# Fidelity D & D Bancorp Inc: Form 10-Q for the period ended Jun 30, 2017

- Company: [Fidelity D & D Bancorp Inc](/companies/fdbc.md) (CIK 1098151)
- Form: 10-Q
- Filed: 2017-08-08
- Accepted by EDGAR: Aug 8, 2017, 16:37 ET
- Period: 2017-06-30
- Accession: 0001098151-17-000038
- Inline XBRL: yes
- Main document: https://www.sec.gov/Archives/edgar/data/1098151/000109815117000038/fdbc-20170630x10q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1098151/000109815117000038/

## Figures reported in this filing

Standardized XBRL line items for the period ended 2017-06-30.

| Line item | Period | Value | XBRL concept |
| --- | --- | ---: | --- |
| Interest expense | 3 months, 2017-04-01 to 2017-06-30 | $787.0k | us-gaap:InterestExpense |
| Interest expense | 6 months, 2017-01-01 to 2017-06-30 | $1.5m | us-gaap:InterestExpense |
| Income tax | 3 months, 2017-04-01 to 2017-06-30 | $739.0k | us-gaap:IncomeTaxExpenseBenefit |
| Income tax | 6 months, 2017-01-01 to 2017-06-30 | $1.4m | us-gaap:IncomeTaxExpenseBenefit |
| Net income | 3 months, 2017-04-01 to 2017-06-30 | $2.2m | us-gaap:NetIncomeLoss |
| Net income | 6 months, 2017-01-01 to 2017-06-30 | $4.2m | us-gaap:NetIncomeLoss |
| Diluted EPS | 3 months, 2017-04-01 to 2017-06-30 | $0.88 | us-gaap:EarningsPerShareDiluted |
| Diluted EPS | 6 months, 2017-01-01 to 2017-06-30 | $1.68 | us-gaap:EarningsPerShareDiluted |
| Basic EPS | 3 months, 2017-04-01 to 2017-06-30 | $0.89 | us-gaap:EarningsPerShareBasic |
| Basic EPS | 6 months, 2017-01-01 to 2017-06-30 | $1.69 | us-gaap:EarningsPerShareBasic |
| Diluted shares (weighted) | 3 months, 2017-04-01 to 2017-06-30 | 2,482,594 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Diluted shares (weighted) | 6 months, 2017-01-01 to 2017-06-30 | 2,479,236 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Capital expenditure | 6 months, 2017-01-01 to 2017-06-30 | $472.0k | us-gaap:PaymentsToAcquirePropertyPlantAndEquipment |
| Cash and equivalents | at 2017-06-30 | $14.9m | us-gaap:CashAndCashEquivalentsAtCarryingValue |
| Total assets | at 2017-06-30 | $855.5m | us-gaap:Assets |
| Total liabilities | at 2017-06-30 | $771.3m | us-gaap:Liabilities |
| Short-term borrowings | at 2017-06-30 | $34.5m | us-gaap:ShortTermBorrowings |
| Shareholders' equity | at 2017-06-30 | $84.1m | us-gaap:StockholdersEquity |

## Management's discussion and analysis

As filed, 83,819 characters.

The following is management's discussion and analysis of the significant changes in the consolidated financial condition of the Company as of June 30, 2017 compared to December 31, 2016 and a comparison of the results of operations for the three and six months ended June 30, 2017 and 2016. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2016 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. Currently, the Company is constructing a new branch in Dallas, PA in order to expand our presence in Luzerne County, which is expected to open in the first quarter of 2018.

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. The Federal Open Market Committee (FOMC) adjusted the short-term federal funds rate up 50 basis points so far during 2017. Expectations are for short-term rates to rise once more this year, potentially pressuring deposit rate pricing. The national unemployment rate for June 2017 was 4.4%, down from 4.7% at December 2016. However, the unemployment rate in Scranton - Wilkes-Barre Metropolitan Statistical Area (local) increased during the first six months of 2017 and continued to lag behind the unemployment rates of the state and nation. According to the U.S. Bureau of Labor Statistics, the local unemployment rate at June 30, 2017 was 5.7%, an increase of 0.3 percentage points from 5.4% at December 31, 2016. During the first half of 2017, there was an increase in the labor force, but employment decreased which caused the unemployment rate to rise. Seasonal fluctuations in unemployment are expected. On the upside, the local unemployment rate decreased year-over-year from 6.4% as of June 30, 2016. The median home values in the region have gone up 4% over the past year, 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 3.3% 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 2016 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 mainly 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 and six months ended June 30, 2017 and 2016

### Overview

For the second quarter of 2017, the Company generated $2.2 million in net income, or $0.88 per diluted share, an increase of $0.3 million over the $1.9 million, or $0.79 per diluted share, generated for the second quarter of 2016. Net income also grew during the first half of 2017 to $4.2 million, or $1.68 per diluted share, an increase of $0.6 million, or 15%, compared to $3.6 million, or $1.48 per diluted share, for the first half of 2016. In the quarter comparison, the increase was due to growth in net interest income which more than offset higher non-interest expenses. In the year-to-date comparison, higher net interest income combined with additional non-interest income was partially offset by higher non-interest expenses.

Return on average assets (ROA) was 1.04% and 1.03% for the second quarters of 2017 and 2016, respectively, and 1.01% and 0.97% for the six months ended June 30, 2017 and 2016, respectively. Return on average shareholders’ equity (ROE) was 10.49% and 9.80% for the second quarters of 2017 and 2016, respectively, and 10.18% and 9.32% for the six months ended June 30, 2017, respectively. In both periods, ROA and ROE increased because of net income growth.

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

For the second quarter of 2017, net interest income increased $0.9 million, or 15%, to $7.1 million from $6.2 million for the second quarter of 2016, due to higher interest income which more than offset increased interest expenses. The $1.2 million increase in interest income was produced by the addition of $82.7 million in total average interest-earning assets combined with a higher yield earned on these assets. The loan portfolio experienced average balance growth of $68.0 million along with a four basis point higher yield which contributed an additional $0.8 million to interest income. Higher average balances of higher-yielding securities also produced $0.4 million more interest income from investments. On the liability side, total average interest-bearing liabilities were $71.1 million higher with a nine basis point increase in average rates paid which resulted in $0.2 million more interest expense for the quarter ended June 30, 2017 compared to the 2016 like period.

Net interest income increased $1.5 million, or 12%, to $13.8 million for the six months ended June 30, 2017 compared to $12.3 million for the same 2016 period. As in the quarter comparison, the growth in average interest-earning assets and the higher yields earned thereon produced $1.8 million more in interest income. The loan portfolio experienced average balance growth of $61.5 million which had the effect of producing $1.2 million in income despite the negative impact of a four basis point decline in yield. The average balance of total investments grew $27.2 million, mostly in higher yielding mortgage-backed securities, resulting in another $0.7 million in interest income. Interest income growth was partially offset by $0.3 million in additional interest expense. The higher interest expense is primarily attributable to $42.3 million more in average borrowings which resulted in $0.2 million more interest expense. Larger average interest-bearing deposits with higher rates contributed another $0.1 million to interest expense.

