Pathfinder Bancorp, Inc.: Form 10-Q for the period ended Sep 30, 2023

General

The Company is a Maryland corporation headquartered in Oswego, New York. The Company is 100% owned by public shareholders. The primary business of the Company is its investment in Pathfinder Bank (the "Bank"), a New York State chartered commercial bank, which is 100% owned by the Company. The Bank has two wholly owned operating subsidiaries, Pathfinder Risk Management Company, Inc. (“PRMC”) and Whispering Oaks Development Corp. All significant inter-company accounts and activity have been eliminated in consolidation. Although the Company owns, through its subsidiary PRMC, 51% of the membership interest in FitzGibbons Agency, LLC (“FitzGibbons” or “Agency”), the Company is required to consolidate 100% of FitzGibbons within the consolidated financial statements. The 49% of which the Company does not own, is accounted for separately as a noncontrolling interest within the consolidated financial statements. At September 30, 2023, the Company and subsidiaries had total consolidated assets of $1.40 billion, total consolidated liabilities of $1.29 billion and shareholders' equity of $113.8 million, plus noncontrolling interest of $672,000, which represents the 49% of FitzGibbons not owned by the Company.

The following discussion reviews the Company's financial condition at September 30, 2023 and the results of operations for the three and nine month periods ended September 30, 2023 and 2022. Operating results for the three and nine months ended September 30, 2023 are not necessarily indicative of the results that may be expected for the year ending December 31, 2023 or any other period.

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The following material under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" is written with the presumption that the users of the interim financial statements have read, or have access to, the Company's latest audited financial statements and notes thereto, together with Management's Discussion and Analysis of Financial Condition and Results of Operations included in the 2022 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2023 (“the consolidated annual financial statements”) as of December 31, 2022 and 2021 and for the two years then ended. Therefore, only material changes in financial condition and results of operations are discussed in the remainder of Item 2.

Statement Regarding Forward-Looking Statements

Certain statements contained herein are “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions, or future or conditional verbs, such as “will,” “would,” “should,” “could,” or “may.” These forward-looking statements are based on current beliefs and expectations of the Company’s and the Bank’s management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company’s and the Bank’s control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from those set forth in the forward-looking statements as a result of numerous factors. Factors that could cause such differences to exist include, but are not limited to: risks related to the real estate and economic environment, particularly in the market areas in which the Company and the Bank operate; fiscal and monetary policies of the U.S. Government; inflation; changes in government regulations affecting financial institutions, including regulatory compliance costs and capital requirements; fluctuations in the adequacy of the allowance for credit losses; decreases in deposit levels necessitating increased borrowing to fund loans and investments; the effects of the COVID-19 pandemic; operational risks including, but not limited to, cybersecurity, fraud and natural disasters; the risk that the Company may not be successful in the implementation of its business strategy; changes in prevailing interest rates; credit risk management; asset-liability management; recent events involving the failure of financial institutions and the impact on the Company's business and the market price of its common stock; any future increase in FDIC insurance assessments or special assessments; and other risks described in the Company’s filings with the Securities and Exchange Commission, which are available at the SEC’s website, www.sec.gov (http://www.sec.gov).

The Company and the Bank caution prospective investors not to place undue reliance on any such forward-looking statements, which speak only as of the date made. The Company disclaims any obligation to revise or update any forward-looking statements contained in this quarterly report on Form 10-Q to reflect future events or developments.

Application of Critical Accounting Estimates

The Company's consolidated quarterly financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated quarterly financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain accounting policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by unaffiliated third-party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management.

The most significant accounting policies followed by the Company are presented in Note 1 to the annual audited consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated quarterly

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financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the allowance for credit losses, deferred income taxes, pension obligations, the evaluation of investment securities for credit losses, the estimation of fair values for accounting and disclosure purposes, and the evaluation of goodwill for impairment to be the accounting areas that require the most subjective and complex judgments. These areas could be the most subject to revision as new information becomes available.

In June 2016, the FASB issued Accounting Standards Update (ASU) 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The standard’s stated main goal is to improve financial reporting by requiring earlier recognition of credit losses on financing receivables (such as loans) and other financial assets in scope. The ASU requires entities to measure credit losses on most financial assets carried at amortized costs and certain other instruments using an expected credit loss model. Banks in the United States above $5.0 billion in assets generally adopted this new way of measuring loan losses called the “Current Expected Credit Loss” (“CECL”) model in 2020, with smaller public and private banks, such as Pathfinder, required to convert to this method in fiscal years beginning after December 15, 2022. The Company computed its Allowance for Loan Losses at December 31, 2022 using a methodology called the "Incurred Loss Model" ("ILM"), which remained applicable GAAP at that date. ILM (previous GAAP) assumes that all loans will be repaid until evidence to the contrary (known as a loss or trigger event) is identified. Only at that point is the impaired loan (or portfolio of loans) written down to a lower value. CECL requires that an estimate of loss for the entire life cycle of each asset with credit loss exposure be recorded at the funding date of that asset as a component of the reported Allowance for Credit Losses ("ACL").

The ACL represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment on the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and environmental factors, all of which may be susceptible to significant change. The Company establishes a specific allowance for all commercial loans in excess of the total related credit threshold of $100,000 and single borrower residential mortgage loans in excess of the total related credit threshold of $300,000 identified as being impaired which are on nonaccrual and have been risk rated under the Company’s risk rating system as substandard, doubtful, or loss. In addition, an accruing substandard loan could be identified as being impaired.

Loan impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses as compared to the loan carrying value. For all other loans and leases, the Company uses the general allocation methodology that establishes an allowance to estimate the probable incurred loss for each risk-rating category. The measurement of impaired loans is generally based upon the present value of future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral, less costs to sell. At September 30, 2023, the Bank’s position in impaired loans consisted of 73 loans totaling $22.8 million. Of these loans, 17 loans, totaling $1.7 million, were valued using the present value of future cash flows method; and 56 loans, totaling $21.1 million, were valued based on a collateral analysis. For all other loans, the Company uses the general allocation methodology that establishes an allowance to estimate the probable incurred loss for each risk-rating category.

In estimating the ACL on loans, management considers the sensitivity of the model and significant judgments and assumptions that could result in an amount that is materially different from management’s estimate. At September 30, 2023, the Bank held $521.8 million in commercial real estate and commercial & industrial loans (collectively, commercial loans) representing 58.2% of the Bank’s entire loan portfolio. The Bank allocated $10.0 million to the ACL for these loans, including $2.9 million derived from the use of qualitative factors in the calculation. Given the concentration of ACL allocation to the total commercial loan portfolio and the significant judgments made by management in deriving the qualitative loss factors, management considers the impact that changes in judgments could have on the ACL. The ACL could increase (or decrease) by approximately $712,000, assuming a 25% negative (or positive) change within the group of qualitative factors used to determine the ACL for commercial loans. The sensitivity and related range of impacts for various judgments on the ACL is a hypothetical analysis and is used to determine management’s judgments or assumptions of qualitative loss factors that were utilized at September 30, 2023 in the final recorded estimation of the ACL on loans recognized on the Statements of Financial Condition.

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Deferred income tax assets and liabilities are determined using the liability method. Under this method, the net deferred tax asset or liability is recognized for the future tax consequences. This is attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as net operating and capital loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates applied 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 tax expense in the period that includes the enactment date. If current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established. The judgment about the level of future taxable income, including that which is considered capital, is inherently subjective and is reviewed on a continual basis as regulatory and business factors change.

