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

Overview.

We strive to remain a leader in meeting the financial service needs of the local community and to provide quality service to the individuals and businesses in the market areas that we have served since 1853. Historically, we have been a community-oriented provider of traditional banking products and services to business organizations and individuals, including products such as residential and commercial real estate loans, commercial and industrial loans, consumer loans and a variety of deposit products. We meet the needs of our local community through a community-based and service-oriented approach to banking.

We have adopted a growth-oriented strategy that continues to focus on increasing commercial lending and residential lending. Our strategy also calls for increasing deposit relationships, specifically core deposits (defined below), and broadening our product lines and services. We believe that this business strategy is best for our long-term success and viability, and complements our existing commitment to high-quality customer service.

In connection with our overall growth strategy, we seek to:

• Grow the Company’s commercial loan portfolio and related commercial deposits by targeting businesses in our primary market areas of Hampden and Hampshire Counties in western Massachusetts and Hartford and Tolland Counties in northern Connecticut to increase the net interest margin and loan income;
• Supplement the Company’s commercial portfolio by growing the Company’s residential real estate portfolio to diversify the Company’s loan portfolio and deepen customer relationships;
• Focus on expanding our retail banking deposit franchise and increase the number of households served within our designated market area;
• Invest in people, systems and technology to grow revenue, improve efficiency and enhance the overall customer experience;
• Grow revenues, increase book value and tangible book value per share (non-GAAP), continue to pay competitive dividends to shareholders and utilize the Company’s stock repurchase plan to leverage our capital and enhance franchise value (tangible book value per share is a non-GAAP measure. See “Explanation of Use of Non-GAAP Financial Measurements” for more information regarding our uses of non-GAAP financial measurements); and
• Consider growth through acquisitions. We may pursue expansion opportunities in existing or adjacent strategic locations with companies that add complementary products to our existing business and at terms that add value to our existing shareholders.

You should read the following financial results for the three months and nine months ended September 30, 2023 in the context of this strategy.

• Net income was $4.5 million, or $0.21 per diluted share, for the three months ended September 30, 2023, compared to net income of $6.0 million, or $0.28 per diluted share, for the three months ended September 30, 2022. For the nine months ended September 30, 2023, net income was $12.6 million, or $0.58 per diluted share, compared to $16.9 million, or $0.77 per diluted share, for the nine months ended September 30, 2022.
• Net interest income decreased $3.9 million, or 19.2%, to $16.4 million, for the three months ended September 30, 2023, from $20.3 million for the three months ended September 30, 2022. The decrease in net interest income was due to an increase in interest expense of $8.1 million, partially offset by an increase in interest and dividend income of $4.1 million, or 19.1%. During the nine months ended September 30, 2023, net interest income decreased $6.7 million, or 11.4%, to $51.7 million, compared to $58.4 million for the nine months ended September 30, 2022. The decrease in net interest income was due to an increase in interest expense of $18.7 million, partially offset by an increase in interest and dividend income of $12.0 million, or 19.3%.
• During the three months ended September 30, 2023, the Company recorded a provision for credit losses of $354,000 under the Current Expected Credit Losses (“CECL”) model, compared to $675,000 during the three months ended September 30, 2022, under the incurred loss model. For the nine months ended September 30, 2023, the Company recorded a provision for credit losses of $386,000, under the CECL model, compared to $550,000, under the incurred loss model, during the nine months ended September 30, 2022. The decrease was primarily due to changes in the economic environment and related adjustments to the quantitative components of the CECL methodology. The Company recorded net charge-offs of $1.9 million for the nine months ended September 30, 2023, as compared to net charge-offs of $129,000 for the nine months ended September 30, 2022. The charge-offs for the nine months ended September 30, 2023 were primarily related to one commercial loan relationship acquired on October 21, 2016 from Chicopee Bancorp, Inc. that was placed on nonaccrual status. The charge-off represented the non-accretable credit mark that was required to be grossed-up to the loan’s amortized cost basis with a corresponding increase to the allowance for credit losses under the CECL implementation. There was no impact to earnings as a result of the charge-off.

CRITICAL ACCOUNTING POLICIES.

Our consolidated financial statements are prepared in accordance with U.S. GAAP and practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Actual results could differ from those estimates.