The fully-taxable equivalent (FTE) net interest rate spread increased by eight and five basis points for the three and six months ended June 30, 2017, respectively, compared to the same 2016 periods. The spread was higher in both periods because yields on interest-earning assets increased faster than rates paid on interest-bearing liabilities. The FTE net interest rate margin increased by ten and six basis points for the three and six months ended June 30, 2017, respectively, compared to the 2016 like periods. Margin growth resulted from a higher-yielding larger average portfolio of interest-earning assets. The overall cost of funds, which includes the impact of non-interest bearing deposits, increased eight and five basis points for the three and six months ended June 30, 2017, respectively, compared to the same 2016 periods. The main reason for the increase was higher average borrowings which were used to fund asset growth. During the first half of 2017, the Company used long-term debt to purchase securities and short-term borrowings to temporarily fund loan growth over deposit growth.

For the second half of 2017, the Company expects to operate in a gradually increasing interest rate environment. A rate environment with rising interest rates positions the Company to improve its interest income performance from new and maturing 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 experience compression. However for 2017, the Company anticipates net interest income to improve as growth in interest-earning assets would help mitigate an adverse impact of rate movements on cost of funds. The Federal Open Market Committee (FOMC) has been gradually increasing the short-term federal funds rate since the end of 2015, but it had a minimal effect on rates paid on funding sources. On the asset side, the prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans, rose 25 basis points in March 2017 and another 25 basis points in June 2017. The focus for the remainder of 2017 is to manage net interest income after years of a sustained low interest rate environment by maintaining a reasonable spread. Interest expense is projected to increase for 2017 from growth in deposits and borrowings and an increase in rates paid on both. Continued growth in the loan portfolios complemented with investment security growth is expected to boost interest income, and when coupled with a proactive relationship approach to deposit cost setting strategies should help contain the interest rate margin at acceptable levels.

The Company’s cost of interest-bearing liabilities was 53 basis points and 51 basis points for the three and six months ended June 30, 2017, respectively, and 44 basis points and 45 basis points for the three and six months ended June 30, 2016, respectively. The increase during both periods was due to an increase in average borrowings. 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 and it is unlikely in the short-term. Interest rates along the treasury yield curve have been volatile with shorter-term rates rising faster than long-term rates producing a flatter yield curve during 2017. Competition could pressure banks to increase deposit rates. If rates continue to rise in 2017, 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. The FTE adjustment to interest income was $325 thousand and $280 thousand for the second quarters of 2017 and 2016, respectively, and $634 thousand and $560 thousand for the six months ended June 30, 2017 and 2016, respectively. 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 $132 thousand and $123 thousand for the second quarters of 2017 and 2016, respectively, and $240 thousand and $236 thousand for the first halves of 2017 and 2016, respectively, are included in interest income from loans. 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 June 30, 2017 Average balance | Interest | Yield / rate | June 30, 2016 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$2,095** | **$4** | **0.88%** | $18,012 | $24 | 0.53% |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **18,185** | **64** | **1.42** | 18,365 | 59 | 1.29 |
| MBS - GSE residential | **91,721** | **594** | **2.60** | 70,198 | 307 | 1.76 |
| State and municipal (nontaxable) | **42,120** | **577** | **5.49** | 34,989 | 494 | 5.68 |
| Other | **3,732** | **45** | **4.78** | 1,532 | 22 | 5.90 |
| Total investments | **155,758** | **1,280** | **3.29** | 125,084 | 882 | 2.84 |
| Loans and leases: |  |  |  |  |  |  |
| Commercial and commercial real estate (taxable) | **295,892** | **3,506** | **4.75** | 275,568 | 3,002 | 4.38 |
| Commercial and commercial real estate (nontaxable) | **32,794** | **329** | **4.02** | 27,319 | 293 | 4.31 |
| Consumer | **101,261** | **1,051** | **4.16** | 68,520 | 923 | 5.42 |
| Residential real estate | **200,572** | **2,009** | **4.02** | 191,154 | 1,871 | 3.94 |
| Total loans and leases | **630,519** | **6,895** | **4.39** | 562,561 | 6,089 | 4.35 |
| Federal funds sold | **-** | **-** | **-** | - | - | - |
| Total interest-earning assets | **788,372** | **8,179** | **4.16%** | 705,657 | 6,995 | 3.99% |
| Non-interest earning assets | **57,535** |  |  | 48,704 |  |  |
| **Total assets** | **$845,907** |  |  | $754,361 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Interest-bearing checking | **$188,950** | **$176** | **0.37%** | $155,447 | $111 | 0.29% |
| Savings and clubs | **127,701** | **41** | **0.13** | 119,620 | 37 | 0.12 |
| MMDA | **117,113** | **183** | **0.62** | 138,782 | 205 | 0.60 |
| Certificates of deposit | **101,933** | **243** | **0.96** | 98,846 | 214 | 0.87 |
| Total interest-bearing deposits | **535,697** | **643** | **0.48** | 512,695 | 567 | 0.44 |
| Repurchase agreements | **9,333** | **5** | **0.21** | 8,821 | 4 | 0.20 |
| Borrowed funds | **47,950** | **139** | **1.16** | 341 | 3 | 4.05 |
| Total interest-bearing liabilities | **592,980** | **787** | **0.53%** | 521,857 | 574 | 0.44% |
| Non-interest bearing deposits | **163,869** |  |  | 148,703 |  |  |
| Non-interest bearing liabilities | **5,603** |  |  | 4,713 |  |  |
| Total liabilities | **762,452** |  |  | 675,273 |  |  |
| Shareholders' equity | **83,455** |  |  | 79,088 |  |  |
| **Total liabilities and shareholders' equity** | **$845,907** |  |  | $754,361 |  |  |
| Net interest income - FTE |  | **$7,392** |  |  | $6,421 |  |
| Net interest spread |  |  | **3.63%** |  |  | 3.55% |
| Net interest margin |  |  | **3.76%** |  |  | 3.66% |
| Cost of funds |  |  | **0.42%** |  |  | 0.34% |

