Eagle Financial Services Inc: Form 10-Q for the period ended Mar 31, 2023

The purpose of this discussion is to focus on the important factors affecting the Company’s financial condition, results of operations, liquidity and capital resources. This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes to the Consolidated Financial Statements presented in Part I, Item 1, Financial Statements, of this Form 10-Q and Item 8, Financial Statements and Supplementary Data, of the 2022 Form 10-K.

GENERAL

Eagle Financial Services, Inc. is a bank holding company which owns 100% of the stock of Bank of Clarke (the “Bank” and, collectively with Eagle Financial Services, Inc., the “Company”, “we”, “us” or “our”). Accordingly, the results of operations for the Company are dependent upon the operations of the Bank. The Bank conducts a commercial banking business which consists of attracting deposits from the general public and investing those funds in commercial, consumer and real estate loans and municipal and U.S. government agency securities. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation to the maximum extent permitted by law. At March 31, 2023, the Company had total assets of $1.76 billion, net loans of $1.39 billion, total deposits of $1.39 billion, and shareholders’ equity of $104.5 million. The Company’s net income was $2.6 million for the three months ended March 31, 2023.

MANAGEMENT’S STRATEGY

The Company strives to be an outstanding financial institution in its market by building solid sustainable relationships with: (1) its customers, by providing highly personalized customer service, a network of conveniently placed branches and ATMs, a competitive variety of products/services and courteous, professional employees, (2) its employees, by providing generous benefits, a positive work environment, advancement opportunities and incentives to exceed expectations, (3) its communities, by participating in local concerns, providing monetary support, supporting employee volunteerism and providing employment opportunities, and (4) its shareholders, by providing sound profits and returns, sustainable growth, regular dividends and committing to its local, independent status.

OPERATING STRATEGY

The Bank is a locally owned and managed financial institution. This allows the Bank to be flexible and responsive in the products and services it offers. The Bank grows primarily by lending funds to local residents and businesses at a competitive price that reflects the inherent risk of lending. The Bank attempts to fund these loans through deposits gathered from local residents and businesses. The Bank prices its deposits by comparing alternative sources of funds and selecting the lowest cost available. When deposits are not adequate to fund asset growth, the Bank relies on borrowings, both short and long term. The Bank’s primary source of borrowed funds is the Federal Home Loan Bank of Atlanta which offers numerous terms and rate structures to the Bank.

As interest rates change, the Bank attempts to maintain its net interest margin. This is accomplished by changing the price, terms, and mix of its financial assets and liabilities. The Bank also earns fees on services provided through its trust department, sales of investments through Eagle Investment Services, secondary market mortgage activities, and deposit operations. The Bank also incurs noninterest expenses such as compensating employees, maintaining and acquiring fixed assets, and purchasing goods and services necessary to support its daily operations.

The Bank has a marketing department which seeks to develop new business. This is accomplished through an ongoing calling program whereby account officers visit with existing and potential customers to discuss the products and services offered. The Bank also utilizes traditional advertising such as television commercials, radio ads, newspaper ads, and billboards.

LENDING POLICIES

Administration and supervision over the lending process is provided by the Bank’s Credit Administration Department. The principal risk associated with the Bank’s loan portfolio is the creditworthiness of its borrowers. In an effort to manage this risk, the Bank’s policy gives loan amount approval limits to individual loan officers based on their position and level of experience. Credit risk is increased or decreased, depending on the type of loan and prevailing economic conditions. In consideration of the different types of loans in the portfolio, the risk associated with real estate mortgage loans, commercial loans and consumer loans varies based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay debt.

The Company has written policies and procedures to help manage credit risk. The Company utilizes a loan review process that includes formulation of portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular portfolio reviews to establish loss exposure and to ascertain compliance with the Company’s policies.

