# Fidelity D & D Bancorp Inc: Form 10-Q for the period ended Mar 31, 2016

- Company: [Fidelity D & D Bancorp Inc](/companies/fdbc.md) (CIK 1098151)
- Form: 10-Q
- Filed: 2016-05-06
- Accepted by EDGAR: May 6, 2016, 14:12 ET
- Period: 2016-03-31
- Accession: 0001098151-16-000070
- Inline XBRL: yes
- Main document: https://www.sec.gov/Archives/edgar/data/1098151/000109815116000070/fdbc-20160331x10q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1098151/000109815116000070/

## Figures reported in this filing

Standardized XBRL line items for the period ended 2016-03-31.

| Line item | Period | Value | XBRL concept |
| --- | --- | ---: | --- |
| Interest expense | 3 months, 2016-01-01 to 2016-03-31 | $598.0k | us-gaap:InterestExpense |
| Income tax | 3 months, 2016-01-01 to 2016-03-31 | $586.0k | us-gaap:IncomeTaxExpenseBenefit |
| Net income | 3 months, 2016-01-01 to 2016-03-31 | $1.7m | us-gaap:NetIncomeLoss |
| Diluted EPS | 3 months, 2016-01-01 to 2016-03-31 | $0.69 | us-gaap:EarningsPerShareDiluted |
| Basic EPS | 3 months, 2016-01-01 to 2016-03-31 | $0.69 | us-gaap:EarningsPerShareBasic |
| Diluted shares (weighted) | 3 months, 2016-01-01 to 2016-03-31 | 2,457,392 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Operating cash flow | 3 months, 2016-01-01 to 2016-03-31 | $1.5m | us-gaap:NetCashProvidedByUsedInOperatingActivitiesContinuingOperations |
| Capital expenditure | 3 months, 2016-01-01 to 2016-03-31 | $440.0k | us-gaap:PaymentsToAcquirePropertyPlantAndEquipment |
| Cash and equivalents | at 2016-03-31 | $41.1m | us-gaap:CashAndCashEquivalentsAtCarryingValue |
| Total assets | at 2016-03-31 | $763.4m | us-gaap:Assets |
| Total liabilities | at 2016-03-31 | $685.1m | us-gaap:Liabilities |
| Short-term borrowings | at 2016-03-31 | $12.8m | us-gaap:ShortTermBorrowings |
| Shareholders' equity | at 2016-03-31 | $78.3m | us-gaap:StockholdersEquity |

## Management's discussion and analysis

As filed, 69,580 characters.

The following is management's discussion and analysis of the significant changes in the consolidated financial condition of the Company as of March 31, 2016 compared to December 31, 2015 and a comparison of the results of operations for the three months ended March 31, 2016 and 2015. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2015 Annual Report filed on Form 10-K.

### Forward-looking statements

Certain of the matters discussed in this Quarterly Report on Form 10-Q may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. The words “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” and similar expressions are intended to identify such forward-looking statements.

The Company’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation:

- the effects of economic conditions on current customers, specifically the effect of the economy on loan customers’ ability to repay loans;
- the costs and effects of litigation and of unexpected or adverse outcomes in such litigation;
- the impact of new or changes in existing laws and regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations promulgated there under;
- impacts of the capital and liquidity requirements of the Basel III standards and other regulatory pronouncements, regulations and rules;
- governmental monetary and fiscal policies, as well as legislative and regulatory changes;
- effects of short- and long-term federal budget and tax negotiations and their effect on economic and business conditions;
- the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters;
- the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities and interest rate protection agreements, as well as interest rate risks;
- the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in our market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet;
- technological changes;
- the interruption or breach in security of our information systems and other technological risks and attacks resulting in failures or disruptions in customer account management, general ledger processing and loan or deposit updates and potential impacts resulting therefrom including additional costs, reputational damage, regulatory penalties, and financial losses;
- acquisitions and integration of acquired businesses;
- the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities;
- volatilities in the securities markets;
- acts of war or terrorism;
- disruption of credit and equity markets; and
- the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

The Company cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document. The Company has no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.

Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

### Executive Summary

The Company is a Pennsylvania corporation and a bank holding company, whose wholly-owned state chartered commercial bank is The Fidelity Deposit and Discount Bank. The Company is headquartered in Dunmore, Pennsylvania. We consider Lackawanna and Luzerne Counties our primary marketplace.

As a leading Northeastern Pennsylvania community bank, our goals are to enhance shareholder value while continuing to build a full-service community bank. We focus on growing our core business of retail and business lending and deposit gathering while maintaining strong asset quality and controlling operating expenses. We continue to implement strategies to diversify earning assets and to increase low cost core deposits. These strategies include a greater level of commercial lending and the ancillary business products and services supporting our commercial customers’ needs as well as residential lending strategies and an array of consumer products. We focus on developing a full banking relationship with existing, as well as new, small- and middle-sized business prospects. In addition, we explore opportunities to selectively expand our franchise footprint, consisting presently of our 10-branch network. During the first quarter of 2016, the Company closed the Eynon branch and took advantage of an opportunity to realize an improved cost structure with minimal disruption to customers. The cost savings will be reallocated to help expand our branch network.

We are impacted by both national and regional economic factors, with commercial, commercial real estate and residential mortgage loans concentrated in Northeastern Pennsylvania, primarily in Lackawanna and Luzerne counties. Although the U.S. economy has shown signs of modest improvement, the general operating environment and our local market area continue to remain challenging. For the near-term, we expect to continue to operate in a low, but slowly-rising interest rate environment. A rising rate environment positions the Company to improve its net interest income performance, but will continue to pressure the interest-rate yield and margin. The Federal Open Market Committee (FOMC) adjusted the short-term federal funds rate up 25 basis points during December 2015. The move represented the first hike in rates by the FOMC in nearly a decade and expectations are for short-term rates to rise gradually throughout 2016, potentially pressuring deposit rate pricing. The treasury yield curve is expected to undergo a bearish flattening over the forecast horizon. The national unemployment rate for March 2016 was 5.0%, unchanged from December 2015. In our region (Scranton, Wilkes-Barre Metropolitan Statistical Area), the unemployment rate increased to 6.4% at March 31, 2016 from 4.7% as of December 31, 2015. The spike in unemployment was due to an increase in the amount of people in the labor force during 2016 while the number of jobs decreased. The fact that more people are entering the labor force is a positive sign for the local economy. Pressure on employment during the first three months of the year is not unusual, as retail and activities such as construction slow down. Year-over-year the unemployment rate decreased with both the labor force and the number of jobs increasing. The median home values in the region fell 1.3% from a year ago, and according to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets, values are expected to rise 1.3% within the next year. In light of these expectations, we will continue to monitor the economic climate in our region and scrutinize growth prospects with credit quality as a principal consideration.

In addition to the challenging economic environment in which we compete, the regulation and oversight of our business has changed significantly in recent years. As described more fully in Part I, Item 1A, “Risk Factors,” and in the “Supervisory and Regulation” section of management’s discussion and analysis of financial condition and results of operations in our 2015 Annual Report filed on Form 10-K, certain aspects of the Dodd-Frank Wall Street Reform Act (Dodd-Frank Act) continue to have a significant impact on us. In addition, final rules to implement Basel III regulatory capital reform, approved by the federal bank regulatory agencies in 2013, subject many banks including the Company, to capital requirements which will be phased in. The initial provisions effective for us began on January 1, 2015. The rules also revise the minimum risk-based and leverage capital ratio requirements applicable to the Company and revise the calculation of risk-weighted assets to enhance their risk sensitivity. We will continue to prepare for the impacts that the Dodd-Frank Act and the Basel III capital standards, and related rulemaking will have on our business, financial condition and results of operations.

### General

The Company’s earnings depend primarily on net interest income. Net interest income is the difference between interest income and interest expense. Interest income is generated from yields earned on interest-earning assets, which consist principally of loans and investment securities. Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is determined by the Company’s interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Interest rate spread is significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in the marketplace.

The Company’s earnings are also affected by the level of its non-interest income and expenses and by the provisions for loan losses and income taxes. Non-interest income consists of: service charges on the Company’s loan and deposit products; interchange fees; trust and asset management service fees; increases in the cash surrender value of the bank owned life insurance and from net gains or losses from sales of loans and securities. Non-interest expense consists of: compensation and related employee benefit costs; occupancy; equipment; data processing; advertising and marketing; FDIC insurance premiums; professional fees; loan collection; net other real estate owned (ORE) expenses; supplies and other operating overhead.