37

*(dollars in thousands)*

| Assets Interest-earning assets | Six months ended June 30, 2017 Average balance | Interest | Yield / rate | June 30, 2016 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$2,083** | **$10** | **1.01%** | $17,376 | $46 | 0.53% |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **18,237** | **128** | **1.41** | 18,408 | 112 | 1.22 |
| MBS - GSE residential | **88,648** | **1,149** | **2.61** | 69,429 | 624 | 1.81 |
| State and municipal (nontaxable) | **41,151** | **1,122** | **5.50** | 34,984 | 990 | 5.69 |
| Other | **3,623** | **71** | **3.95** | 1,620 | 46 | 5.67 |
| Total investments | **151,659** | **2,470** | **3.28** | 124,441 | 1,772 | 2.86 |
| Loans and leases: |  |  |  |  |  |  |
| Commercial and commercial real estate (taxable) | **293,955** | **6,720** | **4.61** | 276,785 | 6,070 | 4.41 |
| Commercial and commercial real estate (nontaxable) | **30,923** | **648** | **4.22** | 27,260 | 583 | 4.30 |
| Consumer | **97,669** | **2,052** | **4.24** | 67,061 | 1,834 | 5.50 |
| Residential real estate | **199,053** | **3,954** | **4.01** | 189,030 | 3,706 | 3.94 |
| Total loans and leases | **621,600** | **13,374** | **4.34** | 560,136 | 12,193 | 4.38 |
| Federal funds sold | **-** | **-** | **-** | - | - | - |
| Total interest-earning assets | **775,342** | **15,854** | **4.12%** | 701,953 | 14,011 | 4.01% |
| Non-interest earning assets | **54,741** |  |  | 48,642 |  |  |
| **Total assets** | **$830,083** |  |  | $750,595 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Interest-bearing checking | **$183,088** | **$341** | **0.38%** | $155,037 | $213 | 0.28% |
| Savings and clubs | **125,289** | **79** | **0.13** | 118,439 | 74 | 0.13 |
| MMDA | **116,524** | **362** | **0.63** | 133,208 | 422 | 0.64 |
| Certificates of deposit | **97,814** | **447** | **0.92** | 101,122 | 438 | 0.87 |
| Total interest-bearing deposits | **522,715** | **1,229** | **0.47** | 507,806 | 1,147 | 0.45 |
| Repurchase agreements | **11,491** | **12** | **0.21** | 11,766 | 12 | 0.21 |
| Borrowed funds | **43,734** | **234** | **1.08** | 1,388 | 13 | 1.86 |
| Total interest-bearing liabilities | **577,940** | **1,475** | **0.51%** | 520,960 | 1,172 | 0.45% |
| Non-interest bearing deposits | **164,103** |  |  | 146,796 |  |  |
| Non-interest bearing liabilities | **5,553** |  |  | 4,554 |  |  |
| Total liabilities | **747,596** |  |  | 672,310 |  |  |
| Shareholders' equity | **82,487** |  |  | 78,285 |  |  |
| **Total liabilities and shareholders' equity** | **$830,083** |  |  | $750,595 |  |  |
| Net interest income - FTE |  | **$14,379** |  |  | $12,839 |  |
| Net interest spread |  |  | **3.61%** |  |  | 3.56% |
| Net interest margin |  |  | **3.74%** |  |  | 3.68% |
| Cost of funds |  |  | **0.40%** |  |  | 0.35% |

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:

38

*(dollars in thousands)*

| Interest income: | Six months ended June 30, 2017 compared to 2016 Increase (decrease) due to Volume | Rate | Total | 2016 compared to 2015 Volume | Rate | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$(58)** | **$22** | **$(36)** | $7 | $22 | $29 |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **(1)** | **17** | **16** | 8 | (5) | 3 |
| MBS - GSE residential | **201** | **324** | **525** | 76 | 124 | 200 |
| State and municipal | **107** | **(27)** | **80** | (4) | (5) | (9) |
| Other | **40** | **(14)** | **26** | (35) | (23) | (58) |
| Total investments | **347** | **300** | **647** | 45 | 91 | 136 |
| Loans and leases: |  |  |  |  |  |  |
| Residential real estate | **188** | **59** | **247** | 242 | (49) | 193 |
| Commercial and CRE | **442** | **250** | **692** | 551 | (180) | 371 |
| Consumer | **704** | **(485)** | **219** | (1) | (19) | (20) |
| Total loans and leases | **1,334** | **(176)** | **1,158** | 792 | (248) | 544 |
| Total interest income | **1,623** | **146** | **1,769** | 844 | (135) | 709 |
| Interest expense: |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Interest-bearing checking | **44** | **84** | **128** | 37 | 33 | 70 |
| Savings and clubs | **4** | **1** | **5** | 4 | (34) | (30) |
| Money market | **(51)** | **(9)** | **(60)** | 53 | 22 | 75 |
| Certificates of deposit | **(15)** | **24** | **9** | (4) | (29) | (33) |
| Total deposits | **(18)** | **100** | **82** | 90 | (8) | 82 |
| Repurchase agreements | **-** | **-** | **-** | (1) | 1 | - |
| Borrowed funds | **229** | **(8)** | **221** | (171) | (83) | (254) |
| Total interest expense | **211** | **92** | **303** | (82) | (90) | (172) |
| Net interest income | **$1,412** | **$54** | **$1,466** | $926 | $(45) | $881 |

#### 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 six months ended June 30, 2017 and 2016, the Company recorded a provision for loan losses of $0.5 million and $0.4 million, respectively. The provision increased $0.1 million during comparable periods primarily because of growth in gross loans. At the same time, the allowance for loan and lease losses did not require additional funding beyond that required from the aforementioned growth due to stable year-over-year asset quality. This was evidenced by a consistent ratio of non-performing loans as a percentage of total loans, which was 1.06% at both June 30, 2017 and 2016. Although the coverage ratio of the allowance as a percentage of non-accrual loans decreased to 1.44x at June 30, 2017 from 1.56x at June 30, 2016, management determined that this coverage ratio was adequate, due to the larger amount of collateral support at June 30, 2017, and that no further provision expense was required. 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 second quarter of 2017, non-interest income amounted to $2.1 million, unchanged from the second quarter of 2016. Increases in trust income of $0.1 million and earnings on bank owned life insurance (BOLI) of $0.1 million were offset by $0.1 million less in financial services revenue and $0.1 million less loan service charges.

Non-interest income amounted to $4.2 million for the six months ended June 30, 2017, an increase of $0.4 million, or 12%, from the $3.8 million recorded for the same 2016 period. The increase was due to $0.1 million more gains on the sale of loans, $0.1 million in additional trust revenue, $0.1 million higher service charges on deposits, $0.1 million more interchange fees and an increase of $0.1 million in BOLI earnings. These increases were partially offset by $0.1 million less loan service fees.

#### Other operating expenses

For the three months ended June 30, 2017, non-interest expenses increased $0.7 million, or 13%, compared to the three months ended June 30, 2016 from $5.4 million to $6.1 million. Salaries and employee benefits grew $0.3 million during the second quarter of 2017 to $3.2 million from $2.9 million during the second quarter of 2016. The increase resulted from more seasonal hires and employees hired in previously open management positions, annual merit increases, increased incentive compensation plus additional expenses for a retirement benefit plan that was implemented in the first quarter of 2017. Advertising and marketing expenses increased $0.1 million due to donations that were made during the second quarter of 2017 through the Educational Improvement Tax Credit (EITC) program that were not made in the second quarter of 2016. Professional fees were $0.1 million higher during the second quarter of 2017 due to one-time professional fees incurred. Premises and equipment expense increased $0.1 million mostly due to higher real estate taxes, maintenance and lease payments. These increases were partially offset by $0.1 million less PA shares tax expense due to tax credits received in the second quarter of 2017 for EITC donations.

For the six months ended June 30, 2017, non-interest expenses increased $1.1 million, or 10%, compared to the six months ended June 30, 2016, from $10.7 million to $11.8 million. Salaries and employee benefits increased $0.6 million, from $5.7 million for the first six months of 2016 to $6.3 million for the same 2017 period. The increase stemmed from select staff additions or replacements to previously vacant positions, annual merit increases, one-time salary increases awarded to certain employees in the normal course of performance management and added retirement benefits. Data processing and communications increased $0.1 million due to additional costs related to a new integrated dealer lending program and higher data center costs incurred during 2017. Premises and equipment increased $0.2 million due to additional expenses for building maintenance, repairs, real estate taxes and lease payments. Professional fees were $0.1 million higher due to the non-recurring expenses incurred in 2017. Automated transaction processing also increased $0.1 million for the six months ended June 30, 2017 compared to the 2016 like period due to expenses incurred related to updating customer debit cards with the new chip technology and increased debit card activity during 2017. Advertising and marketing was up $0.1 million during the six months ended June 30, 2017 because of the EITC donations mentioned above which were offset by a PA shares tax credit. Partially offsetting these increases was a $0.1 million decrease in the FDIC assessment.

