Orrstown Financial Services Inc: Form 10-Q for the period ended Sep 30, 2024

The following discussion and analysis is intended to assist readers in understanding the consolidated financial condition and results of operations of Orrstown and should be read in conjunction with the preceding unaudited condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q, as well as with the audited consolidated financial statements and notes thereto for the year ended December 31, 2023, included in our Annual Report on Form 10-K filed with the SEC on March 14, 2024. Throughout this discussion, the yield on earning assets is stated on a fully taxable-equivalent basis and balances represent average daily balances unless otherwise stated. All dollar amounts presented in the tables, except per share amounts, are in thousands.

Overview

The Company, headquartered in Harrisburg, Pennsylvania, is a one-bank holding company that has elected status as a financial holding company. The consolidated financial information presented herein reflects the Company and its wholly-owned subsidiary, the Bank. At September 30, 2024, the Company had total assets of $5.5 billion, total liabilities of $5.0 billion and total shareholders’ equity of $516.2 million.

The Company acquired Codorus Valley and its wholly-owned bank subsidiary PeoplesBank, A Codorus Valley Company on July 1, 2024. The merger and acquisition method of accounting was used to account for the transaction with the Company as the acquirer. The Company recorded the assets and liabilities of Codorus Valley at their respective fair values as of July 1, 2024. The transaction was valued at $233.4 million and expanded the Bank’s footprint into the York, Pennsylvania market while increasing its market penetration in its existing markets.

For the three months ended September 30, 2024 and 2023, the Company had a net loss of $7.9 million and net income of $9.0 million, respectively. For the nine months ended September 30, 2024 and 2023, the Company had net income of $8.4 million and $28.0 million, respectively. Diluted loss per share was $0.41 and diluted earnings per share was $0.87 for the three months ended September 30, 2024 and 2023, respectively. Diluted earnings per share was $0.62 and $2.68 for the nine months ended September 30, 2024 and 2023, respectively. For the three and nine months ended September 30, 2024, the Company incurred merger-related expenses of $17.0 million and $18.8 million, respectively. In addition, the three months ended September 30, 2024 included non-recurring charges of $15.5 million for the provision for credit losses on acquired non-PCD loans and $4.8 million for the retirement of an executive.

Cautionary Note About Forward-Looking Statements

Certain statements appearing herein, which are not historical in nature, are forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, we may make other written and oral communications, from time to time, that contain such statements. Such forward-looking statements reflect the current views of the Company's management with respect to, among other things, future events and the Company's financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “project,” “forecast,” “goal,” “target,” “would” and “outlook,” or the negative variations of those words or other comparable words of a future or forward-looking nature. Forward-looking statements are statements that include projections, predictions, expectations, estimates or beliefs about events or results or otherwise are not statements of historical facts, many of which, by their nature, are inherently uncertain and beyond the Company's control, and include, but are not limited to, statements related to new business development, new loan opportunities, growth in the balance sheet and fee-based revenue lines of business, merger and acquisition activity, cost savings initiatives, reducing risk assets, and mitigating losses in the future. Accordingly, the Company cautions you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. Although the Company believes that the expectations reflected in these forward-looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements and there can be no assurances that the Company will achieve the desired level of new business development and new loans, growth in the balance sheet and fee-based revenue lines of business, cost savings initiatives, and continued reductions in risk assets or mitigate losses in the future. Factors which could cause the actual results to differ from those expressed or implied by the forward-looking statements include, but are not limited to, the following: general economic conditions (including inflation and concerns about liquidity) on a national basis or in the local markets in which the Company operates; ineffectiveness of the Company's strategic growth plan due to changes in current or future market conditions; changes in interest rates; the diversion of management's attention from ongoing business operations and opportunities; the effects of competition and how it may impact our community banking model, including industry consolidation and development of competing financial products and services; changes in consumer behavior due to changing political, business and economic conditions, or legislative or regulatory initiatives; changes in laws and regulations; changes in credit quality; inability to raise capital, if necessary, under favorable conditions; volatility in the securities markets; the demand for our products and services; deteriorating economic conditions; geopolitical tensions; operational risks including, but not limited to, cybersecurity incidents, fraud, natural disasters and future pandemics; expenses associated with litigation and legal proceedings; the possibility that the anticipated benefits of the merger with Codorus Valley (the “Merger”) are not realized when expected or at all; the possibility that the Merger may be more expensive to complete and integrate than anticipated; the possibility that revenues following the Merger may be lower than expected; potential adverse reactions or changes to business or employee relationships, including those resulting from the completion of the Merger; the ability to complete the integration of the two companies successfully; the dilution caused by the Company’s issuance of additional shares of its capital stock in connection with the Merger; and other risks and uncertainties, including those detailed in our Annual Report on Form 10-K for the year ended December 31, 2023, and our Quarterly Reports on Form 10-Q under the sections titled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other filings made with the SEC. The statements are valid only as of the date hereof and we disclaim any obligation to update this information.

Economic Climate, Inflation and Interest Rates

Preliminary real GDP was 2.8% on an annualized basis for the third quarter of 2024, which was a decrease from 3.0% for the second quarter of 2024 and a decrease from 4.9% during the third quarter of 2023. The decline from the second quarter of 2024 was due to a decrease in residential fixed investment, including residential structures and equipment, and private inventory investment. Fluctuations in real GDP in recent periods, due to inflation, credit conditions and geopolitical tensions, continue to create uncertainty in the current economic environment. The personal consumption expenditures ("PCE") price index increased by 1.5% in the third quarter of 2024 compared to an increase of 2.5% for second quarter of 2024 and 2.9% for the third quarter of 2023. Excluding food and energy prices, the PCE price index increased by 2.2% in the third quarter of 2024 compared to 2.8% in the second quarter of 2024 and 2.4% in the third quarter of 2023.

The national unemployment rate was 4.1% in both October and June 2024 compared to 3.8% in September 2023. Within the Company's geographic footprint, the unemployment rate in Pennsylvania was 3.4% in September 2024 and 2023. The unemployment rate increased in Maryland from 1.6% in September 2023 to 2.9% in September 2024; however, it remains significantly below the national level. These state-wide unemployment rates are consistent with those experienced by the counties in which the Company operates branches and other corporate offices. There were notable job gains nationally in healthcare, construction and government during the third quarter of 2024.

At September 30, 2024, the 10-year Treasury bond yield was 3.81%, a decrease from 3.88% at December 31, 2023 and 4.59% at September 30, 2023 which was attributed to the FOMC's decision to reduce the Federal Funds rate by 50 basis points in September 2024. The decrease was based on the progress towards the FOMC's 2.0% inflation target and the unemployment rate remaining low despite recent slowing in job gains.

The majority of the assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the Company, particularly with respect to the growth of total assets and noninterest expenses, which tend to rise during periods of general inflation. Risks also exist due to supply and demand imbalances, employment shortages, the interest rate environment, and geopolitical tensions. It is possible that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.

Critical Accounting Estimates

The Company’s accounting and reporting policies are in accordance with GAAP and follow accounting and reporting guidelines prescribed by bank regulatory authorities and general practices within the financial services industry in which it operates. Our financial position and results of operations are affected by management's application of accounting policies, including estimates, and assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the balance sheet date and through the date the financial statements are filed with the SEC. Different assumptions in the application of these policies could result in material changes in the consolidated financial position and/or consolidated results of operations and related disclosures. The more critical accounting estimates include accounting for credit losses, income tax methodologies and accounting for business combinations.

Business Combinations

The Company accounts for its mergers and acquisitions using the acquisition method of accounting under the provisions of the FASB ASC Topic 805, Business Combinations. Under ASC 805, the assets acquired, including identified intangible assets such as core deposit intangibles and customer list intangibles, and liabilities assumed in a business combination are recognized at their acquisition-date fair value, while transaction costs and restructuring costs associated with the business combination are expensed as incurred. The excess of the merger consideration over the fair value of assets acquired and liabilities assumed, if any, is allocated to goodwill.

The valuations are based upon management’s assumptions of future growth rates, future attrition, discount rates and other relevant factors, which involves a significant level of estimation and uncertainty. In addition, management engaged independent third-party specialists to assist in the development of the fair values of the acquired assets and assumed liabilities. The preliminary estimates of fair values may be adjusted for a period of time subsequent to the acquisition date if new information is obtained about facts and circumstances that existed as of the merger date that, if known, would have affected the measurement of the amounts recognized as of that date. Adjustments would be recorded to goodwill during the current reporting period. Examples of the impacted acquired loans and assumed liabilities includes loans, deposits, identifiable intangible assets, borrowings and certain other assets and liabilities.