The Company’s effective tax rate typically differs from the 21% federal statutory tax rate due primarily to New York State income taxes, partially offset by tax-exempt income from specific types of investment securities and loans, bank owned life insurance, and to a much lesser degree, the utilization of low income housing tax credits. In addition, the tax effects of certain incentive stock option activity may reduce the Company’s effective tax rate on a sporadic basis.

We maintain a noncontributory defined benefit pension plan covering most employees. The plan provides defined benefits based on years of service and final average salary. On May 14, 2012, we informed our employees of our decision to freeze participation and benefit accruals under the plan, primarily to reduce some of the volatility in earnings that can accompany the maintenance of a defined benefit plan. Pension and post-retirement benefit plan liabilities and expenses are based upon actuarial assumptions of future events; including fair value of plan assets, interest rates, and the length of time the Company will have to provide those benefits. The assumptions used by management are discussed in Note 14 to the consolidated annual financial statements.

When the fair value of a security categorized as available-for-sale ("AFS") or held-to-maturity ("HTM") is less than its amortized cost basis, an assessment is made as to whether or not credit loss is present. Management makes a quantitative determination of potential credit loss for all HTM securities even if the risk of credit loss is considered remote and uses a best estimate threshold for securities categorized as AFS. The Company considers numerous factors when determining whether a potential credit loss exists. The principal factors considered are (1) the financial condition of the issue and (guarantor, if any) and adverse conditions specifically related to the security, industry or geographic area, (2) failure of the issuer of the security to make scheduled interest or principal payments, (3) any changes to the rating of the security by a nationally recognized statistical rating organization (“NRSRO”), and (4) the presence of contractual credit enhancements, if any, including the guarantee of the federal government or any of its agencies.

The Company carries all of its AFS investments at fair value with any unrealized gains or losses reported, net of tax, as an adjustment to shareholders' equity and included in accumulated other comprehensive income (loss), except for the credit-related portion of debt securities’ impairment losses securities which are charged to earnings. The Company's ability to fully realize the value of its investments in various securities, including corporate debt securities, is dependent on the underlying creditworthiness of the issuing organization. In evaluating the debt securities portfolio, for both AFS and HTM securities for credit losses, management considers (1) if we intend to sell the security; (2) if it is “more likely than not” we will be required to sell the security before recovery of its amortized cost basis; or (3) if the present value of expected cash flows is insufficient to recover the entire amortized cost basis.

The estimation of fair value is significant to several of our assets; including AFS and marketable equity investment securities, intangible assets, foreclosed real estate, and the value of loan collateral when valuing loans. These are all recorded at either fair value, or the lower of cost or fair value. Fair values are determined based on third party sources, when available. Furthermore, accounting principles generally accepted in the United States require disclosure of the fair value of financial instruments as a part of the notes to the annual audited consolidated financial statements. Fair values on our AFS securities may be influenced by a number of factors including market interest rates, prepayment speeds, discount rates, and the shape of yield curves.

Fair values for AFS securities are obtained from unaffiliated third party pricing services. Where available, fair values are based on quoted prices on a nationally recognized securities exchange. If quoted prices are not available, fair values are measured using quoted market prices for similar benchmark securities. Management made no adjustments to the fair value quotes that were provided by the pricing sources. Fair values for marketable equity securities are based on quoted prices on a nationally recognized securities exchange for similar benchmark securities. The fair values of foreclosed real estate

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and the underlying collateral value of impaired loans are typically determined based on evaluations by third parties, less estimated costs to sell. When necessary, appraisals are updated to reflect changes in market conditions.

Management performs an annual evaluation of our goodwill for possible impairment at each of our reporting units. Based on the results of the December 31, 2022 evaluation, management has determined that the carrying value of goodwill was not impaired as of that date. Management will continuously evaluate all relevant economic and operational factors potentially affecting the Bank or the fair value of its assets, including goodwill. Should the pandemic or recent banking crisis, or the future economic consequences thereof, require a significant and sustained change in the operations of the Bank, re-evaluations of the Bank’s goodwill valuation will be conducted on a more frequent basis.

Recent Events

On September 30, 2023, the Company announced that its Board of Directors declared a cash dividend of $0.09 per share on the Company's voting common and non-voting common stock, and a cash dividend of $0.09 per notional share for the issued warrant relating to the fiscal quarter ended September 30, 2023. The dividends were payable to all shareholders of record on October 20, 2023 and were paid on November 10, 2023.

Overview and Results of Operations

The following represents the significant highlights of the Company’s operating results between the third quarter of 2023 and the third quarter of 2022.

• Net income attributable to Pathfinder Bancorp, Inc. decreased $1.0 million or 31.6% to $2.2 million.
• Basic and diluted earnings per voting common share were both $0.35 per share and decreased $0.17 per share from $0.52 per share.
• Return on average assets decreased 30 basis points to 0.63% due to a decrease in income and increase in average asset balances.
• Net interest income, after provision for credit losses, decreased $843,000, or 8.4% to $9.2 million. Excluding the provision, net interest income decreased $720,000, or 6.7%, to $10.1 million. The decrease in net interest income, before provision for credit losses, was primarily due to an increase in the average balance of interest-bearing liabilities of $28.9 million, combined with a 183 basis points increase in the average rates paid on interest-bearing liabilities. These increases in interest expense were partially offset by the increase in the average balance of interest-earning assets of $14.4 million, coupled with an increase in the average yield earned on those assets of 126 basis points, from 4.13% for the three months ended September 30, 2022 to 5.39% for the three months ended September 30, 2023.
• The increase in the provision for credit losses of $123,000 was primarily due to management's decision to downgrade certain commercial real estate and commercial loans within two large credit relationships.
• The net interest margin for the third quarter of 2023 was 3.07%, a 25 basis points decrease compared to 3.32% for the same quarter in 2022. This reflects a 183 basis points increase in the average cost paid on interest-bearing liabilities, offset by a 126 basis points increase in the average yield earned on interest-earning assets.
• The effective income tax rate increased 1.2% to 20.7% for the three months ended September 30, 2023 as compared to 19.5% for the same three month period in 2022. The increase in the tax rate in the third quarter of 2023, as compared to the same quarter in 2022, was primarily related to fluctuations in permanent tax differences.

The following represents the significant highlights of the Company’s operating results between the first nine months of 2023 and the first nine months of 2022.

• Net income decreased $2.6 million, or 28.1%, to $6.8 million.
• Basic and diluted earnings per voting common share were both $1.10 per share and decreased $0.45 per share from $1.55 per share
• Return on average assets decreased 29 basis points to 0.65% due to a decrease in income and increase in average asset balances.
• Net interest income, after provision for credit losses, decreased by $2.3 million, or 7.7%, to $27.1 million. Excluding the provision, net interest income decreased by $464,000, or 1.5%, to $29.8 million. The decrease in
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net interest income, before provision for credit losses, was primarily due to the increase in total interest expense, partially offset by an increase in interest income.

• Net interest margin decreased by 16 basis points to 3.02%, primarily as the result of a 165 basis points increase in the average cost of interest-bearing liabilities, offset by a 121 basis points increase in the average yield on interest-earning assets.
• The effective income tax rate increased 1.3% to 20.6% for the nine months ended September 30, 2023 as compared to 19.3% for the same nine month period in 2022. The increase in the tax rate for the nine months ended September 30, 2023, as compared to the same period in 2022, was primarily related to fluctuations in permanent tax differences and the reversal of a deferred tax asset valuation allowance, during the nine months ended September 30, 2022.

The following reflects the significant changes in financial condition between September 30, 2023 and December 31, 2022. In addition, the following reflects significant changes in asset quality metrics between September 30, 2023 and September 30, 2022.