The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at June 30, 2017 and 2016 were 1.83% and 1.87%, respectively. The expense ratio decreased due to higher average assets which were able to absorb the higher non-interest expenses. The efficiency ratio also decreased from 64.75% at June 30, 2016 to 63.17% at June 30, 2017 due to higher revenue.

### Comparison of financial condition at

### June 30, 2017 and December 31, 2016

#### Overview

Consolidated assets increased $62.5 million, or 8%, to $855.4 million as of June 30, 2017 from $792.9 million at December 31, 2016. The increase in assets occurred in the loan and investment portfolios and bank owned life insurance utilizing growth in deposits of $4.0 million, borrowings of $53.9 million and $2.6 million in retained earnings, net of dividends declared. Borrowings consisted of $23.7 million in long-term debt and $30.2 million in additional short-term borrowings. For the second half of 2017, the Company expects to use core deposit growth to pay down short-term borrowings.

### 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. All 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 June 30, 2017, the carrying value of investment securities amounted to $153.4 million, or 18% of total assets, compared to $130.0 million, or 16% of total assets, at December 31, 2016. On June 30, 2017, 59% 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 June 30, 2017. The AFS securities were recorded with a net unrealized gain of $2.8 million and $2.1 million as of June 30, 2017 and December 31, 2016, or a net improvement of $0.7 million during the first six months of 2017. 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 decline, especially at the intermediate and long end, the values of debt securities tend to rise. 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.

As of June 30, 2017, the Company had $119.2 million in public deposits, or 17% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on these public deposits. As of June 30, 2017, the balance of pledged securities required for deposit and repurchase agreement accounts was $121.1 million.

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 six months ended June 30, 2017, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.

During the first six months of 2017, the carrying value of total investments increased $23.4 million, or 18%. 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. The Company expects to grow the portfolio and increase its relative size with a preference 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. During the first quarter of 2017, the Company purchased approximately $20 million of securities, primarily MBS - GSE residential, funded mostly by $10 million in debt maturing in two years and another $7 million in borrowings laddered out from six months to one year matching a spread expected to produce a suitable after-tax return.

A comparison of investment securities at June 30, 2017 and December 31, 2016 is as follows:

*(dollars in thousands)*

|  | June 30, 2017 Amount% |  | December 31, 2016 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| MBS - GSE residential | **$90,349** | **58.9%** | $70,937 | 54.5% |
| State & municipal subdivisions | **44,087** | **28.7** | 40,191 | 30.9 |
| Agency - GSE | **18,250** | **11.9** | 18,276 | 14.1 |
| Equity securities - financial services | **719** | **0.5** | 633 | 0.5 |
| Total | **$153,405** | **100.0%** | $130,037 | 100.0% |

As of June 30, 2017, there were no investments from any one issuer with an aggregate book value that exceeded 10% of the Company’s shareholders’ equity.

The distribution of debt securities by stated maturity and tax-equivalent yield at June 30, 2017 are as follows:

*(dollars in thousands)*

|  | One year or less $% |  | More than one year to five years $% |  | More than five years to ten years $% |  | More than ten years $% |  | Total $% |  |
| --- | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: |
| MBS - GSE residential | $- | -% | $1,881 | 3.83% | $4,535 | 3.59% | $83,933 | 3.30% | $90,349 | 3.32% |
| State & municipal subdivisions | - | - | 908 | 6.44 | 1,996 | 5.67 | 41,183 | 5.09 | 44,087 | 5.14 |
| Agency - GSE | 5,005 | 1.23 | 13,245 | 1.49 | - | - | - | - | 18,250 | 1.42 |
| Total debt securities | $5,005 | 1.23% | $16,034 | 2.01% | $6,531 | 4.22% | $125,116 | 3.87% | $152,686 | 3.60% |

In the above table, the book yields on state & municipal subdivisions were adjusted to a tax-equivalent basis using the corporate federal tax rate of 34%. In addition, average yields on securities AFS are based on amortized cost and do not reflect unrealized gains or losses.

#### 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 balance in FHLB stock was $4.0 million and $2.6 million as of June 30, 2017 and December 31, 2016, respectively. During 2017, the balance of FHLB stock is expected to increase to support anticipated borrowing activities.

#### 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 June 30, 2017 and December 31, 2016, loans HFS consisted of residential mortgages with carrying amounts of $1.9 million and $2.9 million, respectively, which approximated their fair values. During the six months ended June 30, 2017, residential mortgage loans with principal balances of $18.1 million were sold into the secondary market and the Company recognized net gains of $0.4 million, compared to $18.8 million and $0.3 million, respectively during the six months ended June 30, 2016. During 2017, the Company also sold one SBA guaranteed loan with a principal balance of $2.4 million and recognized a net gain on the sale of $0.1 million. The Company did not sell any SBA guaranteed loans in 2016.

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 June 30, 2017 and December 31, 2016, the servicing portfolio balance of sold residential mortgage loans was $291.0 million and $285.2 million, respectively. At June 30, 2017 and December 31, 2016, the servicing portfolio balance of sold SBA loans was $5.8 million and $4.1 million, respectively.

#### Loans and leases

For the period ended June 30, 2017, gross loans and leases totaled $636.4 million compared to $598.0 million at December 31, 2016. The growth of $38.4 million, or 6%, was primarily attributed to the Company’s targeted growth in commercial and industrial loans. Additionally, growth continued in the consumer auto loan and lease portfolio due to an effort to increase volume in this line of business throughout the year. The Company continues to emphasize exceeding customer expectations to achieve this growth by providing an atmosphere of teamwork amongst all departments within the bank.

### Commercial and industrial and commercial real estate

Compared to December 31, 2016, the commercial and industrial (C&I) loan portfolio increased $22.2 million, or 23%, as of June 30, 2017. The major contributors to this growth were local government entities including counties, townships, boroughs, cities and school districts. During the first six months of 2017, the Company had the opportunity to increase lending to these government entities, but the Company does not expect similar opportunities of this type of lending for the second half of 2017. The commercial real estate (CRE) loan portfolio was up $5.5 million, or 3%, from $204.3 million at December 31, 2016 to $209.8 million at June 30, 2017. This growth was higher than anticipated due to a delayed expected payoff of approximately $6.0 million that may now occur in the third quarter. The Company does expect continued growth for the remainder of 2017, but at a slower pace.

### Consumer

The consumer loan portfolio grew 6%, or approximately $9.6 million, from $150.2 million on December 31, 2016 to $159.8 million at June 30, 2017. The growth was largely driven by an increase of $13.7 million in auto loans and leases. Additional support was realized from $2.6 million in home equity line of credit usage from new and existing clients. The increase in the referenced drivers more than offset a $7.1 million reduction in other consumer loans that was directly related to a temporary overdraft at the end of 2016.

### Residential

The residential loan portfolio grew approximately $1.2 million, or 1%, from $145.0 million at December 31, 2016 to $146.2 million at June 30, 2017. Construction loans realized a reduction of $0.9 million while other real estate mortgages, which make up roughly 93%, of this category grew $2.1 million.