Critical accounting estimates are necessary in the application of certain accounting policies and procedures, and are particularly susceptible to significant change. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions.

On January 1, 2023, the Company adopted Accounting Standards Update (ASU) 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires the recognition of the allowance for credit losses be estimated using the CECL methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with Topic 842 on leases. In addition, ASC 326 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities that are determined to have impairment related to credit losses.

There have been no additional material changes to our critical accounting policies during the nine months ended September 30, 2023. For additional information on our critical accounting policies, please refer to the information contained in Note 1 of the accompanying unaudited consolidated financial statements and Note 1 of the consolidated financial statements included in our 2022 Annual Report.

COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 2023 AND DECEMBER 31, 2022

At September 30, 2023, total assets were $2.6 billion and increased $31.8 million, or 1.3%, from December 31, 2022. The increase in total assets was primarily related to an increase in total loans of $23.4 million, or 1.2%, an increase in cash and cash equivalents of $31.9 million, or 105.2%, to $62.3 million, partially offset by a decrease in investment securities of $27.7 million, or 7.2%, to $355.7 million.

At September 30, 2023, the available-for-sale (“AFS”) and held-to-maturity (“HTM”) securities portfolio represented 13.8% of total assets compared to 14.8% at December 31, 2022. At September 30, 2023, the Company’s AFS securities portfolio, recorded at fair market value, decreased $16.3 million, or 11.1%, from $147.0 million at December 31, 2022 to $130.7 million. The HTM securities portfolio, recorded at amortized cost, decreased $5.2 million, or 2.2%, from $230.2 million at December 31, 2022 to $225.0 million at September 30, 2023. The marketable equity securities portfolio decreased $6.2 million, or 100.0%, from $6.2 million at December 31, 2022 due to the redemption of marketable equity securities during the nine months ended September 30, 2023. The decrease in the AFS and HTM securities portfolios was primarily due to amortization and payoffs recorded during the nine months ended September 30, 2023.

At September 30, 2023, the Company reported unrealized losses on the AFS securities portfolio of $38.5 million, or 22.7% of the amortized cost basis of the AFS securities portfolio, compared to unrealized losses of $32.2 million, or 18.0% of the amortized cost basis of the AFS securities at December 31, 2022. At September 30, 2023, the Company reported unrealized losses on the HTM securities portfolio of $48.2 million, or 21.4%, of the amortized cost basis of the HTM securities portfolio, compared to $39.2 million, or 17.0% of the amortized cost basis of the HTM securities portfolio at December 31, 2022.

The securities in which the Company may invest are limited by regulation. Federally chartered savings banks have authority to invest in various types of assets, including U.S. Treasury obligations, securities of various government-sponsored enterprises, mortgage-backed securities, certain certificates of deposit of insured financial institutions, repurchase agreements, overnight and short-term loans to other banks, corporate debt instruments and marketable equity securities. The securities, with the exception of $6.8 million in corporate bonds, are issued by the United States government or government-sponsored enterprises and are therefore either explicitly or implicitly guaranteed as to the timely payment of contractual principal and interest. These positions are deemed to have no credit impairment, therefore, the disclosed unrealized losses with the securities portfolio relate primarily to changes in prevailing interest rates. In all cases, price improvement in future periods will be realized as the issuances approach maturity.

Management regularly reviews the portfolio for securities in an unrealized loss position. At September 30, 2023 and December 31, 2022, the Company did not record any impairment charges on its securities portfolio and attributed the unrealized losses primarily due to fluctuations in general interest rates or changes in expected prepayments and not due to credit quality. The primary objective of the Company’s investment portfolio is to provide liquidity and to secure municipal deposit accounts while preserving the safety of principal. The Company expects to strategically redeploy available cash flows from the securities portfolio to fund loan growth and deposit outflows.

At September 30, 2023, total loans increased $23.4 million, or 1.2%, to $2.0 billion from December 31, 2022. Residential real estate loans, including home equity loans, increased $18.7 million, or 2.7%, commercial real estate loans increased $11.0 million, or 1.0%, and commercial and industrial loans decreased $7.3 million, or 3.3%. All loans where the payments are 90 days or more in arrears as of the closing date of each month are placed on nonaccrual status. If all nonaccrual loans had been performing in accordance with their terms, we would have earned additional interest income of $356,000 and $147,000 for the nine months ended September 30, 2023 and 2022, respectively.