### Comparison of the results of operations

### Three months ended March 31, 2016 and 2015

### Overview

Net income increased $0.1 million, or 8%, for the first quarter of 2016 to $1.7 million, or $0.69 per diluted share, compared to $1.6 million, or $0.64 per diluted share, for the same 2015 quarter. During the first quarter of 2016, the Company produced $0.5 million higher net interest income compared to the first quarter of 2015. The increase in net interest income offset $0.3 million more in non-interest expenses and $0.1 million lower non-interest income during the 2016 period.

Return on average assets (ROA) was 0.92% and 0.91% for the first quarters of 2016 and 2015, respectively. Return on average shareholders’ equity (ROE) was 8.83% and 8.74% for the three months ended March 31, 2016 and 2015, respectively. ROA and ROE increased in both periods because of the increase in net income.

#### Net interest income and interest sensitive assets / liabilities

Net interest income increased $0.5 million, or 9%, from $5.6 million for the three months ended March 31, 2015 to $6.1 million for the three months ended March 31, 2016, with higher interest income and lower interest expense combining for the net increase. Total average interest-earning assets increased $51.5 million and helped offset the negative impact of a four basis point net reduction in their yields resulting in $0.4 million of growth in interest income. Most of the increase was due to the loan portfolio, which experienced average balance growth of $41.2 million, which had the effect of producing $0.4 million of interest income, more than offsetting the negative impact of an 8 basis point lower yield earned thereon. Both the commercial and residential portfolios contributed to this increase in interest income. Although higher average balances of higher-yielding mortgage-backed securities produced $0.1 million in additional interest income from investments, this growth was partially offset by the special dividend from the FHLB which boosted investment income in the first quarter of 2015. On the liability side, total interest-bearing liabilities grew $30.4 million on average but a twelve basis point decline in the average rates paid offset the impact of this growth. The reduction in average rate paid is due to the $10 million payoff of long-term debt carrying an interest rate of 5.26% during the second quarter of 2015 which reduced interest expense from borrowings in 2016 by $0.1 million. Interest expense from deposits was largely unchanged from the first quarter of 2015.

The fully-taxable equivalent (FTE) net interest rate spread and margin increased by eight and six basis points, respectively for the three months ended March 31, 2016 compared to the three months ended March 31, 2015. The increase in spread was due to a twelve basis point reduction in rates paid on interest-bearing liabilities due to the payoff of long-term debt during 2015 which was able to offset the lower yield on interest-earning assets. The improvement in margin was due to higher net interest income. The overall cost of funds, which includes the impact of non-interest bearing deposits, declined nine basis points for the quarter ended March 31, 2016 compared to the same period in 2015. The reason for the decrease was the payoff of long-term debt.

During 2016, the Company expects to operate in a volatile yet overall gradually increasing interest rate environment. A rate environment with rising long-term interest rates positions the Company to improve its interest income performance from new and maturing long-term earning assets. Until there is a sustained period of yield curve steepening, with rates rising more sharply at the long end, the interest rate margin may continue to experience compression. However for the remainder of 2016, the Company anticipates net interest income to improve as growth in interest-earning assets would help mitigate an adverse impact of rate movements. The Federal Open Market Committee (FOMC) adjusted the short-term federal funds rate upward in December 2015, but it had a minimal effect on rates paid on funding sources. Continued growth in the loan portfolios complemented with investment security growth is the Company’s strategy for 2016, and when coupled with a proactive approach to deposit cost setting strategies should help grow net interest income and contain the interest rate margin at acceptable levels.

The Company’s cost of interest-bearing liabilities was 46 basis points for the quarter ended March 31, 2016 or twelve basis points lower than the cost for the same 2015 quarter. The decline in the rate paid on borrowings was the reason for the reduction. Other than retaining maturing long-term CDs, further reductions in deposit rates from the current historic low levels would have an insignificant cost-savings impact. Interest rates along the treasury yield curve have been volatile with stability existing only at the short end. Competition could pressure banks to increase deposit rates. On the asset side, the prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans, began to rise at the end of 2015. Rates were not increased during the first quarter of 2016 but if rates rise later in the year, the effect could pressure net interest income if short-term rates rise more rapidly than longer-term interest rates, thereby compressing the interest rate spread. To help mitigate the impact of the imminent change to the economic landscape, the Company has successfully developed and will continue to strengthen its association with existing customers, develop new business relationships, generate new loan volumes, and retain and generate higher levels of average non-interest bearing deposit balances. Strategically deploying no- and low-cost deposits into interest earning-assets is an effective margin-preserving strategy that the Company expects to continue to pursue and expand to help stabilize net interest margin.

The Company’s Asset Liability Management (ALM) team meets regularly to discuss among other things, interest rate risk and when deemed necessary adjusts interest rates. ALM also discusses revenue enhancing strategies to help combat the potential for a decline in net interest income. The Company’s marketing department, together with ALM, lenders and deposit gatherers, continue to develop prudent strategies that will grow the loan portfolio and accumulate low-cost deposits to improve net interest income performance.

The table that follows sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and rates for the periods indicated. Within the table, interest income was adjusted to a tax-equivalent basis (FTE), using the corporate federal tax rate of 34% to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. This treatment allows a uniform comparison among yields on interest-earning assets. Loans include loans HFS and non-accrual loans but exclude the allowance for loan losses. Net deferred loan cost amortization of $112 thousand and $93 thousand for the first quarters of 2016 and 2015, respectively, are included in interest income from loans. The one-time FHLB special dividend of $57 thousand awarded in the first quarter of 2015 was removed from the annualized yield calculation and then added back to interest income. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Net interest margin is calculated by dividing annualized net interest income - FTE by total average interest-earning assets. Cost of funds includes the effect of average non-interest bearing deposits as a funding source:

*(dollars in thousands)*

| Assets Interest-earning assets | Three months ended March 31, 2016 Average balance | Interest | Yield / rate | March 31, 2015 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$16,740** | **$22** | **0.53%** | $24,679 | $16 | 0.25% |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **18,450** | **53** | **1.15** | 15,746 | 50 | 1.29 |
| MBS - GSE residential | **68,661** | **317** | **1.86** | 53,135 | 210 | 1.60 |
| State and municipal (nontaxable) | **34,979** | **496** | **5.70** | 34,691 | 495 | 5.78 |
| Other | **1,707** | **23** | **5.46** | 1,613 | 79 | 5.46 |
| Total investments | **123,797** | **889** | **2.89** | 105,185 | 834 | 3.00 |
| Loans and leases: |  |  |  |  |  |  |
| Commercial and commercial real estate (taxable) | **278,003** | **3,068** | **4.44** | 256,705 | 2,861 | 4.52 |
| Commercial and commercial real estate (nontaxable) | **27,200** | **290** | **4.28** | 18,377 | 211 | 4.65 |
| Consumer | **65,603** | **911** | **5.58** | 66,897 | 911 | 5.52 |
| Residential real estate | **186,905** | **1,836** | **3.95** | 174,513 | 1,727 | 4.01 |
| Total loans and leases | **557,711** | **6,105** | **4.40** | 516,492 | 5,710 | 4.48 |
| Federal funds sold | **-** | **-** | **-** | 419 | - | 0.26 |
| Total interest-earning assets | **698,248** | **7,016** | **4.04%** | 646,775 | 6,560 | 4.08% |
| Non-interest earning assets | **48,581** |  |  | 51,980 |  |  |
| **Total assets** | **$746,829** |  |  | $698,755 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Savings | **$115,864** | **$36** | **0.13%** | $110,291 | $50 | 0.18% |
| Interest-bearing checking | **154,628** | **102** | **0.26** | 128,575 | 73 | 0.23 |
| MMDA | **127,635** | **217** | **0.68** | 119,332 | 193 | 0.66 |
| CDs \< $100,000 | **52,788** | **100** | **0.76** | 61,319 | 125 | 0.83 |
| CDs \> $100,000 | **50,611** | **124** | **0.99** | 42,862 | 115 | 1.09 |
| Clubs | **1,392** | **1** | **0.16** | 1,470 | 1 | 0.17 |
| Total interest-bearing deposits | **502,918** | **580** | **0.46** | 463,849 | 557 | 0.49 |
| Repurchase agreements | **14,710** | **8** | **0.22** | 15,793 | 8 | 0.20 |
| Borrowed funds | **2,434** | **10** | **1.55** | 10,001 | 132 | 5.35 |
| Total interest-bearing liabilities | **520,062** | **598** | **0.46%** | 489,643 | 697 | 0.58% |
| Non-interest bearing deposits | **144,890** |  |  | 132,327 |  |  |
| Non-interest bearing liabilities | **4,396** |  |  | 3,811 |  |  |
| Total liabilities | **669,348** |  |  | 625,781 |  |  |
| Shareholders' equity | **77,481** |  |  | 72,974 |  |  |
| **Total liabilities and shareholders' equity** | **$746,829** |  |  | $698,755 |  |  |
| Net interest income - FTE |  | **$6,418** |  |  | $5,863 |  |
| Net interest spread |  |  | **3.58%** |  |  | 3.50% |
| Net interest margin |  |  | **3.70%** |  |  | 3.64% |
| Cost of funds |  |  | **0.36%** |  |  | 0.45% |