• Total assets increased $728,000, or 0.05% to $1.40 billion at September 30, 2023 as compared to December 31, 2022, primarily driven by higher investment securities balances.
• Asset quality metrics, as measured by net loan charge-offs, increased in comparison to the year prior reporting periods. The annualized net loan charge-offs to average loans ratio was 0.61% for the third quarter of 2023, compared to 0.03% for the third quarter of 2022, and 0.04% for the fourth quarter of 2022.
• Nonperforming loans to total loans were 1.8% at September 30, 2023, compared to 1.2% at September 30, 2022 and 1.0% at December 31, 2022. Correspondingly, the ratio of the allowance for credit losses to nonperforming loans was 97.5% at September 30, 2023, as compared to 128.3% at September 30, 2022, and 169.9% at December 31, 2022.

The Company had net income of $2.2 million for the three months ended September 30, 2023 compared to net income of $3.2 million for the three months ended September 30, 2022. The $1.0 million decrease in net income was due primarily to a $5.0 million increase in total interest expense, a $123,000 increase in provision for credit losses, and a $386,000 increase in noninterest expense. These year-over-year changes were partially offset by a $4.3 million increase in interest and dividend income, a $199,000 decrease in provision for income taxes, and a $32,000 increase in total noninterest income.

Net interest income before the provision for credit losses decreased $720,000, or 6.7%, to $10.1 million for the three months ended September 30, 2023, as compared to $10.8 million for the same three month period in 2022. The decrease in net interest income was due to a 183 basis points increase in the average cost of total interest-bearing liabilities in the third quarter of 2023, as compared to the same quarter in 2022, combined with a $28.9 million increase in the average balance of total interest-bearing liabilities. The increase in the average rates paid on interest-bearing liabilities in the third quarter of 2023, as compared to the same quarter in 2022, reflects the generally increased rates of interest for all financial instruments that has occurred in 2023 due to the rising interest rate environment and increased competition for deposits.

These decreases in net interest income were partially offset by the result of increases in the average yields of loans and taxable and tax-exempt investment securities portfolios, combined with the increase in the average balance of the loan portfolio of $15.8 million. These increases resulted in a 126 basis points increase to 5.39% in total average interest-earning asset yield for the three months ended September 30, 2023 as compared to 4.13% for the same three month period of the previous year. The increase in the average yield received on interest-earning assets in the third quarter of 2023, as compared to the same quarter in 2022, reflects generally increased rates of interest for newly funded loans and investment securities, as compared to the average yields within these portfolios, as well as increases in coupon rates for certain adjustable-rate loans and securities in the rising interest rate environment that has occurred in 2022 and 2023. To some degree, these increases in the average yield on loans during 2023, were partially offset by reduced fee recognition related to PPP loans. PPP fee recognition revenues were nominal in the third quarter of 2023, as compared to $144,000 in the third quarter of the previous year.

The Company's noninterest income for the third quarter of 2023 amounted to $1.2 million, reflecting an increase of $32,000, compared to the same quarter of 2022. This modest increase was primarily attributable to a $185,000 increase in gains

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(losses) on sales and redemptions of investment securities, a $52,000 increase in insurance agency revenue, and a $25,000 increase in loan servicing fees. These increases were largely offset by a $158,000 decrease in debit card interchange fees.

The decline in debit card income was due in part to the recognition of increased customer card rewards program redemption rates among the Bank’s active debit card users. During the third quarter of 2023, the Bank recognized a $73,000 nonrecurring reduction of debit card interchange income to increase its estimate of currently unused rewards that are likely to be redeemed by customers in future periods. This adjustment was made after a re-evaluation of recent customer reward program redemption patterns. Absent this one-time adjustment related to the rewards program, debit card interchange income would have declined by $85,000, or 47.2% for the three months ended September 30, 2023, compared to the same three month period in 2022. The $85,000 quarterly decline in debit card interchange income, not due to the one-time rewards program revenue adjustment, discussed above, was primarily due to changes in the number of debit card processor reporting cycles in the nine months ended September 30, 2023, as compared to the same nine month period in 2022, adjusted on a year-to-date basis in the third quarter of 2023. Debit card interchange income was also reduced by modest declines in consumer transactional deposit accounts and reduced consumer utilization of the Bank’s debit card offerings.

Total noninterest expense for the third quarter of 2023 was $7.7 million, an increase of $386,000, or 5.3%, compared to the same three month period in 2022. The increase was primarily a result of an increase of $225,000 in professional and other service expense, primarily the result of a $154,000 increase in third-party software service costs, related in part to the Company's continuing efforts to increase process automation, and a $61,000 increase in non-recurring consulting fees.

Management extensively reviews recent trends in changes in the size and composition of the loan portfolio, historical loss experience, qualitative factors, and specific reserve requirements on loans individually evaluated, in its determination of the adequacy of the allowance for credit losses. For the three months ended September 30, 2023, $833,000 was recorded in provision for credit losses as compared to $710,000 in the same prior year three month period. The primary driver of the increased provision expense in the third quarter of 2023, was management's decision to downgrade certain commercial real estate loans and commercial loans within two borrower relationships. These relationships are under active resolution management by the Company. Additionally, the provision in the quarter ended September 30, 2023 was reflective of the qualitative factors used in determining the adequacy of the allowance for credit losses and changes in the levels of delinquent and nonaccrual loans. The third quarter provision for credit losses reflects an addition to reserves considering loan growth and asset quality metrics. The credit-sensitive portfolios continue to be carefully monitored, and the Bank will consistently apply its loan classification and reserve building methodologies to the analysis of these portfolios.

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requiring financial institutions, such as the Bank, to adopt the Current Expected Credit Loss (“CECL”) methodology according to a specified implementation timeline. In order to meet this requirement, the Bank adopted the CECL methodology for calculating its Allowance for Credit Losses (“ACL”) on January 1, 2023. The amended guidance replaces the previously-required Allowance for Loan and Lease Losses (“ALLL”) calculated under what was known as the Incurred Loss Model. The ACL represents a valuation account that is deducted from the amortized cost basis of includable financial assets to present their net carrying value at the amount expected to be collected over the entire life of those assets. The income statement now reflects the measurement of credit losses for newly recognized financial assets as well as expected increases, or decreases, of expected credit losses that have taken place during the reporting period. When determining the ACL, expected credit losses over the expected term of the financial asset will be estimated considering relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the future collectability of the reported amount. In addition, the amended guidance requires credit losses relating to assets such as held-to-maturity debt securities and open contractual funding commitments to be recorded through the ACL. Because the CECL methodology requires that reserves be established within the ACL for a broad range of financial assets, including all loans, through the entirety of their expected lives and also considers new items, such as open funding commitments, the initial ACL upon adoption would, in most cases, be expected to be greater than the ALLL that it replaced.

The transition to CECL also required that new reserves be created in the amounts of $450,000 and $552,000, related to held-to-maturity investments and unfunded commitments, respectively. Including the $1.9 million CECL transition adjustment related to loans, described above, the total CECL transition adjustment was $2.9 million on January 1, 2023, which was charged to retained earnings on that date.

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The total PCL for the three and nine months ended September 30, 2023 was $833,000 and $2.7 million, respectively, of which $798,000 and $2.7 million related to the Company's loan portfolio for the three and nine months ended September 30, 2023, respectively. The ACL related to loans was therefore $15.8 million at September 30, 2023. In addition, during the third quarter of 2023, the Company recorded modest PCL charges of $5,000 and $30,000 for reserves related to held-to-maturity securities and unfunded commitments, respectively.