For acquired loans at the merger date, management evaluated and classified loans based upon whether the loans had experienced a more-than-insignificant amount of credit deteriorating since origination. To determine the fair value of the loans, significant estimates and assumptions were applied, including projected cash flows, discount rates, repayment speeds, credit loss severity rates, default rates and realizable collateral values. At acquisition, the allowance on PCD loans is booked directly to the ACL using the Company’s existing ACL methodology, but there is no initial impact to net income. Subsequent to acquisition, future changes in estimates of expected credit losses on PCD loans are recognized as provision expense (or reversal of provision expense). The ACL for non-PCD loans is recognized as a provision for credit losses in the same reporting period as the business acquisition, using the Company’s existing ACL methodology.

These critical accounting estimates are discussed in detail in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2023. Significant accounting policies and any changes in accounting principles and effects of new accounting pronouncements are discussed in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," in our Annual Report on Form 10-K for the year ended December 31, 2023.

RESULTS OF OPERATIONS

Three months ended September 30, 2024 compared with three months ended September 30, 2023

Summary

Net loss totaled $7.9 million for the three months ended September 30, 2024 compared to net income of $9.0 million for the same period in 2023. Diluted loss per share for the three months ended September 30, 2024 totaled $0.41 compared to diluted earnings per share of $0.87 for the three months ended September 30, 2023. For the three months ended September 30, 2024, the Company incurred merger-related expenses of $17.0 million, provision for credit losses on acquired non-PCD loans of $15.5 million and retirement expenses for one executive of $4.8 million, which were included in non-interest expenses of the unaudited condensed consolidated statements of operations. Excluding these non-recurring expenses, net income and diluted earnings per share totaled $21.4 million and $1.11, respectively, for the three months ended September 30, 2024.

Net interest income totaled $51.7 million for the three months ended September 30, 2024 compared to $26.2 million for the three months ended September 30, 2023.

The provision for credit losses on loans and off-balance sheet reserves totaled $13.7 million and $136 thousand for the three months ended September 30, 2024 and 2023, respectively.

Noninterest income totaled $12.4 million for the three months ended September 30, 2024 compared to $5.9 million for the three months ended September 30, 2023. There was an increase of $6.5 million during the third quarter of 2024 primarily due to higher wealth management income of $2.2 million and increases in service charges and interchange income totaling $1.9 million.

Noninterest expenses totaled $60.3 million for the three months ended September 30, 2024 compared to $20.4 million for the three months ended September 30, 2023. The increase of $39.9 million includes non-recurring expenses of $21.7 million and an increase of $2.2 million in intangible asset amortization. The remainder of the increase is across several line items primarily due to the Merger.

Income tax benefit was $2.0 million and income tax expense was $2.5 million for the three months ended September 30, 2024 and 2023, respectively. The Company's effective tax rate was 20.1% for the three months ended September 30, 2024 compared to 21.9% for the three months ended September 30, 2023.

Net Interest Income

Net interest income increased by $25.5 million from $26.2 million for the three months ended September 30, 2023 to $51.7 million for the three months ended September 30, 2024. Interest income on loans increased by $37.9 million, from $32.7 million for the three months ended September 30, 2023 to $70.6 million for the three months ended September 30, 2024. Interest income on investment securities increased by $4.6 million, from $5.3 million for the three months ended September 30, 2023 to $9.9 million for the three months ended September 30, 2024. Total interest expense increased by $18.8 million from $12.5 million for the three months ended September 30, 2023 to $31.3 million for the three months ended September 30, 2024. Interest expense on deposits increased by $18.0 million from $10.6 million for the three months ended September 30, 2023 to $28.6 million for the three months ended September 30, 2024. Interest expense on borrowings increased by $797 thousand to $2.7 million for the three months ended September 30, 2024 compared to $1.9 million for the three months ended September 30, 2023.

The following table presents net interest income, net interest spread and net interest margin for the three months ended September 30, 2024 and 2023 on a taxable-equivalent basis:

Net interest income on a taxable-equivalent basis increased by $25.5 million to $52.1 million for the three months ended September 30, 2024 from $26.6 million for the three months ended September 30, 2023. The Company's net interest spread increased by 26 basis points from 3.29% for the three months ended September 30, 2023 to 3.55% for the three months ended September 30, 2024.

Taxable-equivalent net interest margin increased by 41 basis points to 4.14% for the three months ended September 30, 2024 from 3.73% for the three months ended September 30, 2023. The taxable-equivalent yield on interest-earning assets increased by 114 basis points from 5.47% for the three months ended September 30, 2023 to 6.61% for the three months ended September 30, 2024, due primarily to the accretion recognized on fair value marks to loans and securities assumed in the Merger. This increase in yield on interest earning assets was partially offset by an increase of 88 basis points in the cost of interest-bearing liabilities from 2.19% to 3.07% due primarily to increased funding costs on deposits from higher market interest rates and competitive pressures and an increase in the interest rate on Orrstown Financial Services, Inc.'s subordinated notes, which converted from a fixed rate to a floating rate on December 30, 2023.

Average loans increased by $1.7 billion to $4.0 billion for the three months ended September 30, 2024 compared to $2.3 billion for the three months ended September 30, 2023. Average investment securities increased by $328.5 million from $521.2 million for the three months ended September 30, 2023 to $849.7 million for the three months ended September 30, 2024. Average interest-bearing liabilities increased by $1.8 billion to $4.1 billion for the three months ended September 30, 2024 from $2.3 billion for the three months ended September 30, 2023.

The yield on loans increased by 129 basis points to 7.07% for the three months ended September 30, 2024 compared to 5.78% for the three months ended September 30, 2023. Taxable-equivalent interest income earned on loans increased by $38.0 million due to the larger loan portfolio from the Merger as well as higher interest rates. Accretion income on loans was $7.3 million for the three months ended September 30, 2024 as compared to $149 thousand for the three months ended September 30, 2023.

The average balance of commercial loans increased by $1.4 billion to $3.2 billion for the three months ended September 30, 2024 from $1.8 billion the three months ended September 30, 2023. Average residential mortgage loans increased by $203.6 million from $251.4 million during the three months ended September 30, 2023 to $455.0 million during the three months ended September 30, 2024. Average home equity loans increased by $110.1 million from $191.4 million for the three months ended September 30, 2023 to $301.5 million for the three months ended September 30, 2024. Average installment and other consumer loans increased by $14.5 million from $19.7 million for the three months ended September 30, 2023 to $34.2 million for the three months ended September 30, 2024.

Accretion of purchase accounting adjustments on loans included in interest income was $7.3 million and $149 thousand for the three months ended September 30, 2024 and 2023, respectively. The increase in accretion was due to recognition of fair value marks from the Merger. Accelerated accretion totaled $2.2 million and $30 thousand for the three months ended September 30, 2024 and 2023, respectively. Prepayment fee income on loans increased from $353 thousand for the three months ended September 30, 2023 to $620 thousand for the three months ended September 30, 2024.

Interest income on investment securities on a tax-equivalent basis increased by $4.6 million to $10.1 million for the three months ended September 30, 2024 from $5.5 million for the three months ended September 30, 2023, with the taxable equivalent yield increasing from 4.26% for the three months ended September 30, 2023 to 4.77% for the three months ended September 30, 2024. The 51 basis point increase primarily reflected the impact from the higher interest rates as well as the recognition of discounts recorded on securities assumed from the Merger. Accretion on acquired investment securities was $870 thousand for the three months ended September 30, 2024. The average balance of investment securities increased by $328.5 million to $849.7 million for the three months ended September 30, 2024 from $521.2 million for the three months ended September 30, 2023 due primarily to the Merger.

Interest income on federal funds sold and interest-bearing bank balances on a tax-equivalent basis increased by $1.8 million to $2.5 million for the three months ended September 30, 2024 from $633 thousand for the three months ended September 30, 2023. The average balance of federal funds sold and interest-bearing bank balances increased by $126.7 million from $57.8 million for the three months ended September 30, 2023 to $184.5 million. The Federal Funds rate had remained unchanged from the prior rate increase of 25 basis points in July 2023 until the FOMC cut the Federal Fund rate by 50 basis points in September 2024.

