QNB Corp.: Form 10-Q for the period ended Sep 30, 2023

QNB Corp. is a bank holding company headquartered in Quakertown, Pennsylvania. QNB Corp., through its wholly-owned subsidiary, the Bank, has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. Due to its limited geographic area, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services. The consolidated entity is referred to herein as “QNB” or the “Company”.

Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.

FORWARD-LOOKING STATEMENTS

In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides a safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.

Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, including the risk factors identified in Item 1A of QNB’s 2022 Form 10-K, could affect the future financial results of QNB and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:

• Volatility in interest rates and shape of the yield curve;
• Credit risk;
• Liquidity risk;
• Operating, legal and regulatory risks;
• Economic, political and competitive forces affecting QNB’s business, including the effects of inflation;
• The effects of unforeseen external events, including acts of terrorism, natural disasters, and pandemics, including the COVID-19 Pandemic; and
• The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful.

QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment securities, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Investment Security Impairment

Securities are evaluated periodically to determine whether a decline in their value is impairment. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term impairment is not intended to indicate that the decline is permanent, it indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities that do not have readily-determinable fair values, once a decline in value is determined to be impairment, the value of the equity security is reduced and a corresponding charge to earnings is recognized. There were no impairment charges recorded during the three or nine months ended September 30, 2023 and 2022, respectively.

The Company follows accounting guidance related to the recognition and presentation of impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an impairment of a debt security in earnings and the remaining portion in other comprehensive income. There were no credit-related impairment charges in the three or nine months ended September 30, 2023 or 2022, respectively.

Allowance for Credit Losses on Loans

The Company maintains an allowance for credit losses on loans, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased or decreased by the provision (reversal) for loan losses and increased by recoveries of previous losses. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio; the provisions or reversals for credit losses are charged to earnings.

The allowance for credit losses is measured on a pool basis when similar risk characteristics exist; these pools are identified in the first table below. The Company establishes a general valuation allowance for performing loans, including non-accrual student loans. QNB calculates each segment's historical loss rate using a full economic cycle of loan balance and historical loss experienced. The level of the allowance is determined by assigning specific reserves to all non-accrual loans, except the homogeneous pool of student loans which are measured in the general reserve. An allowance on these non-accrual loans is established when the discounted cash flows (or collateral value) of the loan is lower than the carrying value of that loan. The portion of the allowance that is allocated to non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general component is adjusted for qualitative factors. These qualitative risk factors include:

1. Concentrations: The Company adjusts historic loss for concentrations in the current portfolio that were not present during the down-turn of economic cycle.

2. Economic Forecast: The Company utilizes an entire economic cycle of data to determine loss rates by segment. This approach reflects an inherent reversion to the historical losses during life of the loans within the pool considering prepayments and loss experience throughout an entire economic cycle. However, the Company feels it is prudent to maintain a floor in its model to assure that there is enough reserve on hand to sustain any losses upon an upcoming recession.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher-than-normal risk of collection. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.

Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets.

Stock-Based Compensation

QNB sponsors a stock-based compensation plan, administered by a Board committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimates the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.

Income Taxes

QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.

RESULTS OF OPERATIONS - OVERVIEW

QNB reported net income for the third quarter of 2023 of $2,344,000, or $0.65 per share on a diluted basis, compared to net income of $3,415,000, or $0.96 per share on a diluted basis, for the same period in 2022. For the nine-month period ended September 30, 2023, QNB reported net income of $8,349,000, or $2.32 per share on a diluted basis, compared to net income of $10,474,000, or $2.94 per share on a diluted basis, for the same period in 2022. The Bank contributed $8,568,000 to net income for the nine months ended September 30, 2023 compared to $12,037,000 for the same period 2022; and the holding company contributed negative $219,000 to net income for the nine months ended September 30, 2023 compared to a negative $1,563,000 for the same period 2022. The results at the Bank were primarily due to net interest margin compression partly offset by the reversal for credit losses on loans of $1,119,000. The results at the holding company are due primarily to the change in the fair value of the equity securities included in the investment portfolio.

Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 0.52% and 5.88%, respectively, for the quarter ended September 30, 2023 compared with 0.78% and 9.20%, respectively, for the quarter ended September 30, 2022. For the nine months ended September 30, 2023, the annualized rate of return on average assets and average shareholders’ equity was 0.64% and 7.13%, respectively, compared with 0.82% and 9.68%, for the same period in 2022.

Total assets as of September 30, 2023 were $1,684,392,000, compared with $1,668,497,000 at December 31, 2022. Loans receivable at September 30, 2023 were $1,060,450,000, a $21,065,000 increase from $1,039,385,000 at December 31, 2022. Total deposits of $1,483,333,000 at September 30, 2023 increased $64,964,000 compared with total deposits of $1,418,369,000 at December 31, 2022.