In comparing the year-over-year third quarter periods, the Company’s return on average assets decreased 30 basis points to 0.63% due to the combined effects of the decrease in net income (the numerator in the ratio), and an increase in average assets (the denominator in the ratio). Average assets increased mostly due to an increase of $15.8 million in the balances of average loans in the third quarter of 2023, as compared to the same quarter of 2022.

The Company had net income of $6.8 million for the nine months ended September 30, 2023 compared to net income of $9.4 million for the nine months ended September 30, 2022. The $2.7 million decrease in net income was due primarily to a $13.7 million increase in total interest expense, a $1.8 million increase in the provision for credit losses, a $686,000 increase in total noninterest expense, and a $188,000 decrease in total noninterest income. These decreases were partially offset by a $13.3 million increase in interest and dividend income, and a $501,000 decrease in provision for income tax.

Net interest income before the provision for credit losses decreased $464,000 to $29.8 million for the nine months ended September 30, 2023, as compared to $30.2 million for the same nine month period in 2022. Interest expense increased $13.7 million to $19.6 million for the nine months ended September 30, 2023 as compared to the prior year period. The average interest rate paid on interest-bearing liabilities increased by 165 basis points for the nine months ended September 30, 2023 as compared to the prior year period, and average interest-bearing liabilities increased by $60.7 million, or 6.0%. Offsetting the increase in interest expense was an increase in average loans for the first nine months of 2023 which grew by $37.7 million, or 4.4%, due to increased loan originations over the prior year period, while the average interest yield earned on average loans increased by 91 basis points, resulting in an increase of $7.4 million in interest income on loans for the nine months ended September 30, 2023 as compared to the prior year period. Income from investment securities increased $5.7 million to $14.2 million for the nine months ended September 30, 2023, as compared to the same prior year period.

Noninterest income decreased $188,000 for the nine months ended September 30, 2023, when compared to the same nine month period in 2022. This decrease was primarily due to a $247,000 loss on marketable equity securities, and a $184,000 decrease in debit card interchange fees, partially offset by a $60,000 gain on sales and redemption of investment securities in the current nine months as compared to a $168,000 loss in the prior nine month period, and a $152,000 increase in insurance agency revenue. The decline in debit card income was due in part to the recognition of increased customer card rewards program redemption rates among the Bank’s active debit card users. During the third quarter of 2023, the Bank recognized a $73,000 nonrecurring reduction of debit card interchange income to increase its estimate of currently unused rewards that are likely to be redeemed by customers in future periods. This adjustment was made after a re-evaluation of recent customer reward program redemption patterns. Absent this one-time adjustment related to the rewards program, debit card interchange income would have declined $111,000, or 17.4%, for the nine months ended September 30, 2023 compared to the same nine month period in 2022.

Total noninterest expense for the first nine month period of 2023 was $22.4 million, an increase of $686,000, or 3.2%, compared with $21.7 million for the prior year period. The increase was primarily a result of an increase in professional and other services of $419,000, higher salaries and employee benefits expense of $213,000, and an increase in building and occupancy of $208,000.

The increase in professional and other services of $419,000 in the first nine months of 2023, as compared to the same period in 2022, was primarily the result of a $282,000 increase in third-party software service costs, related in part to the Company's continuing efforts to increase process automation, a $113,000 increase in non-recurring legal fees, and a $50,000 increase in non-recurring consulting fees. The increase of $213,000 in salaries for the nine months ended September 30, 2023, as compared to the same prior nine month period, was primarily due to increases in individual salaries, enacted early in 2023, as well as modest additions to staff headcount. The Company increased its salary structure where deemed appropriate in order to effectively respond to inflationary and competitive pressures within our marketplace to recruit and retain talent.

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The increase in building and occupancy of $208,000 for the nine months ended September 30, 2023, when compared to the same prior year period, was primarily due to the addition of the Bank's eleventh full-service branch in November 2022.

For the first nine months of 2023, the Bank recorded $2.7 million in provision for credit losses as compared to $871,000 in the same prior year nine month period. The provision was reflective of (1) the qualitative factors used in determining the adequacy of the allowance for credit losses, (2) the size of the loan portfolio, and (3) delinquent and nonaccrual loans. The increase in the provision for credit losses in the first nine months of 2023, as compared to the same period in 2022, was primarily related to the downgrade of two commercial real estate and commercial loan relationships, as compared to the same period in the previous year. The credit sensitive portfolios continue to be carefully monitored. Please refer to the asset quality section below for a further discussion of asset quality as it relates to the allowance for credit losses.

Return on average assets decreased 29 basis points to 0.65% between the year-over-year nine month periods as there was a decrease in net income in the nine month period ended September 30, 2023 (the numerator of the ratio) while the rate of average assets (the denominator of the ratio) grew during the period. Average assets increased due to increases in loans of $37.7 million and investment securities of $16.6 million in the nine month period ended September 30, 2023 as compared to the same period of 2022.

Net Interest Income

Net interest income is the Company's primary source of operating income for payment of operating expenses and providing for credit losses. It is the amount by which interest earned on loans, interest-earning deposits, and investment securities, exceeds the interest paid on deposits and other interest-bearing liabilities. Changes in net interest income and net interest margin result from the interaction between the volume and composition of interest-earning assets, interest-bearing liabilities, related yields, and associated funding costs.

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The following tables set forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. Interest income and resultant yield information in the tables have not been adjusted for tax equivalency. Averages are computed on the daily average balance for each month in the period divided by the number of days in the period. Yields and amounts earned include PPP loan fees income of $3,000 and $688,000 for the nine month periods ended September 30, 2023 and September 30, 2022, respectively. The decrease in loan fees for the year over year periods was primarily due to the decrease in PPP loan fee income. Nonaccrual loans have been included in interest-earning assets for purposes of these calculations.

(Unaudited)

Unaudited

(In thousands)

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Unaudited

(In thousands)

In the third quarter of 2023, net interest income, before provision for credit losses, for the Company decreased by $720,000 or 6.7%, to $10.1 million compared to $10.8 million for the same quarter in 2022. This decrease was due principally to a 183 basis points increase on the average cost of interest-bearing liabilities, partially offset by an increase of 126 basis points in the average yield of interest-earning assets. Net interest income was positively impacted by an increase in the average balance of interest-earning assets of $14.4 million, or 1.1%. The positive effect of this increase on the average balance of interest-earning assets was offset by an increase of $28.9 million, or 2.8%, in average interest-bearing liabilities. In total, net interest margin decreased 25 basis points to 3.07% for the three months ended September 30, 2023 as compared to the same prior year period.

Interest and dividend income increased by $4.3 million, or 32.0%, to $17.7 million for the three months ended September 30, 2023 compared to $13.4 million for the same three month period in 2022. The increase in interest and dividend income between comparable quarters was a result of a $2.6 million increase in loan interest income, and a $1.6 million increase in interest income derived from investment securities. The positive effect on interest income was the result of a 107 basis points increase in the average loan yield, accompanied by a $15.8 million increase in the average outstanding balance of loans and a 168 basis points increase in the average yield on investment securities, accompanied by a $2.4 million increase in the average outstanding balance of investment securities. The increase in the average yield received on interest-earning assets in the third quarter of 2023, as compared to the same quarter in 2022, reflects generally increased rates of interest for newly funded loans and investment securities, as compared to the average yields within these portfolios, as well as increases in coupon rates for certain adjustable-rate loans and securities in the rising interest rate environment that has occurred in 2022 and 2023. These increases in the average yield on loans during 2023 were partially offset by reduced fee recognition related to PPP loans. PPP fee recognition revenues were $1,000 for the three months ended September 30, 2023, as compared to $144,000 for the same three month period of the previous year.