The composition of the loan portfolio at June 30, 2017 and December 31, 2016 is summarized as follows:

*(dollars in thousands)*

|  | June 30, 2017 Amount% |  | December 31, 2016 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Commercial and industrial | **$120,693** | **19.0%** | $98,477 | 16.5% |
| Commercial real estate: |  |  |  |  |
| Non-owner occupied | **108,147** | **17.0** | 93,364 | 15.6 |
| Owner occupied | **97,458** | **15.3** | 106,960 | 17.8 |
| Construction | **4,162** | **0.7** | 3,987 | 0.7 |
| Consumer: |  |  |  |  |
| Home equity installment | **28,763** | **4.5** | 28,466 | 4.8 |
| Home equity line of credit | **54,257** | **8.5** | 51,609 | 8.6 |
| Auto and leases | **70,574** | **11.1** | 56,841 | 9.5 |
| Other | **6,208** | **1.0** | 13,301 | 2.2 |
| Residential: |  |  |  |  |
| Real estate | **136,550** | **21.5** | 134,475 | 22.5 |
| Construction | **9,606** | **1.4** | 10,496 | 1.8 |
| Gross loans | **636,418** | **100.0%** | 597,976 | 100.0% |
| Less: |  |  |  |  |
| Allowance for loan losses | **(9,406)** |  | (9,364) |  |
| Unearned lease revenue | **(574)** |  | (482) |  |
| Net loans | **$626,438** |  | $588,130 |  |
| Loans held-for-sale | **$1,866** |  | $2,854 |  |

#### 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 June 30, 2017, 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 $0.5 million as of June 30, 2017, $1.2 million for the year ended December 31, 2016 and $0.7 million as of June 30, 2016. During the period ended June 30, 2017, a significant charge-off in the amount of $0.3 million, which comprised 48% of total year-to-date charge-offs, occurred in the CRE portfolio from a single borrower. Management does not anticipate any further losses from this borrower. Net charge-offs of $0.1 million, or about 23% of total net charge-offs, occurred from various borrowers in all categories of the consumer loan portfolio. 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 both as of June 30, 2017 and December 31, 2016. 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 six months ended June 30, 2017 | As of and for the twelve months ended December 31, 2016 | As of and for the six months ended June 30, 2016 |
| --- | ---: | ---: | ---: |
| Balance at beginning of period | **$9,364** | $9,527 | $9,527 |
| Charge-offs: |  |  |  |
| Commercial and industrial | **(30)** | (224) | (169) |
| Commercial real estate | **(368)** | (592) | (343) |
| Consumer | **(160)** | (504) | (265) |
| Residential | **(38)** | (60) | (60) |
| Total | **(596)** | (1,380) | (837) |
| Recoveries: |  |  |  |
| Commercial and industrial | **3** | 55 | 21 |
| Commercial real estate | **41** | 37 | 33 |
| Consumer | **44** | 100 | 38 |
| Residential | **-** | - | - |
| Total | **88** | 192 | 92 |
| Net charge-offs | **(508)** | (1,188) | (745) |
| Provision for loan losses | **550** | 1,025 | 425 |
| Balance at end of period | **$9,406** | $9,364 | $9,207 |
| Allowance for loan losses to total loans | **1.48%** | 1.57% | 1.64% |
| Net charge-offs to average total loans outstanding | **0.16%** | 0.21% | 0.27% |
| Average total loans | **$621,600** | $568,953 | $560,136 |
| Loans 30 - 89 days past due and accruing | **$1,188** | $2,241 | $3,114 |
| Loans 90 days or more past due and accruing | **$245** | $19 | $52 |
| Non-accrual loans | **$6,529** | $7,370 | $5,918 |
| Allowance for loan losses to loans 90 days or more past due and accruing | **38.39** **x** | 492.84 x | 177.06 |
| Allowance for loan losses to non-accrual loans | **1.44** **x** | 1.27 x | 1.56 x |
| Allowance for loan losses to non-performing loans | **1.39** **x** | 1.27 x | 1.54 x |

The allowance for loan losses can generally absorb losses throughout the loan portfolio. However, in some instances an allocation is made for specific loans or groups of loans. Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Company, as previously explained. The changes in the allocations from period-to-period are based upon quarter-end reviews of the loan portfolio.

Allocation of the allowance among major categories of loans for the periods indicated, as well as the percentage of loans in each category to total loans, is summarized in the following table. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends. When present, the portion of the allowance designated as unallocated is within the Company’s guidelines:

*(dollars in thousands)*

| Category | June 30, 2017 Allowance | Category % of Loans | December 31, 2016 Allowance | Category % of Loans | June 30, 2016 Allowance | Category % of Loans |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Commercial real estate | **$4,510** | **33%** | $4,706 | 34% | $4,880 | 35% |
| Commercial and industrial | **1,383** | **19** | 1,075 | 17 | 1,231 | 18 |
| Consumer | **1,939** | **25** | 1,834 | 25 | 1,692 | 22 |
| Residential real estate | **1,511** | **23** | 1,622 | 24 | 1,365 | 25 |
| Unallocated | **63** | **-** | 127 | - | 39 | - |
| Total | **$9,406** | **100%** | $9,364 | 100% | $9,207 | 100% |

45

#### 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 June 30, 2017, non-performing assets represented 1.11% of total assets compared with 1.33% as of December 31, 2016 and 1.30% as of June 30, 2016. The improvement resulted from a combination of $99.0 million in total asset growth and a $0.4 million net reduction of total non-performing assets year-over-year.

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

*(dollars in thousands)*

|  | June 30, 2017 | December 31, 2016 | June 30, 2016 |
| --- | ---: | ---: | ---: |
| Loans past due 90 days or more and accruing | **$245** | $19 | $52 |
| Non-accrual loans \* | **6,529** | 7,370 | 5,918 |
| Total non-performing loans | **6,774** | 7,389 | 5,970 |
| Troubled debt restructurings | **1,737** | 1,823 | 2,346 |
| Other real estate owned and repossessed assets | **969** | 1,306 | 1,555 |
| Total non-performing assets | **$9,480** | $10,518 | $9,871 |
| Total loans, including loans held-for-sale | **$637,710** | $600,348 | $562,758 |
| Total assets | **$855,468** | $792,944 | $756,476 |
| Non-accrual loans to total loans | **1.02%** | 1.23% | 1.05% |
| Non-performing loans to total loans | **1.06%** | 1.23% | 1.06% |
| Non-performing assets to total assets | **1.11%** | 1.33% | 1.30% |

\* In the table above, the amount includes non-accrual TDRs of $2.4 million as of June 30, 2017, $1.5 million as of December 31, 2016 and $0.2 million as of June 30, 2016.

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.

From June 30, 2016 to June 30, 2017, non-performing loans, which consists of accruing loans that are over 90 days past due as well as all non-accrual loans, increased from $6.0 million to $6.8 million, a $0.8 million, or 13%, increase. This was driven by a $0.7 million net increase of residential mortgage non-accrual loans due mainly to a single $0.9 million loan, a $0.4 million net increase in consumer non-accrual loans due mainly to a single $0.7 million loan and a $0.2 million accruing residential mortgage loan that became over 90 days delinquent during the six months ended June 30, 2017. These were partially offset by a $0.5 million decrease in commercial non-accrual loans and payments received, charge-offs, transfers to ORE and miscellaneous transfers back to accrual from all loan types.