The Bank uses a tiered approach to approve credit requests consisting of individual lending authorities, joint approval of Category I officers, and a director loan committee. Lending limits for individuals are set by the Board of Directors and are determined by loan purpose, collateral type, and internal risk rating of the borrower. The highest individual authority (Category I) is assigned to the Bank’s President / Chief Executive Officer, Chief Revenue Officer and Chief Credit Officer (approval authority only). Two officers in Category I may combine their authority to approve loan requests to borrowers with credit exposure up to $10.0 million on a secured basis and $6.0 million unsecured; and the three Category I Officers can combine to approve loan requests to borrowers with credit exposure up to $15.0 million on a secured basis and $9.0 million unsecured. Officers in Category II, III, IV, V, VI and VII have lesser authorities and with approval of a Category I officer may extend loans to borrowers with exposure of $5.0 million on a secured basis and $3.0 million unsecured. Officers in Categories I through VII can also utilize the co-approval of the Regional and Small Business Credit Officers to extend loans with exposures up to $2.5 million and $1.5 million respectively on a secured basis, and up to $1 million and $750 thousand respectively on an unsecured basis. Loans exceeding $15.0 million and up to the Bank’s legal lending limit can be approved by the Director Loan Committee consisting of four directors (three directors constituting a quorum). The Director’s Loan Committee also reviews and approves changes to the Bank’s Loan Policy as presented by management.

The following sections discuss the major loan categories within the total loan portfolio:

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Directors Loan Committee. In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, if applicable, flood insurance. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches. Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. In its underwriting of commercial real estate, the Bank’s loan to original appraised value ratio is generally 80% or less. Commercial real estate lending entails significant additional risk as compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation, and the Bank typically requires personal guarantees or endorsements of the borrowers’ principal owners.

Construction and Land Development Lending

The Bank makes local construction loans, primarily residential, and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of most construction loans is less than one year and the Bank offers both fixed and variable rate interest structures. The interest rate structure offered to customers depends on the total amount of these loans outstanding and the impact of the interest rate structure on the Bank’s overall interest rate risk. There are two characteristics of construction lending which impact its overall risk as compared to residential mortgage lending. First, there is more concentration risk due to the extension of a large loan balance through several lines of credit to a single developer or contractor. Second, there is more collateral risk due to the fact that loan funds are provided to the borrower based upon the estimated value of the collateral after completion. This could cause an inaccurate estimate of the amount needed to complete construction or an excessive loan-to-value ratio. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the estimated appraised value of the finished construction project. The Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners. Finally, the Bank performs inspections of the construction projects to ensure that the percentage of construction completed correlates with the amount of draws on the construction line of credit.

Commercial and Industrial Lending

Commercial business loans generally have more risk than residential mortgage loans, but have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate. Refer to the Marine Lending section below for discussion of additional commercial and industrial lending.

Consumer Lending

The Bank offers various secured and unsecured consumer loans, which include personal installment loans, personal lines of credit, automobile loans, and credit card loans. The Bank originates its consumer loans within its geographic market area and these loans are generally made to customers with whom the Bank has an existing relationship. Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral on a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and from any verifiable secondary income. Although creditworthiness of the applicant is the primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Refer to the Marine Lending section below for discussion of additional consumer lending.

Marine Lending

The Bank’s marine lending unit includes originated retail loans, which are classified as commercial and industrial loans or consumer loans, depending on the borrower, and dealer floorplan loans, which are classified as commercial and industrial loans. The Company’s relationships are limited to well established dealers of global premium brand manufacturers. The Company’s top three manufacturer customers have been in business between 30 and 100 years. The Company primarily has secured agreements with premium manufacturers to support dealer floor plan loans which may reduce the Company’s credit exposure to the dealer, despite its underwriting of each respective dealer. The Company has developed incentive retail pricing programs with the dealers to drive retail dealer flow. Retail loans are generally limited to premium manufacturers with established relationships with the Company which have a vested interest in the secondary market pricing of their respective brand due to the limited inventory available for resale. Consequently, while not contractually committed, manufacturers will often support secondary resale values which can have the effect of reducing losses from non-performing retail marine loans. Retail borrowers generally have very high credit scores, substantial down payments, substantial net worth, personal liquidity, and excess cash flow.

CRITICAL ACCOUNTING POLICIES

The financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The financial information contained within these statements is, to a significant extent, based on measurements of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of the transactions would be the same, the timing of events that would impact the transactions could change.

