# Fidelity D & D Bancorp Inc: Form 10-Q for the period ended Sep 30, 2019

- Company: [Fidelity D & D Bancorp Inc](/companies/fdbc.md) (CIK 1098151)
- Form: 10-Q
- Filed: 2019-11-06
- Accepted by EDGAR: Nov 6, 2019, 11:58 ET
- Period: 2019-09-30
- Accession: 0001098151-19-000046
- Inline XBRL: yes
- Main document: https://www.sec.gov/Archives/edgar/data/1098151/000109815119000046/fdbc-20190930x10q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1098151/000109815119000046/

## Figures reported in this filing

Standardized XBRL line items for the period ended 2019-09-30.

| Line item | Period | Value | XBRL concept |
| --- | --- | ---: | --- |
| Interest expense | 3 months, 2019-07-01 to 2019-09-30 | $2.0m | us-gaap:InterestExpense |
| Interest expense | 9 months, 2019-01-01 to 2019-09-30 | $5.6m | us-gaap:InterestExpense |
| Income tax | 3 months, 2019-07-01 to 2019-09-30 | $611.0k | us-gaap:IncomeTaxExpenseBenefit |
| Income tax | 9 months, 2019-01-01 to 2019-09-30 | $1.7m | us-gaap:IncomeTaxExpenseBenefit |
| Net income | 3 months, 2019-07-01 to 2019-09-30 | $3.1m | us-gaap:NetIncomeLoss |
| Net income | 9 months, 2019-01-01 to 2019-09-30 | $8.9m | us-gaap:NetIncomeLoss |
| Diluted EPS | 3 months, 2019-07-01 to 2019-09-30 | $0.80 | us-gaap:EarningsPerShareDiluted |
| Diluted EPS | 9 months, 2019-01-01 to 2019-09-30 | $2.32 | us-gaap:EarningsPerShareDiluted |
| Basic EPS | 3 months, 2019-07-01 to 2019-09-30 | $0.82 | us-gaap:EarningsPerShareBasic |
| Basic EPS | 9 months, 2019-01-01 to 2019-09-30 | $2.35 | us-gaap:EarningsPerShareBasic |
| Diluted shares (weighted) | 3 months, 2019-07-01 to 2019-09-30 | 3,824,501 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Diluted shares (weighted) | 9 months, 2019-01-01 to 2019-09-30 | 3,819,507 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Operating cash flow | 9 months, 2019-01-01 to 2019-09-30 | $21.6m | us-gaap:NetCashProvidedByUsedInOperatingActivities |
| Capital expenditure | 9 months, 2019-01-01 to 2019-09-30 | $2.3m | us-gaap:PaymentsToAcquirePropertyPlantAndEquipment |
| Dividends paid | 9 months, 2019-01-01 to 2019-09-30 | $3.0m | us-gaap:PaymentsOfDividends |
| Cash and equivalents | at 2019-09-30 | $18.7m | us-gaap:CashAndCashEquivalentsAtCarryingValue |
| Total assets | at 2019-09-30 | $1.01bn | us-gaap:Assets |
| Total liabilities | at 2019-09-30 | $906.6m | us-gaap:Liabilities |
| Short-term borrowings | at 2019-09-30 | $24.4m | us-gaap:ShortTermBorrowings |
| Shareholders' equity | at 2019-09-30 | $104.8m | us-gaap:StockholdersEquity |

## Management's discussion and analysis

As filed, 92,134 characters.

The following is management's discussion and analysis of the significant changes in the consolidated financial condition of the Company as of September 30, 2019 compared to December 31, 2018 and a comparison of the results of operations for the three and nine months ended September 30, 2019 and 2018. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2018 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 Tax Cuts and Jobs Act and 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 (see “Funds Deployed” section of this management’s discussion and analysis) and to increase low cost core deposits (see “Funds Provided” section of this management’s discussion and analysis). 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 business prospects. In addition, we explore opportunities to selectively expand our franchise footprint, consisting presently of our 12-branch network. The Company opened a new branch location in Mountain Top, PA in October 2019. We are expecting over $2.0 million in investment related to the construction of this new branch in 2019. The Company is committed to selectively expanding branch banking and wealth management locations in Lackawanna and Luzerne Counties as opportunities arrive going forward.

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 improvement, the general operating environment and our local market area continue to remain challenging due to the lagging unemployment rate and strong local competition. The Federal Open Market Committee (FOMC) had been adjusting the short-term federal funds rate up during 2018, but the outlook looks different for the remainder of 2019 and 2020. The FOMC lowered the federal funds rate 50 basis points during the third quarter of 2019 and expectations are that the Federal Reserve will continue to ease the federal funds rate which will cause short-term rates to decline. According to the U.S. Bureau of Labor Statistics, the national unemployment rate for September 2019 was 3.5%, down 0.4 percentage points from December 2018. The unemployment rate in Scranton - Wilkes-Barre Metropolitan Statistical Area (local) decreased during the first nine months of 2019 but continued to lag behind the unemployment rates of the state and nation. The local unemployment rate at September 30, 2019 was 4.6%, a decrease of 0.1 percentage points from 4.7% at December 31, 2018 and unchanged from September 30, 2018. However, the local unemployment rate decreased over the nine-month period due to the shrinking labor force rather than an increase in jobs. Seasonal fluctuations in unemployment are expected. According to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets, the median home values in the region have risen 4.1% over the past 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.

Our efforts and focus continue on building relationships concentrating on loans, deposits, wealth management, business services and retail opportunities with clients and prospects with the goal to exceed expectations by providing a valued service.

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 2018 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 became effective for the Company on January 1, 2015 and were fully phased in on January 1, 2019. 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 of the continuing implementation of the Dodd-Frank Act and the Basel III capital standards, and related rulemaking will have on our business, financial condition and results of operations.

### Non-GAAP Financial Measures

The following are non-GAAP financial measures which provide useful insight to the reader of the consolidated financial statements but should be supplemental to GAAP used to prepare the Company’s financial statements and should not be read in isolation or relied upon as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Company’s tax rate used to calculate the fully-taxable equivalent (FTE) adjustment was 21% at September 30, 2019 and 2018.

The following table reconciles the non-GAAP financial measures of FTE net interest income:

*(dollars in thousands)*

|  | Three months ended September 30, 2019 | September 30, 2018 | Nine months ended September 30, 2019 | September 30, 2018 |
| --- | ---: | ---: | ---: | ---: |
| Interest income (GAAP) | **$10,008** | $9,028 | **$29,320** | $25,706 |
| Adjustment to FTE | **186** | 182 | **558** | 522 |
| Interest income adjusted to FTE (Non-GAAP) | **10,194** | 9,210 | **29,878** | 26,228 |
| Interest expense | **2,008** | 1,317 | **5,616** | 3,213 |
| Net interest income adjusted to FTE (Non-GAAP) | **$8,186** | $7,893 | **$24,262** | $23,015 |

37

The efficiency ratio is non-interest expenses as a percentage of FTE net interest income plus non-interest income. The following table reconciles the non-GAAP financial measures of the efficiency ratio to GAAP:

*(dollars in thousands)*

| Efficiency Ratio (non-GAAP) | Three months ended September 30, 2019 | September 30, 2018 | Nine months ended September 30, 2019 | September 30, 2018 |
| --- | ---: | ---: | ---: | ---: |
| Non-interest expenses (GAAP) | **$6,643** | $6,172 | **$19,848** | $18,542 |
| Net interest income (GAAP) | **8,000** | 7,711 | **23,704** | 22,493 |
| Plus: taxable equivalent adjustment | **186** | 182 | **558** | 522 |
| Non-interest income (GAAP) | **2,632** | 2,283 | **7,578** | 6,937 |
| Net interest income (FTE) plus non-interest income (non-GAAP) | **$10,818** | $10,176 | **$31,840** | $29,952 |
| Efficiency ratio (non-GAAP) | **61.41%** | 60.65% | **62.34%** | 61.91% |

### 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 nine months ended September 30, 2019 and 2018

### Overview

For the third quarter of 2019, the Company generated net income of $3.1 million, or $0.80 per diluted share, compared to $2.9 million, or $0.75 per diluted share, for the third quarter of 2018. The $0.2 million, or 7%, increase in net income stemmed from $0.3 million more net interest income plus $0.3 million higher non-interest income and a $0.1 million reduction in provision for loan losses which more than offset a $0.5 million rise in non-interest expenses. In the year-to-date comparison, net income grew $0.7 million, or 9%, to $8.9 million, or $2.32 per diluted share, for the first nine months of 2019 from $8.2 million, or $2.15 per diluted share, for the first nine months of 2018. As in the quarterly comparison, higher net interest income and non-interest income combined with a lower provision for loan losses were partially offset by higher non-interest expenses.