Total delinquency was 0.28% of total loans at September 30, 2023, compared to 0.22% of total loans at December 31, 2022. At September 30, 2023, nonperforming loans totaled $6.3 million, or 0.31% of total loans, compared to $5.7 million, or 0.29% of total loans, at December 31, 2022. At September 30, 2023, there were no loans 90 or more days past due and still accruing interest. Nonperforming assets to total assets was 0.24% at September 30, 2023 and 0.22% at December 31, 2022. At September 30, 2023 and at December 31, 2022, the Company did not have any other real estate owned. The allowance for credit losses as a percentage of total loans was 0.99% at September 30, 2023, compared to 1.00% at December 31, 2022. At September 30, 2023, the allowance for credit losses as a percentage of nonperforming loans was 317.6%, compared to 350.0% at December 31, 2022. Total classified loans, defined as special mention and substandard loans, decreased $18.4 million, or 28.7%, from $64.0 million, or 3.2% of total loans, at December 31, 2022 to $45.6 million, or 2.3%, of total loans at September 30, 2023. Management continues to remain attentive to any signs of deterioration in borrowers’ financial conditions and is proactive in taking the appropriate steps to mitigate risk. A summary of our past due and nonaccrual loans by class is listed in Note 5 of the accompanying unaudited consolidated financial statements.

Total deposits decreased $53.1 million, or 2.4%, from December 31, 2022, to $2.2 billion at September 30, 2023, due to industry-wide pressures and a competitive market for deposits but increased $18.3 million, or 0.9%, from June 30, 2023. Core deposits, which the Company defines as all deposits except time deposits, decreased $224.0 million, or 12.3%, from $1.8 billion, or 81.5% of total deposits, at December 31, 2022, to $1.6 billion, or 73.2% of total deposits, at September 30, 2023. Money market accounts decreased $146.2 million, or 18.2%, to $654.9 million, non-interest-bearing deposits decreased $51.9 million, or 8.0%, to $593.6 million, savings accounts decreased $30.1 million, or 13.5%, to $192.3 million and interest-bearing checking accounts increased $4.2 million, or 2.8%, to $152.9 million. Time deposits increased $170.9 million, or 41.5%, from $411.7 million at December 31, 2022 to $582.6 million at September 30, 2023. Brokered time deposits, which are included in time deposits, totaled $1.7 million at September 30, 2023. The Company did not have any brokered deposits at December 31, 2022.

The table below is a summary of our deposit balances for the periods noted:

(Dollars in thousands)

During the nine months ended September 30, 2023, the Company experienced a higher level of competition not only from local competitors but also from money market funds and Treasury notes that were offering higher returns. In addition, the Company also saw an unfavorable shift in deposit mix from low cost core deposits to high cost time deposits as customers migrated to higher yields.

The Company continues to focus on the maintenance, development, and expansion of its core deposit base to meet funding requirements and liquidity needs, with an emphasis to retain a long-term customer relationship base and to efficiently compete for and retain deposits in our local market. At September 30, 2023, the Bank’s uninsured deposits represented 28.3% of total deposits, compared to 30.8% at December 31, 2022.

At September 30, 2023, total borrowings increased $87.6 million, or 140.8%, from $62.2 million at December 31, 2022 to $149.8 million. Short-term borrowings decreased $32.5 million, or 78.5%, to $8.9 million, compared to $41.4 million at December 31, 2022. Long-term borrowings increased $120.0 million, from $1.2 million at December 31, 2022, to $121.2 million at September 30, 2023, to replace deposit attrition. Long-term borrowings consisted of $31.2 million outstanding with the FHLB and $90.0 million outstanding under the BTFP. At September 30, 2023, borrowings also consisted of $19.7 million in fixed-to-floating rate subordinated notes.

The Company’s liquidity position remains strong with solid core deposit relationships, cash, unencumbered securities and access to diversified borrowing sources. During the nine months ended September 30, 2023, the Company participated in the BTFP, made available by the Federal Reserve in March of this year, which enabled the Company to pay off higher rate FHLB advances. With the BTFP, the Company has the ability to pay off the BTFP advance prior to maturity without incurring a penalty or termination fee. The Company advanced $90.0 million under the BTFP during the nine months ended September 30, 2023 and had $25.3 million in availability under the BTFP as of September 30, 2023.