Allowance for Credit Losses on Loans

The Company establishes the allowance for credit losses through charges to earnings in the form of a provision for credit losses. Loan losses are charged against the allowance for credit losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent, when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance represents management’s current estimate of expected credit losses over the contractual term of loans held for investment, and is recorded at an amount that, in management’s judgment, reduces the recorded investment in loans to the net amount expected to be collected. Management’s judgment in determining the level of the allowance is based on evaluations of historical loan losses, current conditions and reasonable and supportable forecasts relevant to the collectability of loans. The measurement of the allowance for credit losses is based in part on forecasts of unemployment, inflation, as well as the consumer price index, and may also consider other factors, which we believe to be indicative of risk factors related to collectability. Management also assesses the risk of credit losses arising from changes in economic conditions; the nature and volume of the loan portfolio; the volume and severity of delinquencies and adversely classified loan balances; lending policy and procedures; credit administration and lending staff; loan review; concentrations of credit and the value of underlying collateral in determining the recorded balance of the allowance for credit losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. In evaluating the level of the allowance, we consider a range of possible assumptions and outcomes related to the various factors identified above. Refer to Note 1 of the interim consolidated financial information contained in Item 1 of this quarterly report on Form 10-Q for additional detail concerning the determination of the allowance for credit losses on loans.

FORWARD LOOKING STATEMENTS

The Company makes forward looking statements in this report that are subject to risks and uncertainties. These forward looking statements include statements regarding our expectations, intentions or objectives concerning our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” "could," “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward looking statements. These forward looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

• difficult market conditions in our industry;
• effects of soundness of other financial institutions;
• potential impact on us of existing and future legislation and regulations;
• the ability to successfully manage growth or implement growth strategies if the Bank is unable to identify attractive markets, locations or opportunities to expand in the future or if the Bank is unable to successfully integrate new branches, business lines or other growth opportunities into its existing operations;
• competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
• the successful management of interest rate risk;
• risks inherent in making loans such as repayment risks and fluctuating collateral values;
• changes in general economic and business conditions in the Bank’s market area;
• reliance on the Bank’s management team, including the ability to attract and retain key personnel;
• changes in interest rates and interest rate policies;
• maintaining capital levels adequate to support growth;
• maintaining cost controls and asset qualities as new branches are opened or acquired;
• demand, development and acceptance of new products and services;
• deposit flows;
• the cost and availability of secondary funding sources;
• problems with technology utilized by the Bank;
• changing trends in customer profiles and behavior;
• geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad;
• the Company's potential exposure to fraud, negligence, computer theft, and cyber-crime;
• changes in accounting policies and banking and other law and regulations; and
• other factors described in Item 1A., "Risk Factors," in the Company's 2022 Form 10-K.

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward looking statements. In addition, past results of operations do not necessarily indicate future results.

RESULTS OF OPERATIONS

Net Income

Net income for the three months ended March 31, 2023 was $2.6 million, an decrease of 20.46% or $665 thousand when compared to the same period in 2022. Earnings per share, basic and diluted were $0.73 and $0.94 for the three months ended March 31, 2023 and 2022, respectively.

Return on average assets ("ROA") measures how efficiently the Company uses its assets to produce net income. Some issues reflected within this efficiency include the Company’s asset mix, funding sources, pricing, fee generation, and cost control. The ROA of the Company, on an annualized basis, for the three months ended March 31, 2023 and 2022 was 0.63% and 0.99%, respectively.

Return on average equity ("ROE") measures the utilization of shareholders’ equity in generating net income. This measurement is affected by the same factors as ROA with consideration to how much of the Company’s assets are funded by shareholders. The ROE of the Company, on an annualized basis, for the three months ended March 31, 2023 and 2022 was 10.14% and 12.15%, respectively.

Net Interest Income

Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-earning assets and the interest paid on deposits and other interest-bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. Net interest income was $12.6 million and $11.1 million for the three months ended March 31, 2023 and 2022, respectively, which represents an increase of $1.5 million or 13.51%. Net interest income increased due to the increase in the average balance of the loan portfolio along with the rising interest rate environment. Average interest earning assets increased $317 million or 25.25% when comparing the three months ended March 31, 2022 to the three months ended March 31, 2023 while the average yield on earning assets increased by 106 basis points over that same period.