31

Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in volumes 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 (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change. The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate. Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis:

*(dollars in thousands)*

| Interest income: | Three months ended March 31, 2016 compared to 2015 Increase (decrease) due to Volume | Rate | Total | 2015 compared to 2014 Volume | Rate | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$(6)** | **$12** | **$6** | $8 | $- | $8 |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **8** | **(5)** | **3** | - | (4) | (4) |
| MBS - GSE residential | **69** | **38** | **107** | 16 | 3 | 19 |
| State and municipal | **4** | **-** | **4** | 12 | (20) | (8) |
| Other | **5** | **(61)** | **(56)** | (11) | 66 | 55 |
| Total investments | **86** | **(28)** | **58** | 17 | 45 | 62 |
| Loans and leases: |  |  |  |  |  |  |
| Residential real estate | **133** | **(24)** | **109** | 186 | (54) | 132 |
| Commercial and CRE | **342** | **(83)** | **259** | 138 | (103) | 35 |
| Consumer | **(13)** | **13** | **-** | 64 | (1) | 63 |
| Total loans and leases | **462** | **(94)** | **368** | 388 | (158) | 230 |
| Federal funds sold | **-** | **-** | **-** | - | - | - |
| Total interest income | **542** | **(110)** | **432** | 413 | (113) | 300 |
| Interest expense: |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Savings | **2** | **(16)** | **(14)** | - | (5) | (5) |
| Interest-bearing checking | **17** | **12** | **29** | 13 | 18 | 31 |
| Money market | **16** | **8** | **24** | 50 | 28 | 78 |
| Certificates of deposit less than $100,000 | **(16)** | **(9)** | **(25)** | 6 | (2) | 4 |
| Certificates of deposit greater than $100,000 | **20** | **(11)** | **9** | (21) | (19) | (40) |
| Clubs | **-** | **-** | **-** | - | - | - |
| Total deposits | **39** | **(16)** | **23** | 48 | 20 | 68 |
| Repurchase agreements | **(1)** | **1** | **-** | - | - | - |
| Borrowed funds | **(63)** | **(59)** | **(122)** | (84) | 5 | (79) |
| Total interest expense | **(25)** | **(74)** | **(99)** | (36) | 25 | (11) |
| Net interest income | **$567** | **$(36)** | **$531** | $449 | $(138) | $311 |

#### Provision for loan losses

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses (the allowance) to a level that represents management’s best estimate of known and inherent losses in the Company’s loan portfolio. Loans determined to be uncollectible are charged off against the allowance. The required amount of the provision for loan losses, based upon the adequate level of the allowance, is subject to the ongoing analysis of the loan portfolio. The Company’s Special Assets Committee meets periodically to review problem loans. The committee is comprised of management, including credit administration officers, loan officers, loan workout officers and collection personnel. The committee reports quarterly to the Credit Administration Committee of the board of directors.

Management continuously reviews the risks inherent in the loan portfolio. Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

- specific loans that could have loss potential;
- levels of and trends in delinquencies and non-accrual loans;
- levels of and trends in charge-offs and recoveries;
- trends in volume and terms of loans;
- changes in risk selection and underwriting standards;
- changes in lending policies, procedures and practices;
- experience, ability and depth of lending management;
- national and local economic trends and conditions; and
- changes in credit concentrations.

For the quarters ending March 31, 2016 and 2015, the Company recorded a provision for loan losses of $0.2 million each period, respectively. The provision funds our allowance for loan losses and its requirement is a function of the allowance’s sufficiency to cover all loans. Within the allowance calculation, there is a rolling twelve-quarter average applied to determine the reserve affecting both qualitative factors and loss ratios. During the first quarter of 2016, a significant loss event rolled off of this historical average which offset the need for additional reserves which would have otherwise been required from an additional $0.7 million TDR and $4.6 million more non-accrual loans. Except for a $0.7 million specific reserve for one large non-accrual loan, collateral securing these impaired loans was considered sufficient to cover their respective principal balances. For a discussion on the allowance for loan losses, see “Allowance for loan losses,” located in the comparison of financial condition section of management’s discussion and analysis contained herein.

#### Other income

For the three months ended March 31, 2016, non-interest income amounted to $1.7 million, a $0.1 million, or 4%, decrease compared to $1.8 million recorded for the three months ended March 31, 2015. The decrease in conforming residential lending activity resulted in $0.1 million fewer gains on the sale of loans at March 31, 2016 compared to the same period of 2015. Trust income and financial services income also saw $47 thousand and $23 thousand decreases, respectively. These decreases were partially offset by a combined $0.1 million in additional service charges on deposits and interchange fees.

#### Other operating expenses

For the three months ended March 31, 2016, total other operating expenses increased $0.3 million, or 6%, compared to the three months ended March 31, 2015. Salary and employee benefits contributed the most to the increase rising $0.2 million, or 8%, in the first quarter of 2016 compared to the same period in 2015. The increase stems from select staff additions or replacements to previously vacant positions, including senior level and mid-level position replacements that did not occur until second quarter of 2015, annual merit increases, one-time salary increases awarded to employees in the normal course of performance management, higher recognized employee incentives and an increase in group insurance from higher claims processing. Professional services increased during the period by $0.1 million, or 15%. The increase was due to a combination of additional legal services and additional compliance review services. Data processing and communications expense increased $0.1 million during the three months ended March 31, 2016 compared to 2015 like period because of fees incurred from outsourcing the Company’s data processing during the third quarter of 2015. Other expenses increased $0.1 million during the first quarter of 2016 due to a credit of $0.1 million against the shares tax due to a donation made during the first quarter of 2015. The Company does not expect to receive the same tax credit for 2016 until the end of the year. Offsetting these items, the lack of the previously mentioned donation during the first quarter of 2016 caused advertising and marketing expenses to decrease by $0.1 million. Other real estate owned (ORE) expense also decreased $0.1 million during the first quarter of 2016 compared to the same period in 2015 because the Company was holding a few large properties that carried large expenses during the first quarter of 2015 that were subsequently sold. Also, there were losses on sales of ORE and write-downs in 2015 totaling $35 thousand and none of the properties in 2016 were sold or needed to be written down.

The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at March 31, 2016 and 2015 were 1.99% and 1.93%, respectively. The expense ratio, which excludes non-recurring expenses, increased due mostly to lower non-interest income.

### Comparison of financial condition at

### March 31, 2016 and December 31, 2015

#### Overview

Consolidated assets increased $34.0 million, or 5%, to $763.4 million as of March 31, 2016 from $729.4 million at December 31, 2015. The increase in assets was funded through growth in deposits of $47.2 million and a $2.0 million increase in shareholders’ equity which was partially offset by the $15.4 million decrease in short-term borrowings. The increase in the funding sources was used to fund investment security growth and pay down short-term borrowings with the balance retained in cash for future liquidity needs from seasonal depositors.

### Funds Deployed:

#### Investment securities

At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (AFS) or held-to-maturity (HTM). To date, management has not purchased any securities for trading purposes. Most of the securities the Company purchases are classified as AFS even though there is no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions. Securities AFS are carried at fair value on the consolidated balance sheets with unrealized gains and losses, net of deferred income taxes, reported separately within shareholders’ equity as a component of accumulated other comprehensive income (AOCI). Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity.

As of March 31, 2016, the carrying value of investment securities amounted to $128.7 million, or 17% of total assets, compared to $125.2 million, or 17% of total assets, at December 31, 2015. On March 31, 2016, 56% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential or mortgage-backed securities) that amortize and provide monthly cash flow that the Company can use for reinvestment, loan demand, unexpected deposit outflow, facility expansion or operations.

Investment securities were comprised of AFS securities as of March 31, 2016. The AFS securities were recorded with a net unrealized gain of $4.4 million as of March 31, 2016 compared to a net unrealized gain of $3.3 million as of December 31, 2015, or a net improvement of $1.1 million during 2016. The direction and magnitude of the change in value of the Company’s investment portfolio is attributable to the direction and magnitude of the change in interest rates along the treasury yield curve. Generally, the values of debt securities move in the opposite direction of the changes in interest rates. As interest rates along the treasury yield curve fall, especially at the intermediate and long end, the values of debt securities tend to increase. Whether or not the value of the Company’s investment portfolio will continue to exceed its amortized cost will be largely dependent on the direction and magnitude of interest rate movements and the duration of the debt securities within the Company’s investment portfolio. When interest rates rise, the market values of the Company’s debt securities portfolio could be subject to market value declines.