Results for the three and nine months ended September 30, 2023 include the following significant components:

• Net interest income decreased $1,166,000, or 10.3%, to $10,213,000 and decreased $3,255,000, or 9.8%, to $29,963,000 for the three and nine months ended September 30, 2023, respectively.
• Net interest margin on a tax-equivalent basis decreased 34 basis points for the quarter and 32 basis points for the nine months ended September 30, 2023, at 2.38% and 2.40% to compared to 2.72% and 2.72% for the same periods in September 30, 2022, respectively.
• QNB recorded $452,000 in its provision for credit losses on loans for the quarter ended September 30, 2023, compared with no provision for the same period in 2022. QNB reversed $1,119,000 in its provision for credit losses on loans for the nine months ended September 30, 2023, compared with no provision for the same period in 2022.
• Non-interest income increased $1,271,000, to $1,755,000 for the third quarter and increased $1,820,000, to $4,554,000 for the nine months ended September 30, 2023 compared with the same periods in 2022. Excluding realized and unrealized gains (losses) on securities, non-interest income increased $106,000, or 6.4%, to $1,762,000 for the quarter and increased $154,000, or 3.2%, to $5,023,000 for the nine months ended September 30, 2023, compared with the same periods in 2022.
• Non-interest expense increased $857,000 to $8,671,000 for the quarter and increased $1,990,000 to $25,363,000 for the nine months ended September 30, 2023 compared to the same periods in 2022.
• Total non-performing loans were $5,872,000, or 0.55% of loans receivable at September 30, 2023, compared to $9,121,000, or 0.88% of loans receivable at December 31, 2022. Loans on non-accrual status were $1,893,000 at September 30, 2023 compared with $4,820,000 at December 31, 2022. Net loan recoveries for the nine months ended September 30, 2023 were $219,000, compared with $154,000 for the same period in 2022.

These items, as well as others, are explained more thoroughly in the next sections.

NET INTEREST INCOME

QNB earns its net income primarily through the Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. Management seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors.

The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three- and nine-month periods ended September 30, 2023 and 2022.

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Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest-bearing deposits.

For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.

The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.

Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)

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Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21 percent for three and nine months ended September 30, 2023 and 2022.

Non-accrual loans are included in earning assets.

* Includes loans held-for-sale

Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume.

Net Interest Income and Net Interest Margin – Quarterly Comparison

Average earning assets for the third quarter of 2023 were $1,726,756,000, an increase of $42,717,000, or 2.5%, from the third quarter of 2022, with average loans increasing $54,922,0000, or 5.6%, average other interest earning assets increasing $54,382,000, primarily interest-earnings cash at the Federal Reserve Bank, and average investment securities decreasing $66,587,000, or 9.6%, over the same period in 2022. Cash generated from maturities and sales in the investment portfolio and an increase in borrowed funds of $19,625,000 supported loan growth. Average loans as a percent of average earning assets was 60.2% for the third quarter of 2023, compared with 58.5% for the third quarter of 2022. On the funding side, average deposits increased $12,964,000, or 0.9%, to $1,488,632,000 for the third quarter of 2023 primarily due to an increase in time deposits and money market products. Average short-term borrowed funds, which consisted primarily of average commercial repurchase agreements, short-term Federal Reserve Bank ("FRB") borrowing and over-night FHLB borrowings, increased $9,625,000 to $95,568,000 during the third quarter of 2023 compared to $85,943,000 for the same period in 2022.

The net interest margin for the third quarter of 2023 decreased 34 basis points to 2.38% from 2.72% or the same period in 2022. Competition for quality loans and deposits in our local market continues to exert pressure on the net interest margin. The increases in interest rates starting in March 2022 have compressed the net interest margin as QNB had been liability sensitive; QNB entered into interest rate hedging derivatives during the second quarter of 2023 moving QNB to be asset sensitive. The net interest margin is expected to improve as loans and securities reprice.

The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis increased $4,918,000, or 35.8%, to $18,641,000 for the third quarter of 2023; total interest expense increased $6,117,000 to $8,284,000.

The yield on earning assets on a tax-equivalent basis increased 105 basis points to 4.28% for the third quarter of 2023, from 3.23% for the third quarter of 2022. The cost of interest-bearing liabilities was 2.35% for the third quarter of 2023, compared with 0.65% for the same period in 2022.

Interest income on investment securities (available-for-sale and equity) increased $907,000 when comparing the quarters ended September 30, 2023 and 2022. The average yield on the investment portfolio was 2.50% for the third quarter of 2023 compared with 1.74% for the same period in 2022.

The yield on U.S. Treasury securities was 5.17% for the third quarter of 2023 compared to 1.32% for the same period in 2022. Income on U.S. Government agency securities remained flat as the average balances increased $9,000 and the rate remained the same.

Interest income on municipal securities, which are primarily tax-exempt, increased $140,000 due to a 92 basis-point increase in rate, partly offset by an $18,772,000 decrease in average balances. The rate and interest income increases on municipal securities was positively impact by an interest rate swap. Typically, QNB purchases municipal bonds with 10- to 20-year maturities and may have call dates between 2-10 years.

Interest income on mortgage-backed securities and CMOs increased $717,000 while average balances decreased $47,345,000 and yield increased 92 basis points. The rate and interest income increases on mortgage-backed securities were positively impacted by an interest rate swap. This portfolio generally provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested as interest rates increase. Since most of these securities were purchased at a premium, any prepayments result in a shorter amortization period of this premium and therefore a reduction in income.

The dividend yield on equities increased 134 basis points as average balances decreased $6,749,000. Proceeds from sales of equities were reinvested in higher yielding treasury securities.