Total interest income was $18.6 million and $11.5 million for the three months ended March 31, 2023 and 2022, respectively, which represents an increase of $7.0 million or 61.25%. Total interest expense was $5.9 million and $370 thousand for the three months ended March 31, 2023 and 2022, respectively, which represents an increase of $5.5 million or 1,498.38%. The increase in interest income was driven by an increase in the average balance of the loan portfolio along with the rising interest rate environment. The current rising interest rate environment, along with the growth of higher-paying deposit accounts, have been the main drivers for the increase interest expense. The increase in interest expense can also be attributed to the 2022 subordinated debt issuance, currently paying a 4.50% fixed rate, on March 31, 2022 along with four Federal Home Loan Bank advances of $220.0 million maturing from December 2023 through March 2026 with varying fixed rates ranging from of 4.71% to 5.07%.

The net interest margin was 3.27% and 3.61% for the three months ended March 31, 2023 and 2022, respectively. Tax-equivalent net interest income is calculated by adding the tax benefit on certain securities and loans, whose interest is tax-exempt, to total interest income then subtracting total interest expense. The tax rate used to calculate the tax benefit was 21% for 2023 and 2022.

Net interest margin may experience some decline due to additional deposit pricing pressure as interest rates continue to increase and increased competition for new deposits is experienced. These combined also could result in the Company having to borrow wholesale funding to fund asset growth which is more expensive than deposits.

The following table shows interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the three months ended March 31, 2023 and 2022 (dollars in thousands):

(1) Income and yields are reported on a tax-equivalent basis using a federal tax rate of 21%.

(2) Non-accrual loans are not included in this total since they are not considered earning assets.

(3) Annualized.

The following table reconciles tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income.

(in thousands)

(1) Tax benefit was calculated using the federal statutory tax rate of 21%.

The tax-equivalent yield on earning assets increased from 3.73% to 4.79% for the three months ended March 31, 2022 compared to the same three month period in 2023. For those same time periods, the tax-equivalent yield on securities increased 46 basis points. The tax equivalent yield on loans increased 85 basis points from 4.25% for the three months ended March 31, 2022 to 5.10% for the same time period in 2023. The increase in the tax-equivalent yield on earning assets for the three months ended March 31, 2023 resulted mostly from the increase in the tax-equivalent yield on loans. The increase in the yield on loans as compared to the corresponding period in 2022 was primarily due to the current rising interest rate environment.

The average rate on interest bearing liabilities increased from 0.21% to 2.23% for the three months ended March 31, 2022 compared to the same three month period in 2023, respectively. The average rate on interest bearing deposits increased 141 basis points during the period. The current rising interest rate environment, along with the growth of higher-cost deposit accounts, have been the main drivers for the increased in the average rate on interest bearing deposits. The cost of interest bearing liabilities was also higher in the first quarter of 2023, due to the subordinated debt issuance in 2022, currently paying a 4.50% fixed rate, on March 31, 2022 along with four Federal Home Loan Bank advances of $220.0 million maturing from December 2023 through March 2026 with varying fixed rates ranging from of 4.71% to 5.07%.

Provision for Credit Losses

The provision for credit losses is based upon management’s estimate of the amount required to maintain an adequate allowance for credit losses as discussed within the Critical Accounting Policies section above and in Note 1 of our interim financial information. The Company's provision for credit losses in 2023 consisted of changes in the allowance for credit losses on loans and the reserve for unfunded loan commitments. The allowance for credit losses on loans represents management’s current estimate of expected credit losses over the contractual term of loans held for investment, and is recorded at an amount that, in management’s judgment, reduces the recorded investment in loans to the net amount expected to be collected. Management’s judgment in determining the level of the allowance is based on evaluations of historical loan losses, current conditions and reasonable and supportable forecasts relevant to the collectability of loans. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. The amount of provision for credit losses on loans is affected by several factors including the growth rate of loans, net charge-offs (recoveries), and the estimated amount of expected losses within the loan portfolio. The provision for credit losses for the three months ended March 31, 2023 and 2022 was $664 thousand and $540 thousand, respectively. The provision for credit losses for the three months ended March 31, 2023 and 2022 resulted mostly from loan growth during the quarters.