From December 31, 2016 to June 30, 2017, non-performing loans decreased from $7.4 million to $6.8 million, a $0.6 million, or 8%, decrease. This was driven by payments received of $0.7 million, charge-offs of $0.4 million, transfers back to accrual $0.7 million and transfers to ORE of $0.2 million. These reductions were offset by loans over 90 days delinquent that increased by $0.2 million due mainly to a single residential real estate mortgage loan as well as $1.1 million in new additions to non-accrual.

From December 31, 2016 to June 30, 2017, the portion of accruing loans that was over 90 days past due increased from $19 thousand to $0.2 million. Accruing loans over 90 days past due at December 31, 2016 consisted of four loans to four unrelated borrowers ranging from $1 thousand to $9 thousand. Accruing loans over 90 days past due at June 30, 2017 consisted of six loans to six unrelated borrowers ranging from $2 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.

From December 31, 2016 to June 30, 2017, non-accruing loans of all types decreased by $0.9 million, 11%, from $7.4 million to $6.5 million. At December 31, 2016, there were a total of 46 loans to 39 unrelated borrowers with balances that ranged from less than $1 thousand to $2.3 million. At June 30, 2017, there were a total of 37 loans to 31 unrelated borrowers with balances that ranged from less than $1 thousand to $1.9 million. During the third quarter of 2017, the Company foreclosed on the collateral for two significant non-accrual CRE loans to one borrower with balances totaling $2.5 million at June 30, 2017. The Company expects to sell the foreclosed asset by the end of the third quarter of 2017.

The composition of non-performing loans as of June 30, 2017 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 | **$120,693** | **$-** | **$-** | **$-** | **0.00%** |
| Commercial real estate: |  |  |  |  |  |
| Non-owner occupied | **108,147** | **-** | **1,182** | **1,182** | **1.09%** |
| Owner occupied | **97,458** | **-** | **2,922** | **2,922** | **3.00%** |
| Construction | **4,162** | **-** | **177** | **177** | **4.25%** |
| Consumer: |  |  |  |  |  |
| Home equity installment | **28,763** | **-** | **16** | **16** | **0.06%** |
| Home equity line of credit | **54,257** | **-** | **805** | **805** | **1.48%** |
| Auto loans and leases \* | **70,000** | **25** | **-** | **25** | **0.04%** |
| Other | **6,208** | **2** | **6** | **8** | **0.13%** |
| Residential: |  |  |  |  |  |
| Real estate | **136,550** | **218** | **1,421** | **1,639** | **1.20%** |
| Construction | **9,606** | **-** | **-** | **-** | **-** |
| Loans held-for-sale | **1,866** | **-** | **-** | **-** | **-** |
| Total | **$637,710** | **$245** | **$6,529** | **$6,774** | **1.06%** |

\*Net of unearned lease revenue of $0.6 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 June 30, 2017 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $0.2 million.

The Company, on a regular basis, reviews changes to loans to determine if they meet the definition of a troubled debt restructure (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.

From December 31, 2016 to June 30, 2017, TDRs increased from nine loans totaling $3.3 million to fifteen loans totaling $4.1 million. This increase of $0.8 million, or 24%, was primarily due to the addition of six CRE loans to four unrelated borrowers totaling $1.0 million during the first six months of 2017. At December 31, 2016, the nine TDRs consisted of six CRE loans totaling $1.8 million, one C&I loan totaling $25 thousand, one residential mortgage totaling $0.9 million, and one HELOC totaling $0.7 million. At June 30, 2017, the fifteen TDRs consisted of twelve CRE loans totaling $2.6 million, one C&I loan totaling $25 thousand, one residential mortgage loan totaling $0.9 million and one HELOC totaling $0.7 million.

At December 31, 2016, two TDRs totaling $1.5 million were on non-accrual. These consisted of one residential mortgage and one HELOC. At June 30, 2017, five TDRs totaling $2.4 million were on non-accrual. These consisted of three CRE loans, one residential mortgage and one HELOC.

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

*(dollars in thousands)*

| As of and for the six months ended June 30, 2017 Troubled Debt Restructures: | Accruing Commercial & industrial | Commercial real estate | Non-accruing Consumer HELOC | Commercial real estate | Residential real estate | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Beginning balance | **$25** | **$1,798** | **$650** | **$-** | **$881** | **$3,354** |
| Additions | **-** | **900** | **-** | **146** | **-** | **1,046** |
| Transfers | **-** | **(970)** | **-** | **970** | **-** | **-** |
| Pay downs / payoffs | **-** | **(16)** | **-** | **(218)** | **(18)** | **(252)** |
| Charge offs | **-** | **-** | **-** | **-** | **-** | **-** |
| Ending balance | **$25** | **$1,712** | **$650** | **$898** | **$863** | **$4,148** |

47

*(dollars in thousands)*

| As of and for the year ended December 31, 2016 Troubled Debt Restructures: | Accruing Commercial & industrial | Commercial real estate | Non-accruing Consumer HELOC | Commercial real estate | Residential real estate | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Beginning balance | $525 | $1,898 | $- | $- | $- | $2,423 |
| Additions | - | 4 | 650 | - | 881 | 1,535 |
| Transfers | - | (20) | - | 20 | - | - |
| Pay downs / payoffs | (500) | (84) | - | - | - | (584) |
| Charge offs | - | - | - | (20) | - | (20) |
| Ending balance | $25 | $1,798 | $650 | $- | $881 | $3,354 |

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

From December 31, 2016 to June 30, 2017, foreclosed assets held-for-sale (ORE) decreased from $1.3 million to $1.0 million, a $0.3 million, or 25%, decrease. The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale:

*(dollars in thousands)*

|  | June 30, 2017 Amount | # | December 31, 2016 Amount | # |
| --- | ---: | ---: | ---: | ---: |
| Balance at beginning of period | **$1,298** | **13** | $1,074 | 14 |
| Additions | **201** | **3** | 1,056 | 11 |
| Pay downs | **(9)** |  | (18) |  |
| Write downs | **(91)** |  | (80) |  |
| Sold | **(430)** | **(4)** | (734) | (12) |
| Balance at end of period | **$969** | **12** | $1,298 | 13 |

As of June 30, 2017, ORE consisted of twelve properties from twelve unrelated borrowers totaling $1.0 million.

Three of these properties ($0.1 million) were added in 2017; three were added in 2016 ($0.5 million); two were added in 2015 ($0.1 million); two were added in 2014 ($42 thousand); one was added in 2012 ($100); and one was added in 2011 ($0.2 million). Of the twelve properties, one totaling $0.2 million had a signed sales agreement; six totaling $0.7 million were listed for sale, while the five remaining properties totaling $0.1 million were either in litigation, in process for disposition, in the process of eviction or disposal or in process of being listed for sale.

As of June 30, 2017, the Company had no other repossessed assets held-for-sale. There was one repossessed assets held-for-sale at December 31, 2016, with a balance of $8 thousand.