Income on loans increased $3,211,000 to $13,871,000 when comparing the third quarters of 2023 and 2022, with a $54,922,000 increase in average balances contributing to an increase in interest income of $526,000 and a 100-basis point increase in yield contributing to a $2,685,000 increase in interest income. Higher interest rates during the repricing period were partially offset by competitive pressures that compressed the yields on new loans.

The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, hotels and restaurants, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans increased $2,371,000 when comparing the third quarters of 2023 and 2022, primarily due to an 88-basis point increase in rate from 4.22% in 2022 to 5.10% and increased average balances of $72,715,000, or 11.2%.

Income on commercial and industrial loans increased $378,000 when comparing the third quarters of 2023 and 2022. The average yield on these loans increased 198 basis points to 7.23% resulting in an increase in income of $642,000; average balances decreased $19,944,000, to $128,601,000 for the third quarter of 2023 resulting in a $264,000 decrease in interest income. Many of the loans in this category are indexed to the prime interest rate.

Tax-exempt loan income was $178,000 for the third quarter of 2023, an increase of $9,000 from the same period in 2022. Average balances increased $95,000, or 0.5%, to $19,630,000 for the third quarter of 2023. The yield on municipal loans increased 16 basis points, to 3.59% for the third quarter of 2023, compared with the same period in 2022.

QNB desires to be the “local consumer lender of choice”, focusing its retail lending efforts on product offerings and marketing and promotion. Interest income on residential mortgage loans secured by first lien 1-4 family increased $142,000 when comparing the third quarter of 2023 to the same period in 2022. Average residential mortgage loan balances increased by $1,609,000, or 1.5%, to $107,332,000 for the third quarter of 2023 compared to the same period in 2022, which contributed a $13,000 increase in interest income.

The average yield on the portfolio increased 48 basis points and contributed an increase of $129,000 to interest income. QNB chose to retain certain mortgage loans instead of selling them in the secondary market, as the yield on our originated mortgages was higher than comparable mortgage-backed securities. Average home equity loans increased during the 2023 period by $1,025,000 to $57,694,000; interest income increased $302,000 as the average yield increased 200 basis points to 6.65%. The yield on the consumer portfolio increased 177 basis points to 7.53% for the third quarter of 2023 and there was a $578,000 decrease in average balances resulting in a net $9,000 increase in interest income.

Earning assets are funded by deposits and borrowed funds. Interest expense increased $6,117,000, when comparing the third quarter of 2023 to the same period in 2022. QNB experienced a decrease in accounts with greater liquidity and an increase in time deposits. Average non-interest-bearing demand accounts decreased $33,693,000 to $205,402,000 for the third quarter of 2023. QNB offered several new interest-bearing demand and money market products offering higher yields to retain large depositors and reduce the reliance on higher-cost short-term borrowings. Average interest-bearing demand accounts decreased $22,676,000, or 6.6%, to $319,335,000 for the third quarter of 2023; however interest expense on interest-bearing demand accounts increased $399,000 to $600,000 for the same period, as the average rate paid increased 51 basis points to 0.74% for the third quarter of 2023. Average money market accounts increased $66,686,000, or 49.5%, to $201,277,000 for the third quarter of 2023 compared with the same period in 2022. Interest expense on money market accounts increased $1,357,000 to $1,527,000, and the average interest rate paid on money market accounts increased 251 basis point to 3.01% for the third quarter of 2023. Most of the balances in this category are in products that pay tiered rates based on account balances.

Interest expense on municipal interest-bearing demand accounts increased $1,220,000 to $1,837,000 for the third quarter of 2023. The average interest rate paid on municipal interest-bearing demand accounts increased 286 basis points to 4.63% for the third quarter of 2023 over the same quarter of 2022, and average balances increased $19,204,000, or 13.9%, to $157,391,000. Many of these accounts are indexed to the Federal funds rate with rate floors. Municipal deposits are seasonal in nature and are received during the second and third quarters as tax receipts are collected and are withdrawn over the course of the year.

Interest expense on savings accounts increased $430,000 when comparing the third quarter of 2023 to the same quarter of 2022. The average interest rate paid on savings accounts increased 74 basis points to 1.27% for the third quarter of 2023. When comparing these same periods, average savings accounts decreased $126,304,000, or 28.0%, to $325,567,000 for the third quarter of 2023 primarily due to decreases in the e-Savings product. QNB’s online e-Savings product is the largest category of savings deposits, with average balances for the third quarter of 2023 of $236,589,000 compared to $342,334,000 in the same period of 2022. The average yield paid on these accounts was 1.68% for the third quarter of 2023 and 0.65% for the same period in 2022. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category and average balances in these types of savings accounts decreased $7,939,000 when comparing the third quarter of 2023 to the same period in 2022.

Interest expense on time deposits totaled $2,320,000 for the third quarter of 2023 compared to $342,000 in 2022. Average total time deposits increased $109,747,000 to $279,660,000 for the third quarter of 2023. As with fixed-rate loans and investment securities, these deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment; however, the maturity and repricing characteristics of time deposits tend to be shorter. The average rate paid on total time deposits increased 249 basis points from 0.80% to 3.29% when comparing the third quarter of 2023 to the same period in 2022.

Approximately $224,457,000, or 77%, of time deposits at September 30, 2023 will mature over the next 12 months. The average rate paid on these time deposits is approximately 3.85%. The yield on the time deposit portfolio may change in the next quarter as short-term time deposits reprice; however, given the short-term nature of these deposits, interest expense may increase if short-term time deposit rates were to increase suddenly or if customers select higher paying time deposits.