Return on average assets (ROA) was 1.22% for both the third quarters of 2019 and 2018, respectively, and 1.21% for both the nine months ended September 30, 2019 and 2018, respectively. During the same time periods, return on average shareholders’ equity (ROE) was 11.77% and 12.65%, respectively, and 11.96% and 12.34%, respectively. ROA remained unchanged because the net income grew with average assets while ROE declined as net income grew at a slower pace than average equity.

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

For the third quarter of 2019, net interest income increased $0.3 million, or 4%, to $8.0 million from $7.7 million for the third quarter of 2018. The $1.0 million growth in interest income was produced by the addition of $50.1 million in average interest-earning assets combined with a 20 basis point higher FTE yield earned on those assets. The loan portfolio contributed $0.7 million to this interest income growth due to $30.7 million more average loans earning a higher yield. In the investment portfolio, a larger average balance of higher yielding mortgage-backed securities was the biggest driver of interest income growth of $0.1 million from investments. On the liability side, total interest-bearing liabilities grew $51.4 million, on average, with a 34 basis point increase in rates paid thereon. Growth of $76.2 million in average interest-bearing deposits with a 36 basis point increase in rates paid on these deposits resulted in $0.7 million more interest expense from deposits for the third quarter of 2019 compared to the 2018 like period.

Net interest income increased $1.2 million, or 5%, from $22.5 million for the nine months ended September 30, 2018 to $23.7 million for the nine months ended September 30, 2019, due to higher interest income which more than offset the additional interest expense. Total average interest-earning assets increased $62.7 million along with a 25 basis point increase in the FTE yields earned thereon resulting in $3.7 million of growth in FTE interest income. In the loan portfolio, the Company experienced average balance growth of $49.0 million combined with higher yields in each loan portfolio, which had the effect of producing $2.9 million more interest income. In the investment portfolio, an increase in the yields on a higher average balance of mortgage-backed securities and a higher average balance of municipal securities produced interest income growth of $0.5 million. On the liability side, total interest-bearing liabilities grew $56.7 million, on average, with a 42 basis point increase in rates paid on these interest-bearing liabilities. Growth in average interest-bearing deposits of $48.7 million combined with a 34 basis point increase in the rates paid on deposits contributed $1.8 million in additional interest expense. In addition, the Company utilized $8.0 million more in average borrowings during the first nine months of 2019 at higher rates which resulted in $0.6 million more interest expense.

The FTE net interest rate spread decreased by 14 and 17 basis points, respectively, for the three and nine months ended September 30, 2019 compared to the same 2018 periods. Over the same periods, the FTE net interest margin decreased by 7 and 6 basis points, respectively. The rates paid on interest-bearing liabilities rose faster than the yields earned on interest-earning assets causing the decline in net interest rate spread. The overall cost of funds, which includes the impact of non-interest bearing deposits, increased 28 and 34 basis points for the three and nine months ended September 30, 2019 compared to the same periods in 2018. The primary reason for the rise was the increase in rates paid on interest-bearing liabilities compared to the prior year’s periods, respectively.

For the last quarter of 2019, the Company expects to operate in a declining interest rate environment. A rate environment with falling interest rates positions the Company to reduce 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. The FOMC completed gradually increasing the short-term federal funds rate at the end of 2018, and it effected the rates paid on funding sources. Currently, the FOMC began easing the federal funds rate during the second half of 2019 which is expected to eventually result in reduced rates paid on interest-bearing liabilities. On the asset side, the prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans, rose 100 basis points in 2018, but was cut 50 basis points in the third quarter of 2019. The focus for 2019 is to manage net interest income through a declining rate environment by managing interest-bearing deposit costs to maintain a reasonable spread. Interest income is projected to decline for the remainder of 2019 from floating rate loans and repricing of our assets. Management expects to actively reduce the cost of funds to partially mitigate spread compression throughout this declining rate cycle. 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 1.17% and 1.12% for the three and nine months ended September 30, 2019, or 34 and 42 basis points higher than the cost for the same 2018 periods. Quarter-over-quarter, the increase resulted from the growth in the average balance of interest-bearing deposits and the higher rates paid thereon. In the year-to-date comparison, the increase in average borrowings and average interest-bearing deposits combined with higher rates paid on both led to the higher cost of interest-bearing liabilities. Interest rates along the treasury yield curve have been volatile with shorter-term rates rising faster than long-term rates producing an inverted yield curve in early 2019. Competition had been pressuring banks to increase deposit rates. We expect this trend to begin to reverse as the FOMC reduces the federal funds rate leading to the short-to-intermediate portion of the yield curve to flatten, but the reduction in rates paid on deposits will lag the lower yields earned over the upcoming year. 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 is actively addressing the Company's sensitivity to a declining rate environment to ensure interest rate risks are contained within acceptable levels. 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 FTE adjusted, using the corporate federal tax rate of 21% for September 30, 2019 and 2018, to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. See “Non-GAAP Financial Measures” within this management’s discussion and analysis for the FTE adjustments. This treatment allows a uniform comparison among yields on interest-earning assets. Loans include loans held-for-sale (HFS) and non-accrual loans but exclude the allowance for loan losses. Home equity lines of credit (HELOC) are included in the residential real estate category since they are secured by real estate. Net deferred loan cost amortization of $179 thousand and $182 thousand during the third quarters of 2019 and 2018, respectively, and $525 thousand and $485 thousand for the nine months ended September 30, 2019 and 2018, respectively, are included in interest income from loans. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Residual values for direct finance leases are included in the average balances for consumer loans. Net interest margin is calculated by dividing 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 September 30, 2019 Average balance | Interest | Yield / rate | September 30, 2018 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$2,355** | **$12** | **2.12%** | $2,142 | $10 | 1.77% |
| Restricted regulatory securities | **4,038** | **157** | **15.41** | 4,374 | 44 | 4.03 |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **5,935** | **40** | **2.69** | 5,920 | 40 | 2.69 |
| MBS - GSE residential | **130,180** | **868** | **2.64** | 116,126 | 759 | 2.59 |
| State and municipal (nontaxable) | **50,276** | **546** | **4.31** | 44,801 | 510 | 4.51 |
| Total investments | **186,391** | **1,454** | **3.10** | 166,847 | 1,309 | 3.11 |
| Loans and leases: |  |  |  |  |  |  |
| C&I and CRE (taxable) | **318,332** | **4,163** | **5.19** | 303,581 | 3,755 | 4.91 |
| C&I and CRE (nontaxable) | **34,156** | **342** | **3.97** | 33,196 | 323 | 3.86 |
| Consumer | **162,681** | **1,582** | **3.86** | 157,029 | 1,463 | 3.70 |
| Residential real estate | **221,929** | **2,484** | **4.44** | 212,572 | 2,306 | 4.30 |
| Total loans and leases | **737,098** | **8,571** | **4.61** | 706,378 | 7,847 | 4.41 |
| Total interest-earning assets | **929,882** | **10,194** | **4.35%** | 879,741 | 9,210 | 4.15% |
| Non-interest earning assets | **65,337** |  |  | 50,194 |  |  |
| **Total assets** | **$995,219** |  |  | $929,935 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Interest-bearing checking | **$239,471** | **$474** | **0.79%** | $198,166 | $287 | 0.57% |
| Savings and clubs | **108,714** | **36** | **0.13** | 131,637 | 60 | 0.18 |
| MMDA | **162,518** | **616** | **1.50** | 112,264 | 265 | 0.94 |
| Certificates of deposit | **120,107** | **557** | **1.84** | 112,585 | 369 | 1.30 |
| Total interest-bearing deposits | **630,810** | **1,683** | **1.06** | 554,652 | 981 | 0.70 |
| Repurchase agreements | **-** | **-** | **-** | 9,662 | 3 | 0.14 |
| Overnight borrowings | **34,096** | **210** | **2.44** | 45,479 | 260 | 2.26 |
| FHLB advances | **15,000** | **115** | **3.05** | 18,725 | 73 | 1.54 |
| Total interest-bearing liabilities | **679,906** | **2,008** | **1.17%** | 628,518 | 1,317 | 0.83% |
| Non-interest bearing deposits | **198,188** |  |  | 203,530 |  |  |
| Non-interest bearing liabilities | **14,008** |  |  | 8,077 |  |  |
| Total liabilities | **892,102** |  |  | 840,125 |  |  |
| Shareholders' equity | **103,117** |  |  | 89,810 |  |  |
| **Total liabilities and shareholders' equity** | **$995,219** |  |  | $929,935 |  |  |
| Net interest income - FTE |  | **$8,186** |  |  | $7,893 |  |
| Net interest spread |  |  | **3.18%** |  |  | 3.32% |
| Net interest margin |  |  | **3.49%** |  |  | 3.56% |
| Cost of funds |  |  | **0.91%** |  |  | 0.63% |