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Interest expense for the three months ended September 30, 2023 increased by $5.0 million to $7.6 million when compared to the same prior year period due primarily to an increase in interest expense on time deposits and the Company's short-term and long-term borrowings. Interest expense increased due to a 183 basis points increase in the average rates paid on interest-bearing liabilities between the two periods, accompanied by an increase in the average outstanding balance of those liabilities of $28.9 million. The increase in the quarterly interest expense was primarily a result of the increase in cost of deposits resulting from the rapidly rising interest rate environment and increased competition. The deposit mix included a $53.7 million increase in average time deposit balances, an increase of $32.5 million in the Company's average borrowings, partially offset by a decrease of $3.8 million in the average balance of all other types of interest-bearing deposits.

In the nine month period ended September 30, 2023, net interest income before provision for credit losses slightly decreased by $464,000, or 1.5%, to $29.8 million compared to the same nine month period in 2022. This downtrend was primarily attributable to the increase in interest expense of $19.6 million, marking a 235% increase from the corresponding period in 2022. These increases were the result of general increases in short-term rates that have occurred in persistent upward increments since the first quarter of 2022.

The Company's interest and dividend income increased to $49.3 million, a 36.8%, or $13.3 million increase from $36.0 million during the same nine months in 2022. The average yield of interest earning assets increased 121 basis points primarily due to the rising interest rate environment. The change in interest and dividend income for the first nine months of 2023 was mainly from an increase in interest generated from loans totaling $34.9 million, up $7.4 million from $27.5 million in the same nine months of 2022. In addition to the increase in interest generated from loans in the nine month period ended September 30, 2023, there was a $5.7 million increase in interest earned on investment securities totaling $14.2 million, up from $8.5 million during the same period in 2022. The average balance of all interest-earning assets for the nine month period ended September 30, 2023 was $1.32 billion, an increase of $46.1 million from $1.27 billion, primarily due to loan growth, in the same nine month period in 2022.

The increase in interest and dividend income was offset by an increase of $13.7 million in interest expense on the Company's interest-bearing liabilities reaching $19.6 million in the nine month period ended September 30, 2023, up from $5.9 million in the same period in 2022. There was an increase in the average balance of the Company's interest-bearing liabilities in the first nine months of 2023 totaling $1.08 billion, up $60.7 million from the same nine month period in 2022. This upward change in interest-bearing liabilities was primarily due to an increase of $71.3 million in average time deposits and a $1.7 million increase in expense on the Company's average borrowings in the first nine months of 2023 compared to the same nine months in 2022. The increase in average time deposits for the nine month period ended September 30, 2023 compared to the same nine months in 2022 was partially offset by the decrease of all other average interest-bearing deposits of $39.0 million in the first nine months of 2023. The 165 basis points increase in the Company's average cost of interest-bearing liabilities for the nine month period ended September 30, 2023 exemplified the effect rising interest rates have on this competitive deposit market.

The resultant net interest margin for the first nine months of 2023 was 3.02%, a 16 basis points decrease compared to a net interest margin of 3.18% in the first nine months of 2022.

Rate/Volume Analysis

Net interest income can also be analyzed in terms of the impact of changing interest rates on interest-earning assets and interest-bearing liabilities and changes in the volume or amount of these assets and liabilities. The following table represents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (change in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) total increase

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or decrease. Changes attributable to both rate and volume have been allocated ratably. Tax-exempt securities have not been adjusted for tax equivalency.

Unaudited

(In thousands)

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Provision for Credit Losses

We establish a provision for credit losses, which is charged to operations, at a level management believes is appropriate to absorb expected credit losses in the loan portfolio. In evaluating the level of the allowance for credit losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events change. The provision for credit losses represents management’s estimate of the amount necessary to maintain the allowance for credit losses at an adequate level.

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requiring financial institutions, such as the Bank, to adopt the Current Expected Credit Loss (“CECL”) methodology according to a specified implementation timeline. In order to meet this requirement, the Bank adopted the CECL methodology for calculating its Allowance for Credit Losses (“ACL”) on January 1, 2023. The amended guidance replaces the previously-required Allowance for Loan and Lease Losses (“ALLL”) calculated under what was known as the Incurred Loss Model. The ACL represents a valuation account that is deducted from the amortized cost basis of includable financial assets to present their net carrying value at the amount expected to be collected over the entire life of those assets. The income statement now reflects the measurement of credit losses for newly recognized financial assets as well as expected increases, or decreases, of expected credit losses that have taken place during the reporting period. When determining the ACL, expected credit losses over the expected term of the financial asset will be estimated considering relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the future collectability of the reported amount. In addition, the amended guidance requires credit losses relating to assets such as held-to-maturity debt securities and open contractual funding commitments to be recorded through the ACL. Because the CECL methodology requires that reserves be established within the ACL for a broad range of financial assets, including all loans, through the entirety of their expected lives and also considers new items, such as open funding commitments, the initial ACL upon adoption would, in most cases, be expected to be greater than the ALLL that it replaced.

The Company recorded $833,000 in provision for credit losses for the three month period ended September 30, 2023, as compared to $710,000 for the three month period ended September 30, 2022. The provisioning in the third quarter of 2023 and 2022 reflects management’s determination of the appropriate level of additions to reserves, the composition of the loan portfolio, changes in quantifiable econometric data statistically correlated to historical charge-off rates, subjective qualitative assessments of changes in a broad array of factors including changes to underwriting criteria, loan staffing and local market conditions. The $88,000 increase in provision for credit losses in the third quarter of 2023, as compared to the same period in 2022, primarily reflected management's decision to downgrade certain loans within two specifically-identified commercial real estate and commercial loan credit relationships with an aggregate outstanding balance of $11.5 million. The Bank's credit sensitive portfolios continue to be carefully monitored, and the Bank will consistently apply its loan classification and reserve building methodologies to the analysis of these portfolios. Please refer to the asset quality section below for a further discussion of asset quality as it relates to the allowance for credit losses.

There was an increase in the provision for credit losses in the first nine months of 2023 to $2.7 million, an increase of $1.8 million from the same nine months in 2022, which was $871,000. The Bank has two large credit relationships that are experiencing deterioration and are the primary impact of this provision, mitigating potential risk. The Lending Department, along with highly experienced specialists, are carefully managing these commercial relationships to the best possible outcome. We are currently working with the borrowers associated with these credit relationships on individual loan repayment plans and the liquidation of loan collateral, where appropriate.

The transition to CECL also required that new reserves be created in the amounts of $450,000 and $552,000, related to held-to-maturity investments and unfunded commitments, respectively. Including the $1.9 million CECL transition adjustment related to loans, described above, the total CECL transition adjustment was $2.9 million on January 1, 2023, which was charged to retained earnings on that date.

The total PCL for the three and nine months ended September 30, 2023 was $833,000 and $710,000, respectively, of which $798,000 and $710,000 related to the Company's loan portfolio for the three and nine months ended September 30, 2023,

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respectively. The ACL related to loans was therefore $15.8 million at September 30, 2023. In addition, during the third quarter of 2023, the Company recorded modest PCL charges of $5,000 and $30,000 for reserves related to held-to-maturity securities and unfunded commitments, respectively.

The Company measures delinquency based on the amount of past due loans as a percentage of total loans. The ratio of delinquent loans to total loans increased to 3.2% at September 30, 2023 as compared to 2.9% at December 31, 2022. Delinquent loans (numerator) increased $2.7 million while total loan balances (denominator) decreased $2.3 million at September 30, 2023, as compared to December 31, 2022. The increase in past due loans was driven by a $7.3 million increase in loans delinquent 90 days and over past due at September 30, 2023, offset by a decrease of $4.6 million in loans delinquent 30-59 days, and a decrease of $68,000 in loans delinquent 60-89 days, offset by a as compared to December 31, 2022. The increase of $2.7 million primarily consisted of increases in commercial real estate, commercial lines of credit and commercial loans.