#### Cash surrender value of bank owned life insurance

The Company maintains bank owned life insurance (BOLI) for a chosen group of employees at the time of purchase, namely its officers, where the Company is the owner and sole beneficiary of the policies. BOLI is classified as a non-interest earning asset. Increases in the cash surrender value are recorded as components of non-interest income. The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance and its tax-free advantage to the Company. This profitability is used to offset a portion of current and future employee benefit costs. In March 2017, the Company invested $8.0 million in additional BOLI as a source of funding for additional life insurance benefits for officers and employee benefit expenses related to the Company’s non-qualified Supplemental Executive Retirement Plan (SERP) implemented for certain executive officers that provides for payments upon death. The BOLI can be liquidated if necessary with associated tax costs. However, the Company intends to hold this pool of insurance, because it provides income that enhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value.

#### Other assets

The $3.1 million increase in other assets was due mostly to $1.5 million in higher residual values associated with recording new automobile leases, net of lease disposals, $0.8 million higher prepaid expenses and $0.4 million more in construction-in-process.

### 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)*

|  | June 30, 2017 Amount% |  | December 31, 2016 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Interest-bearing checking | **$185,734** | **26.2%** | $161,563 | 23.0% |
| Savings and clubs | **128,471** | **18.2** | 120,512 | 17.1 |
| Money market | **115,971** | **16.4** | 117,478 | 16.7 |
| Certificates of deposit | **102,350** | **14.5** | 92,753 | 13.2 |
| Total interest-bearing | **532,526** | **75.3** | 492,306 | 70.0 |
| Non-interest bearing | **174,909** | **24.7** | 211,153 | 30.0 |
| Total deposits | **$707,435** | **100.0%** | $703,459 | 100.0% |

Total deposits increased $4.0 million, or 1%, from $703.4 million at December 31, 2016 to $707.4 million at June 30, 2017. A majority of the increase came from growth in interest-bearing checking accounts of $24.2 million. Most of the growth in interest-bearing checking accounts was from public deposits which fluctuate throughout the year. The increased lending to local government entities along with a focus on obtaining a full banking relationship with these customers has caused public deposit growth during the first half of 2017. CDs and savings and clubs added another $9.6 million and $8.0 million, respectively, to deposit growth. Non-interest bearing deposits fell $36.2 million due to a temporary deposit of $48.7 million received at the end of 2016 that was transferred to a trust escrow account in January. Excluding this temporary deposit, the Company experienced growth in non-interest-bearing deposits. Money market deposits also decreased $1.5 million during the first six months of 2017. During the first quarter of 2017, the Company also completed the acquisition of Wayne Bank’s West Scranton branch which increased deposits by $13.9 million. For a discussion on the acquisition, see “Acquisition” located in the financial statement footnotes. The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop deposit gathering programs for its customers. The Company expects asset growth for 2017 funded primarily by growth in deposits plus utilization of available borrowing capacity. Transactional deposit and CD growth is projected as a result of our relationship strategy. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset this deposit growth.

Customers’ interest in long-term time deposit products continues to be weak with a sustaining preference for non-maturing transaction deposits. The Company’s portfolio of CDs would have decreased; if not for $11.5 million in CDs acquired from the West Scranton branch of Wayne Bank during the first quarter of 2017. The Company expects CDs to increase 14% in 2017 mostly as a result of this acquisition. 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 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 from other institutions are considered reciprocal deposits by regulatory definitions. As of June 30, 2017 and December 31, 2016, CDARS represented $1.1 million, or less than 1%, of total deposits.

The maturity distribution of certificates of deposit at June 30, 2017 is as follows:

*(dollars in thousands)*

|  | Three months or less | More than three months to six months | More than six months to twelve months | More than twelve months | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| CDs of $100,000 or more | $14,230 | $7,436 | $8,444 | $20,610 | $50,720 |
| CDARS | - | 1,134 | - | - | 1,134 |
| Total CDs of $100,000 or more | 14,230 | 8,570 | 8,444 | 20,610 | 51,854 |
| CDs of less than $100,000 | 7,516 | 5,337 | 9,940 | 27,703 | 50,496 |
| Total CDs | $21,746 | $13,907 | $18,384 | $48,313 | $102,350 |

Certificates of deposit of $250,000 or more amounted to $26.5 million and $25.7 million as of June 30, 2017 and December 31, 2016, respectively.

Including CDARS, approximately 35% of the CDs, with a weighted-average interest rate of 0.69%, are scheduled to mature in 2017 and an additional 29%, with a weighted-average interest rate of 0.91%, are scheduled to mature in 2018. 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 other than from the branch purchase during 2017, but will 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, 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, which during the first half of 2017 increased $0.8 million from the end of 2016. 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. The Company required $29.4 million in overnight borrowings at June 30, 2017 compared to no overnight borrowings at December 31, 2016. A $48.7 million temporary deposit at the end of 2016 prevented the Company from having to use overnight borrowings at year-end. Short-term borrowings are expected to increase temporarily in 2017 to fund asset growth above deposit balance growth.

During the first quarter of 2017, the Company borrowed $17 million from the FHLB to purchase securities. The borrowings were laddered out with maturities ranging from July 2017 to January 2019 and interest rates ranging from 0.64% to 1.34%. During the second quarter of 2017, the Company borrowed another $6.7 million from the FHLB to fund loan growth and replace seasonal deposits. The borrowing matures in two years and has an interest rate of 1.43%.

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

*(dollars in thousands)*

|  | June 30, 2017 Amount% |  | December 31, 2016 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Overnight borrowings | **$29,387** | **50.5%** | $- | -% |
| Securities sold under repurchase agreements | **5,068** | **8.7** | 4,223 | 100.0 |
| Long-term FHLB advances | **23,704** | **40.8** | - | - |
| Total | **$58,159** | **100.0%** | $4,223 | 100.0% |

## Market risk

As filed, 27,283 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 June 30, 2017, the Company maintained a one-year cumulative gap of positive (asset sensitive) $42.6 million, or 5%, 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 June 30, 2017:

*(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 | $86 | $- | $- | $14,791 | $14,877 |
| Investment securities (1)(2) | 6,239 | 14,448 | 50,714 | 86,033 | 157,434 |
| Loans and leases(2) | 198,920 | 110,612 | 167,151 | 151,621 | 628,304 |
| Fixed and other assets | - | 19,699 | - | 35,154 | 54,853 |
| Total assets | $205,245 | $144,759 | $217,865 | $287,599 | $855,468 |
| Total cumulative assets | $205,245 | $350,004 | $567,869 | $855,468 |  |
| Non-interest-bearing transaction deposits (3) | $- | $17,508 | $48,065 | $109,336 | $174,909 |
| Interest-bearing transaction deposits (3) | 171,730 | 22,648 | 159,368 | 76,430 | 430,176 |
| Certificates of deposit | 21,746 | 32,291 | 40,267 | 8,046 | 102,350 |
| Repurchase agreements | 5,068 | - | - | - | 5,068 |
| Short-term borrowings | 29,387 | - | - | - | 29,387 |
| Long-term debt | 2,000 | 5,000 | 16,704 | - | 23,704 |
| Other liabilities | - | - | - | 5,738 | 5,738 |
| Total liabilities | $229,931 | $77,447 | $264,404 | $199,550 | $771,332 |
| Total cumulative liabilities | $229,931 | $307,378 | $571,782 | $771,332 |  |
| Interest sensitivity gap | $(24,686) | $67,312 | $(46,539) | $88,049 |  |
| Cumulative gap | $(24,686) | $42,626 | $(3,913) | $84,136 |  |
| Cumulative gap to total assets | -2.9% | 5.0% | -0.5% | 9.8% |  |

(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 the adjusted interest-earning asset and interest-bearing liability levels at June 30, 2017 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 June 30, 2017 levels:

| Earnings at risk: | % change Rates +200 | Rates -200 |
| --- | ---: | ---: |
| Net interest income | 2.3% | (6.5)% |
| Net income | 6.4 | (14.3) |
| Economic value at risk: |  |  |
| Economic value of equity | (0.8) | (28.0) |
| Economic value of equity as a percent of total assets | (0.1) | (4.2) |

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 June 30, 2017, the Company’s risk-based capital ratio was 14.5%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning July 1, 2017, 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 | $29,413 | $675 | 2.3% |
| +100 basis points | 29,110 | 372 | 1.3 |
| Flat rate | 28,738 | - | - |
| -100 basis points | 27,468 | (1,270) | (4.4) |
| -200 basis points | 26,880 | (1,858) | (6.5) |

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 June 30, 2017, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.