Interest expense on interest-bearing liabilities increased by $18.8 million from $12.5 million for the three months ended September 30, 2023 to $31.3 million for the three months ended September 30, 2024. The cost of interest-bearing liabilities increased by 88 basis points from 2.19% for the three months ended September 30, 2023 to 3.07% for the three months ended September 30, 2024 as funding costs increased due to higher market interest rates and competitive pressures on deposit pricing. The average balance of interest-bearing deposits increased by $1.8 billion to $3.9 billion for the three months ended September 30, 2024 from $2.1 billion for the three months ended September 30, 2023. For the three months ended September 30, 2024, average interest-bearing demand deposits increased by $1.0 billion, average time deposits increased by $657.4 million and average saving deposits increased by $92.5 million compared to the prior period. Amortization of fair value marks on acquired time deposits was $1.4 million for the three months ended September 30, 2024.

Interest expense on borrowings was $2.7 million for the three months ended September 30, 2024 compared to $1.9 million for the three months ended September 30, 2023. The cost of borrowings increased by 88 basis points to 5.17% for the three months ended September 30, 2024 from 4.29% for the three months ended September 30, 2023. Average borrowings increased by $31.7 million from $175.2 million for the three months ended September 30, 2023 to $206.9 million for the three months ended September 30, 2024, which included average subordinated debt and trust preferred debt of $68.4 million for the three months ended September 30, 2024, an increase of $36.3 million, from an average of $32.1 million for the three months ended September 30, 2023. This increase is due to the assumed subordinated debt of $31.0 million and trust preferred debt of $10.3 million from the Merger, net of fair value marks. The interest rate increased on Orrstown Financial Services, Inc.'s outstanding subordinated notes of $32.5 million, which converted from a fixed rate of 6.00% to a floating rate of 8.77% on December 30, 2023. The subordinated notes from the Merger have a fixed rate of interest equal to 4.50% until December 30, 2025. The trust preferred debt has a variable rate of three-month CME term SOFR rate, plus a spread adjustment and margin. The contractual interest rate on Orrstown Financial Services, Inc.'s subordinated notes was 8.75% at September 30, 2024. Amortization of fair value marks on acquired borrowings was $152 thousand for the three months ended September 30, 2024.

Provision for Credit Losses

The Company recorded a provision for credit losses of $13.7 million for the three months ended September 30, 2024 compared to $136 thousand for the same period in 2023. For the three months ended September 30, 2024, the provision for credit losses increased primarily due to $15.5 million of reserves on acquired non-PCD loans as a result of the Merger, partially offset by a provision reversal of $1.8 million due to changes in qualitative factors, a change in the peer group utilized for the calculation and a reduction of $434 thousand in the required reserve for unfunded commitments. The change in qualitative factors included a reduction in the Economic Conditions qualitative factor and removal of the Other External Factors qualitative factor. The ACL to total loan ratio was 1.25% at both September 30, 2023 and September 30, 2024. For the three months ended September 30, 2023, the provision for credit losses was driven by an increase in commercial loans and an increase in the Delinquency and Classified Loan Trends qualitative factor for the commercial & industrial and owner-occupied commercial real estate loan classes. The change in this qualitative factor was based on a recent trend of increases in loans downgraded to the special mention risk rating, which is reflected in the provision for credit losses noted above. In addition, the provision for credit losses was impacted by the change in expected loss rates under CECL. Favorable published trends in unemployment and GDP rates impacted the extent of provisioning required in the third quarter of 2023.

Net charge-offs for the three months ended September 30, 2024 totaled $269 thousand compared to net charge-offs of $241 thousand for the three months ended September 30, 2023. Nonaccrual loans were 0.68% of gross loans at September 30, 2024, compared with 0.98% of gross loans at September 30, 2023. Nonaccrual loans increased by $4.8 million from $22.3 million at September 30, 2023 to $27.1 million at September 30, 2024. This reflects $12.8 million of nonaccrual loans assumed in the Merger and additions of $16.2 million at the Bank, mainly consisting of commercial and industrial and commercial real estate loans, partially offset by repayments of $24.0 million.

Additional information is included in the "Credit Risk Management" section herein.

Noninterest Income

The following table compares noninterest income for the three months ended September 30, 2024 and 2023:

Noninterest income increased by $6.5 million from $5.9 million for the three months ended September 30, 2023 to $12.4 million for the three months ended September 30, 2024. The primary driver of the overall increase was the impact of the Merger in the three months ended September 30, 2024. The following were significant components of the change in this line item that did not result from the Merger:

• Wealth management income, which includes trust and investment management income and brokerage income, continues to grow due to strong market performance and growth in managed assets, both organically and through the acquisition of two registered investment advisory firms since September 2023 with total assets under management of $151 million.
• Swap fee income increased by $250 thousand as swap fee income will fluctuate based on market conditions and client demand.
• Mortgage banking income increased by $633 thousand. Mortgage loans sold totaled $10.0 million in the third quarter of 2024 compared to $5.2 million in the third quarter of 2023. In addition, the fair value mark on the mortgage loans held-for-sale increased by $411 thousand from a negative fair value mark of $369 thousand for the three months ended September 30, 2023 to a positive fair value mark of $42 thousand for the three months ended September 30, 2024.
• Other income increased by $513 thousand due primarily to solar tax credits of $349 thousand.
• The gain on investment securities was due to a security redemption and the mark-to-market activity on an equity security.
• Other line items within noninterest income showed fluctuations attributable to normal business operations.

Noninterest Expenses

The following table compares noninterest expenses for the three months ended September 30, 2024 and 2023:

Noninterest expense increased by $39.9 million from $20.4 million for the three months ended September 30, 2023 to $60.3 million for the three months ended September 30, 2024. The primary driver of the overall increase was the impact of the Merger in the three months ended September 30, 2024. The following were additional significant components of the change in this line item:

• Merger-related expenses totaled $17.0 million, which primarily included employee separation costs, vendor contract terminations and professional fees incurred in connection with the Merger.
• Salaries and employee benefits expense includes a $4.8 million charge associated with the retirement of an executive.
• Data processing expense increased by $798 thousand due to the use of two core processing systems until the system conversion process is completed in the fourth quarter of 2024.
• Intangible asset amortization expense increased by $2.2 million due to the amortization recognized on the core deposit intangible and wealth customer relationship intangible established on July 1, 2024 as a result of the Merger.
• Restructuring expense of $257 thousand was recorded in the three months ended September 30, 2024 due to the announced closure of six branch locations to occur in the fourth quarter of 2024.
• Other operating expenses increased by $2.2 million, partially due to an increase in credit valuation adjustments on derivatives of $780 thousand. The remaining change is attributed to the impact of the merger and normal business operations.
• Other line items within noninterest expenses showed fluctuations attributable to normal business operations.

Income Tax Expense

Income tax benefit totaled $2.0 million, an effective tax rate of 20.1%, for the three months ended September 30, 2024 compared with income tax expense of $2.5 million and an effective tax rate of 21.9% for the three months ended September 30, 2023. The Company’s effective tax rate is less than the 21% federal statutory rate due to interest earned on tax-exempt loans and investment securities, income from life insurance policies and tax credits partially offset by disallowed interest expenses and the impact of nondeductible merger-related costs. The decrease in the effective tax rate from the three months ended September 30, 2023 to the three months ended September 30, 2024 was primarily due to the impact of the Merger and fluctuation in the portion of interest expense disallowed as a deduction against earnings under the Tax Equity and Fiscal Responsibility Act of 1982.

Nine months ended September 30, 2024 compared with nine months ended September 30, 2023

Summary

Net income totaled $8.4 million for the nine months ended September 30, 2024 compared to $28.0 million for the same period in 2023. Diluted earnings per share for the nine months ended September 30, 2024 totaled $0.62 compared to $2.68 for the nine months ended September 30, 2023. For the nine months ended September 30, 2024, the Company incurred merger-related expenses of $18.8 million, provision for credit losses on acquired non-PCD loans of $15.5 million and retirement expenses for one executive of $4.8 million, which were included in non-interest expenses of the unaudited condensed consolidated statements of operations. Excluding these non-recurring expenses, net income and diluted earnings per common share totaled $39.4 million and $2.93, respectively, for the nine months ended September 30, 2024. For the nine months ended September 30, 2023, the Company recorded a gain of $1.2 million from the sale of the Bank's Path Valley branch. See “Supplemental Reporting of Non-GAAP Measures” for additional information.

Net interest income totaled $104.7 million for the nine months ended September 30, 2024 compared to $78.9 million for the nine months ended September 30, 2023.

The provision for credit losses on loans and off-balance sheet reserves totaled $14.8 million and $1.3 million for the nine months ended September 30, 2024 and 2023, respectively.