At September 30, 2023, there were $28.7 million in loans past due including $8.5 million in loans 30-59 days past due, $4.1 million in loans 60-89 days past due and $16.1 million in loans 90 or more days past due. At December 31, 2022, there were $26.0 million in loans past due including $13.0 million in loans 30-59 days past due, $4.3 million in loans 60-89 days past due and $8.7 million in loans 90 or more days past due.

Noninterest Income

The Company's noninterest income is primarily comprised of fees on deposit account balances and transactions, loan servicing, commissions, including insurance agency commissions, and net gains on sales of securities, loans, and foreclosed real estate.

The following table sets forth certain information on noninterest income for the periods indicated:

Unaudited

(In thousands)

Third quarter noninterest income was $1.2 million, an increase of $32,000, or 2.8% compared to the same three month period in 2022. For the nine months ended September 30, 2023, noninterest income was $3.9 million, a decrease of $188,000, or 4.6%, compared to the same nine month period in 2022.

This modest increase for the third quarter of 2023 as compared to the prior year period was primarily attributable to a $185,000 increase in gains (losses) on sales and redemptions of investment securities, a $52,000 increase in insurance agency revenue, and a $25,000 increase in loan servicing fees. These increases were largely offset by a $158,000 decrease in debit card interchange fees. Noninterest income decreased $188,000 for the nine months ended September 30, 2023, when compared to the same nine month period in 2022. This decrease was primarily due to a $247,000 loss on marketable equity securities, and a $184,000 decrease in debit card interchange fees, partially offset by a $60,000 gain on sales and redemption of investment securities in the current nine months as compared to a $168,000 loss in the prior nine month period, and a $152,000 increase in insurance agency revenue.

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The decline in debit card income was due in part to the recognition of increased customer card rewards program redemption rates among the Bank’s active debit card users. During the third quarter of 2023, the Bank recognized a $73,000 nonrecurring reduction of debit card interchange income to increase its estimate of currently unused rewards that are likely to be redeemed by customers in future periods. This adjustment was made after a re-evaluation of recent customer reward program redemption patterns. Absent this one-time adjustment related to the rewards program, debit card interchange income would have declined by $85,000, or 47.2%, and $111,000, or 17.4%, for the three and nine months ended September 30, 2023, respectively, compared to the same three and nine month periods in 2022. The $85,000 quarterly decline in debit card interchange income, not due to the one-time rewards program revenue adjustment, discussed above, was primarily due to changes in the number of debit card processor reporting cycles in the nine months ended September 30, 2023, as compared to the same nine month period in 2022, adjusted on a year-to-date basis in the third quarter of 2023. Debit card interchange income was also reduced by modest declines in consumer transactional deposit accounts and reduced consumer utilization of the Bank’s debit card offerings.

Noninterest Expense

The following table sets forth certain information on noninterest expense for the periods indicated:

Unaudited

(In thousands)

Total noninterest expense for the third quarter of 2023 was $7.7 million, an increase of $386,000, or 5.3%, compared to the same three month period in 2022. This increase in noninterest expenses was attributable to several factors, including the persistent inflation rate. Additionally, our strategic opening of the Bank's eleventh full-service branch in November 2022, contributed to this quarterly year-over-year increase.

The primary driver of this year-over-year quarterly increase in noninterest expenses was an increase of $225,000 or 84.3%, in professional and other services expense. Absent that increase, noninterest expenses increased $161,000, or 2.3%, in the quarter ended September 30, 2023, as compared to the same quarter in 2022. The increase in professional and other services expense was primarily the result of a $154,000 increase in third-party software service costs, related in part to the Company's continuing efforts to increase process automation, and a $61,000 increase in non-recurring consulting fees.

In the nine months ended September 30, 2023, the Company reported noninterest expenses totaling $22.4 million, which marked an increase of $686,000, or 3.2%, in comparison to the same period in 2022. The primary driver of this year-over-year nine month increase in noninterest expenses was an increase of $419,000 or 37.7%, in professional and other services expense. Absent that increase, noninterest expenses increased $267,000, or 1.3%, in the nine months ended September 30, 2023, as compared to the same nine month period in 2022. This increase in professional and other services expense in the nine months ended September 30, 2023, as compared to the same nine month period in 2022, was primarily the result of a $282,000 increase in third-party software service costs, related in part to the Company's continuing efforts to increase process automation, a $113,000 increase in non-recurring legal fees, and a $50,000 increase in non-recurring consulting fees.

The moderate increase in noninterest expenses in the first nine months of 2023, when contrasted with the corresponding period in 2022, underscores the Company's robust expense management strategies. These practices have proven effective,

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even in the face of a fluctuating economic landscape marked by inflationary pressures, particularly within the labor market. Our unwavering commitment to striking a balance between competitive employee compensation and prudent expense management has enabled us to navigate the challenges of rising labor costs. Our strategic financial approach prioritizes both sustained profitability and investment in our workforce, thereby enhancing customer service and strengthening our position in the market.

There were also noteworthy changes in building and occupancy costs for the three and nine month periods ended September 30, 2023. During the third quarter of 2023, these costs increased by $33,000, representing a 4.0% rise, reaching a total of $868,000. Over the first nine months of 2023, we observed a more substantial increase of $208,000, or 8.4%, to $2.7 million. These increases were primarily driven by expenses related to the opening of our newest full-service branch and secondarily related to increases in general maintenance and other costs associated with operating facilities due to general inflationary factors.

Income Tax Expense

Income tax expense decreased $199,000 to $573,000, with an effective tax rate of 20.7%, for the quarter ended September 30, 2023, as compared to $772,000 with an effective tax rate of 19.5% for the same three month period in 2022. The decrease in income tax expense for the quarter ended September 30, 2023, as compared to the same quarter in 2022, was primarily driven by a decrease of $1.2 million in income before taxes. The effective income tax rate increased 1.2% to 20.7% for the three months ended September 30, 2023 as compared to 19.5% for the same three month period in 2022. The increase in the tax rate in the third quarter of 2023, as compared to the same quarter in 2022, was primarily related to fluctuations in permanent tax differences.

Income tax expense decreased $501,000 to $1.8 million, with an effective tax rate of 20.6%, for the nine months ended September 30, 2023, as compared to $2.3 million with an effective tax rate of 19.3%, for the same nine month period in 2022. The decrease in income tax expense for the nine months ended September 30, 2023, as compared to the same nine month period in 2022, was primarily driven by the year-over-year decrease in income before taxes. The effective income tax rate increased 1.3% to 20.6% for the nine months ended September 30, 2023 as compared to 19.3% for the same nine month period in 2022. The increase in the tax rate for the nine months ended September 30, 2023, as compared to the same period in 2022, was primarily related to fluctuations in permanent tax differences and the reversal of a deferred tax asset valuation allowance during the nine months ended September 30, 2022.

The Company’s tax liability is a function of the 21% statutory federal tax rate, the level of pretax income, the varying effects of New York State income taxes, and is partially reduced by tax-exempt income from specific types of investment securities and loans, bank owned life insurance, and, to a much lesser degree, the utilization of low income housing tax credits. In addition, the tax effects of certain incentive stock option activity may reduce the Company’s effective tax rate on a sporadic basis.