Short-term borrowings are comprised of sweep accounts structured as repurchase agreements with our commercial customers, overnight FHLB borrowing and short-term FRB borrowing. Interest expense on short-term borrowings increased $551,000 for the third quarter of 2023 to $740,000 when compared to the same period in 2022. When comparing these same periods, average balances increased $9,625,000 to $95,568,000. The yield on customer repos increased 114 basis points for the third quarter of 2023 to 1.63%. The yield on the short-term FHLB borrowing was 2.48% for the third quarter of 2022. During the first quarter of 2023, QNB borrowed $50,000,000 from the FRB under its Bank Term Funding Program and locked in a rate of 4.39%; there are no pre-payment penalties. During 2020, QNB borrowed long-term debt of $10,000,000 to lock in borrowing at a lower yield than short-term borrowings at that time; this borrowing matured during the first quarter of 2023. During the second quarter of 2023, QNB borrowed long-term debt of $20,000,000 to lock in borrowing at a lower yield than short-term borrowings.

Net Interest Income and Net Interest Margin – Nine-Month Comparison

For the nine-month period ending September 30, 2023, average earning assets increased $33,421,000, or 2.0%, to $1,693,304,000, with average loans increasing $79,912,000 slightly offset by a decrease in average investment securities of $67,424,000. Other earning assets, primarily interest-earning balances at the Federal Reserve Bank, increased $20,933,000. Average total deposits decreased $15,846,000, or 1.1%, to $1,443,816,000 for the nine-month period ended September 30, 2023 compared to the same period in 2022. The net interest margin on a tax-equivalent basis was 2.40% for the nine-month period ended September 30, 2023, a 32-basis point decrease from the same period in 2022.

Total interest income on a tax-equivalent basis increased $12,044,000, or 31.5%, to $50,267,000 from $38,223,000, when comparing the nine-month periods ended September 30, 2023 and September 30, 2022 due to an increase in volume and rate on loans. Interest income on loans increased $7,890,000 as a result of yields and increased $2,498,000 as a result of volume. The yield on investments increased 30 basis points from 1.71% to 2.01% when comparing the nine-month periods. The analysis of the nine-month comparison periods is similar to what was described in the quarterly analysis.

The yield on earning assets increased from 3.08% to 3.97% for the nine-month periods with the yield on loans up 103 basis points. QNB continues to experience pressure on yields due to competitive pressures on loan pricing.

Total interest expense increased $15,398,000 for the nine-month period ended September 30, 2023 compared with the same period in 2022, attributable to increases in rates. The average rate paid on interest bearing deposits increased 140 basis points to 1.84% for the nine-month period ended September 30, 2023 versus the same period in 2022. The average balance of total short-term borrowings increased $33,730,000 primarily due to overnight FHLB borrowing. The yield on interest-bearing liabilities increased 150 basis points to 1.96% for the nine months ended September 30, 2023. QNB invested proceeds from maturities of investment securities and growth in borrowings into loans.

PROVISION FOR CREDIT LOSSES, ALLOWANCE FOR CREDIT LOSSES ON LOANS AND ALLOWANCE FOR CREDIT LOSSES ON UNUSED COMMITMENTS

On January 1, 2023, the Company adopted ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326), as amended ("ASU 326"), which replaces the incurred loss methodology with an expected credit losses (“CECL”) for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts. On January 1, 2023, QNB recorded a decrease to its allowance for credit losses on loans of $989,000 and an increase to its allowance for credit losses on unused commitments of $5,000.

The provision for credit losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for credit losses on loans and the allowance for credit losses on unused commitments to amounts that are intended to absorb historical loss experience, current conditions and reasonable and supportable forecasts, in the outstanding loan portfolio and the unused commitments. Management believes that it uses the best information available to make determinations about the adequacy of these allowances and that it has established its existing allowances for credit losses on loan and on unused commitments in accordance with U.S. GAAP. The determination of an appropriate level for the allowance for credit losses on loans and the allowance for credit losses on unused commitments are based upon an analysis of the risks inherent in QNB’s loan portfolio.

Since the allowance for credit losses on loans and the reserve on unused commitments is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s calculations and actual results could differ. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for credit losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Actual loan losses, net of recoveries, serve to reduce the allowance.

Based on this analysis, QNB recorded a reversal of $1,119,000 for the nine months ended September 30, 2023, through the allowance for credit losses on loans, compared to no provision for the same period in 2022. QNB recorded a reversal of $18,000 for the allowance for credit losses for unused commitments in the nine months ended September 30, 2023 compared to a provision of $21,000 for the same period in 2022.

QNB's allowance for credit losses on loans of $8,542,000 represents 0.81% of loans receivable at September 30, 2023 compared with an allowance for loan losses of $10,531,000, or 1.01% of loans receivable, at December 31, 2022, and $11,338,000, or 1.12%, at September 30, 2022. Management believes the allowance for credit losses on loans at September 30, 2023 is adequate as of that date based on its analysis of historical loss experience, current conditions and reasonable and supportable forecasts in the portfolio.