40

*(dollars in thousands)*

| Assets Interest-earning assets | Nine months ended September 30, 2019 Average balance | Interest | Yield / rate | September 30, 2018 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$2,437** | **$40** | **2.23%** | $7,540 | $94 | 1.66% |
| Restricted regulatory securities | **4,366** | **342** | **10.48** | 3,228 | 122 | 5.06 |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **5,931** | **120** | **2.70** | 6,205 | 110 | 2.37 |
| MBS - GSE residential | **128,216** | **2,669** | **2.78** | 115,219 | 2,267 | 2.63 |
| State and municipal (nontaxable) | **49,462** | **1,648** | **4.46** | 44,231 | 1,499 | 4.53 |
| Other | **-** | **-** | **-** | 252 | 13 | 6.85 |
| Total investments | **183,609** | **4,437** | **3.23** | 165,907 | 3,889 | 3.13 |
| Loans and leases: |  |  |  |  |  |  |
| C&I and CRE (taxable) | **315,293** | **12,225** | **5.18** | 294,645 | 10,679 | 4.85 |
| C&I and CRE (nontaxable) | **33,298** | **994** | **3.99** | 31,464 | 872 | 3.71 |
| Consumer | **158,712** | **4,604** | **3.88** | 140,941 | 3,893 | 3.69 |
| Residential real estate | **216,655** | **7,236** | **4.47** | 207,957 | 6,679 | 4.29 |
| Total loans and leases | **723,958** | **25,059** | **4.63** | 675,007 | 22,123 | 4.38 |
| Total interest-earning assets | **914,370** | **29,878** | **4.37%** | 851,682 | 26,228 | 4.12% |
| Non-interest earning assets | **61,232** |  |  | 50,528 |  |  |
| **Total assets** | **$975,602** |  |  | $902,210 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Interest-bearing checking | **$228,281** | **$1,161** | **0.68%** | $206,905 | $822 | 0.53% |
| Savings and clubs | **114,185** | **109** | **0.13** | 134,404 | 181 | 0.18 |
| MMDA | **148,661** | **1,669** | **1.50** | 110,871 | 684 | 0.83 |
| Certificates of deposit | **119,509** | **1,550** | **1.73** | 109,736 | 984 | 1.20 |
| Total interest-bearing deposits | **610,636** | **4,489** | **0.98** | 561,916 | 2,671 | 0.64 |
| Repurchase agreements | **-** | **-** | **-** | 10,792 | 13 | 0.16 |
| Overnight borrowings | **37,968** | **742** | **2.61** | 19,443 | 324 | 2.22 |
| FHLB advances | **19,109** | **385** | **2.70** | 18,876 | 205 | 1.45 |
| Total interest-bearing liabilities | **667,713** | **5,616** | **1.12%** | 611,027 | 3,213 | 0.70% |
| Non-interest bearing deposits | **195,757** |  |  | 195,392 |  |  |
| Non-interest bearing liabilities | **13,094** |  |  | 7,384 |  |  |
| Total liabilities | **876,564** |  |  | 813,803 |  |  |
| Shareholders' equity | **99,038** |  |  | 88,407 |  |  |
| **Total liabilities and shareholders' equity** | **$975,602** |  |  | $902,210 |  |  |
| Net interest income - FTE |  | **$24,262** |  |  | $23,015 |  |
| Net interest spread |  |  | **3.25%** |  |  | 3.42% |
| Net interest margin |  |  | **3.55%** |  |  | 3.61% |
| Cost of funds |  |  | **0.87%** |  |  | 0.53% |

Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in volumes of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change. The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate. Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis:

*(dollars in thousands)*

| Interest income: | Nine months ended September 30, 2019 compared to 2018 Increase (decrease) due to Volume | Rate | Total | 2018 compared to 2017 Volume | Rate | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Interest-bearing deposits | **$(78)** | **$24** | **$(54)** | $58 | $14 | $72 |
| Restricted regulatory securities | **55** | **165** | **220** | (2) | 28 | 26 |
| Investments: |  |  |  |  |  |  |
| Agency - GSE | **(5)** | **15** | **10** | (166) | 85 | (81) |
| MBS - GSE residential | **266** | **136** | **402** | 522 | 49 | 571 |
| State and municipal | **137** | **-** | **137** | 74 | 7 | 81 |
| Other | **(11)** | **-** | **(11)** | (3) | (3) | (6) |
| Total investments | **387** | **151** | **538** | 427 | 138 | 565 |
| Loans and leases: |  |  |  |  |  |  |
| Residential real estate | **285** | **272** | **557** | 241 | 449 | 690 |
| C&I and CRE | **811** | **831** | **1,642** | (27) | 514 | 487 |
| Consumer | **506** | **205** | **711** | 871 | (153) | 718 |
| Total loans and leases | **1,602** | **1,308** | **2,910** | 1,085 | 810 | 1,895 |
| Total interest income | **1,966** | **1,648** | **3,614** | 1,568 | 990 | 2,558 |
| Interest expense: |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Interest-bearing checking | **91** | **248** | **339** | 72 | 202 | 274 |
| Savings and clubs | **(24)** | **(47)** | **(71)** | 9 | 50 | 59 |
| Money market | **289** | **695** | **984** | (34) | 140 | 106 |
| Certificates of deposit | **94** | **472** | **566** | 68 | 193 | 261 |
| Total deposits | **450** | **1,368** | **1,818** | 115 | 585 | 700 |
| Repurchase agreements | **(13)** | **-** | **(13)** | 1 | (3) | (2) |
| Overnight borrowings | **353** | **65** | **418** | (42) | 169 | 127 |
| FHLB advances | **2** | **178** | **180** | (2) | 33 | 31 |
| Total interest expense | **792** | **1,611** | **2,403** | 72 | 784 | 856 |
| Net interest income | **$1,174** | **$37** | **$1,211** | $1,496 | $206 | $1,702 |

#### 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 and legal and regulatory requirements;
- experience, ability and depth of lending management;
- national and local economic trends and conditions; and
- changes in credit concentrations.

For the third quarter of 2019, the provision for loan losses decreased $0.1 million to $0.3 million from $0.4 million for the third quarter of 2018. For the nine months ended September 30, 2019 and 2018, the Company recorded a provision for loan losses of

$0.8 million and $1.1 million, respectively, a $0.3 million, or 26%, decrease. This decrease in the provision for loan losses in both periods was due primarily to a deceleration in the Company’s loan growth along with strong asset quality. The provision for loan losses derives from the reserve required from the allowance for loan losses calculation. The Company continued provisioning for the nine months ended September 30, 2019 in order to maintain an allowance level that management deemed adequate.

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 third quarter of 2019, non-interest income amounted to $2.6 million, an increase of $0.3 million, or 15%, compared to $2.3 million recorded for the same 2018 period. Service charges on loans, which increased the most, was almost $0.2 million higher than the third quarter of 2018 driven by mortgage loan service charges. Financial service fees also increased $0.1 million quarter-over-quarter.

Non-interest income totaled $7.5 million for the nine months ended September 30, 2019, an increase of $0.6 million, or 9%, from the $6.9 million recorded for the same 2018 period. Service charges on loans were up $0.4 million primarily due to service charges on commercial loans and mortgages. There were also increases in financial service fees of $0.2 million and debit card interchange fees of $0.1 million. These increases were partially offset by $0.1 million lower gains on the sale of securities.

#### Operating expenses

For the quarter ended September 30, 2019, total non-interest operating expenses were $6.6 million, an increase of $0.5 million, or 8%, compared to $6.1 million for the same 2018 quarter. Salary and employee benefits rose $0.2 million, or 7%, to $3.7 million for the third quarter of 2019 from $3.5 million for the third quarter of 2018. The increase was primarily due to higher salaries from additional employees, including bankers at the 2 new branches, plus merit increases partially offset by lower expenses for bonuses and group insurance. Premises and equipment expense was $0.1 million higher primarily due to depreciation related to the branch that was opened during December 2018 and higher equipment maintenance and rental expenses. Data processing and communications expense and professional service expenses also both increased $0.1 million during the third quarter of 2019 compared to the third quarter of 2018. These increases were partially offset by a $0.1 million FDIC assessment reduction.