Earnings per Share

Basic and diluted earnings per Voting and Series A Non-Voting share were $0.35 per share for the third quarter of 2023, as compared to $0.52 per basic and diluted Voting and Series A Non-Voting share for the same quarter of 2022. Basic and diluted earnings per Voting and Series A Non-Voting share were $1.10 for the nine month period ended September 30, 2023, as compared to $1.55 for the same prior year period. The decrease in earnings per share between these two periods was due to the decrease in net income between these two time periods. Further information on earnings per share can be found in Note 3 of this Form 10-Q.

Changes in Financial Condition

Assets

Total assets slightly increased $728,000, or 0.05%, to $1.40 billion at September 30, 2023 as compared to December 31, 2022. This increase was due primarily to increases in investment securities.

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Loans totaled $896.1 million at September 30, 2023, a decrease of $1.6 million, or 0.18%, compared to $897.7 million at December 31, 2022. This was primarily due to decreases of $10.9 million in total consumer loans, and $7.7 million in total residential mortgage loans, offset by increases of $16.3 million in commercial loans. Investment securities, including investment in FHLB-NY stock, increased $7.3 million, or 1.9%, to $401.3 million at September 30, 2023, as compared to $394.0 million at December 31, 2022. This was due to an increase of $15.1 million in available-for-sale securities, and an increase of $1.2 million in marketable equity securities. The increase was offset by a decrease of $8.8 million in held-to-maturity securities, and a decrease of $158,000 in FHLB-NY stock

Liabilities

Total liabilities decreased $2.1 million, or 0.17%, to $1.29 billion at September 30, 2023 as compared to December 31, 2022. This decrease was due primarily to a decrease in borrowed funds balances from the FHLB-NY of $5.4 million, or 4.6%, to $110.6 million at September 30, 2023, from $116.0 million at December 31, 2022.

These decreases were slightly offset by a $2.4 million, or 0.22% increase in total deposits to $1.13 billion at September 30, 2023, as compared to December 31, 2022. This includes an increase of $11.4 million, or 1.2%, in interest-bearing deposits, offset by a decrease of $9.0 million, or 4.9%, in noninterest-bearing deposits.

Shareholders’ Equity

Shareholders' equity increased by $2.8 million, or 2.5%, from $111.0 million at December 31, 2022, to $113.8 million on September 30, 2023. This increase was primarily due to the Company’s recorded net income of $6.8 million, partially reduced by declared dividends to shareholders of $1.7 million.

Additionally, on January 1, 2023, the Company adopted the CECL methodology for computing its ACL and related provision for credit losses. This adoption resulted in the recognition of a one-time transitional adjustment that reduced the Company’s retained earnings by $2.1 million on that date. In total therefore, retained earnings increased by $3.0 million in the nine months ended September 30, 2023. Shareholders' equity was also affected due to an increase in accumulated other comprehensive loss of $1.2 million, offset primarily by an increase in all other components of shareholders' equity totaling $997,000.

Capital

Capital adequacy is evaluated primarily by the use of ratios which measure capital against total assets, as well as against total assets that are weighted based on defined risk characteristics. The Company’s goal is to maintain a strong capital position, consistent with the risk profile of its banking operations. This strong capital position serves to support growth and expansion activities while at the same time exceeding regulatory standards. At September 30, 2023, the Bank met the regulatory definition of a “well-capitalized” institution, i.e. a leverage capital ratio exceeding 5%, a Tier 1 risk-based capital ratio exceeding 8%, Tier 1 common equity exceeding 6.5%, and a total risk-based capital ratio exceeding 10%.

In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions and certain discretionary bonus payments to management if the institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above the amount necessary to meet its minimum risk-based capital requirements. The buffer is separate from the capital ratios required under the Prompt Corrective Actions (“PCA”) standards. In order to avoid these restrictions, the capital conservation buffer effectively increases the minimum levels of the following capital to risk-weighted assets ratios: (1) Core Capital, (2) Total Capital and (3) Common Equity. At September 30, 2023, the Bank exceeded all regulatory required minimum capital ratios, including the capital buffer requirements.

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Pathfinder Bank’s capital amounts and ratios as of the indicated dates are presented in the following table:

(In thousands)

Non-GAAP Financial Measures

Regulation G, a rule adopted by the Securities and Exchange Commission (SEC), applies to certain SEC filings, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” GAAP is generally accepted accounting principles in the United States of America. Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure (if a comparable GAAP measure exists) and a statement of the Company’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. Financial institutions like the Company and its subsidiary bank are subject to an array of bank regulatory capital measures that are financial in nature but are not based on GAAP. The Company follows industry practice in disclosing its financial condition under these various regulatory capital measures, including period-end regulatory capital ratios for its subsidiary bank, in its periodic reports filed with the SEC. The Company provides, below, an explanation of the calculations, as supplemental information, for non-GAAP measures included in the consolidated annual financial statements. In addition, the Company provides a reconciliation of its subsidiary bank’s disclosed regulatory capital measures, below.

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(In thousands)

Loan and Asset Quality and Allowance for Credit Losses

The following table represents information concerning the aggregate amount of non-accrual loans at the indicated dates:

(In thousands)

Nonperforming assets include nonaccrual loans, including nonaccrual loans classified as troubled debt restructurings (“TDRs”) prior to January 1, 2023, and foreclosed real estate (‘‘FRE”). The Company generally places a loan on nonaccrual status and ceases accruing interest when loan payment performance is deemed unsatisfactory and the loan is past due 90 days or more. There are no loans that are past due 90 days or more and still accruing interest at September 30, 2023, December 31, 2022 and September 30, 2022.

As indicated in the table above, nonperforming assets at September 30, 2023 were $16.4 million, and were $7.1 million higher than the $9.2 million reported at December 31, 2022 and $5.5 million higher than the reported $10.8 million at

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September 30, 2022. The increase in the nonperforming loan portfolio on September 30, 2023, as compared to December 31, 2022, was primarily the result of the placement of $11.5 million into nonaccrual status of certain loans within two large commercial real estate loan and commercial loan relationships. These relationships are under active resolution management at September 30, 2023.

Fair values for commercial FRE are initially recorded based on market value evaluations by third parties, less costs to sell (“initial cost basis”). On a prospective basis, residential FRE assets will be initially recorded at the lower of the net amount of loan receivable or the real estate’s fair value less costs to sell. Any write-downs required when the related loan receivable is exchanged for the underlying real estate collateral at the time of transfer to FRE are charged to the allowance for credit losses. Values are derived from appraisals, similar to impaired loans, of underlying collateral or discounted cash flow analysis. Subsequent to foreclosure, valuations are updated periodically and assets are marked to current fair value, not to exceed the initial cost basis for the FRE property.

The allowance for credit losses on loans represents management’s estimate of the probable losses inherent in the loan portfolio as of the date of the statement of condition. The allowance for credit losses was $15.8 million and $15.3 million at September 30, 2023 and December 31, 2022, respectively. The ratio of the allowance for credit losses to total loans was 1.8% as of September 30, 2023, as compared to 1.7% at December 31, 2022 and 1.6% at September 30, 2022. Management performs a quarterly evaluation of the allowance for credit losses based on quantitative and qualitative factors and has determined that the current level of the allowance for credit losses is adequate to absorb the losses in the loan portfolio as of September 30, 2023.