Noninterest income totaled $26.2 million and $19.2 million for the nine months ended September 30, 2024 and 2023, respectively. The increase of $7.0 million was primarily due to an increase in wealth management income of $3.1 million, increases in service charges and interchange income totaling $1.9 million, an increase in swap fee income of $628 thousand and an increase in mortgage banking income of $870 thousand. These increases were partially offset by the gain of $1.2 million recorded to other income from the sale of the Path Valley branch for the nine months ended September 30, 2023.

Noninterest expenses totaled $105.4 million and $61.5 million for the nine months ended September 30, 2024 and 2023, respectively. The increase of $44.0 million is primarily due to merger-related expenses of $18.8 million and an increase of $2.2 million in intangible asset amortization. The remainder of the increase is across several line items primarily due to the Merger.

Income tax expense totaled $2.3 million and $7.3 million for the nine months ended September 30, 2024 and 2023, respectively. The Company's effective tax rate was 21.6% for the nine months ended September 30, 2024 compared to 20.7% for the nine months ended September 30, 2023 due primarily to the impact of non-deductible merger-related expenses in 2024.

Net Interest Income

Net interest income increased by $25.8 million from $78.9 million for the nine months ended September 30, 2023 to $104.7 million for the nine months ended September 30, 2024. Interest income on loans increased by $49.8 million, from $92.7 million for the nine months ended September 30, 2024 to $142.4 million for the nine months ended September 30, 2024. Interest income on investment securities increased by $5.4 million, from $15.8 million for the nine months ended September 30, 2023 to $21.2 million for the nine months ended September 30, 2024. Total interest expense increased by $33.2 million from $31.0 million for the nine months ended September 30, 2023 to $64.2 million for the nine months ended September 30, 2024. Interest expense on deposits increased by $32.0 million from $25.4 million for the nine months ended September 30, 2023 to $57.4 million for the nine months ended September 30, 2024. Interest expense on borrowings increased by $1.3 million from $5.6 million in the nine months ended September 30, 2023 to $6.9 million for the nine months ended September 30, 2024.

The following table presents net interest income, net interest spread and net interest margin for the nine months ended September 30, 2024 and 2023 on a taxable-equivalent basis:

65

Net interest income on a taxable-equivalent basis increased by $25.9 million to $105.9 million for the nine months ended September 30, 2024 from $79.9 million for the nine months ended September 30, 2023. The Company's net interest spread decreased by 11 basis points from 3.44% for the nine months ended September 30, 2023 to 3.33% for the nine months ended September 30, 2024 primarily due to the increase in cost of funds.

Taxable-equivalent net interest margin increased by 5 basis points to 3.88% for the nine months ended September 30, 2024 from 3.83% for the nine months ended September 30, 2023. The recognition of interest income previously applied to principal of $1.6 million from the payoff of a commercial real estate loan on nonaccrual status contributed five basis points to the Company's net interest margin during the nine months ended September 30, 2024. The taxable-equivalent yield on interest-earning assets increased by 92 basis points from 5.31% for the nine months ended September 30, 2023 to 6.23% for the nine months ended September 30, 2024, due primarily to the accretion recognized on fair value marks to loans and securities assumed in the Merger. This increase in yield on interest earning assets was more than offset by the increase of 103 basis points in the cost of interest-bearing liabilities from 1.87% to 2.90% due primarily to increased funding costs on deposits from higher market interest rates and competitive pressures and an increase in the interest rate on Orrstown Financial Services, Inc.'s subordinated notes, which converted from a fixed rate to a floating rate on December 30, 2023.

Average loans increased by $654.5 million to $2.9 billion for the nine months ended September 30, 2024 compared to $2.2 billion for the nine months ended September 30, 2023. Average investment securities increased by $112.4 million from $524.4 million for the nine months ended September 30, 2023 to $636.8 million for the nine months ended September 30, 2024. Average interest-bearing liabilities increased by $747.6 million to $3.0 billion for the nine months ended September 30, 2024 from $2.2 billion for the nine months ended September 30, 2023.

The yield on loans increased by 104 basis points to 6.63% for the nine months ended September 30, 2024 compared to 5.59% for the nine months ended September 30, 2023. Taxable-equivalent interest income earned on loans increased by $49.9 million due to higher interest rates. Accretion income on loans was $7.6 million for the nine months ended September 30, 2024 as compared to $603 thousand for the nine months ended September 30, 2023.

The average balance of commercial loans increased by $516.0 million from $1.8 billion for the nine months ended September 30, 2023 to $2.3 billion for the nine months ended September 30, 2024. Average residential mortgage loans increased by $94.6 million from $240.9 million during the nine months ended September 30, 2023 to $335.5 million during the nine months ended September 30, 2024. Average home equity loans increased by $41.7 million from $188.8 million for the nine months ended September 30, 2023 to $230.5 million for the nine months ended September 30, 2024. Average installment and other consumer loans decreased by $2.2 million from $20.5 million for the nine months ended September 30, 2023 to $22.7 million for the nine months ended September 30, 2024.

Accretion of purchase accounting adjustments included in interest income was $7.6 million and $603 thousand for the nine months ended September 30, 2024 and 2023, respectively. The increase in accretion was due to the recognition of fair value marks from the Merger. Accelerated accretion totaled $2.3 million and $212 thousand during the nine months ended September 30, 2024 and 2023, respectively. Prepayment income on commercial loans increased by from $627 thousand for the nine months ended September 30, 2023 to $878 thousand for the nine months ended September 30, 2024.

Interest income on investment securities on a tax-equivalent basis increased by $5.4 million to $21.9 million for the nine months ended September 30, 2024 from $16.5 million for the nine months ended September 30, 2023, with the taxable equivalent yield increasing from 4.21% for the nine months ended September 30, 2023 to 4.60% for the nine months ended September 30, 2024. The 39 basis point increase reflected the impact from the higher interest rates as well as the recognition of discounts recorded on securities assumed from the Merger. Accretion on acquired investment securities was $870 thousand for the nine months ended September 30, 2024. . The average balance of investment securities increased by $112.4 million to $636.8 million for the nine months ended September 30, 2024 from $524.4 million for the nine months ended September 30, 2023 due primarily to the Merger.

Interest income on federal funds sold and interest-bearing bank balances on a tax-equivalent basis increased by $3.9 million to $5.3 million for the nine months ended September 30, 2024 from $1.3 million for the nine months ended September 30, 2023. The average balance of federal funds sold and interest-bearing bank balances increased by $92.2 million from $41.9 million for the nine months ended September 30, 2023 to $134.1 million for the nine months ended September 30, 2024. The Federal Funds rate had remained unchanged from the prior rate increase of 25 basis points in July 2023 until the FOMC cut the Federal Fund rate by 50 basis points in September 2024.

Interest expense on interest-bearing liabilities increased by $33.2 million from $31.0 million for the nine months ended September 30, 2023 to $64.2 million for the nine months ended September 30, 2024. The cost of interest-bearing liabilities increased by 103 basis points from 1.87% for the nine months ended September 30, 2023 to 2.90% for the nine months ended September 30, 2024 as funding costs increased due to higher market interest rates and competitive pressures on deposit pricing.

The average balance of interest-bearing deposits increased by $733.0 million to $2.8 billion for the nine months ended September 30, 2024 from $2.0 billion for the nine months ended September 30, 2023. Average interest-bearing demand deposits increased by $408.3 million, average time deposits increased by $323.0 million and average savings deposits increased by $1.7 million for the nine months ended September 30, 2024 in relation to the comparable prior period. Amortization of fair value marks on acquired time deposits was $1.4 million for the nine months ended September 30, 2024.

Interest expense on borrowings increased by $1.3 million to $6.9 million for the nine months ended September 30, 2024 from $5.6 million for the nine months ended September 30, 2023 as the cost of borrowings increased by 57 basis points to 5.00% for the nine months ended September 30, 2024 from 4.43% for the nine months ended September 30, 2023. Average borrowings increased by $14.5 million from $168.5 million for the nine months ended September 30, 2023 to $183.1 million for the nine months ended September 30, 2024, which included average subordinated debt and trust preferred debt of $44.3 million for the three months ended September 30, 2024, an increase of $12.3 million, from an average of $32.0 million for the three months ended September 30, 2023. The increase is due to the assumed subordinated debt of $31.0 million and trust preferred debt of $10.3 million from the Merger. The interest rate increased on Orrstown Financial Services, Inc.'s outstanding subordinated notes of $32.5 million, which converted from a fixed rate of 6.00% to a floating rate of 8.77% on December 30, 2023. The subordinated notes assumed from the Merger have a fixed rate of interest equal to 4.50% until December 30, 2025. The trust preferred debt has a variable rate of three-month CME term SOFR rate, plus a spread adjustment and margin. The contractual interest rate on Orrstown Financial Services, Inc.'s subordinated notes was 8.75% at September 30, 2024 compared to 6.00% at September 30, 2023. Amortization of fair value marks on acquired borrowings was $152 thousand for the nine months ended September 30, 2024.