Quarterly, management performs a review of the investment portfolio to determine the causes of declines in the fair value of each security. The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio. Inputs provided by the third parties are reviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed to determine whether impairment exists and whether the impairment is temporary or other-than-temporary. Considerations such as the Company’s intent and ability to hold the securities to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, the receipt of amounts contractually due and whether or not there is an active market for the securities, for example, are applied, along with an analysis of the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security is other-than-temporarily impaired. If a decline in value is deemed to be other-than-temporary, the amortized cost of the security is reduced by the credit impairment amount and a corresponding charge to current earnings is recognized. During the three months ended March 31, 2016 and 2015, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.

During the first three months of 2016, the carrying value of total investments increased $3.4 million, or 3%. The Company attempts to maintain a well-diversified and proportionate investment portfolio that is structured to complement the strategic direction of the Company. Its growth typically supplements the lending activities but also considers the current and forecasted economic conditions, the Company’s liquidity needs and interest rate risk profile. At the end of 2014, the Company began to restructure its investment portfolio by selling mortgage-backed securities with the longest duration and lowest coupon rates as well as intermediate term agency bonds. The proceeds were used to reduce the Company’s long-term debt with the balance retained in cash that was reinvested along with available cash holdings during the first half of 2015. The Company expects to grow the portfolio and increase its relative size with a bias toward mortgage-backed securities. If rates rise, the strategy will provide a good source of cash flow to reinvest into higher yielding interest-sensitive assets.

A comparison of investment securities at March 31, 2016 and December 31, 2015 is as follows:

*(dollars in thousands)*

|  | March 31, 2016 Amount% |  | December 31, 2015 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| MBS - GSE residential | **$72,002** | **56.0%** | $69,415 | 55.4% |
| State & municipal subdivisions | **37,609** | **29.2** | 36,885 | 29.5 |
| Agency - GSE | **18,528** | **14.4** | 18,386 | 14.7 |
| Equity securities - financial services | **534** | **0.4** | 546 | 0.4 |
| Total | **$128,673** | **100.0%** | $125,232 | 100.0% |

#### Federal Home Loan Bank Stock

Investment in Federal Home Loan Bank (FHLB) stock is required for membership in the organization and is carried at cost since there is no market value available. The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB of Pittsburgh. Excess stock is repurchased from the Company at par if the amount of borrowings decline to a predetermined level. In addition, the Company earns a return or dividend based on the amount invested. The dividends received from the FHLB totaled $14 thousand and $74 thousand for the three months ended March 31, 2016 and 2015, respectively. The Company received a $57 thousand one-time special dividend during the first quarter of 2015. The balance in FHLB stock was $1.4 million and $2.1 million as of March 31, 2016 and December 31, 2015, respectively.

#### Loans held-for-sale (HFS)

Upon origination, most residential mortgages and certain Small Business Administration (SBA) guaranteed loans may be classified as held-for-sale (HFS). In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In low interest rate environments, the Company would be exposed to prepayment risk and, as rates on adjustable-rate loans decrease, interest income would be negatively affected. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as HFS. Occasionally, residential mortgage and/or other nonmortgage loans may be transferred from the loan portfolio to HFS. The carrying value of loans HFS is based on the lower of cost or estimated fair value. If the fair values of these loans decline below their original cost, the difference is written down and charged to current earnings. Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.

As of March 31, 2016 and December 31, 2015, loans HFS consisted of residential mortgages with carrying amounts of $1.2 million and $1.4 million, respectively, which approximated their fair values. During the quarter ended March 31, 2016, residential mortgage loans with principal balances of $6.5 million were sold into the secondary market and the Company recognized net gains of $0.1 million, compared to $10.2 million and $0.2 million, respectively during the quarter ended March 31, 2015. A decrease in residential mortgage origination activities caused the decrease in gains from loan sales in the first quarter of 2016 compared to the same 2015 period.

The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market. MSRs are retained so that the Company can foster personal relationships with its loyal customer base. At March 31, 2016 and December 31, 2015, the servicing portfolio balance of sold residential mortgage loans was $269.6 million and $269.5 million, respectively.

#### Loans and leases

The Company remains proactive in the desire to maintain, develop and grow relationships. Relationship managers along with their service partners have developed and continue to sharpen their skills to provide the opportunity of being trusted financial advisors. The loan portfolio remains stable with a modest growth based upon the condition of our local economy and our desire to manage risk. The expectation for the remainder of the year continues to be controlled growth within the confines of the marketplace.

### Commercial and industrial and commercial real estate

Compared to year-end 2015, the commercial and industrial (C&I) loan portfolio increased $1.1 million, or 1%, from $102.6 million to $103.7 million and the commercial real estate (CRE) loan portfolio retracted $3.2 million, or 2%, from $201.9 million to $198.7 million as of March 31, 2016. Both the modest increase and reduction in both categories were anticipated due to the payoffs of multiple credit facilities. The Company anticipates the commercial loan portfolio to increase approximately 5% by year end.

### Consumer

The consumer loan portfolio realized a nominal reduction of $1.3 million, or 1.1%, from a high of $115.0 million at December 31, 2015 to $113.7 million at March 31, 2016. The reduction is largely tied to amortization which is expected to be neutralized by volume derived from seasonal consumer loan campaigns scheduled over the remainder of 2016.

### Residential

The residential loan portfolio grew $3.3 million, or 2.4%, from $137.1 million at December 31, 2015 to $140.4 million at March 31, 2016. The held to maturity loan portfolio grew due mostly to residential construction and non-conforming loan originations.

The composition of the loan portfolio at March 31, 2016 and December 31, 2015, is summarized as follows:

*(dollars in thousands)*

|  | March 31, 2016 Amount% |  | December 31, 2015 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Commercial and industrial | **$103,703** | **18.7%** | $102,653 | 18.4% |
| Commercial real estate: |  |  |  |  |
| Non-owner occupied | **95,303** | **17.1** | 95,745 | 17.2 |
| Owner occupied | **98,523** | **17.7** | 101,652 | 18.3 |
| Construction | **4,904** | **0.9** | 4,481 | 0.8 |
| Consumer: |  |  |  |  |
| Home equity installment | **30,017** | **5.4** | 30,935 | 5.6 |
| Home equity line of credit | **48,331** | **8.7** | 48,060 | 8.7 |
| Auto and leases | **29,556** | **5.3** | 29,758 | 5.3 |
| Other | **5,770** | **1.0** | 6,208 | 1.1 |
| Residential: |  |  |  |  |
| Real estate | **130,270** | **23.4** | 126,992 | 22.8 |
| Construction | **10,109** | **1.8** | 10,060 | 1.8 |
| Gross loans | **556,486** | **100.0%** | 556,544 | 100.0% |
| Less: |  |  |  |  |
| Allowance for loan losses | **(9,384)** |  | (9,527) |  |
| Unearned lease revenue | **(395)** |  | (335) |  |
| Net loans | **$546,707** |  | $546,682 |  |
| Loans held-for-sale | **$1,202** |  | $1,421 |  |

#### Allowance for loan losses

Management evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for loan losses (the allowance) on a quarterly basis. The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio. Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans. Those estimates may be susceptible to significant change. The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.

Management applies two primary components during the loan review process to determine proper allowance levels. The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:

- identification of specific impaired loans by loan category;
- calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;
- determination of loans with similar credit characteristics within each class of the loan portfolio segment and eliminating the impaired loans;
- application of historical loss percentages (trailing twelve-quarter average) to pools to determine the allowance allocation;
- application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio, and/or current economic conditions.

Through March 31, 2016, allocation of the allowance for different categories of loans is based on the methodology as explained above. A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk grading of individual commercial loans. Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower. Upon review, the commercial loan credit risk grade is revised or reaffirmed. The credit risk grades may be changed at any time management determines an upgrade or downgrade may be warranted. The credit risk grades for the commercial loan portfolio are taken into account in the reserve methodology and loss factors are applied based upon the credit risk grades. The loss factors applied are based upon the Company’s historical experience as well as what management believes to be best practices and within common industry standards. Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs. The changes in allocations in the commercial loan portfolio from period-to-period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.

Each quarter, management performs an assessment of the allowance for loan losses. The Company’s Special Assets Committee meets monthly and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount, if applicable, based on current accounting guidance. The Special Assets Committee’s focus is on ensuring the pertinent facts are considered regarding not only loans considered for specific reserves, but also the collectability of loans that may be past due. The assessment process also includes the review of all loans on non-accrual status as well as a review of certain loans to which the lenders or the Credit Administration function have assigned a criticized or classified risk rating.