The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan. The measurement of impaired loans is generally based upon the fair value of the collateral, with a portion of the impaired loans measured based upon the present value of future cash flows discounted at the historical effective interest rate. A specific reserve is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral. For loans secured by real estate, estimated fair values are determined primarily through third-party appraisals or broker price opinions. When a loan is determined to be impaired, the Bank will reevaluate the collateral which secures the loan. For real estate, the Company will obtain a new appraisal or broker’s opinion whichever is considered to provide the most accurate value in the event of sale. An evaluation of equipment held as collateral will be obtained from a firm able to provide such an evaluation. Collateral will be inspected not less than annually for all impaired loans and will be reevaluated not less than every two years. Appraised values and broker opinion values are discounted due to the market’s perception of a reduced price of Bank-owned property and the Bank’s desire to sell the property more quickly to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

At September 30, 2023 and December 31, 2022, the Company had $22.7 million and $20.2 million in loans, respectively, which were deemed to be impaired, having established specific reserves of $3.5 million and $4.8 million, respectively, on these loans. The $2.5 million increase in impaired loans between these two dates was primarily the result of the placement into nonaccrual status of loans within two large commercial loan and commercial real estate borrower relationships.

Management has identified potential credit problems which may result in the borrowers not being able to comply with the current loan repayment terms and which may result in those loans being included in future impaired loan reporting. Potential problem loans totaled $43.1 million at September 30, 2023, an increase of $4.5 million, or 11.7%, as compared to $38.6 million at December 31, 2022. These loans have been internally classified as special mention, substandard, or doubtful, yet are not currently considered impaired.

Appraisals are obtained at the time a real estate secured loan is originated. For commercial real estate held as collateral, the property is inspected every two years.

In the normal course of business, the Bank sells residential mortgage loans and has infrequently sold participation interests in commercial loans. As is typical in the industry, the Bank makes certain representations and warranties to the buyers of these loans or loan participations. The Bank maintains a quality control program for closed loans and considers the risks and uncertainties associated with potential repurchase requirements to be minimal.

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The future performance of the Company’s loan portfolios with respect to credit losses will be highly dependent upon the course and duration, both nationally and within the Company’s market area, of the concentrations in the Company’s loan portfolio. Concentrations of loans within a portfolio that are made to a single borrower, to a related group of borrowers, or to a limited number of industries, are generally considered to be additional risk factors in estimating future credit losses. Therefore, the Company monitors all of its credit relationships to ensure that the total loan amounts extended to one borrower, or to a related group of borrowers, does not exceed the maximum permissible levels defined by applicable regulation or the Company’s generally more restrictive internal policy limits.

Liquidity

Liquidity management involves the Company’s ability to generate cash or otherwise obtain funds at reasonable rates to support asset growth, meet deposit withdrawals, maintain reserve requirements, and otherwise operate the Company on an ongoing basis. The Company's primary sources of funds are deposits, borrowed funds, amortization and prepayment of loans and maturities of investment securities and other short-term investments, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company manages the pricing of deposits to maintain a desired deposit composition and balance. In addition, the Company invests excess funds in short-term interest-earning and other assets, which provide liquidity to meet lending requirements.

The Company's liquidity has been enhanced by its ability to borrow from the Federal Home Loan Bank of New York (“FHLBNY”), whose competitive advance programs and lines of credit provide the Company with a safe, reliable, and convenient source of funds. A significant decrease in deposits in the future could result in the Company having to seek other sources of funds for liquidity purposes. Such sources could include, but are not limited to, additional borrowings, brokered deposits, negotiated time deposits, the sale of "available-for-sale" investment securities, the sale of securitized loans, or the sale of whole loans. Such actions could result in higher interest expense and/or losses on the sale of securities or loans.

Through the first nine months of 2023, as indicated in the consolidated statement of cash flows, the Company reported net cash flow from operating activities of $7.0 million and net cash inflow of $13.9 million related to investing activities. The net cash flow from investing activities was generated principally by a $11.5 million increase in net investment activity, a $736,000 increase in net loan activity and an increase of $1.7 million in all other investing activities in aggregate. The Company reported net cash outflows from financing activities of $3.9 million, primarily due to a $4.8 million decrease in net borrowings, a $2.4 million increase in deposits, and an aggregate decrease of $1.5 million in net cash from all other financing sources, including dividends paid to common voting and non-voting shareholders and warrants of $1.7 million.

The Bank’s management monitors liquidity on a continuous basis through a broad range of internal programs and considers effective liquidity management to be one of its primary objectives. At September 30, 2023 the Bank had deposits of $1.13 billion, of which $307.8 million were nominally uninsured, as they were above the insurance limits established by the Federal Deposit Insurance Corporation (“FDIC”) on that date. Of the $307.8 million in nominally uninsured deposits at September 30, 2023, $62.1 million were insured through a long-standing reciprocal deposit program managed by a third-party entity. In addition, $80.3 million in municipal deposits are fully protected against principal loss by a collateral program whereby the Bank places high-quality securities with an independent custodian as collateral. Therefore, the Bank had $165.4 million in deposits, representing 15.0% of all deposits, that were considered to be uninsured at September 30, 2023.

The Company has a number of existing credit facilities available to it. At September 30, 2023, total credit available under the existing lines of credit was approximately $189.3 million at FHLBNY, the Federal Reserve Bank, and two other correspondent banks. At September 30, 2023, the Company had $110.6 million of the available lines of credit utilized on its existing lines of credit with the remainder of $78.7 million available.

In an effort to increase depositor confidence across the United States' banking system, the Federal Reserve Board, pursuant to section 13(3) of the Federal Reserve Act, authorized all 12 Reserve Banks to establish the Bank Term Funding Program ("BTFP") to make available additional funding to eligible depository institutions, such as the Bank, in order to help assure those institutions have the ability to meet the liquidity needs of all their depositors. The Bank is fully qualified for the BTFP at September 30, 2023 and the BTFP is an additional potential source of liquidity for the Bank until the date of the Program's termination. The BTFP may be accessed by the Bank if management determines that there is a potential or realized

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short-term liquidity requirement for which this facility should be used to support the Bank's operations. Management could also electively choose to use the facility in certain other circumstances to create other financial or operational benefits at the time that the BTFP line is accessed.

The Asset Liability Management Committee of the Company is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity. As of September 30, 2023, management reported to the Board of Directors that the Company is in compliance with its liquidity policy guidelines.

Off-Balance Sheet Arrangements

The Company is also a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. At September 30, 2023, the Company had $203.3 million in outstanding commitments to extend credit and standby letters of credit.

The Company's exposure to credit loss in the event of nonperformance related to off-balance sheet arrangements is proportional to the contractual amount of those instruments. Such financial instruments are recorded when they are funded. The Company records an allowance for credit losses on off-balance sheet credit exposures, unless such commitments are unconditionally cancelable, through the provision for credit losses expense. The allowance for credit losses on off-balance sheet credit exposures as of September 30, 2023 was $576,000 and is included in other liabilities on the Company's consolidated Statements of Condition.

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Under the supervision and with the participation of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”) (the Company’s principal executive officer and principal financial officer), management conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2023. The term “disclosure controls and procedures,” under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to our management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Based on the evaluation of our disclosure controls and procedures as of September 30, 2023, our CEO and CFO concluded that our disclosure controls and procedures were effective as of that date.

As disclosed elsewhere within this document, during the first quarter of 2023 the Company adopted ASU 2016-13 and consequently, the CECL model for accounting for credit losses related to financial assets. The adoption of the model and the ongoing calculations under CECL involve significant complexity and management has engaged expert independent third parties to complete significant portions of the transition to CECL and to manage the ongoing processes involved in CECL calculations, documentation and reporting. In many cases, our disclosure controls and procedures have been modified significantly to accommodate the requirements of the CECL model and those controls require increased reliance on the services and expertise provided by the engaged independent parties. Management believes that these new disclosure controls are currently effective, and will be effective in the future, with respect to the calculation of the Company's allowance for credit losses. Other than the adoption of the CECL model, there were no changes made in our internal controls during the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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