For the nine months ended September 30, 2019, non-interest operating expenses increased $1.3 million, or 7%, compared to the nine months ended September 30, 2018, from $18.5 million to $19.8 million. Salaries and employee benefit expenses contributed the most to the increase growing $0.7 million, or 7%. The increase stemmed from salary increases, additional 401k contributions and higher post-retirement benefit expenses partially offset by less bonuses and group insurance. Premises and equipment expenses increased $0.3 million, or 11%, due to higher depreciation and expenses for equipment maintenance. Data processing and communications expense also increased $0.3 million. Loan collection expenses and automated transaction processing both also increased $0.1 million. Partially offsetting these increases was $0.3 million less professional service fees and $0.1 million less FDIC assessment expenses.

The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, were 1.68% and 1.72% for the nine months ended September 30, 2019 and 2018. The expense ratio decreased because of higher average assets during the nine months ended September 30, 2019 compared to the same 2018 period. The efficiency ratio increased from 61.91% at September 30, 2018 to 62.34% at September 30, 2019. For more information on the calculation of the efficiency ratio, see “Non-GAAP Financial Measures” located within this management’s discussion and analysis.

#### Provision for income taxes

The provision for income taxes increased $0.1 million for both the three and nine months ended September 30, 2019 and 2018 due to higher income before taxes. The Company's effective tax rate was 16.4% at September 30, 2019 compared to 16.4% at September 30, 2018.

### Comparison of financial condition at

### September 30, 2019 and December 31, 2018

#### Overview

Consolidated assets increased $30.3 million, or 3%, to $1.0 billion as of September 30, 2019 from $981.1 million at December 31, 2018. The increase in assets occurred principally in the loan portfolio. Cash inflow from growth in deposits of $82.1 million was used to pay down borrowings which declined $68.7 million and fund loan growth.

### 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. Debt 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). Beginning on January 1, 2018, equity securities were carried at fair value on the consolidated balance sheets with unrealized gains and losses, net of deferred income taxes, reported separately within the consolidated statements of income as a component of non-interest income. The Company sold all of its remaining equity securities during the first half of 2018. 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 September 30, 2019, the carrying value of investment securities amounted to $189.2 million, or 19% of total assets, compared to $182.8 million, or 19% of total assets, at December 31, 2018. As of September 30, 2019, 68% 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 September 30, 2019 and December 31, 2018. The AFS securities were recorded with a net unrealized gain of $4.3 million as of September 30, 2019 and a net unrealized loss of $1.4 million as of December 31, 2018. Of the net improvement in the unrealized gain position of $5.7 million, $3.4 million was net unrealized gains on mortgage-backed securities, $2.1 million was net unrealized gains on municipal securities and $0.2 million was net unrealized gains on agency securities. 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 maintain above 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 September 30, 2019, the Company had $142.5 million in public deposits, or 17% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on these public deposits or otherwise obtain a FHLB letter of credit or FDIC insurance for these customers. As of September 30, 2019, the balance of pledged securities required for deposit accounts was $75.5 million, or 40% of total securities.

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 until or sell prior 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 quarter ended September 30, 2019, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.

During the nine months ended September 30, 2019, the carrying value of total investments increased $6.4 million, or 4%. 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 intermediate to long-term rates rise, the strategy is expected to provide a good source of cash flow to reinvest into higher yielding interest-sensitive assets.

A comparison of investment securities at September 30, 2019 and December 31, 2018 is as follows:

*(dollars in thousands)*

|  | September 30, 2019 Amount% |  | December 31, 2018 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| MBS - GSE residential | **$128,552** | **67.9%** | $124,318 | 68.0% |
| State & municipal subdivisions | **54,519** | **28.8** | 52,575 | 28.8 |
| Agency - GSE | **6,175** | **3.3** | 5,917 | 3.2 |
| Total | **$189,246** | **100.0%** | $182,810 | 100.0% |

As of September 30, 2019, 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 September 30, 2019 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 | $- | -% | $85 | 5.90% | $6,137 | 3.44% | $122,330 | 3.38% | $128,552 | 3.39% |
| State & municipal subdivisions | 1,015 | 4.22 | 1,490 | 5.82 | 1,007 | 3.64 | 51,007 | 4.45 | 54,519 | 4.47 |
| Agency - GSE | - | - | 6,175 | 2.70 | - | - | - | - | 6,175 | 2.70 |
| Total debt securities | $1,015 | 4.22% | $7,750 | 3.32% | $7,144 | 3.47% | $173,337 | 3.68% | $189,246 | 3.66% |

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 21%. 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 declined to a predetermined level. In addition, the Company earns a return or dividend based on the amount invested. The dividends received from the FHLB totaled $82 thousand and $267 thousand for the three and nine months ended September 30, 2019 and $44 thousand and $122 thousand for the three and nine months ended September 30, 2018, respectively. The balance in FHLB stock was $3.8 million and $6.3 million as of September 30, 2019 and December 31, 2018, respectively.

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

Upon origination, most residential mortgages and certain Small Business Administration (SBA) guaranteed loans may be classified as held-for-sale (HFS). In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In declining interest rate environments, the Company would be exposed to prepayment risk as rates on fixed-rate loans decrease, and customers look to refinance loans. 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 September 30, 2019 and December 31, 2018, loans HFS consisted of residential mortgages with carrying amounts of $1.8 million and $5.7 million, respectively, which approximated their fair values. During the nine months ended September 30, 2019, residential mortgage loans with principal balances of $36.5 million were sold into the secondary market and the Company recognized net gains of $0.6 million, compared to $24.9 million and $0.5 million, respectively, during the nine months ended September 30, 2018. During the nine months ended September 30, 2018, the Company also sold one SBA guaranteed loan with a principal balance of $0.4 million and recognized a net gain on the sale of $47 thousand.

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. At September 30, 2019 and December 31, 2018, the servicing portfolio balance of sold residential mortgage loans was $301.5 million and $304.9 million, respectively. At September 30, 2019 and December 31, 2018, the servicing portfolio balance of sold SBA loans was $5.1 million and $5.5 million, respectively.

#### Loans and leases

As of September 30, 2019, the Company had gross loans and leases totaling $749.6 million compared to $729.1 million at December 31, 2018 which represented an increase of $20.5 million, or 3%. The loan growth was primarily driven by residential real estate activity during the third quarter of 2019.

### Commercial & industrial and commercial real estate

As of September 30, 2019, the commercial loan portfolio, which consisted of commercial and industrial (C&I) and commercial real estate (CRE) loans, increased $3.6 million, or 1%, compared to December 31, 2018. This increase was attributed to growth of $7.3 million in owner occupied CRE loans and $3.0 million in non-owner occupied CRE loans, partially offset by reductions of $4.8 million in C&I loans and $1.9 million in commercial construction loans. CRE loan growth activity can be attributed to new client acquisition and expansion of existing relationships.

### Consumer

The consumer loan portfolio experienced a slight reduction, decreasing $0.2 million, or less than 1%, compared to December 31, 2018. This reduction in the consumer loan portfolio was attributed to a decline of $2.5 million in home equity lines of credit

(HELOC), $0.7 million in direct finance leases and $0.6 million in consumer other loans, partially offset by growth of $2.7 million in auto loans and $0.9 million in home equity installment loans.

Demand for HELOCs decreased during the first three quarters of 2019 because of homeowners’ preference for conventional mortgage loan products, which had longer terms and lower rates. This trend drove the $2.5 million, or 5%, year-to-date reduction for the Company’s HELOC portfolio, as well as challenged growth in the HEIL portfolio.

During the last quarter of 2019, management expects increased demand for fixed rate home equity installment loans to offset the decline in home equity lines of credit.

Direct finance leases also declined $0.7 million as originations did not replace amortization. For the last quarter of 2019, the Company’s strategy is to offer competitive terms on direct finance leases to drive demand for high credit quality borrowers.

### Residential

The residential loan portfolio grew $17.1 million, or 11%, during the first three quarters of 2019. This growth was driven by a $16.7 million increase in residential real estate loans and a $0.4 million increase in residential construction loans. The Company’s mortgage loan modification program which offered refinancing to qualified customers predominantly caused the lift in residential real estate loans. Homeowners’ aforementioned preference for residential mortgage products supplemented the growth from the mortgage modification program. Management expects continued growth in residential loans for the last quarter of 2019.