Net charge-offs were $275,000 for the three months ended September 30, 2023 compared to net recoveries of $41,000 for the three months ended September 30, 2022. Charge-offs consisted of $273,000 in commercial loans and overdrafts of $21,000. Recoveries of approximately $25,000 during the three months ended September 30, 2023 consisted of $18,000 in repayments from borrowers of previously charged-off credits and overdrafts recoveries of $7,000. Annualized net charge-offs as a percentage of average loans receivable were 0.10% for the three months ended September 30, 2023, compared to annualized net recoveries of 0.02% for the three months ended September 30, 2022.

Net recoveries were $219,000 for the nine months ended September 30, 2023 compared to net recoveries of $154,000 for the nine months ended September 30, 2022. Charge-offs of approximately $438,000 during the nine months ended September 30, 2023 consisted primarily of commercial loans of $313,000, student loans of $43,000, consumer loans of $9,000 and overdrafts of $73,000. These were offset by $657,000 in recoveries comprising $635,000 in repayments from borrowers of previously charged-off credits, and $22,000 related to overdraft recoveries. Annualized net recoveries as a percentage of average loans receivable were 0.03% for the nine months ended September 30, 2023, compared to annualized net recoveries of 0.02% for the nine months ended September 30, 2022.

Non-performing assets were $5,872,000 at September 30, 2023 compared to $9,121,000 as of December 31, 2022 and $10,694,000 at September 30, 2022. Total non-performing loans, which represent loans on non-accrual status, loans past due 90 days or more and still accruing interest and restructured loans, were 0.55% of loans receivable at September 30, 2023, 0.88% at December 31, 2022, and 1.06% of loans receivable at September 30, 2022. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. At September 30, 2023, $1,489,000, or approximately 79%, of the loans classified as non-accrual are current or past due less than 30 days. Commercial loans classified as substandard or doubtful totaled $11,914,000, a decrease of $1,770,000 from the $13,684,000 reported at December 31, 2022 and a decrease of $5,640,000, or 32.1%, from the $17,554,000 reported at September 30, 2022. The decrease in classified loans since December 31, 2022 and September 30, 2022 is primarily due to repayments and pay-offs on existing substandard loans.

QNB had no loans past due 90 days or more and still accruing interest at September 30, 2023, December 31, 2022, or September 30, 2022. Total loans 30 days or more past due, which includes non-accrual loans by actual number of days delinquent, represented 0.97% of loans receivable at September 30, 2023 compared with 0.23% at December 31, 2022, and 0.30% at September 30, 2022.

Legacy troubled debt restructured loans, not classified as non-accrual loans or loans past due 90 days or more and accruing, were $3,979,000 at September 30, 2023, compared with $4,301,000 at December 31, 2022, and $4,357,000 at September 30, 2022. There were no troubled debt modifications identified during the nine months ended September 30, 2023. QNB had no other real estate owned or repossessed assets at September 30, 2023, December 31, 2022 or September 30, 2022.

A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for all non-accrual loans, except student loans, by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.

The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality:

An analysis of net loan charge-offs (recoveries) for the three and nine months ended September 30, 2023 compared to 2022 is as follows:

At September 30, 2023 and December 31, 2022, the recorded investment in loans for which impairment has been identified totaled $1,893,000 and $9,567,000 of which $1,209,000 and $4,943,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $684,000 and $4,624,000 at September 30, 2023 and December 31, 2022, respectively, and the related allowance for loan losses associated with these loans was $347,000 and $696,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans.

NON-INTEREST INCOME

Quarter to Quarter Comparison

Total non-interest income for the third quarter of 2023 was $1,755,000, an increase of $1,271,000, compared to $484,000 for the third quarter of 2022. Excluding realized and unrealized gains (losses) on securities, non-interest income increased $106,000, or 6.4%, to $1,762,000 for the quarter ended September 30, 2023 compared with the same period in 2022.

During the third quarter of 2023, unrealized losses on investment equity securities of $138,000 were recorded compared to losses of $1,174,000 in the same period of 2022. The unrealized losses and gains for the three months ended September 30, 2023 and 2022 resulted from the change in the fair value of the equities included in the investment portfolio. The equities portfolio comprises blue-chip large-capitalized stocks, providing a year-to-date taxable equivalent dividend yield of 4.07%. The estimated cumulative contribution (realized and unrealized net gains (losses), plus dividends) of the equity portfolio to earnings per share from January 1, 2011 through September 30, 2023 is $2.39 per diluted share. Details of the equity portfolio’s contribution to net income since January 1, 2016 is detailed in the following table.

QNB originates residential mortgage loans for sale in the secondary market. Net gains on sale of loans was $4,000 for third quarter of 2023; compared to $6,000 in the third quarter of 2022. The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination.

Fees for services to customers decreased $2,000 to $421,000 for the third quarter of 2023, due primarily to a decrease in net overdraft income. ATM and debit card income increased $16,000 to $685,000 for the third quarter of 2023, compared to the same period in 2022.

QNB provides securities and advisory services under the name QNB Financial Services. Retail brokerage and advisory fees increased for the third quarter of 2023 compared to the same period in 2022. Advisory fees increased $17,000 for the third quarter of 2023 compared with the same period in 2022 due to new clients and the value of assets under management; and transactional fees increased $8,000.

Merchant fees remained flat for the third quarter of 2023 compared with the same period in 2022. Other non-interest income increased $106,000 primarily due to a sales tax refund of $115,000.