Provision for Credit Losses

The Company recorded a provision for credit losses of $14.8 million for the nine months ended September 30, 2024 compared to $1.3 million for the same period in 2023, which included a reversal of the provision for credit losses for off-balance sheet credit exposures of $557 thousand for the nine months ended September 30, 2024. The provision for credit losses increased primarily due to $15.5 million of reserves on acquired non-PCD loans. The ACL to total loan ratio remained at 1.25% at September 30, 2023 and September 30, 2024. The provision expense recorded in the nine months ended September 30, 2023 was due to commercial loan growth, an increase in the Delinquency and Classified Loan Trends qualitative factor for the commercial & industrial and owner-occupied commercial real estate loan classes and an increase in the Economic Conditions qualitative factor for consumer loans and an overall increase in expected loss rates under CECL, which was adopted on January 1, 2023.

Net charge-offs for the nine months ended September 30, 2024 totaled $340 thousand compared to net charge-offs of $587 thousand for the nine months ended September 30, 2023. Nonaccrual loans were 0.68% of gross loans at September 30, 2024, compared with 0.98% of gross loans at September 30, 2023. Nonaccrual loans increased by $4.8 million from $22.3 million at September 30, 2023 to $27.1 million at September 30, 2024. This reflects $12.8 million of nonaccrual loans assumed in the Merger and additions of $16.2 million at the Bank, mainly consisting of commercial and industrial and commercial real estate loans, partially offset by repayments of $24.0 million.

Additional information is included in the "Credit Risk Management" section herein.

Noninterest Income

The following table compares noninterest income for the nine months ended September 30, 2024 and 2023:

Noninterest income increased by $7.0 million from $19.2 million for the nine months ended September 30, 2023 to $26.2 million for the nine months ended September 30, 2024. The primary driver of the overall increase was the impact of the Merger in the nine months ended September 30, 2024. The following were significant components of the change in this line item that did not result from the Merger:

• Wealth management income increased by $3.1 million due to strong market performance and growth in managed assets, both organically and through the acquisition of two registered investment advisory firms since September 2023 with total assets under management of $151 million.
• Swap fee income increased by $628 thousand as swap fee income will fluctuate based on market conditions and client demand.
• Mortgage banking income increased by $870 thousand. Mortgage loans sold totaled $33.1 million in the nine months ended September 30, 2024, which included a $7.2 million portfolio sold to another institution in the three months ended March 31, 2024, compared to $19.9 million in the nine months ended September 30, 2023.
• Other income decreased by $408 thousand due primarily to a gain of $1.2 million from the sale of the Bank's Path Valley branch during the second quarter of 2023, partially offset by $349 thousand of solar tax credit income recognized in the nine months ended September 30, 2024.
• The gain on investment securities was due to a security redemption and the mark-to-market activity on an equity security.
• Other line items within noninterest income showed fluctuations attributable to normal business operations.

Noninterest Expenses

The following table compares noninterest expenses for the nine months ended September 30, 2024 and 2023:

Noninterest expense increased by $44.0 million from $61.5 million for the nine months ended September 30, 2023 to $105.4 million for the nine months ended September 30, 2024. The primary driver of the overall increase was the impact of the Merger in the nine months ended September 30, 2024. The following were additional significant components of the change in this line item:

• Merger-related expenses totaled $18.8 million, which primarily included employee separation costs, vendor contract terminations and professional fees incurred in connection with the Merger.
• Salaries and employee benefits expense includes a $4.8 million charge associated with the retirement of an executive.
• Data processing expense increased by $882 thousand due to the use of two core processing systems until the system conversion process is completed in the fourth quarter of 2024.
• Intangible asset amortization expense increased by $2.2 million due to the amortization recognized on the core deposit intangible and wealth customer relationship intangible established on July 1, 2024 as a result of the Merger.
• Restructuring expense of $257 thousand was recorded in the three months ended September 30, 2024 due to the announced closure of six branch locations to occur in the fourth quarter of 2024.
• Other operating expenses increased by $1.9 million partially due to an increase in credit valuation adjustments on derivatives of $545 thousand. The remaining change is attributed to the impact of the merger and normal business operations.
• Other line items within noninterest expenses showed fluctuations attributable to normal business operations.

Income Tax Expense

Income tax expense totaled $2.3 million, an effective tax rate of 21.6%, for the nine months ended September 30, 2024 compared with $7.3 million and an effective tax rate of 20.7% for the nine months ended September 30, 2023. The Company’s effective tax rate is greater than the 21% federal statutory rate due to disallowed interest expense, state income taxes and nondeductible merger-related expenses partially offset by tax-exempt income, including interest earned on tax-exempt loans and investment securities, income from life insurance policies and tax credits. The increase in the effective tax rate from the nine months ended September 30, 2023 to the nine months ended September 30, 2024 was primarily due to an increase in the portion of interest expense disallowed as a deduction against earnings under the Tax Equity and Fiscal Responsibility Act of 1982, an increase in state taxes as a result of a greater percentage of taxable income earned in a state with a state income tax and the nondeductible merger-related expenses.

FINANCIAL CONDITION

Management devotes substantial time to overseeing the investment in and costs to fund loans and investment securities through deposits and borrowings, as well as the formulation and adherence to policies directed toward enhancing profitability and managing the risks associated with these investments.

Investment Securities

The Company utilizes investment securities to manage interest rate risk, enhance income through interest and dividend income and collateralize certain deposits and borrowings.

The Company has established investment policies and an asset/liability management policy to assist in administering its investment portfolio. Decisions to purchase or sell these securities are based on economic conditions and management’s strategy to respond to changes in interest rates, liquidity, pledges to secure deposits and repurchase agreements and other factors while trying to maximize return on the investments. The Company may segregate its investment security portfolio into three categories: “securities available-for-sale,” “trading securities” and “securities held-to-maturity.” At September 30, 2024 and December 31, 2023, management classified the entire investment securities portfolio as AFS, which is accounted for at current market value with non-credit related losses and gains reported in OCI, net of income taxes.

The Company's investment securities portfolio includes debt investments that are subject to varying degrees of credit and market risks, which arise from general market conditions and factors impacting specific industries, as well as news that may impact specific issues. Management monitors its debt securities, using various indicators in determining whether unrealized losses on debt securities are credit related and require an ACL. These indicators include the amount of time the security has been in an unrealized loss position, the cause and extent of the unrealized loss and the credit quality of the issuer and underlying assets. In addition, management assesses whether it is likely the Company will have to sell the investment security prior to recovery, or it expects to be able to hold the investment security until the price recovers. The Company determined that the declines in market value were due to increases in interest rates and market movements, and not due to credit factors. The Company does not intend to sell these securities with unrealized losses and it is more likely than not that the Company will not be required to sell them before recovery of their amortized cost basis, which may be maturity. Therefore, the Company has concluded that the unrealized losses for the AFS securities did not require an ACL at September 30, 2024 and December 31, 2023.

At September 30, 2024, AFS securities totaled $826.8 million, an increase of $313.3 million, from $513.5 million at December 31, 2023. During the nine months ended September 30, 2024, the Company purchased $190.3 million of AFS securities excluding AFS securities acquired in the Merger, which included $188.0 million of agency MBS and CMO securities, $1.5 million of non-agency CMO securities and $788 thousand of investment securities issued by state and political subdivisions. Pursuant to the Merger, the Company acquired AFS securities with a fair value totaling $327.1 million. To align with the Company's investment strategy and to achieve higher yielding results, $162.7 million of the acquired AFS securities were sold, which included $91.5 million of MBS and CMO's, $27.1 million of corporate debt securities, $24.4 million of securities issued by state and political subdivisions and $19.7 million of securities issued by U.S. government agencies. In addition, calls of non-agency CMO securities totaled $18.0 million and there were paydowns of $40.0 million. The balance of investment securities included net unrealized losses of $19.0 million at September 30, 2024 compared to net unrealized losses of $35.6 million at December 31, 2023 for a decrease of $16.7 million. This decrease in net unrealized losses was primarily due to lower treasury rates and narrower credit spreads compared to December 31, 2023. The overall duration of the Company's investment securities portfolio was 4.6 years at September 30, 2024 compared to 4.3 years at December 31, 2023. The Company has sufficient access to liquidity such that management does not believe it would be necessary to sell any of its investment securities at a loss to offset any unexpected deposit outflows. Management believes the structure of the Company's investment security portfolio is appropriately aligned with the rest of the balance sheet to protect against volatile interest rate environments, to provide a source of liquidity and to generate steady earnings.