The composition of the loan portfolio at September 30, 2019 and December 31, 2018 is summarized as follows:

*(dollars in thousands)*

|  | September 30, 2019 Amount% |  | December 31, 2018 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Commercial and industrial | **$122,129** | **16.3%** | $126,884 | 17.4% |
| Commercial real estate: |  |  |  |  |
| Non-owner occupied | **98,542** | **13.1** | 95,515 | 13.1 |
| Owner occupied | **131,398** | **17.6** | 124,092 | 17.0 |
| Construction | **4,819** | **0.6** | 6,761 | 0.9 |
| Consumer: |  |  |  |  |
| Home equity installment | **33,635** | **4.5** | 32,729 | 4.5 |
| Home equity line of credit | **50,016** | **6.7** | 52,517 | 7.2 |
| Auto | **108,295** | **14.4** | 105,576 | 14.5 |
| Direct finance leases | **16,284** | **2.2** | 17,004 | 2.3 |
| Other | **5,723** | **0.8** | 6,314 | 0.9 |
| Residential: |  |  |  |  |
| Real estate | **162,692** | **21.7** | 145,951 | 20.0 |
| Construction | **16,109** | **2.1** | 15,749 | 2.2 |
| Gross loans | **749,642** | **100.0%** | 729,092 | 100.0% |
| Less: |  |  |  |  |
| Allowance for loan losses | **(9,441)** |  | (9,747) |  |
| Unearned lease revenue | **(923)** |  | (1,028) |  |
| Net loans | **$739,278** |  | $718,317 |  |
| Loans held-for-sale | **$1,751** |  | $5,707 |  |

#### 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, regulations, and/or current economic conditions.

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 quarterly 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.

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 nine months ended September 30, 2019 | As of and for the twelve months ended December 31, 2018 | As of and for the nine months ended September 30, 2018 |
| --- | ---: | ---: | ---: |
| Balance at beginning of period | **$9,747** | $9,193 | $9,193 |
| Charge-offs: |  |  |  |
| Commercial and industrial | **(131)** | (196) | (106) |
| Commercial real estate | **(531)** | (268) | (166) |
| Consumer | **(255)** | (391) | (275) |
| Residential | **(330)** | (371) | (117) |
| Total | **(1,247)** | (1,226) | (664) |
| Recoveries: |  |  |  |
| Commercial and industrial | **17** | 77 | 67 |
| Commercial real estate | **28** | 42 | 36 |
| Consumer | **58** | 211 | 187 |
| Residential | **8** | - | - |
| Total | **111** | 330 | 290 |
| Net charge-offs | **(1,136)** | (896) | (374) |
| Provision for loan losses | **830** | 1,450 | 1,125 |
| Balance at end of period | **$9,441** | $9,747 | $9,944 |
| Allowance for loan losses to total loans | **1.26%** | 1.34% | 1.40% |
| Net charge-offs to average total loans outstanding | **0.21%** | 0.13% | 0.07% |
| Average total loans | **$723,958** | $687,853 | $675,007 |
| Loans 30 - 89 days past due and accruing | **$2,478** | $5,938 | $4,013 |
| Loans 90 days or more past due and accruing | **$7** | $1 | $14 |
| Non-accrual loans | **$3,858** | $4,298 | $3,777 |
| Allowance for loan losses to non-accrual loans | **2.45** **x** | 2.27 x | 2.63 x |
| Allowance for loan losses to non-performing loans | **2.44** **x** | 2.27 x | 2.62 x |

For the nine months ended September 30, 2019, the allowance declined by $0.3 million, or 3%, to $9.4 million from $9.7 million at December 31, 2018. Total loans, which represent gross loans less unearned lease revenue, increased by $20.6 million, or 3%, to $748.7 million at September 30, 2019 from $728.1 million at December 31, 2018. The allowance for loan losses decreased as a percentage of total loans to 1.26% at September 30, 2019 from 1.34% at December 31, 2018 due to loan growth and improved asset quality.

Management believes that the current balance in the allowance for loan losses is sufficient to meet the identified potential credit quality issues that may arise and other issues 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.

During the first quarter of 2019, management increased the qualitative factors associated with its consumer and residential portfolios related to changes in national and local economic and business conditions and developments that will ultimately affect the collectability of these portfolios. The justification for the increase in these qualitative factors was an economic summary report indicating a weakening consumer financial wherewithal. Based upon management’s judgement, this consumer weakness will cause estimated credit losses associated with the Company’s existing portfolio to differ from historical loss experience, which necessitated increasing the qualitative factors for the loan portfolios deemed most sensitive to this development, which are its consumer and residential portfolios.

During the second quarter of 2019, management decreased the qualitative factor for its home equity installment loans and residential construction loans. The reduction was due to a decreasing trend in delinquency for the home equity installment portfolio. Further, 0% delinquency in the residential construction portfolio over the past several quarters with no expectation for future delinquency in this portfolio for the foreseeable future justified the decrease in this qualitative factor.

During the third quarter of 2019, management decreased the qualitative factor for its C&I loans because of an improving delinquency trend along with a history of low delinquency levels, attributed mainly to high quality municipal loans within the C&I portfolio.

Management also reduced qualitative factors to reflect the positive impact the Federal Reserve’s decision to cut the federal funds rate 0.25% twice during the third quarter of 2019 will have on estimated credit losses for the following portfolios: commercial & industrial, owner occupied commercial real estate, non-owner occupied commercial real estate, commercial construction, residential real estate, HELOC, consumer auto, and consumer other. Estimated credit losses are anticipated to decline for commercial and residential real estate secured loans as lower interest rates improve real estate valuations due to the inverse relationship between capitalization rates and the market values of real estate. Lower rates also reduce debt service requirements for variable rate loans in all portfolios, which is particularly impactful for the commercial construction, HELOC, and consumer other portfolios due to the high concentration of variable rate loans within these portfolios. Portfolios with a high concentration of fixed rate loans, such as residential real estate and consumer auto, are also likely to observe a positive change in estimated credit losses as new customers lock in lower rates than existing customers.

The allocation of net charge-offs among major categories of loans are as follows for the periods indicated:

*(dollars in thousands)*

| Net charge-offs | For the nine months ended September 30, 2019 | % of Total Net Charge-offs | For the nine months ended September 30, 2018 | % of Total Net Charge-offs |
| --- | ---: | ---: | ---: | ---: |
| Commercial and industrial | **$(113)** | **10%** | $(39) | 10% |
| Commercial real estate | **(503)** | **44** | (130) | 35 |
| Consumer | **(198)** | **18** | (88) | 24 |
| Residential | **(322)** | **28** | (117) | 31 |
| Total net charge-offs | $(1,136) | **100%** | $(374) | 100% |

For the nine months ended September 30, 2019, net charge-offs against the allowance totaled $1.1 million compared with $0.4 million for the nine months ended September 30, 2018, representing a $0.7 million increase. This increase was primarily attributed to a $0.4 million charge-off to a single commercial borrower occurring in the first quarter of 2019. During the third quarter of 2019, the Company also charged-off an aggregate of $0.3 million in collection expenses incurred since 2016 on 14 residential loans sold to Fannie Mae but serviced by the Company. The Company will pursue recovery of these costs. During the fourth quarter of 2019, the Company anticipates completing resolution of one commercial borrower on non-accrual status which, upon payoff, could lead to a recovery of $0.3 million as well as $0.1 million in lost interest.

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 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 | September 30, 2019 Allowance | Category % of Loans | December 31, 2018 Allowance | Category % of Loans | September 30, 2018 Allowance | Category % of Loans |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Commercial real estate | **$3,775** | **32%** | $3,901 | 31% | $4,030 | 31% |
| Commercial and industrial | **1,276** | **16** | 1,432 | 18 | 1,334 | 17 |
| Consumer | **2,083** | **28** | 2,548 | 29 | 2,674 | 29 |
| Residential real estate | **2,238** | **24** | 1,844 | 22 | 1,777 | 23 |
| Unallocated | **69** | **-** | 22 | - | 129 | - |
| Total | **$9,441** | **100%** | $9,747 | 100% | $9,944 | 100% |

The allocation of the allowance for the commercial loan portfolio, which is comprised of commercial real estate and commercial & industrial loans, accounted for approximately 54% of the total allowance for loan losses at September 30, 2019, which represents a one percentage point decrease from 55% of the total allowance for loan losses at December 31, 2018.

The allocation of the allowance for the consumer loan portfolio, accounted for approximately 22% of the total allowance for loan losses at September 30, 2019, which represents a four percentage point decrease from 26% of the total allowance for loan losses at December 31, 2018. This reduction in the allowance allocated to the consumer loan portfolio was mostly related to the payoff of a consumer installment troubled debt restructured (TDR) loan with a large specific impairment that occurred during the first quarter of 2019.

The allocation of the allowance for the residential real estate portfolio, accounted for approximately 24% of the total allowance for loan losses at September 30, 2019, which represents a five percentage point increase from 19% of the total allowance for loan losses at December 31, 2018. The year-to-date increase in the allowance allocated to residential real estate was attributed to an increase in the residential loan portfolio relative to the overall loan portfolio. The residential portfolio grew by $17.1 million, or 11%, to $178.8 million at September 30, 2019 from $161.7 million at December 31, 2018 compared to year-to-date total loan growth of 3%.

