor have not materially changed.

For the second quarter of 2023, the provision for credit losses on loans was $524 thousand and the provision for unfunded commitments was $8 thousand, resulting in a total provision for credit loss expense of $532 thousand.

The ACL ratio for loans was 1.29% at June 30, 2024 compared to 1.28% at December 31, 2023. The ACL for unfunded commitments was $2.0 million at June 30, 2024 and December 31, 2023. For more information refer to the Loan Quality and Allowance for Credit Losses discussion in the Financial Condition section.

Noninterest Income

For the second quarter of 2024, noninterest income increased $821 thousand from the same period in 2023. Wealth Management fees increased, primarily because of growth in assets under management. Loan service charges, gains on sale of loans, other service charges and debit card income increased but were partially offset by a decrease in deposit fees. The decrease in other income was due, in part, to a nonrecurring IRS refund payment to the bank in 2023. There were no debt securities sales in 2024 compared to a loss of $517 thousand from sales in 2023.

The following table presents a comparison of noninterest income for the three months ended June 30, 2024 and 2023:

(Dollars in thousands)

33

Noninterest Expense

Noninterest expense for the second quarter of 2024 increased $1.7 million compared to the same period in 2023. Salaries and benefits increased $1.1 million primarily in salaries due to a highly competitive labor market and wage increases, and an increase in health insurance costs. Data processing costs increased due to software expenses. FDIC insurance increased due to growth in the balance sheet. The increase in other expense is due, in part, to the amortization of solar tax credit investments and taxes paid to states other than Pennsylvania.

The following table presents a comparison of noninterest expense for the three months ended June 30, 2024 and 2023:

(Dollars in thousands)

Provision for Income Taxes

For the second quarter of 2024, the Corporation recorded a Federal income tax expense of $646 thousand compared to $568 thousand for the same quarter in 2023. The effective tax rate for the second quarter of 2024 was 17.6% compared to 16.6% for the same period in 2023. The federal statutory tax rate is 21% for 2024 and 2023.

Comparison of the six months ended June 30, 2024 to the six months ended June 30, 2023:

Tax equivalent net interest income increased $1.7 million to $28.3 million in the first half of 2024 compared to $26.6 million for the same period in 2023. Tax-equivalent net interest income increased $801 thousand from balance sheet volume changes and $881 thousand from interest rate changes.

(Dollars in thousands)

Provision for Credit Losses

For the first half of 2024, the provision for credit losses on loans was $1.1 million and the provision for unfunded commitments was a reversal of $52 thousand, resulting in a total provision for credit loss expense of $998 thousand. The loan provision expense was due primarily to growth in the loan portfolio as the historical credit loss rate and the qualitative loss factor have not materially changed.

For the first half of 2023, the provision for credit losses on loans was $991 thousand and the provision for unfunded commitments was $70 thousand, resulting in a total provision for credit loss expense of $1.1 million.

The ACL ratio for loans was 1.29% at June 30, 2024 compared to 1.28% at December 31, 2023. The ACL for unfunded commitments was $2.0 million at June 30, 2024 and December 31, 2023. For more information refer to the Loan Quality and Allowance for Credit Losses discussion in the Financial Condition section.

Noninterest Income

For the first half of 2024, noninterest income increased $1.8 million from the same period in 2023. Wealth Management fees increased, primarily due to growth in assets under management. Gains on sales of loans, other service charges (increases in ATM fees) and debit card income increased but were partially offset by a decrease in loan fees from commercial service charges. There were no debt securities sales in 2024 compared to a loss of $1.1 million from sales in 2023.

The following table presents a comparison of noninterest expense for the six months ended June 30, 2024 and 2023:

(Dollars in thousands)

Noninterest Expense

Noninterest expense for the first half of 2024 increased $3.0 million compared to the same period in 2023. Salaries and benefits increased $1.9 million primarily in salaries due to a highly competitive labor market and health insurance costs. Data processing costs increased due to software expenses. FDIC insurance increased due to growth in the balance sheet. Other expenses increased partially from the amortization of investments in solar tax credits and entertainment tax credits, partially offset with a decrease in Pennsylvania bank shares tax expense.

The following table presents a comparison of noninterest expense for the six months ended June 30, 2024 and 2023:

(Dollars in thousands)

Provision for Income Taxes

For the first half of 2024, the Corporation recorded a Federal income tax expense of $1.3 million compared to $790 thousand for the same quarter in 2023. The effective tax rate for the first half of 2024 was 16.6% compared to 11.2% for the same period in 2023. The 2023 rate reflects the benefit of $280 thousand in tax credits recorded in the first quarter of 2023. Without the tax credits, the 2023 rate would have been 15.2%. The federal statutory tax rate is 21% for 2024 and 2023.