Noninterest Income

Total noninterest income for the three months ended March 31, 2023 and 2022 was $3.5 million and $3.2 million, respectively. Management reviews the activities which generate noninterest income on an ongoing basis. The following table provides the components of noninterest income for the three months ended March 31, 2023 and 2022, which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

(dollars in thousands)

NM - Not Meaningful

Wealth management fee income increased from 2023 to 2022. Wealth management fee income is comprised of income from fiduciary activities as well as commissions from the sale of non-deposit investment products. The amount of income from fiduciary activities is determined by the number of active accounts and total assets under management. Total assets under management have seen an increase during the three months ended March 31, 2023 when compared to the three months ended March 31, 2022.

Services charges on deposit accounts increased during the three months ended March 31, 2023 when compared to the same periods in 2022. This increase is mainly due to increases in overdraft charges. Overdraft charges can fluctuate based on changes in customer activity.

Other service charges and fees increased during the three months ended March 31, 2023. This increase can be attributed to increased ATM fee income. ATM fee income can fluctuate based on ATM usage by non-customers.

Other operating income decreased for the three months ended March 31, 2023 when compared to the same period in 2022. This increase can be mainly attributed to cash distributions received during the first quarter of 2022 from investments in Small Business Investment Companies, that were not received during the first quarter of 2023.

Noninterest Expenses

Total noninterest expenses increased $2.4 million or 24.82% for the three months ended March 31, 2023 compared to the same period in 2022. The following table presents the components of noninterest expense for the three months ended March 31, 2023 and 2022, which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

(dollars in thousands)

NM - Not Meaningful

The Company’s growth has had an impact on noninterest expenses. Total assets have grown by $382.4 million or 27.83% from March 31, 2022 to March 31, 2023. This growth has required investments to be made in the Company’s infrastructure, causing increases in salaries and employee benefits, equipment expenses, advertising and marketing expenses and computer software expense. In addition, increases in asset size and capital levels have impacted the FDIC assessment and bank franchise tax amounts.

Salaries and employee benefits increased during the three months ended March 31, 2023 over 2022. Annual pay increases, newly hired employees, increasing insurance costs and enhanced employee incentive plans have attributed to these increases. The number of full-time equivalent employees has increased from 221 at March 31, 2022 to 253 at March 31, 2023.

ATM network fees increased during the three months ended March 31, 2023 over 2022. This is due mainly to fluctuations in customer usage.

An increase in professional fees was also noted between both periods. This increase is mainly due to increased audit expenses related to new FDICIA requirement after reaching $1 billion in asset size, as well as, fees associated with SEC filings during the first quarter of 2023.

Data processing fees decreased during the three months ended March 31, 2023 over 2022. This was mainly due to credits with our core provider that the Company was able to apply to an invoice during the first quarter of 2023 in order to reduce the bill amount.

For the three months ended March 31, 2023 other operating expenses increased over 2022. This increase is due to increased loan related expenses due to a higher volume, increased wealth management expenses due to growth in assets under management, and employee travel expense for training, marketing and sales meetings.

The efficiency ratio of the Company was 76.52% and 68.87% for the three months ended March 31, 2023 and 2022, respectively. The efficiency ratio is not a measurement under accounting principles generally accepted in the United States. It is calculated by dividing noninterest expense by the sum of tax equivalent net interest income and noninterest income excluding gains and losses on the investment portfolio and other gains/losses from OREO, repossessed vehicles, disposals of bank premises and equipment, etc. The tax rate utilized is 21%. The Company calculates and reviews this ratio as a means of evaluating operational efficiency.

The calculation of the efficiency ratio for the three months ended March 31, 2023 and 2022 was as follows:

(in thousands)

(1) Includes tax-equivalent adjustments on loans and securities using the federal statutory tax rate of 21%.

Income Taxes

Income tax expense was $535 thousand and $669 thousand during the three months ended March 31, 2023 and 2022, respectively. The effective tax rate was 17.15% and 17.07% for the three months ended March 31, 2023 and 2022, respectively. The effective tax rate is below the statutory rate of 21% due to tax-exempt income on investment securities and loans. The effective tax rate is also impacted by BOLI as well as income tax credits on qualified affordable housing project investments as discussed in Note 12 to the Consolidated Financial Statements as well as qualified rehabilitation credits.