The following table summarizes the credit ratings and collateral associated with the Company's investment security portfolio, excluding equity securities, at September 30, 2024:

Loan Portfolio

The Company offers a variety of products to meet the credit needs of its borrowers, principally commercial real estate loans, commercial and industrial loans, retail loans secured by residential properties, and, to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.

The risks associated with lending activities differ among loan segments and classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans and general economic conditions. Any of these factors may adversely impact a borrower’s ability to repay loans, and also impact the associated collateral. A further discussion on the Company's loan segments and classes, the related risks, ACL and FDM are included in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Credit Losses, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information."

The following table presents the loan portfolio, excluding residential LHFS, by segment and class at September 30, 2024 and December 31, 2023:

Total loans increased by $1.7 billion from December 31, 2023 to September 30, 2024. This increase is due to $1.6 million in loans acquired in the Merger and continued portfolio growth in the commercial loans segment and residential mortgage segment during the nine months ended September 30, 2024.

Asset Quality

Risk Elements

The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is managed through the Company's underwriting standards, on-going credit reviews and monitoring of asset quality measures. Additionally, loan portfolio diversification, which limits exposure to a single industry or borrower, and collateral requirements also mitigate the Company's risk of credit loss.

The loan portfolio consists principally of loans to borrowers in south central Pennsylvania and the greater Baltimore, Maryland region. As the majority of loans are concentrated in these geographic regions, a substantial portion of the borrowers' ability to honor their obligations may be affected by the level of economic activity in these market areas.

Nonperforming assets include nonaccrual loans and foreclosed real estate. In addition, loan modifications to borrowers experiencing financial difficulty and loans past due 90 days or more and still accruing are also deemed to be risk assets. For all loan classes, the accrual of interest income on loans, including individually evaluated loans, ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to accrue on loans past due 90 days or more if the collateral is adequate to cover principal and interest, and the loan is in the process of collection. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is generally reversed and charged against interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, the loans have performed in accordance with the contractual terms of the note for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on contract terms of the loan.

In accordance with ASU 2022-02, the Company is required to evaluate, based on the accounting for loan modifications, whether the borrower is experiencing financial difficulty and if the modification results in a more-than-insignificant direct change in the contractual cash flows and represents a new loan or a continuation of an existing loan, which the Company refers to these loans as "financial difficulty modifications" or "FDMs."

The following table presents the Company’s risk elements and relevant asset quality ratios at September 30, 2024 and December 31, 2023.

(1) Annualized

Nonperforming assets include nonaccrual loans and foreclosed real estate. Risk assets, which include nonperforming assets, FDMs still accruing and loans past due 90 days or more and still accruing, totaled $36.9 million at September 30, 2024, an increase of $11.3 million from $25.6 million at December 31, 2023. Nonaccrual loans increased by $1.4 million from December 31, 2023 to September 30, 2024 due primarily to additions in commercial and commercial real estate loans partially offset by the payoffs of two commercial real estate loans with outstanding balances totaling $15.0 million with no charge-offs recorded on these relationships. Nonaccrual loans totaling $12.8 million were acquired in the Merger. During 2024, the Company had $11.4 million in loan modifications meeting the FDM criteria under ASU 2022-02, which included $6.4 million in acquired loans from the Merger and three new loan modifications during the third quarter of 2024 totaling $5.0 million. There were $1.9 million in FDM loans in nonaccrual status at September 30, 2024.

The following table presents the amortized cost basis of nonaccrual loans, according to loan class, with and without reserves on individually evaluated loans at September 30, 2024 and December 31, 2023. At September 30, 2024, there was a specific reserve of $3 thousand on nonaccrual loans, excluding the ACL recorded on acquired PCD loans from the Merger, compared to $49 thousand at December 31, 2023.

During 2024, two commercial real estate loans on nonaccrual status totaling $15.0 million were paid off.

The following table presents our exposure to relationships that are individually evaluated and the partial charge-offs taken to date and specific reserves established on those relationships at September 30, 2024 and December 31, 2023.

The Company takes partial charge-offs on collateral-dependent loans when carrying value exceeds estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Specific reserves remain in place if updated appraisals are pending and represent management’s estimate of potential loss.

Internal loan reviews are completed annually on all commercial relationships, secured by commercial real estate, with a committed loan balance in excess of $1.0 million, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed and corresponding risk ratings are reaffirmed by the Bank's Problem Loan Committee, with subsequent reporting to the Management ERM Committee.

In its individually evaluated loan analysis, the Company determines the extent of any full or partial charge-offs that may be required, or any reserves that may be needed. The determination of the Company’s charge-offs or specific reserve include an evaluation of the outstanding loan balance and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships at September 30, 2024. However, over time, additional information may result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed.

Credit Risk Management

Allowance for Credit Losses

The Company maintains the ACL at a level deemed adequate by management for expected credit losses. As disclosed in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Credit Losses, on January 1, 2023 the Company implemented CECL and increased the ACL with a cumulative-effect adjustment to the ACL of $2.4 million. In addition, the Company recorded a cumulative-effect adjustment to the ACL for off-balance sheet exposures of $100 thousand. The Company’s ACL is calculated quarterly, with any adjustment recorded to the provision for credit losses in the unaudited condensed consolidated statements of operations. A comprehensive analysis of the ACL is performed by the Company on a quarterly basis. Management evaluates the adequacy of the ACL utilizing a defined methodology to determine if it properly addresses the current and expected risks in the loan portfolio, which considers the performance of borrowers and specific evaluation of individually evaluated loans, including historical loss experiences, trends in delinquencies, nonperforming loans and other risk assets, and the qualitative factors. Risk factors are continuously reviewed and adjusted, as needed, by management when conditions support a change. Management believes its approach properly addresses relevant accounting and bank regulatory guidance for loans both collectively and individually evaluated. The results of the comprehensive analysis, including recommended changes, are governed by the Company's Reserve Adequacy Committee and subsequently presented to the Enterprise Risk Management Committee.

The ACL is evaluated based on a review of the collectability of loans in light of historical experience; the nature and volume of the loan portfolio; adverse situations that may affect a borrower’s ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A description of the methodology for establishing the allowance and provision for credit losses and related procedures in establishing the appropriate level of reserve is included in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Credit Losses, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information."

The following table presents the amortized cost basis of the loan portfolio, by year of origination, loan class and credit quality as of September 30, 2024. For residential and consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan and payment activity. Residential mortgage and installment and other consumer loans are presented below based on payment performance: performing or nonperforming. During 2024, commercial and land development loans totaling $20.6 million were recharacterized to a permanent commercial real estate class upon the completion of construction or receiving a certificate of occupancy. In addition, 1-4 family residential construction loans totaling $14.9 million were recharacterized to a permanent 1-4 family residential mortgage upon the completion of construction.

75

76

77

78

79

The Special Mention classification is intended to be a temporary classification reflective of loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Company’s position at some future date. Special Mention loans represent an elevated risk, but their weakness does not yet justify a more severe, or classified, rating. These loans require inquiry by lenders on the cause of the potential weakness and, once evaluated, the loan classification may be downgraded to Substandard or, alternatively, could be upgraded to Pass.

Special Mention loans increased by $43.9 million from $24.2 million at December 31, 2023 to $68.1 million at September 30, 2024 due to acquired loans from the Merger of $51.1 million and downgrades at the Bank of $14.2 million, partially offset by repayments, including $8.6 million from two commercial and industrial clients and $3.9 million from two commercial real estate clients.

Classified loans totaled $105.5 million at September 30, 2024, or 2.6% of total loans outstanding, reflecting an increase from $49.0 million, or 2.1% of total loans outstanding, at December 31, 2023.