Financial Condition

Cash and Cash Equivalents:

Cash and cash equivalents totaled $179.7 million at June 30, 2024, an increase of $156.6 million from the prior year-end balance of $23.1 million, as a result of the $200.0 million FHLB advance that has not yet been fully invested. Short-term interest-earning deposits are held primarily at the Federal Reserve ($158.7 million).

Investment Securities:

AFS Securities: At June 30, 2024, the AFS securities portfolio had an amortized cost of $503.8 million, a decrease of $18.1 million from the prior year-end, and had a fair value of $454.5 million, a decrease of $18.0 million from the prior year-end. During the first half of 2024, the portfolio returned $24.5 million of principal while $8.0 million was reinvested into the portfolio. The Bank did not sell any of its holdings during 2024. The AFS portfolio had a net unrealized loss of $49.3 million at June 30, 2024 compared to a net unrealized loss of $49.4 million at the prior year-end. The AFS portfolio averaged $466.7 million with a tax-equivalized yield of 3.82% for the three months ended June 30, 2024. This compares to an average of $454.4 million and a tax-equivalized yield of 3.29% for the same period in 2023.

The AFS portfolio holdings are classified by type of security issuer. U.S. Treasury and Agency mortgage & asset-backed securities are direct obligations of the U.S. Treasury or are issued by a U.S. Government Agency or a government sponsored entity and securitized by pools of residential mortgages and other loan assets. Municipal securities are issued by state and local government entities and consist of taxable and tax-exempt securities. Many municipal securities have credit enhancements in the form of private bond insurance or other credit support. Corporate securities are mostly subordinated notes issued by community banks with the remainder consisting of five trust preferred securities. Non-Agency mortgage & asset-backed securities are issued by private entities and securitized by residential and commercial mortgages as well as other loan assets. Many of these securities benefit from credit enhancements in the form of subordinated tranches and overcollateralization.

At December 31, 2023, the Bank held four Build America Bonds within the municipal portfolio with an amortized cost of $4.6 million. These bonds were purchased at a premium and included a call provision under an extraordinary redemption clause. This call provision was exercised on two bonds during the first half of 2024 resulting in accelerated amortization of $261 thousand. The Bank expects the remaining bonds to be called under this extraordinary redemption clause and if this occurs the remaining premium to amortize as of June 30, 2024 is $319 thousand.

Restricted Stock at Cost: The Bank held $10.4 million of restricted stock at June 30, 2024. 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 $18.5 million over year-end 2023, primarily in consumer first lien loans. For the first six months of 2024, the Bank originated $51.6 million in mortgages compared to $35.0 million for the same period in 2023, including $13.3 million for sale through the secondary market. 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 ($15.8 million), while loans for individuals to construct personal residences totaled $11.5 million at June 30, 2024. 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 $743.6 million from $703.8 million at the end of 2023. Included in commercial real estate are approximately $563 million of nonowner occupied loans located primarily in the Bank’s market area of south-central Pennsylvania.

The following table presents the largest sectors by collateral in the commercial real estate category:

(Dollars in thousands)

Also included in CRE are real estate construction loans totaling $154.7 million. At June 30, 2024, the Bank had $55.3 million in real estate construction loans funded with an interest reserve and capitalized $1.4 million of interest in the first six months of 2024 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 $974 thousand to $243.6 million at June 30, 2024, compared to $242.7 million at the end of 2023. At June 30, 2024, the Bank had approximately $111.3 million in tax-free loans.

The following table presents the largest sectors by industry in the commercial category:

(Dollars in thousands)

Participations: The Bank may supplement its own commercial loan production by purchasing loan participations. These participations are primarily located in south-central Pennsylvania. At June 30, 2024, the outstanding commercial participations were $104.7 million, or 9.8%, of commercial purpose loans and 7.9% of total gross loans compared to $97.8 million at December 31, 2023, or 9.5%, of commercial purpose loans and 7.8% of total gross loans. The Bank’s total exposure (including outstanding balances and unfunded commitments) to purchased participations is $133.9 million, compared to $135.4 million at December 31, 2023. The commercial loan participations are comprised of $30.2 million of Commercial loans and $74.5 million of CRE loans, reported in the respective loan class.

Consumer loans: This category had a balance of $7.4 million at June 30, 2024, compared to $6.8 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 June 30, 2024 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 $27.9 million at June 30, 2024 compared to $17.2 million at December 31, 2023. The watch list includes both performing and nonperforming loans. Included in the watchlist total are $723 thousand of nonaccrual loans as of June 30, 2024 and $147 thousand as of December 31, 2023. 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 individually evaluated 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 credit 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 June 30, 2024, the Bank had loans of $9.3 million (0.7% of gross loans) that exceeded the supervisory limit, compared to 1.1% at year-end 2023.