Business Segments

The Company has two reportable operating segments: community banking and marine lending. Revenue from community banking operations consist primarily of net interest income related to investments in loans and securities and outstanding deposits and borrowings, fees earned on deposit accounts and debit card interchange activity. Revenue from marine lending operations consist primarily of net interest income related to commercial and consumer marine loans and gains on sales of loans.

Financial information for the parent company and the Bank of Clarke Wealth Management Division is included in the "All Other" category. The parent company's operating results are comprised primarily of interest expense associated with subordinated debt. The wealth management division's net recenues are comprised primarily of income from offering wealth management services and insurance products through third-party service providers. Refer to Note 16 for additional information.

The following table provides income and asset information as of and for the three months ended March 31, 2023 and 2022 and as of March 31, 2023 and December 31, 2022, which are included within the Consolidated Balance Sheets and Consolidated Statements of Income. Variances that the Company believes require explanation are discussed below the table.

(in thousands)

46

FINANCIAL CONDITION

Securities

Total securities available for sale were $148.9 million at March 31, 2023, compared to $149.2 million at December 31, 2022. This represents a decrease of $266 thousand or 0.18%. The Company purchased no securities during the three months ended March 31, 2023. The Company had total maturities, calls, and principal repayments of $3.9 million during the three months ended March 31, 2023. Note 4 to the Consolidated Financial Statements provides additional details about the Company’s securities portfolio at March 31, 2023 and December 31, 2022. The Company had a net unrealized loss on available for sale securities of $22.1 million at March 31, 2023 as compared to a net unrealized loss of $25.9 million at December 31, 2022. Unrealized gains or losses on available for sale securities are reported within shareholders’ equity, net of the related deferred tax effect, as accumulated other comprehensive income (loss). The primary cause of the unrealized losses at March 31, 2023 and December 31, 2022 was changes in market interest rates and other market conditions and not credit concerns of the issuers. Since the losses can be primarily attributed to changes in market interest rates and conditions and not expected cash flows or an issuer’s financial condition and management does not intend to sell and it is likely that management will not be required to sell the securities prior to their anticipated recovery, the unrealized losses were deemed to be temporary.

Loan Portfolio

The Company’s primary use of funds is supporting lending activities from which it derives the greatest amount of interest income. Gross loans were $1.40 billion and $1.32 billion at March 31, 2023 and December 31, 2022, respectively. This represents an increase of $76.9 million or 5.81% during the three months ended March 31, 2023. The ratio of gross loans to deposits increased during the three months ended March 31, 2023 from 104.72% at December 31, 2022 to 100.77% at March 31, 2023.

The loan portfolio consists primarily of loans for owner-occupied single-family dwellings and loans secured by commercial real estate. Note 5 to the Consolidated Financial Statements provides the composition of the loan portfolio at March 31, 2023 and December 31, 2022. During the quarter ended March 31, 2023, $27.8 million in loans were sold. The Company sold 2.1 million in mortgage loans on the secondary market and 25.7 million of loans from the commercial and consumer loan portfolios. These loan sales resulted in net gains of $456 thousand. The growth in loans was largely due to organic loan portfolios growth as the Company expands lending types and markets.

Commercial real estate loans (including multifamily loans) were $591.9 million or 42.49% and $547.4 million or 41.59% of total loans at March 31, 2023 and December 31, 2022, respectively, representing an increase of $44.5 million or 8.12% during the three months ended March 31, 2023. Marine loans were $253.9 million or 18.23% and $230.9 million or 17.54% of total loans at March 31, 2023 and December 31, 2022, respectively, representing an increase of $23.0 million or 9.97%. Loan growth was mainly concentrated in commercial real estate loans, which experienced an increase during the three months ended March 31, 2023 due largely to the continued growth and expansion of the Bank’s current market area. In addition to the commercial real state lending growth, growth of our marine lending portfolio was strong due to continued growth in the marine lending team and market area.