During the six months ended June 30, 2017, the Company used $11.0 million of cash. During the period, the Company’s operations provided approximately $6.8 million mostly from $14.0 million of net cash inflow from the components of net interest income and $3.4 million in proceeds of loans HFS over originations; partially offset by net non-interest expense/income related payments of $8.1 million, $0.9 million in estimated tax payments and a $1.5 million increase in the residual value from the Company’s automobile leasing activities. Cash inflow from interest-earning assets, borrowings and the acquisition of a bank branch were used to purchase investment securities and replace maturing and cash runoff of securities, purchase bank owned life insurance, fund the loan portfolio and make net dividend payments. The Company received a large amount of public deposits over the past two years. 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, including maintaining the requirements to pledge investment securities. 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, 2016.

During the third quarter of 2016, the Company entered into an agreement to acquire all the deposits, certain loans and fixed assets of a bank branch. The transaction was completed in March 2017. As a result of this transaction, the Company experienced an increase of $13.9 million in deposits in March 2017.

As of June 30, 2017, the Company maintained $14.9 million in cash and cash equivalents and $155.3 million of investments AFS and loans HFS. Also as of June 30, 2017, the Company had approximately $181.1 million available to borrow from the FHLB, $21.0 million from correspondent banks, $63.2 million from the FRB and $42.7 million from the CDARS program. The combined total of $478.2 million represented 56% of total assets at June 30, 2017. Management believes this level of liquidity to be strong and adequate to support current operations.

#### Capital

During the six months ended June 30, 2017, total shareholders' equity increased $3.5 million, or 4%, due principally from the $4.2 million in net income added into retained earnings. Capital was further enhanced by the $0.5 million, after tax, improvement in the net unrealized gain position in the Company’s investment portfolio, $0.1 million from investments in the Company’s common stock via the Employee Stock Purchase Plan (ESPP), $0.1 million from issuance of common stock through the dividend reinvestment plan and $0.2 million from stock-based compensation expense from the ESPP and unvested restricted stock. These items were partially offset by $1.5 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 are paid to shareholders, was 37.0% for the six months ended June 30, 2017. The balance of earnings is retained to further strengthen the Company’s capital position.

As of June 30, 2017, the Company reported a net unrealized gain position of $1.9 million, net of tax, from the securities AFS portfolio compared to a net unrealized gain of $1.4 million as of December 31, 2016. The improvement during the first half of 2017 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. 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. Beginning in 2009, the Company’s board of directors had allowed a benefit to its loyal shareholders as a discount on the purchase price for shares issued directly from the Company through the DRP and voluntary cash feature.

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 ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. 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%. A capital conservation buffer, comprised of common equity Tier I capital, is also established above the regulatory minimum capital requirements rising up to 2.50% by 2019. As of June 30, 2017 and December 31, 2016, the Company and the Bank exceeded all capital adequacy requirements to which it was subject.

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, on a combined basis, and the Bank as of June 30, 2017 and December 31, 2016:

*(dollars in thousands)*

| As of June 30, 2017: 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 | **$89,840** | **14.5%** | **≥** | **$57,309** | **≥** | **9.3%** | (1) |  | **N/A** |  | **N/A** |
| Bank | **$89,620** | **14.5%** | **≥** | **$57,298** | **≥** | **9.3%** | (1) | **≥** | **$61,944** | **≥** | **10.0%** |
| Tier 1 common equity (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$82,074** | **13.3%** | **≥** | **$35,624** | **≥** | **5.8%** | (1) |  | **N/A** |  | **N/A** |
| Bank | **$81,855** | **13.2%** | **≥** | **$35,618** | **≥** | **5.8%** | (1) | **≥** | **$40,263** | **≥** | **6.5%** |
| Tier I capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$82,074** | **13.3%** | **≥** | **$44,918** | **≥** | **7.3%** | (1) |  | **N/A** |  | **N/A** |
| Bank | **$81,855** | **13.2%** | **≥** | **$44,909** | **≥** | **7.3%** | (1) | **≥** | **$49,555** | **≥** | **8.0%** |
| Tier I capital (to average assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$82,074** | **9.7%** | **≥** | **$33,898** | **≥** | **4.0%** |  |  | **N/A** |  | **N/A** |
| Bank | **$81,855** | **9.7%** | **≥** | **$33,898** | **≥** | **4.0%** |  | **≥** | **$42,373** | **≥** | **5.0%** |

(1) Includes 1.25% capital conservation buffer.

| As of December 31, 2016: Total capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| --- | ---: | ---: | --- | ---: | --- | ---: | ---: | --- | ---: | --- | ---: |
| Consolidated | $86,702 | 14.9% | ≥ | $46,550 | ≥ | 8.6% | (2) |  | N/A |  | N/A |
| Bank | $86,332 | 14.8% | ≥ | $46,538 | ≥ | 8.6% | (2) | ≥ | $58,172 | ≥ | 10.0% |
| Tier 1 common equity (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $79,250 | 13.6% | ≥ | $26,184 | ≥ | 5.1% | (2) |  | N/A |  | N/A |
| Bank | $79,033 | 13.6% | ≥ | $26,178 | ≥ | 5.1% | (2) | ≥ | $37,812 | ≥ | 6.5% |
| Tier I capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $79,250 | 13.6% | ≥ | $34,912 | ≥ | 6.6% | (2) |  | N/A |  | N/A |
| Bank | $79,033 | 13.6% | ≥ | $34,903 | ≥ | 6.6% | (2) | ≥ | $46,538 | ≥ | 8.0% |
| Tier I capital (to average assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $79,250 | 10.3% | ≥ | $30,717 | ≥ | 4.0% |  |  | N/A |  | N/A |
| Bank | $79,033 | 10.3% | ≥ | $30,650 | ≥ | 4.0% |  | ≥ | $38,313 | ≥ | 5.0% |

(2) Includes a 0.625% capital conservation buffer.

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 2016 Form 10-K for a discussion on the regulatory environment and recent legislation and rulemaking.

## Controls and procedures

As filed, 1,064 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 June 30, 2017.

## 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 2016 Form 10-K filed with the Securities and Exchange Commission on March 10, 2017.

Filed Aug 8, 2017.
Source: SEC EDGAR, the filing index for accession 0001098151-17-000038. Last ingested by Listed: Nov 6, 2026, 18:40 ET. No prices; not investment advice.