Net charge-offs were $0.3 million as of March 31, 2016, $0.7 million for the year ended December 31, 2015 and $0.1 million as of March 31, 2015. During the period ended March 31, 2016, no specific loan class significantly underperformed as charge-offs were taken across a variety of consumer, commercial and residential loans. For a discussion on the provision for loan losses, see the “Provision for loan losses,” located in the results of operations section of management’s discussion and analysis contained herein.

The allowance for loan losses was $9.4 million as of March 31, 2016, $9.5 million as of December 31, 2015 and $9.2 million as of March 31, 2015. Management believes that the current balance in the allowance for loan losses is sufficient to withstand the identified potential credit quality issues that may arise and others unidentified but inherent to the portfolio. Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more. There could be additional instances which become identified in future periods that may require additional charge-offs and/or increases to the allowance due to continued sluggishness in the economy and pressure on property values. In contrast, an abrupt significant increase in the U.S. Prime lending rate could adversely impact the debt service capacity of existing borrowers' ability to repay.

The following tables set forth the activity in the allowance for loan losses and certain key ratios for the period indicated:

*(dollars in thousands)*

|  | As of and for the three months ended March 31, 2016 | As of and for the twelve months ended December 31, 2015 | As of and for the three months ended March 31, 2015 |
| --- | ---: | ---: | ---: |
| Balance at beginning of period | **$9,527** | $9,173 | $9,173 |
| Charge-offs: |  |  |  |
| Commercial and industrial | **(14)** | (25) | (24) |
| Commercial real estate | **(85)** | (432) | (67) |
| Consumer | **(175)** | (437) | (92) |
| Residential | **(60)** | (15) | - |
| Total | **(334)** | (909) | (183) |
| Recoveries: |  |  |  |
| Commercial and industrial | **9** | 47 | 9 |
| Commercial real estate | **4** | 18 | 7 |
| Consumer | **28** | 95 | 24 |
| Residential | **-** | 28 | 28 |
| Total | **41** | 188 | 68 |
| Net charge-offs | **(293)** | (721) | (115) |
| Provision for loan losses | **150** | 1,075 | 150 |
| Balance at end of period | **$9,384** | $9,527 | $9,208 |
| Allowance for loan losses to total loans | **1.69%** | 1.71% | 1.77% |
| Net charge-offs to average total loans outstanding | **0.21%** | 0.13% | 0.09% |
| Average total loans | **$557,711** | $534,903 | $516,492 |
| Loans 30 - 89 days past due and accruing | **$2,390** | $3,707 | $2,135 |
| Loans 90 days or more past due and accruing | **$619** | $356 | $505 |
| Non-accrual loans | **$8,306** | $9,003 | $3,816 |
| Allowance for loan losses to loans 90 days or more past due and accruing | **15.16** **x** | 26.76 x | 18.23 x |
| Allowance for loan losses to non-accrual loans | **1.13** **x** | 1.06 x | 2.41 x |
| Allowance for loan losses to non-performing loans | **1.05** **x** | 1.02 x | 2.13 x |

#### Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, troubled debt restructured loans (TDRs), other real estate owned (ORE) and repossessed assets. At March 31, 2016, non-performing assets represented 1.77% of total assets compared with 1.76% as of December 31, 2015. Although non-accrual loans decreased in the first quarter of 2016, past due loans over 90 days, TDRs and ORE all increased over the same time period, causing an increase in the ratio. Most of the non-performing loans are collateralized, thereby mitigating the Company’s potential for loss.

The following table sets forth non-performing assets data as of the period indicated:

*(dollars in thousands)*

|  | March 31, 2016 | December 31, 2015 | March 31, 2015 |
| --- | ---: | ---: | ---: |
| Loans past due 90 days or more and accruing | **$619** | $356 | $505 |
| Non-accrual loans \* | **8,306** | 9,003 | 3,816 |
| Total non-performing loans | **8,925** | 9,359 | 4,321 |
| Troubled debt restructurings | **2,857** | 2,423 | 2,358 |
| Other real estate owned and repossessed assets | **1,766** | 1,074 | 1,433 |
| Total non-performing assets | **$13,548** | $12,856 | $8,112 |
| Total loans, including loans held-for-sale | **$557,293** | $557,630 | $520,855 |
| Total assets | **$763,382** | $729,358 | $702,507 |
| Non-accrual loans to total loans | **1.49%** | 1.61% | 0.73% |
| Non-performing loans to total loans | **1.60%** | 1.68% | 0.83% |
| Non-performing assets to total assets | **1.77%** | 1.76% | 1.15% |

\* In the table above, the amount includes non-accrual TDRs of $0.2 million as of March 31, 2016 and $0.9 million as of March 31, 2015. There were no non-accrual TDRs as of December 31, 2015.

In the review of loans for both delinquency and collateral sufficiency, management concluded that there were a number of loans that lacked the ability to repay in accordance with contractual terms. The decision to place loans on non-accrual status is made on an individual basis after considering factors pertaining to each specific loan. Generally, commercial loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection. Consumer loans secured by residential real estate and residential mortgage loans are placed on non-accrual status at 120 days past due as to principal and interest, and unsecured consumer loans are charged-off when the loan is 90 days or more past due as to principal and interest. Uncollected interest income accrued on all loans placed on non-accrual is reversed and charged to interest income.

Non-performing loans, which consists of accruing loans that are over 90 days past due as well as all non-accrual loans, decreased $0.4 million, or 5%, from $9.3 million at December 31, 2015 to $8.9 million at March 31, 2016. At March 31, 2016, the portion of accruing loans that was over 90 days past due totaled $0.6 million and consisted of nine loans to nine unrelated borrowers ranging from $6 thousand to $0.2 million. At December 31, 2015, the portion of accruing loans that was over 90 days past due totaled $0.4 million and consisted of eight loans to seven unrelated borrowers ranging from less than $1 thousand to $0.2 million. The Company seeks payments from all past due customers through an aggressive customer communication process. A past due loan will be placed on non-accrual at the 90 day point when it is deemed that a customer is non-responsive and uncooperative to collection efforts.

At March 31, 2016, there were 45 loans to 38 unrelated borrowers ranging from less than $1 thousand to $5.0 million in the non-accrual category. At December 31, 2015, there were 51 loans to 46 unrelated borrowers on non-accrual ranging from less than $1 thousand to $5.1 million. Non-accrual loans decreased during the period ending March 31, 2016 for the following reasons: $0.8 million in new non-accrual loans plus capitalized expenditures on these loans were added; $0.3 million were paid down or paid off; $0.2 million were charged off; $0.7 million were transferred to ORE, and $0.3 million was moved back to accrual status.

The composition of non-performing loans as of March 31, 2016 is as follows:

*(dollars in thousands)*

|  | Gross loan balances | Past due 90 days or more and still accruing | Non- accrual loans | Total non- performing loans | % of gross loans |
| --- | ---: | ---: | ---: | ---: | ---: |
| Commercial and industrial | **$103,703** | **$27** | **$32** | **$59** | **0.06%** |
| Commercial real estate: |  |  |  |  |  |
| Non-owner occupied | **95,303** | **-** | **6,178** | **6,178** | **6.48%** |
| Owner occupied | **98,523** | **35** | **559** | **594** | **0.60%** |
| Construction | **4,904** | **-** | **218** | **218** | **4.45%** |
| Consumer: |  |  |  |  |  |
| Home equity installment | **30,017** | **-** | **92** | **92** | **0.31%** |
| Home equity line of credit | **48,331** | **-** | **438** | **438** | **0.91%** |
| Auto loans and leases \* | **29,161** | **557** | **23** | **580** | **1.99%** |
| Other | **5,770** | **-** | **6** | **6** | **0.10%** |
| Residential: |  |  |  |  |  |
| Real estate | **130,270** | **-** | **760** | **760** | **0.58%** |
| Construction | **10,109** | **-** | **-** | **-** | **-** |
| Loans held-for-sale | **1,202** | **-** | **-** | **-** | **-** |
| Total | **$557,293** | **$619** | **$8,306** | **$8,925** | **1.60%** |

\*Net of unearned lease revenue of $0.4 million.

Payments received from non-accrual loans are recognized on a cost recovery method. Payments are first applied to the outstanding principal balance, then to the recovery of any charged-off loan amounts. Any excess is treated as a recovery of interest income. If the non-accrual loans that were outstanding as of March 31, 2016 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $0.3 million.

The Company, on a regular basis, reviews changes to loans to determine if they meet the definition of a TDR. TDRs arise when a borrower experiences financial difficulty and the Company grants a concession that it would not otherwise grant based on current underwriting standards in order to maximize the Company’s recovery. TDRs aggregated $3.0 million at March 31, 2016, an increase of $0.6 million, from $2.4 million at December 31, 2015, due to the addition of one home equity line of credit (HELOC) being classified as a TDR during the quarter. The $3.0 million in TDRs as of March 31, 2016, consisted of nine commercial loans (7 CRE and 2 C&I) and one consumer loan (HELOC) to six unrelated borrowers.