Allowance for Credit Losses on Loans

The purpose of, and the methods for, measuring the allowance for credit losses on loans are discussed in the Critical Accounting Policies section above and in note 1 of the interim consolidated financial information.. Note 5 to the Consolidated Financial Statements shows the activity within the allowance for credit losses on loans during the three months ended March 31, 2023 and 2022 and the year ended December 31, 2022. Charged-off loans were $75 thousand and $47 thousand for the three months ended March 31, 2023 and 2022, respectively. Recoveries were $21 thousand and $35 thousand for the three months ended March 31, 2023 and 2022, respectively. This resulted in net charge-offs of $54 thousand and $12 thousand for the three months ended March 31, 2023 and 2022, respectively. The ratio of net charge-offs to average loans was 0.00% for the three months ended March 31, 2023 and 2022. The allowance for credit losses as a percentage of loans was 1.00% at March 31, 2023 and 0.85% at December 31, 2022 and 1.00% as of January 1, 2023, the date of adoption for ASC 326. The increase as compared to December 31, 2022 was attributable to the adoption of ASC 326.

Management believes that the allowance for credit losses on loans is currently adequate to absorb the current expected losses in the loan portfolio.

Nonperforming Assets and Other Assets

Nonperforming assets consist of nonaccrual loans, repossessed assets, OREO (foreclosed properties), and loans past due 90 days or more and still accruing as detailed in the table below.

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Nonperforming assets decreased by $173 thousand during the three months ended March 31, 2023. Nonaccrual loans were $1.8 million and $2.2 million at March 31, 2023 and December 31, 2022. There was no OREO at March 31, 2023 and $108 thousand at December 31, 2022. There were $576 thousand in loans past due 90 days or more and still accruing at March 31, 2023 and $318 thousand in loans past due 90 days or more and still accruing at December 31, 2022. The percentage of nonperforming assets to loans and OREO was 0.17% at March 31, 2023 and 0.20% at December 31, 2022, respectively.

Total past due loans, as disclosed in note 5 to the Consolidated Financial Statements, increased to $2.6 million at March 31, 2023 compared to $973 thousand at December 31, 2022. The majority of the increase in past due loans was due to one large relationship totaling $1.3 million that was past due 32 days at March 31, 2023. This relationship was not past due at December 31, 2022.

During the three months ended March 31, 2023, no loans were placed on nonaccrual status. Management evaluates the financial condition of borrowers and the value of any collateral on nonaccrual loans. The results of these evaluations are used to estimate the amount of losses which may be realized on the disposition of these nonaccrual loans and are reflected in the allowance for credit losses on loans.

Loans are placed on nonaccrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due. There are three negative implications for earnings when a loan is placed on non-accrual status. First, all interest accrued but unpaid at the date that the loan is placed on non-accrual status is either deducted from interest income or written off as a loss. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Finally, there may be actual losses to principal that require additional provisions for credit losses to be charged against earnings.

For real estate loans, upon foreclosure, the balance of the loan is transferred to OREO and carried at the fair value of the property based on current appraisals and other current market trends, less estimated selling costs. If a write down of the OREO property is necessary at the time of foreclosure, the amount is charged-off to the allowance for credit losses. A review of the recorded property value is performed in conjunction with normal quarterly reviews, and if market conditions indicate that the recorded value exceeds the fair value, additional write downs of the property value are charged directly to operations.

Deposits

Total deposits were $1.39 billion and $1.26 billion at March 31, 2023 and December 31, 2022, respectively. This represents an increase of $125.9 million or 9.96% during the three months ended March 31, 2023. Note 7 to the Consolidated Financial Statements provides the composition of total deposits at March 31, 2023 and December 31, 2022. Growth in deposits has been divided between core and non-core accounts. During the first quarter of 2023, approximately $52.5 million or 41.7% of total deposit growth was organic growth as the Company continued to expand and grow into newer market areas. The remaining growth was attributable to brokered deposits. As interest rates have risen, the Company has noticed a shift in the mix of deposits away from non-interest bearing deposits and towards time deposits and, to a lesser degree, other interest bearing deposits. Time deposits increased by $115.1 million or 72.9% between December 31, 2022 and March 31, 2023, while non-interest bearing deposits have decreased $14.6 million or 3.1% and savings and interest bearing demand deposits have increased by $25.4 million or 4.0% for the same time period. Time deposits as a percentage of total deposits have increased from 10.0% and 12.5% at March 31, 2022 and December 31, 2022, respectively, to 19.6% at March 31, 2023. The increase in time deposits is partially due to $30.0 million in brokered accounts that the Company entered into during the first quarter of 2023. At March 31, 2023, over 73% of deposits were fully FDIC insured.