Non-IEL substandard loans are performing loans, which have characteristics that cause management concern over the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as nonperforming, or individually evaluated, loans in the future. Generally, management feels that substandard loans that are currently performing and not considered individually evaluated result in some doubt as to the borrower’s ability to continue to perform under the terms of the loan and represent potential problem loans. Non-IEL substandard loans totaled $78.3 million at September 30, 2024, an increase of $49.0 million, compared to $29.3 million at December 31, 2023, due primarily to acquired loans from the Merger of $35.7 million and downgrades at the Bank consisting of two commercial and industrial clients and two commercial real estate clients with loans totaling $7.6 million and $2.6 million, respectively. The Substandard-IEL category increased from $25.7 million at December 31, 2023 to $27.1 million at September 30, 2024, primarily due to acquired loans from the Merger of $12.9 million and downgrades at the Bank totaling $9.4 million consisting of two commercial and industrial clients with loans totaling $6.6 million and two commercial real estate clients with loans totaling $2.7 million, partially offset by repayments including the payoff of loans to three commercial real estate clients with an outstanding balance of $16.4 million and a residential mortgage loan of $1.6 million at December 31, 2023.

The following table presents the activity in the ACL for the three and nine months ended September 30, 2024 and 2023:

The ACL totaled $49.6 million at September 30, 2024, an increase of $20.9 million from December 31, 2023, resulting primarily from the provision for credit losses on non-PCD loans of $15.5 million related to the Merger, the allowance for credit losses on PCD loans from the Merger of $5.9 million, other provision for credit losses of $15,348 thousand and net charge-offs of $340 thousand during the nine months ended September 30, 2024. The ACL as a percentage of the total loan portfolio was 1.25% at both September 30, 2024 and September 30, 2023.

For the nine months ended September 30, 2023, the provision for credit losses was driven by the increase in commercial loans, the increase in the loss reserve rates under the CECL methodology and an increase in the Delinquency and Classified Loan Trends qualitative factor for the commercial & industrial and owner-occupied commercial real estate loan classes.

The Company takes partial charge-offs on collateral-dependent loans when the carrying value exceeds the estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Specific reserves remain in place if updated appraisals are pending and represent management's estimate of potential loss. In addition to the specific reserve allocations on individually evaluated loans noted previously, 11 loans, with aggregate outstanding principal balances of $1.2 million, had cumulative partial charge-offs to the ACL totaling $757 thousand through September 30, 2024. As updated appraisals are received on collateral-dependent loans, partial charge-offs are taken to the extent the loans’ principal balance exceeds their fair value.

Management believes the allocation of the ACL among the various loan classes adequately reflects the life expected credit losses in each loan class and is based on the methodology outlined in Note 1, Summary of Significant Accounting Policies, and

Note 4, Loans and Allowance for Credit Losses, to the Consolidated Financial Statements under Part I, Item 1, "Financial Information." Management re-evaluates and makes enhancements to its reserve methodology to better reflect the risks inherent in the different segments of the portfolio, particularly in light of increased charge-offs, with noticeable differences between the different loan classes. Management believes these enhancements to the ACL methodology improve the accuracy of quantifying the expected credit losses inherent in the portfolio. Management charges actual loan losses to the reserve and bases the provision for credit losses on its overall analysis.

Management believes the Company’s ACL is adequate based on currently available information. Future adjustments to the ACL and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management’s assumptions as to future delinquencies or loss rates.

Deposits

Total deposits increased by $2.1 billion to $4.7 billion at September 30, 2024 from $2.6 billion at December 31, 2023, which included $1.9 billion in deposits assumed from the Merger. Money market deposits increased by $718.4 million, time deposits increased by $600.4 million, non-interest bearing demand deposits increased by $384.4 million, interest-bearing demand deposits increased by $285.4 million and savings deposits increased by $103.4 million. These increases were primarily attributable to the Merger. Interest-bearing demand deposits can fluctuate based on seasonal public funds activity. The increase in time deposits also reflected promotional offerings of up to 18-month terms. At September 30, 2024, deposits that are uninsured and not collateralized totaled $692.6 million, or 15% of total deposits, compared to $442.7 million, or 17% of total deposits, at December 31, 2023.

Borrowings

In addition to deposits, the Company uses borrowing sources to meet liquidity needs and for temporary funding. Sources of short-term borrowings include the FHLB of Pittsburgh, federal funds purchased and the FRB discount window. Short-term borrowings also may include securities sold under agreements to repurchase with deposit clients, in which a client sweeps a portion of a deposit balance into a repurchase agreement, which is a secured borrowing with a pool of securities pledged against the balance.

The Company also utilizes long-term debt, consisting principally of FHLB fixed and amortizing advances, to fund its balance sheet with original maturities greater than one year. Prior to entering into long-term borrowings, the Company evaluates its funding needs, interest rate movements, the cost of options and the availability of attractive structures.

FHLB advances and other borrowings decreased by $22.5 million to $115.0 million at September 30, 2024 compared to $137.5 million at December 31, 2023. The Bank repaid overnight borrowings during the first quarter of 2024 based on available liquidity from deposits.

In December 2018, the Company issued unsecured subordinated notes payable totaling $32.5 million, which mature on December 30, 2028, and the proceeds of which were designated for general corporate use, including funding of cash consideration for mergers and acquisitions. The subordinated notes had a fixed interest rate of 6.0% through December 30, 2023, which then converted to a variable rate, three-month CME term SOFR rate plus 3.16%, through maturity. At September 30, 2024, the contractual interest rate on the subordinated debt was 8.75%.

The Company assumed unsecured subordinated notes of $31.0 million from the Merger. The subordinated notes have a fixed rate of interest equal to 4.50% until December 30, 2025. After that term, the variable rate of interest is equal to the three-month CME term SOFR rate plus 4.04%. The Company also assumed junior subordinated trust preferred debt of $10.3 million from the Merger, which have variable rates of three-month CME term SOFR rate, plus a spread adjustment of 0.26161% and an additional margin adjustment.

See Note 10, Short-Term Borrowings, Note 11, Long-Term Borrowings and Note 12, Subordinated Notes and Trust Preferred Debt, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information," for a description and terms of the Company’s borrowings and access to alternative sources of liquidity.

Shareholders' Equity, Capital Adequacy and Regulatory Matters

Capital management in a regulated financial services industry must properly balance return on equity to its shareholders while maintaining sufficient levels of capital and related risk-based regulatory capital ratios to satisfy statutory regulatory requirements. The Company’s capital management strategies have been developed to provide attractive rates of returns to its shareholders, while remaining “well-capitalized” under applicable banking regulations.

Shareholders’ equity totaled $516.2 million at September 30, 2024, an increase of $251.2 million from $265.1 million at December 31, 2023. The increase was primarily attributable to the issuance of common stock of $233.4 million to acquire Codorus Valley, other comprehensive income of $12.6 million, net income of $8.4 million and the issuance of treasury shares for share-based compensation which reduced treasury stock by $5.5 million, partially offset by dividends paid of $8.7 million and for the nine months ended September 30, 2024. Other comprehensive income included an after-tax increase of $12.8 million from net unrealized gains on investment securities, partially offset by $249 thousand in net unrealized losses from cash flow hedges. For the nine months ended September 30, 2024, total comprehensive income totaled $21.0 million, a decrease of $2.6 million, from total comprehensive income of $23.6 million for the same period in 2023 due primarily to a decrease in net income of $19.7 million and an increase in after-tax net unrealized losses on cash flow hedges of $2.5 million, partially offset by a decline in after-tax net unrealized losses on investment securities of $19.5 million between the comparative periods. The decrease in net unrealized losses on investment securities was primarily caused by a decline in treasury rates and narrower credit spreads.

At September 30, 2024, book value per common share was $26.65 compared to $24.98 at December 31, 2023. Tangible book value per share decreased from $23.03 at December 31, 2023 to $21.12 at September 30, 2024, primarily as a result of the common stock issued in the Merger and purchase accounting marks recorded through shareholders' equity as a result of the Merger. See “Supplemental Reporting of Non-GAAP Measures.”

The Company routinely evaluates its capital levels in light of its risk profile to assess its capital needs. The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. At September 30, 2024 and December 31, 2023, the Bank was considered well-capitalized under applicable banking regulations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Prompt corrective action provisions are not applicable to bank holding companies, including financial holding companies.

Note 13, Shareholders' Equity and Regulatory Capital, to the Notes to Unaudited Condensed Consolidated Financial Statements under Part I, Item 1, "Financial Information," includes a table presenting capital amounts and ratios for the Company and the Bank at September 30, 2024 and December 31, 2023.

In addition to the minimum capital ratio requirement and minimum capital ratio to be well-capitalized presented in the referenced table in Note 13, the Bank must maintain a capital conservation buffer as more fully described in the Company's Annual Report on Form 10-K for the year ended December 31, 2023, Item 1 - Business, under the topic Basel III Capital Rules. At September 30, 2024, the Bank's capital conservation buffer, based on the most restrictive Total Capital to risk weighted assets capital ratio, was 4.2%, which is greater than the 2.5% requirement.