Nine-Month Comparison

Total non-interest income for the nine-month periods ended September 30, 2023 and 2022 was $4,554,000 and $2,734,000, respectively, an increase of $1,820,000. Excluding realized and unrealized gain and losses on securities, total non-interest income was $5,023,000 and $4,869,000, respectively, an increase of $154,000, or 3.2%.

Net investment securities gains decreased $308,000 to $185,000 for the nine months ended September 30, 2023 compared to $493,000 for the comparable nine months in 2022. Market conditions in the equities market for the nine months ended September 30, 2023 versus the same period in 2022 resulted in greater opportunities for profitable sales in 2022; these were partly offset by losses on debt securities. QNB recorded realized gains of $442,000 compared to gains of $489,000 on equity securities for the nine months ended September 30, 2023 and 2022, respectively. Losses on sales of debt securities were $257,000 as QNB sold securities to lower its market risk in a rising rate environment.

Net gains on sales of loans for the nine months ended September 30, 2023 were $5,000; there were $6,000 in gains no loan sales in the 2022 period. Proceeds from the sale of residential mortgages were $640,000 and $304,000 for the nine-month periods ended September 30, 2023 and 2022, respectively.

Fees for services to customers increased $27,000 to $1,237,000 for the first nine months of 2023, due primarily to an increase in net overdraft income. ATM and debit card increased $33,000 for the first nine months of 2023 compared to 2022, due to volume of transactions.

Retail brokerage and advisory fees increased $51,000, or 8.4%, to $655,000 for the nine months ended September 30, 2023 compared to the same period in 2022; advisory fees increased $4,000 and transaction-based fees increased $47,000.

Merchant income decreased $4,000. Other non-interest income increased $80,000 primarily due to a sales tax refund of $115,000 and an increase in credit card income of $20,000, partly offset by a decrease in title company income of $31,000 and $22,000 in broker-dealer conversion fees in 2022.

NON-INTEREST EXPENSE

Quarter to Quarter Comparison

Total non-interest expense was $8,671,000 for the third quarter of 2023, an increase of $857,000 compared to the third quarter of 2022.

Salaries and benefits comprise the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense increased $600,000, or 13.7%, to $4,971,000 when comparing the two quarters. Salary expense and related payroll taxes increased $405,000 to $4,132,000 during the third quarter of 2023 compared to the same period in 2022 due to pay increases and filling open positions. Medical and dental premiums, net of employee contributions, increased $161,000 when comparing the two quarters due to timing of medical claims. Retirement and post-retirement costs increased $37,000.

Net occupancy and furniture and equipment expenses combined increased $190,000, or 14.5%, when comparing the third quarters of 2023 and 2022. This is due primarily to increased software maintenance expense. Marketing expense increased $75,000, or 53.2%, to $216,000 for the quarter ended September 30, 2023, due to timing of promotions and community support donations.

Third-party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, IT services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense increased $10,000. Telephone, postage and supplies expense decreased $53,000 primarily due to a reduction in postage and mailing expenses as there was an increase in the use of electronic delivery. State taxes decreased $212,000, or 77.9%, due to lower banks shares tax as there was a decline in capital from year-end 2021 to year-end 2022. FDIC insurance premiums increased $97,000 due to an increase in the assessment rate.

Other non-interest expense increased $150,000, or 19.5%, due to a $74,000 increase in write-offs primarily due to fraud on customer accounts, $46,000 in loan work-out costs as there was a large recovery in 2022 of $45,000 to reimburse the Bank for insurance costs, and an increase in director fees of $26,000.

Nine-Month Comparison

Total non-interest expense was $25,363,000 for the nine-month period ended September 30, 2023, an increase of $1,990,000, or 8.5%, compared to the nine months ended September 30, 2022.

Salaries and benefits expense increased $1,467,000 to $14,309,000 for the nine months ended September 30, 2023 compared to the same period in 2022. Salary and related payroll tax expense increased $1,209,000 during the period, to $12,078,000, medical expense increased $153,000 and retirement and post-retirement costs increased $102,000.

Net occupancy and furniture and equipment expense increased $495,000, or 12.8%, to $4,348,000, due to the reasons described in the quarter to quarter comparison. Marketing expense increased $46,000. FDIC insurance premiums increased $171,000, state taxes decreased $488,000, and telephone, postage and supplies decreased $121,000, due to the reasons described in the quarter to quarter comparison. Other non-interest expense increased due to the reasons described above in the quarter to quarter comparison.

INCOME TAXES

QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of September 30, 2023, QNB’s net deferred tax asset was $23,859,000. The primary components of deferred taxes are deferred tax assets of which $24,703,000 relates to investment securities fair value adjustments and $1,794,000 relates to the allowance for credit losses on loans, partly offset by a deferred tax liability on interest rate swap fair value adjustments of $2,231,000. As of December 31, 2022, QNB’s net deferred tax asset was $23,077,000 of which $21,565,000 related to investment securities fair value adjustments and $2,212,000 was related to the allowance for loan losses. The increase in the balance of net deferred tax assets when comparing September 30, 2023 to December 31, 2022 of $782,000 is due to the reduction in unrealized losses on available for sale securities contributing $3,138,000 of the increase, partly offset by the unrealized gains on interest rate swaps contributing a reduction of $2,231,000 and a decrease in the allowance for credit losses on loans contributing a reduction of $418,000.