The unallocated amount represents the portion of the allowance not specifically identified with a loan or groups of loans. The unallocated reserve was less than 1% of the total allowance for loan losses at September 30, 2019, unchanged from less than 1% of the total allowance for loan losses at December 31, 2018.

#### Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, TDRs, other real estate owned (ORE) and repossessed assets.

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

*(dollars in thousands)*

|  | September 30, 2019 | December 31, 2018 | September 30, 2018 |
| --- | ---: | ---: | ---: |
| Loans past due 90 days or more and accruing | **$7** | $1 | $14 |
| Non-accrual loans \* | **3,858** | 4,298 | 3,777 |
| Total non-performing loans | **3,865** | 4,299 | 3,791 |
| Troubled debt restructurings | **964** | 1,830 | 1,841 |
| Other real estate owned and repossessed assets | **685** | 190 | 577 |
| Total non-performing assets | **$5,514** | $6,319 | $6,209 |
| Total loans, including loans held-for-sale | **$750,470** | $733,771 | $715,413 |
| Total assets | **$1,011,424** | $981,102 | $949,854 |
| Non-accrual loans to total loans | **0.51%** | 0.59% | 0.53% |
| Non-performing loans to total loans | **0.52%** | 0.59% | 0.53% |
| Non-performing assets to total assets | **0.55%** | 0.64% | 0.65% |

\* In the table above, the amount includes non-accrual TDRs of $0.8 million as of September 30, 2019, $1.7 million as of December 31, 2018 and $1.9 million as of September 30, 2018.

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

Non-performing assets represented 0.55% of total assets at September 30, 2019 compared with 0.65% at December 31, 2018. The non-performing assets ratio improved due to the net reduction in non-performing assets by $0.8 million (13%) to $5.5 million along with a $30.3 million (3%) increase in total assets to $1.0 billion. The improvement in non-performing assets resulted primarily from the payoff of two TDRs to a single borrower totaling $0.7 million and $0.3 million in charge-offs for two commercial TDRs to a single borrower.

From December 31, 2018 to September 30, 2019, non-accrual loans decreased by $0.4 million, or 10%, from $4.3 million to $3.9 million. At December 31, 2018, there were a total of 40 loans to 34 unrelated borrowers with balances that ranged from less than $1 thousand to $0.6 million. At September 30, 2019, there were a total of 40 loans to 35 unrelated borrowers with balances that ranged from less than $1 thousand to $0.7 million. The decline in non-accrual loans was attributed to payments received of $1.4 million, charge-offs of $0.7 million, transfers back to accrual of $0.1 million and transfers to ORE of $0.9 million. These decreases were partially offset by the addition of $2.5 million of loans to non-accrual status along with expenses added to balances of $0.2 million.

From December 31, 2018 to September 30, 2019, accruing loans that were over 90 days past due increased from three loans totaling $1 thousand to one loan totaling $7 thousand. 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.

During the fourth quarter of 2019, despite the fact that all interest is and expects to be paid as agreed, a significant commercial relationship has the potential to deteriorate from Special Mention to Substandard.

The composition of non-performing loans as of September 30, 2019 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 | **$122,129** | **$-** | **$206** | **$206** | **0.17%** |
| Commercial real estate: |  |  |  |  |  |
| Non-owner occupied | **98,542** | **-** | **428** | **428** | **0.43%** |
| Owner occupied | **131,398** | **-** | **1,791** | **1,791** | **1.36%** |
| Construction | **4,819** | **-** | **-** | **-** | **-** |
| Consumer: |  |  |  |  |  |
| Home equity installment | **33,635** | **-** | **44** | **44** | **0.13%** |
| Home equity line of credit | **50,016** | **-** | **260** | **260** | **0.52%** |
| Auto loans | **108,295** | **7** | **68** | **75** | **0.07%** |
| Direct finance leases \* | **15,361** | **-** | **-** | **-** | **-** |
| Other | **5,723** | **-** | **-** | **-** | **-** |
| Residential: |  |  |  |  |  |
| Real estate | **162,692** | **-** | **1,061** | **1,061** | **0.65%** |
| Construction | **16,109** | **-** | **-** | **-** | **-** |
| Loans held-for-sale | **1,751** | **-** | **-** | **-** | **-** |
| Total | **$750,470** | **$7** | **$3,858** | **$3,865** | **0.52%** |

\*Net of unearned lease revenue of $0.9 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 September 30, 2019 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $172 thousand.

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

*(dollars in thousands)*

| As of and for the nine months ended September 30, 2019 Troubled Debt Restructures: | Accruing Commercial & industrial | Commercial real estate | Non-accruing Commercial real estate | Residential real estate | Consumer installment | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Beginning balance | **$24** | **$1,806** | **$520** | **$764** | **$413** | **$3,527** |
| Additions | **-** | **-** | **44** | **-** | **-** | **44** |
| Transfers | **-** | **(645)** | **645** | **(430)** | **-** | **(430)** |
| Pay downs / payoffs | **(24)** | **(197)** | **(67)** | **(316)** | **(413)** | **(1,017)** |
| Charge offs | **-** | **-** | **(361)** | **(18)** | **-** | **(379)** |
| Ending balance | **$-** | **$964** | **$781** | **$-** | **$-** | **$1,745** |
| Number of loans | **-** | **6** | **3** | **-** | **-** | **9** |

51

*(dollars in thousands)*

| As of and for the year ended December 31, 2018 Troubled Debt Restructures: | Accruing Commercial & industrial | Commercial real estate | Non-accruing Consumer HELOC | Commercial real estate | Residential real estate | Consumer installment | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: | ---: |
| Beginning balance | $24 | $1,847 | $395 | $542 | $636 | $- | $3,444 |
| Additions | - | - | - | - | 365 | 414 | 779 |
| Transfers | - | - | (395) | - |  | - | (395) |
| Pay downs / payoffs | - | (41) | - | (22) | - | (1) | (64) |
| Charge offs | - | - | - | - | (237) | - | (237) |
| Ending balance | $24 | $1,806 | $- | $520 | $764 | 413 | $3,527 |
| Number of loans | 1 | 10 | - | 1 | 2 | 1 | 15 |

The Company, on a regular basis, reviews changes to loans to determine if they meet the definition of a TDR. TDRs arise when a borrower experiences financial difficulty and the Company grants a concession that it would not otherwise grant based on current underwriting standards in order to maximize the Company’s recovery.

From December 31, 2018 to September 30, 2019, TDRs decreased by $1.8 million, or 50%, from $3.5 million to $1.7 million. At December 31, 2018, there were a total of 15 TDRs by 11 unrelated borrowers with balances that ranged from $24 thousand to $0.5 million. At September 30, 2019, there were a total of 9 TDRs by 8 unrelated borrowers with balances that ranged from $80 thousand to $0.5 million. The decrease was driven by the payoff of two TDRs by a single borrower totaling $0.7 million, $0.3 million in additional paydowns/payoffs, charge-offs to a single unrelated borrower totaling $0.4 million and a $0.4 million transfer to ORE of a residential real estate TDR in 2019.

Loans modified in a TDR may or may not be placed on non-accrual status. At December 31, 2018, four TDRs totaling $1.7 million were on non-accrual. At September 30, 2019, three TDRs totaling $0.8 million were on non-accrual. During the first quarter of 2019, a non-accrual residential real estate TDR and a non-accrual consumer installment TDR, both to the same borrower, were paid off. During the second quarter of 2019, a residential real estate TDR was moved to ORE.

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, 2018 to September 30, 2019, foreclosed assets held-for-sale (ORE) increased from $0.2 million to $0.7 million, a $0.5 million increase. The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale:

*(dollars in thousands)*

|  | September 30, 2019 Amount | # | December 31, 2018 Amount | # |
| --- | ---: | ---: | ---: | ---: |
| Balance at beginning of period | **$190** | **6** | $973 | 11 |
| Additions | **868** | **3** | 714 | 8 |
| Pay downs | **(18)** |  | (2) |  |
| Write downs | **(62)** |  | (123) |  |
| Sold | **(296)** | **(2)** | (1,372) | (13) |
| Balance at end of period | **$682** | **7** | $190 | 6 |

As of September 30, 2019, ORE consisted of seven properties from seven unrelated borrowers totaling $0.7 million. Two of these properties ($0.6 million) were added in 2019; two of these properties ($61 thousand) were added in 2018; two of these properties ($10 thousand) were added in 2017; and one was added in 2014 ($42 thousand). All seven of the properties are currently listed for sale.