CAPITAL RESOURCES

The Bank continues to be a well capitalized financial institution. Total shareholders’ equity at March 31, 2023 was $104.5 million, reflecting a percentage of total assets of 5.95%, as compared to $101.7 million and 6.29% at December 31, 2022. The reason for the increase in shareholders’ equity was due to an improvement in unrealized losses on the securities available for sale portfolio of $3.8 million as well as net income of $2.6 million earned during the three months ended March 31, 2023. During the three months ended March 31, 2023 and 2022, the Company declared dividends of $0.30 and $0.28 per share, respectively. The Company has a Dividend Investment Plan that allows shareholders to reinvest dividends in Company stock.

At March 31, 2023, the Bank met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions. The Bank monitors these ratios on a quarterly basis and has several strategies, including without limitation the issuance of common stock, to ensure that these ratios remain above regulatory minimums.

On September 17, 2019, the Federal Deposit Insurance Corporation finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio or “CBLR” framework), as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework. In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital. Under the final rule, an eligible banking organization may opt out and revert to the risk-weighting framework without restriction. As a qualifying community banking organization, the Bank elected to measure its capital adequacy under the CBLR framework as of March 31, 2023, and its leverage ratio was 9.02%. At December 31, 2022, the Bank's leverage ratio was 9.19% Management believes, that as of March 31, 2023, that the Bank met all capital adequacy requirements to which it is subject. We are closely monitoring our capital position and are taking appropriate steps to ensure our level of capital remains strong. Our capital, while significant, may fluctuate in future periods and limit our ability to pay dividends.

On March 31, 2022, the Company entered into Subordinated Note Purchase Agreements with certain purchasers pursuant to which the Company issued and sold $30.0 million in aggregate principal amount of its 4.50% Fixed-to-Floating Rate Subordinated Notes due April 1, 2032. See Note 14 to the Consolidated Financial Statements included in this Form 10-Q, for discussion of subordinated debt.

LIQUIDITY

Liquidity management involves meeting the present and future financial obligations of the Company with the sale or maturity of assets or with the occurrence of additional liabilities. Liquidity needs are met with cash on hand, deposits in banks, federal funds sold, securities classified as available for sale and loans maturing within one year. At March 31, 2023, liquid assets totaled $319.1 million as compared to $317.1 million at December 31, 2022. These amounts represented 19.31% and 20.93% of total liabilities at March 31, 2023 and December 31, 2022, respectively. The Company generally attempts to minimize liquidity demand by primarily utilizing core deposits to fund asset growth. Securities provide a constant source of liquidity through paydowns and maturities. Also, the Company maintains short-term borrowing arrangements, namely federal funds lines of credit, with larger financial institutions as an additional source of liquidity. The Bank’s membership with the Federal Home Loan Bank of Atlanta provides a source of borrowings with numerous rate and term structures. The Company’s senior management monitors the liquidity position regularly and attempts to maintain a position which utilizes available funds most efficiently.

OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS

There have been no material changes in off-balance sheet arrangements and contractual obligations as reported in the 2022 Form 10-K.

There have been no material changes in Quantitative and Qualitative Disclosures about Market Risk as reported in the 2022 Form 10-K.

Disclosure Controls and Procedures

The Company, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2023 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Control over Financial Reporting

Management is also responsible for establishing and maintaining adequate internal control over the Company’s financial reporting (as defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934, as amended). The Company is currently using the 2013 COSO Framework.

The Company adopted ASC 326, as described further in Note 1 to the consolidatd interim financial statements, effective January 1, 2023. Related to the adoption of these new accounting standards, the Company modified certain internal controls and designed and implemented certain new internal controls over the measurement of the allowance for credit losses on loans and the reserve for unfnded commitments and related disclosures. New internal controls related primarily to the modeling of expected credit losses on loans, including controls over critical data and other inputs and model results. There were no other changes in the Company’s internal control over financial reporting during the Company’s three months ended March 31, 2023 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2022.