The realizability of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets.

Applicable income tax expense was $494,000 for the quarter and $1,942,000 for the nine months ended September 30, 2023, compared to $634,000 for the quarter and $2,105,000 for the nine months ended September 30, 2022, respectively. The effective tax rate for the third quarter and nine-month period ended September 30, 2023 was 17.4% and 18.9%, respectively, compared with 15.7% and 16.7%, respectively, for the same period in 2022. The increase in the effective tax rate for the nine months ended September 30, 2023 is due to the state income tax at the parent company and there was a lower proportion of tax-exempt net interest income to income before taxes for 2023 over 2022.

FINANCIAL CONDITION ANALYSIS

Financial service organizations are challenged to demonstrate they can generate sustainable and consistent earnings growth in a dynamic operating environment. Rate competition for quality loans is anticipated to continue through 2023. It is also anticipated that the rate competition for attracting and retaining deposits may increase in the remainder of 2023, which could result in a lower net interest margin and a decline in net interest income.

QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices. QNB is committed to make credit available to its customers.

Total assets at September 30, 2023 were $1,684,392,000 compared with $1,668,497,000 at December 31, 2022. Cash and cash equivalents increased $39,242,000 from $15,899,000 at December 31, 2022 to $55,141,000 at September 30, 2023.

The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio to take advantage of changes in the shape of the yield curve and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio. The available-for-sale securities portfolio decreased $41,135,000, due to maturities and prepayments of $38,040,000, sales of $9,081,000 and a negative adjustment in the fair value mark of $4,326,000; this was partly offset by purchases of $11,922,000.

Loans receivable increased $21,065,000 with commercial loans increasing $18,502,000 to $890,047,000 at September 30, 2023, compared with $871,545,000 at year-end 2022.

Deposits grew $64,964,000 from December 31, 2022 to September 30, 2023. Non-interest-bearing demand deposits decreased $39,623,000, with balances of $192,226,000 at September 30, 2023 compared with $231,849,000 at year-end 2022. Interest-bearing demand balances, excluding municipal deposits, decreased $14,469,000, or 4.3%, to $320,117,000, with decreases in personal interest-bearing checking products as customers used funds to paydown higher-yielding loans or moving funds to high-yielding products. The $91,106,000 increase in money market accounts was primarily to a new premium money market product offered to both personal and business customers. The $118,248,000 decrease in savings was primarily due to declines in the E-Savings on-line product as some of these funds moved to higher-yield certificates of deposit or the new premium money market accounts. Total time deposits increased $114,737,000 from December 31, 2022 to September 30, 2023 as customers took advantage of higher-yielding time deposits, moving from lower-yielding products. Municipal deposit balances increased $31,461,000, to $149,802,000, during the first nine months of 2023. Municipal deposits can be volatile depending on the timing of deposits and withdrawals, and the cash flow needs of the school districts or municipalities. Municipal deposits increase as tax money is received from the local school districts during second and third quarters and it is anticipated that these funds will flow out for the subsequent twelve months as the schools use the funds for operations. These deposits provide an incremental funding source as they are used to fund loans as opposed to borrowing at a higher rate; this improves the net interest margin as it increases the spread related to the net interest margin.

Short-term borrowings decreased 40.1%, from $161,327,000 at December 31, 2022 to $96,703,000 at September 30, 2023. Commercial sweep accounts decreased $22,606,000; these funds may be volatile based on businesses’ receipt and disbursement of funds and is offset by business non-interest-bearing demand accounts. There were $92,018,000 in overnight borrowings from FHLB at December 31, 2022, and none at September 30, 2023; however, during the first quarter of 2023, QNB borrowed $50,000,000 from the FRB under its Bank Term Funding Program and locked in a rate of 4.39%; there are no pre-payment penalties. During the nine months ended September 2023, QNB borrowed long-term debt from the FHLB of $20,000,000 to lock in a low yield. In 2020, QNB borrowed long-term debt from the FHLB of $10,000,000 to lock in a rate at a low yield; this debt matured during the first three months of 2023.

LIQUIDITY

Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. Liquidity is provided from asset sources through repayments and maturities of loans and investment securities. The portfolio of investment securities classified as available for sale and QNB's policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Core deposits and cash management repurchase agreements have historically been the most significant funding source for QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area.

Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At September 30, 2023 the Bank had a maximum borrowing availability with the FHLB of approximately $289,114,000, which is net of long-term borrowing outstanding of $20,000,000, a $283,000 letter of credit and accrued interest payable. The maximum borrowing depends upon qualifying collateral assets and the Bank’s asset quality and capital adequacy. In addition, the Bank maintains unsecured Federal funds lines with six correspondent banks totaling $91,000,000. At September 30, 2023 there were no outstanding borrowings under these lines. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn. Additional funding is available at the FRB Discount Window under its Bank Term Funding Program; QNB had $50,000,000 in outstandings at September 30, 2023.