The following tables set forth the activity in TDRs as and for the periods indicated:

*(dollars in thousands)*

| As of and for the three months ended March 31, 2016 Troubled Debt Restructures: | Accruing Commercial & industrial | Commercial real estate | Consumer HELOC | Non-accruing Commercial real estate | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Beginning balance | **$525** | **$1,898** | **$-** | **$-** | **$2,423** |
| Additions | **-** | **-** | **650** | **-** | **650** |
| Transfers | **-** | **(156)** | **-** | **156** | **-** |
| Pay downs / payoffs | **-** | **(60)** | **-** | **-** | **(60)** |
| Ending balance | **$525** | **$1,682** | **$650** | **$156** | **$3,013** |

40

*(dollars in thousands)*

| As of and for the year ended December 31, 2015 Troubled Debt Restructures: | Accruing Commercial & industrial | Commercial real estate | Non-accruing Commercial real estate | Total |
| --- | ---: | ---: | ---: | ---: |
| Beginning balance | $25 | $728 | $875 | $1,628 |
| Additions | 500 | 1,267 | - | 1,767 |
| Sold | - | - | (604) | (604) |
| Pay downs / payoffs | - | (97) | (71) | (168) |
| Charge offs | - | - | (200) | (200) |
| Ending balance | $525 | $1,898 | $- | $2,423 |

If applicable, a TDR loan classified as non-accrual would require a minimum of six months of payments before consideration for a return to accrual status. The concessions granted consisted of temporary interest-only payments or a reduction in the rate of interest to a below-market rate for a contractual period of time. The Company believes concessions have been made in the best interests of the borrower and the Company. If loans characterized as a TDR perform according to the restructured terms for a satisfactory period of time, the TDR designation may be removed in a new calendar year if the loan yields a market rate of interest.

#### Foreclosed assets held-for-sale

Foreclosed assets held-for-sale aggregated $1.8 million at March 31, 2016 and $1.1 million at December 31, 2015. The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale:

*(dollars in thousands)*

|  | March 31, 2016 Amount | # | December 31, 2015 Amount | # |
| --- | ---: | ---: | ---: | ---: |
| Balance at beginning of period | **$1,074** | **14** | $1,961 | 12 |
| Additions | **692** | **6** | 466 | 10 |
| Pay downs | **-** |  | (1) |  |
| Write downs | **-** |  | (37) |  |
| Sold | **-** |  | (1,315) | (8) |
| Balance at end of period | **$1,766** | **20** | $1,074 | 14 |

As of March 31, 2016, ORE consisted of twenty properties from eighteen unrelated borrowers totaling $1.8 million. Six of these properties ($0.7 million) were added in 2016; six were added in 2015 ($0.4 million); three were added in 2014 ($0.1 million); two were added in 2013 ($0.2 million); two were added in 2012 ($0.3 million); and one was added in 2011 ($0.1 million). In addition, of the twenty properties, eleven ($1.3 million) were either listed for sale or awaiting listing, while the remaining properties (nine totaling $0.5 million) are either in litigation, awaiting closing, have disposition plans or are undergoing renovations.

There was no other repossessed assets held-for-sale at March 31, 2016 or December 31, 2015.

#### Other assets

The $2.1 million increase in other assets was due mostly to $1.4 million in higher residual values associated with recording new automobile leases, net of lease disposals, a $0.3 million increase in construction in process, a $0.5 million investment receivable that has not been settled yet and $0.3 million higher prepaid expenses.

### Funds Provided:

#### Deposits

The Company is a community based commercial depository financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Generally, deposits are obtained from consumers, businesses and public entities within the communities that surround the Company’s 10 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law. Deposit products consist of transaction accounts including: savings; clubs; interest-bearing checking; money market and non-interest bearing checking (DDA). The Company also offers short- and long-term time deposits or certificates of deposit (CDs). CDs are deposits with stated maturities which can range from seven days to ten years. Cash flow from deposits is influenced by economic conditions, changes in the interest rate environment, pricing and competition. To determine interest rates on its deposit products, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as short-term borrowings and long-term FHLB advances.

The following table represents the components of deposits as of the date indicated:

*(dollars in thousands)*

|  | March 31, 2016 Amount% |  | December 31, 2015 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Money market | **$138,685** | **20.8%** | $125,433 | 20.2% |
| Interest-bearing checking | **152,433** | **22.8** | 132,598 | 21.4 |
| Savings and clubs | **119,706** | **17.9** | 115,668 | 18.6 |
| Certificates of deposit | **99,729** | **14.9** | 104,202 | 16.8 |
| Total interest-bearing | **510,553** | **76.4** | 477,901 | 77.0 |
| Non-interest bearing | **157,358** | **23.6** | 142,774 | 23.0 |
| Total deposits | **$667,911** | **100.0%** | $620,675 | 100.0% |

Total deposits increased $47.2 million, or 8%, from $620.7 million at December 31, 2015 to $667.9 million at March 31, 2016. Growth in public fund accounts caused the increase from year end due to the seasonal timing of public tax deposits. Public non-interest bearing checking, public interest-bearing checking and public money market accounts increased $14.8 million, $21.8 million and $12.4 million. Tax deposits are usually received mid-quarter and retained for a short period of time with disbursements occurring shortly after they are received. The increase in public fund accounts was partially offset by a $4.5 million reduction in CDs. The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop creative programs for its customers. The Company’s focus of building a relationship of trust with its customers brought a few large deposits into the bank during 2015, with similar expectations for 2016. Although these deposits fluctuate depending on customer needs, the Company plans to continue to form these types of relationships with customers in order to grow the deposit base to fund loan growth. The Company expects moderate asset growth for the remainder of 2016 funded primarily by growth in transactional deposits.

Customers’ appetite for long-term time deposit products continues to be non-existent with a sustaining preference for non-maturing transaction deposits. The Company’s portfolio of CDs continues to decrease; having declined $4.5 million, or 5%, from year-end 2015. The Company expects CDs to continue to decline in 2016. The Company’s relationship strategy resulted in a successful bid for a large public CD account, but otherwise the low rate environment has basically enticed customers to vacate the CD marketplace. If rates continue to rise, demand for CDs may also increase thereby possibly increasing funding costs. The Company will continue to pursue strategies to grow and retain retail and business customers including the development of creative CD campaigns with an emphasis on deepening and broadening existing and creating new relationships.

The Company uses the Certificate of Deposit Account Registry Service (CDARS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum amount of $250,000 per person. In the CDARS program, deposits with varying terms and interest rates, originated in the Company’s own markets, are exchanged for deposits of other financial institutions that are members in the CDARS network. By placing the deposits in other participating institutions, the deposits of our customers are fully insured by the FDIC. In return for deposits placed with network institutions, the Company receives from network institutions deposits that are approximately equal in amount and are comprised of terms similar to those placed for our customers. Deposits the Company receives, or reciprocal deposits, from other institutions are considered brokered deposits by regulatory definitions. As of March 31, 2016 and December 31, 2015, CDARS represented $1.1 million, or less than 1%, and $3.4 million, or 1%, respectively, of total deposits.

Excluding CDARS, certificates of deposit accounts of $100,000 or more amounted to $50.0 million and $50.8 million at March 31, 2016 and December 31, 2015, respectively. Certificates of deposit of $250,000 or more amounted to $28.1 million and $31.7 million as of March 31, 2016 and December 31, 2015, respectively.

Including CDARS, approximately 48% of the CDs, with a weighted-average interest rate of 0.70%, are scheduled to mature in 2016 and an additional 23%, with a weighted-average interest rate of 0.73%, are scheduled to mature in 2017. Renewing CDs may re-price to lower or higher market rates depending on the rate on the maturing CD, the pace and direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative, non-term products. As noted, the widespread preference continues for customers with maturing CDs to hold their deposits in readily available transaction accounts. The Company does not expect significant CD growth during 2016, but will continue to develop CD promotional programs when the Company deems that it is economically feasible to do so or when demand exists. As with all promotions, the Company will consider the needs of the customers and simultaneously be mindful of the liquidity levels and the interest rate sensitivity exposure of the Company.

#### Borrowings

Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Company will borrow under customer repurchase agreements in the local market, short-term advances from the FHLB and other correspondent banks for asset growth and liquidity needs.