As of September 30, 2019, the Company had one other repossessed asset held-for-sale, with a balance of $2 thousand. There was no other repossessed asset held-for-sale at December 31, 2018.

#### 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 2019, the Company invested $2.0 million in additional BOLI as a source of funding for additional life insurance benefits that provides for payments upon death for officers and employee benefit expenses related to the Company’s non-qualified SERP implemented for certain executive officers. 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.

#### Premises and equipment

Net of depreciation, premises and equipment decreased $0.1 million during the first nine months of 2019. The Company recorded $1.1 million in depreciation expense which was partially offset by $1.0 million in additions to fixed assets. For the last quarter of 2019, we expect premises and equipment to increase due to the opening of the new Mountaintop branch in October 2019.

#### Other assets

During the first nine months of 2019, the $0.3 million, or 4%, decrease in other assets was due mostly to a $1.4 million larger net deferred tax liability, $0.2 million less prepaid dealer reserve, $0.2 million reduction from the sale of a building held for sale, $0.2 million decrease in non-accrual borrowing receivables, $0.4 million less negative escrow receivable and $0.1 million less mortgage servicing rights partially offset by $1.4 million in additional construction in process and $0.8 million higher prepaid expenses.

### Funds Provided:

#### Deposits

The Company is a community based commercial depository financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Generally, deposits are obtained from consumers, businesses and public entities within the communities that surround the Company’s 12 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 FHLB advances.

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

*(dollars in thousands)*

|  | September 30, 2019 Amount% |  | December 31, 2018 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Interest-bearing checking | **$251,119** | **29.5%** | $224,185 | 29.1% |
| Savings and clubs | **105,578** | **12.4** | 118,971 | 15.4 |
| Money market | **173,041** | **20.3** | 116,010 | 15.1 |
| Certificates of deposit | **118,768** | **13.9** | 116,286 | 15.1 |
| Total interest-bearing | **648,506** | **76.1** | 575,452 | 74.7 |
| Non-interest bearing | **203,816** | **23.9** | 194,731 | 25.3 |
| Total deposits | **$852,322** | **100.0%** | $770,183 | 100.0% |

Total deposits increased $82.1 million, or 11%, from $770.2 million at December 31, 2018 to $852.3 million at September 30, 2019. Money market accounts contributed the most to the deposit growth with an increase of $57.0 million, mostly due to increases in the balances of existing accounts. Additionally, the Company added new money market accounts and customers also shifted money from savings and checking accounts to earn higher rates. Interest-bearing checking accounts increased $26.9 million due to an increase in balances from existing business and public customers. Non-interest bearing checking accounts increased $9.1 million primarily from existing business accounts despite shifts to interest-bearing accounts. The Company focused on obtaining a full-banking relationship with existing customers as well as forming new customer relationships. Savings and club accounts declined $13.4 million due to customers’ preference for products with higher earnings potential. Most of the decline in savings accounts was due to shifts to money market accounts. The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop creative programs for its customers. For the remainder of 2019, the Company will focus on deposit growth to fund asset growth and pay down short-term borrowings. Growth in deposits from new markets is expected from a full year with the

Back Mountain branch plus the Mountaintop branch opening during the fourth quarter of 2019. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset this deposit growth.

Additionally, CDs also increased $2.5 million mostly due to an ongoing 15-month CD promotion and customers’ desire for higher-yielding deposit alternatives. During 2019, deposit customers moved some money from savings and interest-bearing checking accounts to CDs. Demand for higher rate money market accounts and CDs may continue to grow thereby 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 and Insured Cash Sweep (ICS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum insured amount of $250,000. 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. The Company did not have any CDARs as of September 30, 2019 and December 31, 2018. As of September 30, 2019 and December 31, 2018, ICS reciprocal deposits represented $29.9 million and $4.7 million, or 4% and 1%, of total deposits which are included in interest-bearing checking accounts in the table above. The increase in ICS deposits is primarily due to an account opened by a public customer during the third quarter of 2019 that had a balance of $13.4 million at September 30, 2019.

The maturity distribution of certificates of deposit at September 30, 2019 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 | $7,125 | $15,940 | $31,694 | $16,847 | $71,606 |
| CDs of less than $100,000 | 6,272 | 9,005 | 13,373 | 18,512 | 47,162 |
| Total CDs | $13,397 | $24,945 | $45,067 | $35,359 | $118,768 |

Certificates of deposit of $250,000 or more amounted to $44.4 million and $38.4 million as of September 30, 2019 and December 31, 2018, respectively.

Approximately 11% of the CDs, with a weighted-average interest rate of 1.59%, are scheduled to mature during the remainder of 2019 and an additional 67%, with a weighted-average interest rate of 2.06%, are scheduled to mature during 2020. 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. The Company does expect CD growth to continue during 2019, and will develop CD promotional programs when the Company deems that it is economically feasible to do so or when demand exists. The Company currently expects the cost of deposit funds to slowly decline due to the current decreasing interest rate environment. As with all promotions, the Company will consider the needs of the customers and simultaneously be mindful of the liquidity levels, borrowing rates 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 of Pittsburgh and other correspondent banks for asset growth and liquidity needs.

At the end of 2018, the Company transferred all repurchase agreement accounts to interest-bearing checking accounts. In addition, short-term borrowings may include overnight balances with FHLB line of credit and/or correspondent bank’s federal funds lines which the Company may require to fund daily liquidity needs such as deposit outflow, loan demand and operations. Short-term borrowings decreased $52.0 million during the first nine months of 2019 as deposits grew.

During the first quarter of 2019, the Company paid off $10 million in FHLB advances with an interest rate of 1.34%. During the second quarter of 2019, the Company paid off $6.7 million in FHLB advances with an interest rate of 1.43%. As of September 30, 2019, the Company had the ability to borrow an additional $204.7 million from the FHLB.

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

*(dollars in thousands)*

|  | September 30, 2019 Amount% |  | December 31, 2018 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Overnight borrowings | **$24,355** | **61.9%** | $76,366 | 70.7% |
| FHLB advances | **15,000** | **38.1** | 31,704 | 29.3 |
| Total | **$39,355** | **100.0%** | $108,070 | 100.0% |

The original maturity dates of FHLB advances as of September 30, 2019 are as follows:

*(dollars in thousands)*

|  | Amount | Weighted average rate |
| --- | ---: | ---: |
| Maturity date 1 year or less | $- | -% |
| After 1 but within 2 | 5,000 | 2.95 |
| After 2 but within 3 | 5,000 | 2.99 |
| After 3 but within 4 | 5,000 | 3.07 |
| After 4 years | - | - |
| Total | $15,000 | 3.01% |

## Market risk

As filed, 27,142 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 September 30, 2019, the Company maintained a one-year cumulative gap of positive (asset sensitive) $45.0 million, or 4%, 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 September 30, 2019:

*(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 | $1,395 | $- | $- | $17,292 | $18,687 |
| Investment securities (1)(2) | 8,511 | 27,010 | 42,495 | 115,048 | 193,064 |
| Loans and leases(2) | 190,506 | 145,070 | 229,740 | 175,713 | 741,029 |
| Fixed and other assets | - | 23,094 | - | 35,550 | 58,644 |
| Total assets | $200,412 | $195,174 | $272,235 | $343,603 | $1,011,424 |
| Total cumulative assets | $200,412 | $395,586 | $667,821 | $1,011,424 |  |
| Non-interest-bearing transaction deposits (3) | $- | $20,402 | $56,008 | $127,406 | $203,816 |
| Interest-bearing transaction deposits (3) | 222,442 | - | 153,648 | 153,648 | 529,738 |
| Certificates of deposit | 13,397 | 70,022 | 30,851 | 4,498 | 118,768 |
| Short-term borrowings | 24,355 | - | - | - | 24,355 |
| FHLB advances | - | - | 10,000 | 5,000 | 15,000 |
| Other liabilities | - | - | - | 14,958 | 14,958 |
| Total liabilities | $260,194 | $90,424 | $250,507 | $305,510 | $906,635 |
| Total cumulative liabilities | $260,194 | $350,618 | $601,125 | $906,635 |  |
| Interest sensitivity gap | $(59,782) | $104,750 | $21,728 | $38,093 |  |
| Cumulative gap | $(59,782) | $44,968 | $66,696 | $104,789 |  |
| Cumulative gap to total assets | -5.9% | 4.4% | 6.6% | 10.4% |  |

(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 September 30, 2019 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 September 30, 2019 levels:

| Earnings at risk: | % change Rates +200 | Rates -200 |
| --- | ---: | ---: |
| Net interest income | 4.9% | (5.2)% |
| Net income | 12.3 | (12.7) |
| Economic value at risk: |  |  |
| Economic value of equity | 7.7 | (42.8) |
| Economic value of equity as a percent of total assets | 1.1 | (5.2) |

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 September 30, 2019, the Company’s risk-based capital ratio was 15.56%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning October 1, 2019, 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 | $34,314 | $1,597 | 4.9% |
| +100 basis points | 33,643 | 926 | 2.8 |
| Flat rate | 32,717 | - | - |
| -100 basis points | 31,496 | (1,221) | (3.7) |
| -200 basis points | 31,022 | (1,695) | (5.2) |

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, 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 September 30, 2019, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.