Liquid sources of funds, including cash, available-for-sale and equity investment securities, and loans held-for-sale have decreased $8,738,000 since December 31, 2022, totaling $565,742,000 at September 30, 2023. The reduction in the liquid sources of funds is primarily due to maturities and sales of available-for-sale securities. Growth in deposits provided cash flows of $64,964,000, net proceeds from available-for-sale investment activities provided $35,199,000 and net proceeds from long-term debt provided $10,000,000 in net proceeds; combined, the proceeds enabled the net paydown on short-term borrowings of $64,624,000 and funding for the net growth in loans of $20,847,000. Management expects these liquid sources will be adequate to meet normal fluctuations in loan demand or deposit withdrawals. The investment portfolio is expected to continue to provide sufficient liquidity, as municipal bonds are called or mature and cash flow on mortgage-backed and CMO securities continues to be steady.

Approximately $294,104,000 and $237,645,000 of available-for-sale debt securities at September 30, 2023 and December 31, 2022, respectively, were pledged as collateral for repurchase agreements and deposits of public funds and the FRB short-term borrowing. The level of pledged securities corresponds with the municipal deposit and repurchase agreement balances.

QNB is a member of the Certificate of Deposit Account Registry Services (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. QNB also has available Insured Cash Sweep (ICS), another program through Promontory Interfinancial Network, LLC, which is a product similar to CDARS, but one that provides liquidity like a money market or savings account.

CAPITAL ADEQUACY

A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB's shareholders' equity at September 30, 2023 was $74,081,000, or 4.40% of total assets, compared with shareholders' equity of $70,958,000, or 4.25% of total assets, at December 31, 2022. Shareholders’ equity at September 30, 2023 included a negative adjustment of $84,544,000 compared to a negative adjustment of $81,127,000 at December 31, 2022, related to net unrealized holding losses, net of taxes, on investment securities available-for-sale and gains on fair value hedges, net of tax. Without these adjustments, shareholders' equity to total assets would have been 8.97% and 8.69% at September 30, 2023 and December 31, 2022, respectively.

Average shareholders' equity and average total assets were $156,499,000 and $1,737,417,000 for the nine months ended September 30, 2023, an increase of 8.2% and 2.1%, respectively, from the averages for the nine months ended September 30, 2022. The ratio of average total equity to average total assets was 9.01% for the nine months ended September 30, 2023 compared to 8.50% for the same period in 2022.

Retained earnings at September 30, 2023 were impacted by nine months of net income totaling $8,349,000 and the cumulative effect of a change in accounting policy of $857,0000, offset by dividends declared and paid of $3,997,000 for the nine-month period. QNB offers a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares. The Plan also allows participants to make additional cash purchases of stock. Stock purchases under the Plan contributed $1,131,000 to capital during the nine months ended September 30, 2023.

The Board of Directors has authorized the repurchase of up to 200,000 shares of QNB common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of September 30, 2023, 102,000 shares have been repurchased since the initial authorization at an average price of $24.93 and a total cost of $2,543,000.

QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier 1 capital and Tier 2 capital. Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk.

The required minimum Common equity Tier 1 capital to risk-weighted assets ratio is 4.5%, the required minimum ratio of Tier 1 capital to risk-weighted assets is 6.0%, the required minimum ratio of Total Capital to risk-weighted assets is 8.0%, and the required minimum Tier 1 leverage ratio is 4.0%. A capital conservation buffer of 2.5% of risk-weighted assets also applies to avoid limitations on certain capital distributions.

The following table sets forth consolidated information for QNB:

57

At September 30, 2023, common equity Tier 1, Tier 1 capital, and total regulatory capital ratios improved since December 31, 2022. The Company remains well-capitalized by all applicable regulatory requirements as of September 30, 2023.

MARKET RISK MANAGEMENT

Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. QNB’s primary market risk exposure is interest rate risk and liquidity risk. QNB’s liquidity position was discussed in a prior section.

QNB’s largest source of revenue is net interest income, which is subject to changes in market interest rates. Interest rate risk management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability and Investment Management Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.

QNB uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation considers current balance sheet volumes and the scheduled repricing dates, instrument level optionality, and maturities of assets and liabilities. It incorporates assumptions for growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.

A balance sheet is considered asset sensitive when its assets (investment securities and loans) reprice faster than its interest-bearing liabilities (deposits and borrowings). An asset sensitive balance sheet will produce relatively higher net interest income when interest rates rise and less net interest income when they decline. A balance sheet is considered liability sensitive when its liabilities (deposits and borrowings) reprice faster than its earning assets (investments securities and loans). A liability sensitive balance sheet will produce relatively less net interest income when interest rates rise and more net interest income when they decline. Based on our simulation analysis, management believes QNB’s interest sensitivity position at September 30, 2023 is asset sensitive. Management expects that market interest rates may increase over the next 12 months, based on the economic environment and policy of the Board of Governors of the Federal Reserve System.

The following table shows the estimated impact of changes in interest rates on net interest income as of September 30, 2023 and 2022 assuming instantaneous rate shocks, and consistent levels of assets and liabilities. Net interest income for the subsequent twelve months is projected to decrease when interest rates are higher than current rates.

Estimated Change in Net Interest Income

Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect QNB’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt. At September 30, 2023, QNB had two derivatives designated as fair value hedging instruments, these interest rate swaps had a notional value of $300,000,000.

QNB is not subject to foreign currency exchange or commodity price risk.

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal control over financial reporting during the nine month period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

September 30, 2023

There were no material changes to the Risk Factors described in Item 1A in QNB’s Annual Report on Form 10-K for the period ended December 31, 2023.