Repurchase agreements are non-insured interest-bearing liabilities that have a perfected security interest in qualified investments of the Company as required by the FDIC Depositor Protection Act of 2009. Repurchase agreements are offered through a sweep product. A sweep account is designed to ensure that on a daily basis, an attached DDA is adequately funded and excess funds are transferred, or swept, into an interest-bearing overnight repurchase agreement account. Due to the constant inflow and outflow of funds of the sweep product, their balances tend to be somewhat volatile, similar to a DDA. Customer liquidity is the typical cause for variances in repurchase agreements. In addition, short-term borrowings may include overnight balances which the Company may require to fund daily liquidity needs such as deposit and repurchase agreement cash outflow, loan demand and operations. Short-term borrowings decreased $15.4 million during 2016. Less borrowing was needed because of growth in public deposits during the first quarter of 2016.

The following table represents the components of borrowings as of the date indicated:

*(dollars in thousands)*

|  | March 31, 2016 Amount% |  | December 31, 2015 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Overnight borrowings | **$-** | **-%** | $22,289 | 79.0% |
| Securities sold under repurchase agreements | **12,765** | **100.0** | 5,915 | 21.0 |
| Total | **$12,765** | **100.0%** | $28,204 | 100.0% |

## Market risk

As filed, 27,423 characters.

#### Management of interest rate risk and market risk analysis.

The adequacy and effectiveness of an institution’s interest rate risk management process and the level of its exposures are critical factors in the regulatory evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy. Management believes the Company’s interest rate risk measurement framework is sound and provides an effective means to measure, monitor, analyze, identify and control interest rate risk in the balance sheet.

The Company is subject to the interest rate risks inherent in its lending, investing and financing activities. Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity. Interest rate risk management is an integral part of the asset/liability management process. The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position. Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations. The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.

*Asset/Liability Management.* One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income. The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and members of the board of directors. ALCO meets quarterly to monitor the relationship of interest sensitive assets to interest sensitive liabilities. The process to review interest rate risk is a regular part of managing the Company. Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect. In addition, there is an annual process to review the interest rate risk policy with the board of directors which includes limits on the impact to earnings from shifts in interest rates.

*Interest Rate Risk Measurement.* Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation. While each of the interest rate risk measurements has limitations, collectively, they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.

*Static Gap.* The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.

To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or re-price within given time intervals. A positive gap (asset sensitive) indicates that more assets will re-price during a given period compared to liabilities, while a negative gap (liability sensitive) indicates the opposite effect. The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest-sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread. At March 31, 2016, the Company maintained a one-year cumulative gap of positive (asset sensitive) $68.2 million, or 9%, of total assets. The effect of this positive gap position provided a mismatch of assets and liabilities which may expose the Company to interest rate risk during periods of falling interest rates. Conversely, in an increasing interest rate environment, net interest income could be positively impacted because more assets than liabilities will re-price upward during the one-year period.

Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table. Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees 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 interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table amounts. The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.

The following table illustrates the Company’s interest sensitivity gap position at March 31, 2016:

*(dollars in thousands)*

|  | Three months or less | More than three months to twelve months | More than one year to three years | More than three years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Cash and cash equivalents | $28,432 | $- | $- | $12,659 | $41,091 |
| Investment securities (1)(2) | 6,344 | 15,471 | 39,641 | 68,637 | 130,093 |
| Loans and leases(2) | 195,090 | 88,020 | 143,225 | 121,574 | 547,909 |
| Fixed and other assets | - | 11,169 | - | 33,120 | 44,289 |
| Total assets | $229,866 | $114,660 | $182,866 | $235,990 | $763,382 |
| Total cumulative assets | $229,866 | $344,526 | $527,392 | $763,382 |  |
| Non-interest-bearing transaction deposits (3) | $- | $15,752 | $43,242 | $98,364 | $157,358 |
| Interest-bearing transaction deposits (3) | 170,184 | 20,712 | 148,378 | 71,550 | 410,824 |
| Certificates of deposit | 17,546 | 39,347 | 26,707 | 16,129 | 99,729 |
| Repurchase agreements | 12,765 | - | - | - | 12,765 |
| Other liabilities | - | - | - | 4,397 | 4,397 |
| Total liabilities | $200,495 | $75,811 | $218,327 | $190,440 | $685,073 |
| Total cumulative liabilities | $200,495 | $276,306 | $494,633 | $685,073 |  |
| Interest sensitivity gap | $29,371 | $38,849 | $(35,461) | $45,550 |  |
| Cumulative gap | $29,371 | $68,220 | $32,759 | $78,309 |  |
| Cumulative gap to total assets | 3.8% | 8.9% | 4.3% | 10.3% |  |

(1) Includes FHLB stock and the net unrealized gains/losses on available-for-sale securities.

(2) Investments and loans are included in the earlier of the period in which interest rates were next scheduled to adjust or the period in which they are due. In addition, loans were included in the periods in which they are scheduled to be repaid based on scheduled amortization. For amortizing loans and MBS – GSE residential, annual prepayment rates are assumed reflecting historical experience as well as management’s knowledge and experience of its loan products.

(3) The Company’s demand and savings accounts were generally subject to immediate withdrawal. However, management considers a certain amount of such accounts to be core accounts having significantly longer effective maturities based on the retention experiences of such deposits in changing interest rate environments. The effective maturities presented are the recommended maturity distribution limits for non-maturing deposits based on historical deposit studies.

*Earnings at Risk and Economic Value at Risk Simulations.* The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.

*Earnings at Risk.* An earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.

*Economic Value at Risk.* An earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.

The following table illustrates the simulated impact of an immediate 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity). This analysis assumed that interest-earning asset and interest-bearing liability levels at March 31, 2016 remained constant. The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the March 31, 2016 levels:

| Earnings at risk: | % change Rates +200 | Rates -200 |
| --- | ---: | ---: |
| Net interest income | 6.0% | (2.6)% |
| Net income | 15.8 | (6.5) |
| Economic value at risk: |  |  |
| Economic value of equity | (3.4) | (23.8) |
| Economic value of equity as a percent of total assets | (0.4) | (3.0) |

Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%. At March 31, 2016, the Company’s risk-based capital ratio was 15.1%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning April 1, 2016, under alternate interest rate scenarios using the income simulation model described above:

*(dollars in thousands)*

| Simulated change in interest rates | Net interest income | $% variance | variance |
| --- | ---: | ---: | ---: |
| +200 basis points | $26,238 | $1,478 | 6.0% |
| +100 basis points | 25,450 | 690 | 2.8 |
| Flat rate | 24,760 | - | - |
| -100 basis points | 24,252 | (508) | (2.1) |
| -200 basis points | 24,124 | (636) | (2.6) |

Simulation models require assumptions about certain categories of assets and liabilities. The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity. MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Company uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and interest-bearing checking accounts do not have stated maturities or re-pricing terms and can be withdrawn or re-price at any time. This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates. As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.

#### Liquidity

Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities, facility expansion and normal operating expenses. Sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans HFS, investments AFS, growth of core deposits and repurchase agreements, utilization of borrowing capacities from the FHLB, correspondent banks, CDARs, the Discount Window of the Federal Reserve Bank of Philadelphia (FRB) and proceeds from the issuance of capital stock. Though regularly scheduled investment and loan payments are dependable sources of daily liquidity, sales of both loans HFS and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions including the interest rate environment. During low and declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity that can be used to invest in other interest-earning assets but at lower market rates. Conversely, in periods of high or rising interest rates, prepayments from interest-sensitive assets tend to decelerate causing prepayment cash flows from mortgage loans and mortgage-backed securities to decrease. Rising interest rates may also cause deposit inflow but priced at higher market interest rates or could also cause deposit outflow due to higher rates offered by the Company’s competition for similar products. The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.

The Company’s contingency funding plan (CFP) sets a framework for handling liquidity issues in the event circumstances arise which the Company deems to be less than normal. The Company established guidelines for identifying, measuring, monitoring and managing the resolution of potentially serious liquidity crises. The CFP outlines required monitoring tools, acceptable alternative funding sources and required actions during various liquidity scenarios. Thus, the Company has implemented a proactive means for the measurement and resolution for handling potentially significant adverse liquidity conditions. At least quarterly, the CFP monitoring tools, current liquidity position and monthly projected liquidity sources and uses are presented and reviewed by the Company’s Asset/Liability Committee. As of March 31, 2016, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.

During the three months ended March 31, 2016, the Company acquired $28.8 million of cash. During the period, the Company’s operations provided approximately $1.5 million mostly from $6.6 million of net cash inflow from the components of net interest income and $0.8 million in proceeds of loans HFS over originations; partially offset by net non-interest expense/income related payments of $4.5 million and a $1.4 million increase in the residual value from the Company’s automobile leasing activities. Cash inflow from interest-earning assets and growth in deposits were used to replace maturing and cash runoff of investment securities, reduce short-term borrowings and net dividend payments. The Company received a large amount of public deposits during the first quarter of 2016 which are expected to be taken out during the second quarter of 2016. The seasonal nature of deposits from municipalities and other public funding sources requires the Company to be prepared for the inherent volatility and the unpredictable timing of cash outflow from this customer base. Accordingly, the use of short-term overnight borrowings could be used to fulfill funding gap needs. The CFP is a tool to help the Company ensure that alternative funding sources are available to meet its liquidity needs.