During the nine months ended September 30, 2019, the Company generated $1.2 million of cash. During the period, the Company’s operations provided approximately $21.5 million mostly from $24.3 million of net cash inflow from the components of net interest income and $9.8 million in proceeds of loans HFS over originations; partially offset by net non-interest expense/income related payments of $11.2 million and $1.4 million in estimated tax payments. Cash inflow from interest-earning assets, deposits, loan payments and the sale of securities were used to purchase investment securities and replace maturing and cash runoff of securities, fund the loan portfolio, pay down FHLB advances and overnight borrowings, purchase bank-owned life insurance, invest in bank premises and equipment and make net dividend payments. The Company received a large amount of public deposits over the past three 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. During 2019, the Company made an effort to open new public accounts as ICS accounts and transfer some existing public accounts to ICS accounts in order to provide the customer with FDIC insurance and to free up the Company’s unencumbered securities to improve liquidity. 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.

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.

As of September 30, 2019, the Company maintained $18.7 million in cash and cash equivalents and $191.0 million of investments AFS and loans HFS. Also as of September 30, 2019, the Company had approximately $204.7 million available to borrow from the FHLB, $21.0 million from correspondent banks, $96.0 million from the FRB and $150.0 million from the Promontory One-Way Buy program. The combined total of $681.4 million represented 67% of total assets at September 30, 2019. Management believes this level of liquidity to be strong and adequate to support current operations.

#### Capital

During the nine months ended September 30, 2019, total shareholders' equity increased $11.2 million, or 12%, due principally from the $8.9 million in net income added into retained earnings. The Company’s capital position was further enhanced by the $4.5 million, after tax improvement in the net unrealized gain position in the Company’s investment portfolio, $0.2 million from investments in the Company’s common stock via the Employee Stock Purchase Plan (ESPP) and $0.7 million from stock-based compensation expense from the ESPP and unvested restricted stock and SSARs. These items were partially offset by $3.0 million of cash dividends declared on the Company’s common stock and a $0.1 million adjustment to retained earnings resulting from adoption of ASU 2016-02. The Company’s dividend payout ratio, defined as the rate at which current earnings are paid to shareholders, was 33.5% for the nine months ended September 30, 2019. The balance of earnings is retained to further strengthen the Company’s capital position.

As of September 30, 2019, the Company reported a net unrealized gain position of $3.4 million, net of tax, from the debt securities AFS portfolio compared to a net unrealized loss of $1.1 million as of December 31, 2018. The increase during the first nine months of 2019 was due to $2.7 million in net unrealized gains on mortgage-backed securities, $1.6 million in net unrealized gains on municipal securities and $0.2 million in net unrealized gains on agency securities. 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 declining rate environment is expected and during the period of falling rates, the Company expects pricing in the bond portfolio to improve. There is no assurance that future realized and unrealized losses will not be recognized from the Company’s portfolio of investment securities. To help maintain a healthy capital position, the Company can issue stock to participants in the DRP and ESPP plans. The DRP affords the Company the option to acquire shares in open market purchases and/or issue shares directly from the Company to plan participants. During the first nine months of 2019, the Company acquired shares in the open market to fulfill the needs of the DRP. Both the DRP and the ESPP plans have been a consistent source of capital from the Company’s loyal employees and shareholders and their participation in these plans will continue to help strengthen the Company’s balance sheet.

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

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets. The guidelines require all banks and bank holding companies to maintain a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I common equity to total risk-weighted assets (Tier I Common Equity) of 4.5%, Tier I capital to total risk-weighted assets (Tier I Capital) of 6% and Tier I capital to average total assets (Leverage Ratio) of at least 4%. A capital conservation buffer, comprised of common equity Tier I capital, is also established above the regulatory minimum capital requirements of 2.50%. As of September 30, 2019 and December 31, 2018, 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 consolidated basis, and the Bank as of September 30, 2019 and December 31, 2018:

*(dollars in thousands)*

| As of September 30, 2019: Total capital (to risk-weighted assets) | Actual Amount | Ratio | For capital adequacy purposes Amount |  | Ratio |  | For capital adequacy purposes with capital conservation buffer\* Amount | Ratio | To be well capitalized under prompt corrective action provisions Amount |  | Ratio |
| --- | ---: | ---: | --- | ---: | ---: | --- | ---: | ---: | --- | ---: | ---: |
| Consolidated | **$109,990** | **15.6%** | **≥** | **$56,554** | **8.0%** | **≥** | **$74,227** | **10.5%** |  | **N/A** | **N/A** |
| Bank | **$109,939** | **15.6%** | **≥** | **$56,548** | **8.0%** | **≥** | **$74,219** | **10.5%** | **≥** | **$70,685** | **10.0%** |
| Tier 1 common equity (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$101,145** | **14.3%** | **≥** | **$31,812** | **4.5%** | **≥** | **$49,485** | **7.0%** |  | **N/A** | **N/A** |
| Bank | **$101,095** | **14.3%** | **≥** | **$31,808** | **4.5%** | **≥** | **$49,479** | **7.0%** | **≥** | **$45,945** | **6.5%** |
| Tier I capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$101,145** | **14.3%** | **≥** | **$42,415** | **6.0%** | **≥** | **$60,088** | **8.5%** |  | **N/A** | **N/A** |
| Bank | **$101,095** | **14.3%** | **≥** | **$42,411** | **6.0%** | **≥** | **$60,082** | **8.5%** | **≥** | **$56,548** | **8.0%** |
| Tier I capital (to average assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | **$101,145** | **10.2%** | **≥** | **$39,650** | **4.0%** | **≥** | **$39,650** | **4.0%** |  | **N/A** | **N/A** |
| Bank | **$101,095** | **10.2%** | **≥** | **$39,650** | **4.0%** | **≥** | **$39,650** | **4.0%** | **≥** | **$49,563** | **5.0%** |

59

| As of December 31, 2018: Total capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| --- | ---: | ---: | --- | ---: | ---: | --- | ---: | ---: | --- | ---: | ---: |
| Consolidated | $103,201 | 14.8% | ≥ | $55,975 | 8.0% | ≥ | $69,094 | 9.9% |  | N/A | N/A |
| Bank | $103,313 | 14.8% | ≥ | $55,970 | 8.0% | ≥ | $69,088 | 9.9% | ≥ | $69,962 | 10.0% |
| Tier 1 common equity (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $94,442 | 13.5% | ≥ | $31,486 | 4.5% | ≥ | $44,605 | 6.4% |  | N/A | N/A |
| Bank | $94,554 | 13.5% | ≥ | $31,483 | 4.5% | ≥ | $44,601 | 6.4% | ≥ | $45,475 | 6.5% |
| Tier I capital (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $94,442 | 13.5% | ≥ | $41,981 | 6.0% | ≥ | $55,100 | 7.9% |  | N/A | N/A |
| Bank | $94,554 | 13.5% | ≥ | $41,977 | 6.0% | ≥ | $55,095 | 7.9% | ≥ | $55,970 | 8.0% |
| Tier I capital (to average assets) |  |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $94,442 | 9.8% | ≥ | $38,593 | 4.0% | ≥ | $38,593 | 4.0% |  | N/A | N/A |
| Bank | $94,554 | 9.8% | ≥ | $38,591 | 4.0% | ≥ | $38,591 | 4.0% | ≥ | $48,238 | 5.0% |

\* The minimums under Basel III increased by 0.625% (the capital conservation buffer) annually until 2019.

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 2018 Form 10-K for a discussion on the regulatory environment and recent legislation and rulemaking.

## Controls and procedures

As filed, 1,069 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 September 30, 2019.

## 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 2018 Form 10-K filed with the Securities and Exchange Commission on March 14, 2019.

Filed Nov 6, 2019.
Source: SEC EDGAR, the filing index for accession 0001098151-19-000046. Last ingested by Listed: Nov 6, 2026, 18:40 ET. No prices; not investment advice.