Liquidity

The primary function of asset/liability management is to ensure adequate liquidity and manage the Company’s sensitivity to changing interest rates. Liquidity management involves the ability to meet the cash flow requirements of clients who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The Company's primary sources of funds consist of deposit inflows, loan repayments, borrowings from the FHLB of Pittsburgh and maturities and prepayments of investment securities. While maturities and scheduled amortization of loans and investment securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

The Company regularly adjusts its investments in liquid assets based upon its assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and investment securities and the objectives of its asset/liability management policy. The Company's most liquid assets are cash and cash equivalents.

At September 30, 2024, cash and cash equivalents totaled $236.8 million compared to $65.2 million at December 31, 2023, which reflects the increase in deposits of $2.1 billion and net income of $8.4 million, partially offset by the decrease in borrowings of $22.5 million for the nine months ended September 30, 2024. Unencumbered investment securities totaled $90.3 million at September 30, 2024 compared to $73.7 million at December 31, 2023. At September 30, 2024, the Company had $16.5 million of investment securities pledged at the FRB Discount Window, with no associated borrowings outstanding, compared to $17.4 million at December 31, 2023. The Company's maximum borrowing capacity from the FHLB of Pittsburgh was $1.1 billion at both September 30, 2024 and December 31, 2023, of which $118.2 million and $138.7 million in advances and letters of credit were outstanding at these same periods, respectively. In addition, the Company had $20.0 million in available unsecured lines of credit with other banks at September 30, 2024 and December 31, 2023. The Bank tested its various sources of funding during 2024 to ensure accessibility.

See Note 10, Short-Term Borrowings, Note 11, Long-Term Borrowings and Note 12, Subordinated Notes and Trust Preferred Debt, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information," for a description and terms of the Company’s borrowings and access to alternative sources of liquidity.

Supplemental Reporting of Non-GAAP Measures

Management believes providing certain “non-GAAP” financial information will assist investors in their understanding of the effect on recent financial results from non-recurring charges.

As a result of prior acquisitions, the Company had intangible assets consisting of goodwill and core deposit and other intangible assets totaling $116.8 million and $21.1 million at September 30, 2024 and December 31, 2023, respectively. During the three and nine months ended September 30, 2024, the Company incurred merger-related expenses of $17.0 million and $18.8 million, respectively, in connection with the Merger with Codorus Valley. During the three and nine months ended September 30, 2024, the Company incurred other non-recurring charges totaling $20.3 million.

Tangible book value per share and the impact of the merger-related expenses on net income and diluted earnings per share, as used by the Company in this supplemental reporting presentation, is determined by methods other than in accordance with GAAP. While we believe this information is a useful supplement to GAAP-based measures presented in this Form 10-Q, readers are cautioned that this non-GAAP disclosure has limitations as an analytical tool, should not be viewed as a substitute for financial measures determined in accordance with GAAP, and should not be considered in isolation or as a substitute for analysis of our results and financial condition as reported under GAAP, nor are such measures necessarily comparable to non-GAAP performance measures that may be presented by other companies. This supplemental presentation should not be construed as an inference that our future results will be unaffected by similar adjustments to be determined in accordance with GAAP.

The decrease in tangible book value per share (non-GAAP) from December 31, 2023 to September 30, 2024 is primarily due to the common stock issued to acquire Codorus Valley of $233.4 million and dividends paid of $8.7 million, partially offset by other comprehensive income, net of taxes, of $12.6 million and net income of $8.4 million. Other comprehensive income increased due to net unrealized gains on AFS securities partially offset by net unrealized losses on interest rate swaps designated as hedging instruments.

The following table presents the computation of each non-GAAP based measure shown together with its most directly comparable GAAP-based measure.

84

Adjusted Net Income and Adjusted Diluted (Earnings Per Share

Market risk comprises exposure to interest rate risk, foreign currency exchange rate risk, commodity price risk and other relevant market rate or price risks. In the banking industry, a major risk exposure is changing interest rates. The primary objective of monitoring our interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. FRB monetary control efforts, the effects of deregulation, economic uncertainty and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.

Interest Rate Risk

Interest rate risk is the exposure to fluctuations in the Bank’s future earnings (earnings at risk) and value (value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest-earning assets and interest-bearing liabilities that reprice within a specified time period as a result of scheduled maturities, scheduled and unscheduled repayments, the propensity of borrowers and depositors to react to changes in their economic interests and loan contractual interest rate changes.

We attempt to manage the level of repricing and maturity mismatch through our asset/liability management process so that fluctuations in net interest income are maintained within policy limits across a range of market conditions, while satisfying liquidity and capital requirements. Management recognizes that a certain amount of interest rate risk is inherent, appropriate and necessary to ensure the Bank’s profitability. Thus, the goal of interest rate risk management is to evaluate the amount of reward for taking risk and adjusting both the size and composition of the balance sheet relative to the level of reward available for taking risk.

Management endeavors to control the exposure to changes in interest rates by understanding, reviewing and making decisions based on its risk position. The Bank primarily uses its investment securities portfolio, FHLB advances, interest rate swaps and brokered deposits to manage its interest rate risk position. Additionally, pricing, promotion and product development activities are directed in an effort to emphasize the loan and deposit term or repricing characteristics that best meet current interest rate risk objectives.

We use simulation analysis to assess earnings at risk and net present value analysis to assess value at risk. These methods allow management to regularly monitor both the direction and magnitude of our interest rate risk exposure. These analyses require numerous assumptions including, but not limited to, changes in balance sheet mix, prepayment rates on loans and investment securities, cash flows and repricing of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity. Assumptions are based on management’s best estimates but may not accurately reflect actual results under certain changes in interest rates due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and providing a relative gauge of our interest rate risk position over time.

Our Asset/Liability Committee operates under management policies, approved by the Board of Directors, which define guidelines and limits on the level of risk. The committee meets regularly and reviews our interest rate risk position and monitors various liquidity ratios to ensure a satisfactory liquidity position. By utilizing our analyses, we can determine changes that may need to be made to the asset and liability mixes to mitigate the change in net interest income under various interest rate scenarios. Management continually evaluates the condition of the economy, the pattern of market interest rates and other economic data to inform the committee on the selection of investment securities. Regulatory authorities also monitor our interest rate risk position along with other liquidity ratios.

Net Interest Income Sensitivity

Simulation analysis evaluates the effect of upward and downward changes in market interest rates on future net interest income. The analysis involves changing the interest rates used in determining net interest income over the next twelve months. The resulting percentage change in net interest income in various rate scenarios is an indication of our short-term interest rate risk. The analysis assumes recent pricing trends in new loan and deposit volumes will continue while balances remain constant. Additional assumptions are applied to modify pricing under the various rate scenarios.

The simulation analysis results are presented in the table below. At September 30, 2024, the balance sheet is asset sensitive and assets are now expected to reprice faster over the next twelve months than in prior models. The change was driven by the Merger as the assets acquired are shorter term in maturity and repricing characteristics. The funding profile is characterized similarly to the original portfolio where shorter term certificate of deposit balances had grown due to the interest rate environment, but also contain significant non-maturity deposits as well. Through the consolidation of the two portfolios, we anticipate changes to the mix of the asset and liability profiles.

Economic Value

Net present value analysis provides information on the risk inherent in the balance sheet that might not be considered in the simulation analysis due to the short time horizon used in that analysis. The net present value of the balance sheet incorporates the discounted present value of expected asset cash flows minus the discounted present value of expected liability cash flows. The analysis involves changing the interest rates used in determining the expected cash flows and in discounting the cash flows. The resulting percentage change in net present value in various rate scenarios is an indication of the longer term repricing risk and options embedded in the balance sheet.

Funding cost, the level of interest rates, infrastructure cost and repricing speed will continue to be a factor in the results of the model. The behavior of the business and retail clients also varies across the rate scenarios, which is reflected in the results but will continue to be refined through the combination of the two balance sheets. To improve the comparability across periods, the Bank strives to follow best practices related to the assumption setting and maintains the size and mix of the period end balance sheet; thus, the results do not reflect actions management may take through the normal course of business that would impact results.

Based on the evaluation required by Exchange Act Rules 13a-15(b) and 15d-15(b), the Company's management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of its disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e), at September 30, 2024. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective at September 30, 2024.

There were no significant changes made to the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or that are reasonably likely to affect, our internal control over financial reporting during the nine months ended September 30, 2024.

There have been no material changes from the risk factors as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2023.