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy. These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk. In accordance with GAAP, these instruments are either not recorded in the consolidated financial statements or are recorded in amounts that differ from the notional amounts. Such instruments primarily include lending commitments and lease obligations.

Lending commitments include commitments to originate loans and commitments to fund unused lines of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

In addition to lending commitments, the Company has contractual obligations related to operating lease commitments. Operating lease commitments are obligations under various non-cancelable operating leases on buildings and land used for office space and banking purposes. The Company’s position with respect to lending commitments and significant contractual lease obligations, both on a short- and long-term basis has not changed materially from December 31, 2015.

As of March 31, 2016, the Company maintained $41.1 million in cash and cash equivalents and $129.9 million of investments AFS and loans HFS. Also as of March 31, 2016, the Company had approximately $190.6 million available to borrow from the FHLB, $21.0 million from correspondent banks, $29.9 million from the FRB and $36.5 million from the CDARS program. The combined total of $449.0 million represented 59% of total assets at March 31, 2016. Management believes this level of liquidity to be strong and adequate to support current operations.

#### Capital

During the quarter ended March 31, 2016, total shareholders' equity increased $2.0 million, or 3%, due principally from the $1.7 million in net income added into retained earnings and $0.7 million in after-tax unrealized gains in the Company’s investment portfolio. Capital was further enhanced by $0.1 million from investments in the Company’s common stock via the Employee Stock Purchase (ESPP) and $0.1 million from stock options exercised and stock-based compensation expense from the ESPP and unvested restricted stock and SSARS. These items were partially offset by $0.7 million of cash dividends declared on the Company’s common stock. The Company’s dividend payout ratio, defined as the rate at which current earnings is paid to shareholders, was 39% for the three months ended March 31, 2016. The balance of earnings is retained to further strengthen the Company’s capital position.

As of March 31, 2016, the Company reported a net unrealized gain position of $2.9 million, net of tax, from the securities AFS portfolio compared to a net unrealized gain of $2.2 million as of December 31, 2015. The improvement during 2016 was from all security types. Management believes that changes in fair value of the Company’s securities are due to changes in interest rates and not in the creditworthiness of the issuers. Generally, when U.S. Treasury rates rise, investment securities’ pricing declines and fair values of investment securities also decline. While volatility has existed in the yield curve within the past twelve months, a rising rate environment is inevitable and during the period of rising rates, the Company expects pricing in the bond portfolio to decline. There is no assurance that future realized and unrealized losses will not be recognized from the Company’s portfolio of investment securities. To help maintain a healthy capital position, the Company can issue stock to participants in the DRP and ESPP plans. The DRP affords the Company the option to acquire shares in open market purchases and/or issue shares directly from the Company to plan participants. During 2016, the Company purchased all of the shares in the open market to fulfill the needs of the DRP. Both the DRP and the ESPP plans have been a consistent source of capital from the Company’s loyal employees and shareholders and their participation in these plans will continue to help strengthen the Company’s balance sheet.

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets. The guidelines require all banks and bank holding companies to maintain a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I common equity to total risk-weighted assets (Tier I Common Equity) of 4.5%, Tier I capital to total risk-weighted assets (Tier I Capital) of 6% and Tier I capital to average total assets (Leverage Ratio) of at least 4%. As of March 31, 2016 and 2015, the Company and the Bank exceeded all capital adequacy requirements to which it was subject.

In July 2013, the federal bank regulatory agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. Under the final rules, which became effective for the Company on January 1, 2015 and are subject to a phase-in period through January 1, 2019, minimum requirements increased for both the quantity and quality of capital held by the Company. The rules require all banks and bank holding companies to maintain a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raise the minimum ratio of Tier 1 capital to risk-weighted assets (Tier I capital) from 4.0% to 6.0%, require a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Based Capital) of 8.0%, and require a minimum Tier I capital to average total assets (Leverage Ratio) of 4.0%. A new capital conservation buffer, comprised of common equity Tier I capital, is also established above the regulatory minimum capital requirements. The rule increases the minimum Tier 1 capital to risk-based assets requirement with a capital conservation buffer to 8.5% by 2019 and increases the minimum total capital requirement with a capital conservation buffer to 10.5% by 2019 and assigns higher risk-weightings to certain assets: certain past due and commercial real estate loans and some equity exposures.

The Company continues to closely monitor and evaluate alternatives to enhance its capital ratios as the regulatory and economic environments change. The following table depicts the capital amounts and ratios of the Company and the Bank as of March 31, 2016:

*(dollars in thousands)*

| As of March 31, 2016 Total capital (to risk-weighted assets) | Actual Amount | Ratio | For capital adequacy purposes Amount |  | Ratio |  | To be well capitalized under prompt corrective action provisions Amount |  | Ratio |  |
| --- | ---: | ---: | --- | ---: | --- | ---: | --- | ---: | --- | ---: |
| Consolidated | **$82,227** | **15.1%** | **≥** | **$43,438** | **≥** | **8.0%** |  | **N/A** |  | **N/A** |
| Bank | **$81,747** | **15.1%** | **≥** | **$43,389** | **≥** | **8.0%** | **≥** | **$54,237** | **≥** | **10.0%** |
| Tier 1 common equity (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$75,406** | **13.9%** | **≥** | **$24,434** | **≥** | **4.5%** |  | **N/A** |  | **N/A** |
| Bank | **$74,934** | **13.8%** | **≥** | **$24,406** | **≥** | **4.5%** | **≥** | **35,254** | **≥** | **6.5%** |
| Tier I capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$75,406** | **13.9%** | **≥** | **$44,916** | **≥** | **6.0%** |  | **N/A** |  | **N/A** |
| Bank | **$74,934** | **13.8%** | **≥** | **$44,876** | **≥** | **6.0%** | **≥** | **$59,835** | **≥** | **8.0%** |
| Tier I capital (to average assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$75,406** | **10.1%** | **≥** | **$29,944** | **≥** | **4.0%** |  | **N/A** |  | **N/A** |
| Bank | **$74,934** | **10.0%** | **≥** | **$29,918** | **≥** | **4.0%** | **≥** | **$37,397** | **≥** | **5.0%** |

| As of December 31, 2015: Total capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| --- | ---: | ---: | --- | ---: | --- | ---: | --- | ---: | --- | ---: |
| Consolidated | $81,074 | 15.0% | ≥ | $43,278 | ≥ | 8.0% |  | N/A |  | N/A |
| Bank | $80,547 | 14.9% | ≥ | $43,306 | ≥ | 8.0% | ≥ | $54,132 | ≥ | 10.0% |
| Tier 1 common equity (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $74,163 | 13.7% | ≥ | $24,344 | ≥ | 4.5% |  | N/A |  | N/A |
| Bank | $73,744 | 13.6% | ≥ | $24,360 | ≥ | 4.5% | ≥ | $35,186 | ≥ | 6.5% |
| Tier I capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $74,163 | 13.7% | ≥ | $43,723 | ≥ | 6.0% |  | N/A |  | N/A |
| Bank | $73,744 | 13.6% | ≥ | $43,635 | ≥ | 6.0% | ≥ | $58,180 | ≥ | 8.0% |
| Tier I capital (to average assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $74,163 | 10.2% | ≥ | $29,149 | ≥ | 4.0% |  | N/A |  | N/A |
| Bank | $73,744 | 10.1% | ≥ | $29,090 | ≥ | 4.0% | ≥ | $36,362 | ≥ | 5.0% |

The Company advises readers to refer to the Supervision and Regulation section of Management’s Discussion and Analysis of Financial Condition and Results of Operation, of its 2015 Form 10-K for a discussion on the regulatory environment and recent legislation and rulemaking.

## Controls and procedures

As filed, 1,065 characters.

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company’s management, with the participation of its President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934. Based on such evaluation, the President and Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations, and are effective. The Company made no changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended March 31, 2016.

## Risk factors

As filed, 210 characters.

Management of the Company does not believe there have been any material changes to the risk factors that were disclosed in the 2015 Form 10-K filed with the Securities and Exchange Commission on March 15, 2016.

Filed May 6, 2016.
Source: SEC EDGAR, the filing index for accession 0001098151-16-000070. Last ingested by Listed: Nov 6, 2026, 18:40 ET. No prices; not investment advice.