Loan quality, as measured by nonaccrual loans, totaled $723 thousand at June 30, 2024 compared to $147 thousand at December 31, 2023 and the nonperforming loan to gross loans ratio was 0.04% at June 30, 2024 compared to 0.01% at December 31, 2023. Loans past due 90-days or more, but still accruing, totaled $165 thousand at June 30, 2024.

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.

As of June 30, 2024 and December 31, 2023 there were no modifications made to borrowers experiencing financial difficulty.

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 forecasts and 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 current accrued interest is reversed against income and prior year accrued interest is deducted from the ACL.

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.

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 loss rate is calculated over a historical period the Bank believes best represents a period that will be the most similar and relevant to the next four quarters.

The historical credit loss rate is applied to each WARM bucket through the next four quarter period.

At the end of the four quarter 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. At June 30, 2024, approximately 68% of the ACL for Loans was from the qualitative component, unchanged from year-end 2023.

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 June 30, 2024 and December 31, 2023:

(Dollars in thousands)

Deposits:

Total deposits increased $48.5 million during the first half of 2024 to $1.586 billion. Interest-bearing checking decreased by $53.3 million primarily in municipal deposits and savings decreased by $4.2 million, while the Bank’s Money Management increased $44.9 million. Time deposits increased $51.2 million as customers shifted to higher rate products. The Bank has $22.0 million of brokered CDs at June 30, 2024.

As of June 30, 2024, the Bank had deposits of $222.8 million placed in the IntraFi Network deposit program ($101.1 million in interest-bearing checking and $129.6 million in money management) and $19.4 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 June 30, 2024, the Bank’s reciprocal deposits were 13.3% of total liabilities compared to 14.3% at year-end 2023.

The Bank estimates that approximately 90% of its deposits are FDIC insured or collateralized as of June 30, 2024.

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

(Dollars in thousands)

Borrowings:

At June 30, 2024, the Bank had $40.0 million borrowed from the Federal Reserve’s Bank Term Funding Program (BTFP) with a rate of 4.81% due January 10, 2025. At June 30, 2024, the fair value of debt securities pledged for the BTFP was $44.1 million.

At June 30, 2024, the Bank had $240.0 million in total borrowings from the Federal Home Loan Bank of Pittsburgh (FHLB). The borrowings are comprised of $40.0 million in short-term borrowings with a blended rate of 5.80%, due during the third quarter of 2024, and $200.0 million in long-term borrowings with a rate of 4.32%, due January 12, 2027.

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 $4.7 million to $136.8 million as of June 30, 2024 from December 31, 2023. Retained earnings increased $3.6 million in 2024 and accumulated other comprehensive income/(loss) (AOCI) remained essentially unchanged since year-end 2023. The increase in retained earnings was from net income of $6.4 million partially offset by cash dividends of $2.8 million. The Corporation’s Dividend Reinvestment Plan (DRIP) added $644 thousand in new capital from optional cash contributions and $511 thousand from the reinvestment of quarterly dividends. The Corporation’s dividend payout ratio was 43.88% for the first half of 2024 compared to 44.77% for the same period in 2023.

As part of its quarterly dividend decision, the Corporation considers, among other factors, current and future income projections, dividend yield, payout ratio, current and future capital ratios, reserves and allocations. For the second quarter of 2024, the Corporation paid a $0.32 per share dividend, compared to $0.32 paid in the second quarter of 2023. On July 11, 2024, the Board of Directors declared a $0.32 per share regular quarterly dividend for the third quarter of 2024, which will be paid on August 28, 2024.

In December 2023, the Board of Directors authorized a 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 over a one-year period. During the first six months of 2024, the Corporation repurchased 14,684 shares for $440 thousand.

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 June 30, 2024 was 5.52% 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 June 30, 2024, 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 June 30, 2024 and December 31, 2023 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 County, PA, and Washington County, MD. This area is diverse in demographic and economic composition. County populations range from a low of approximately 15,000 in Fulton County to over 280,000 in Dauphin County. The market area has a diverse economic base and local industries include warehousing, truck and rail shipping centers, light and heavy manufacturers, health care, higher education institutions, farming and agriculture, and a varied service sector. The 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, marketable securities that are unencumbered ($168.0 million fair value) 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 June 30, 2024.

(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.

(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 2023 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 six months ended June 30, 2024. For more information on market risk refer to the Corporation’s 2023 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 June 30, 2024, 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 June 30, 2024, 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 and six months ended June 30, 2024. For more information, refer to the Corporation’s 2023 Annual Report on Form 10-K.