At September 30, 2023, the Company had available borrowing capacity with the FHLB of $551.6 million, including its overnight Ideal Way Line of Credit. In addition, at September 30, 2023, the Company had available borrowing capacity of $48.4 million from the Federal Reserve Discount Window, with no outstanding borrowings. At September 30, 2023, the Company also had available borrowing capacity of $25.0 million from two unsecured credit lines with correspondent banks, with no outstanding borrowings. At September 30, 2023, the Company has $650.3 million in total available borrowing capacity.

During the nine months ended September 30, 2023, the Company executed a $200 million fair value hedge on fixed-rate assets with maturities up to 18 months, where the Company exchanged, or swapped, fixed rate payments for floating rate payments. The Company’s hedging program aims to reduce the Company’s sensitivity to interest rates by locking in a spread.

At September 30, 2023, shareholders’ equity was $230.9 million, or 8.9% of total assets, compared to $228.1 million, or 8.9% of total assets, at December 31, 2022. The increase was primarily attributable to net income of $12.6 million, partially offset by an increase in accumulated other comprehensive loss of $3.6 million, $3.1 million for the repurchase of common stock and cash dividends paid of $4.6 million. At September 30, 2023, total shares outstanding were 21,927,242.

The Company’s regulatory capital ratios continue to be strong and in excess of regulatory minimum requirements to be considered well-capitalized as defined by regulators and internal Company targets. Total Risk-Based Capital Ratio at September 30, 2023 was 14.4%, compared to 14.2% at December 31, 2022. The Bank’s Tier 1 Leverage Ratio to adjusted average assets was 9.69% at September 30, 2023 and 9.49% at December 31, 2022. The Bank’s tangible common equity (“TCE”) to tangible assets ratio, a non-GAAP financial measure, was 8.58% at September 30, 2023, compared to 8.52% at December 31, 2022. Fluctuations in the TCE ratio were driven by the changes in the unrealized loss on available-for-sale securities. TCE is a non-GAAP measure. See “Explanation of Use of Non-GAAP Financial Measurements” for the related ratio calculation and a reconciliation of GAAP to non-GAAP financial measures.

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2023 AND SEPTEMBER 30, 2022

General.

The Company reported net income of $4.5 million, or $0.21 per diluted share, for the three months ended September 30, 2023, compared to net income of $6.0 million, or $0.28 per diluted share, for the three months ended September 30, 2022. Return on average assets and return on average equity were 0.70% and 7.60%, respectively, for the three months ended September 30, 2023, compared to 0.93% and 10.90%, respectively, for the three months ended September 30, 2022.

Net Interest and Dividend Income.

The following tables set forth the information relating to our average balance and net interest income for the three months ended September 30, 2023 and 2022, and reflect the average yield on interest-earning assets and average cost of interest-bearing liabilities for the periods indicated. Yields and costs are derived by dividing interest income by the average balance of interest-earning assets and interest expense by the average balance of interest-bearing liabilities for the periods shown. The interest rate spread is the difference between the total average yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin represents tax-equivalent net interest and dividend income as a percentage of average interest-earning assets. Average balances are derived from actual daily balances over the periods indicated. Interest income includes fees earned when the real estate loans are prepaid or refinanced. For analytical purposes, the interest earned on tax-exempt assets is adjusted to a tax-equivalent basis to recognize the income tax savings which facilitates comparison between taxable and tax-exempt assets.

(Dollars in thousands)

(1) Loans, including nonaccrual loans, are net of deferred loan origination costs and unadvanced funds.

(2) Loan and securities income are presented on a tax-equivalent basis using a tax rate of 21%. The tax-equivalent adjustment is deducted from tax-equivalent net interest and dividend income to agree to the amount reported on the consolidated statements of net income.

(3) Short-term investments include federal funds sold.

(4) Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.

(5) Net interest rate spread, on a tax-equivalent basis, represents the difference between the tax-equivalent weighted average yield on interest-earning assets and the tax-equivalent weighted average cost of interest-bearing liabilities. See “Explanation of Use of Non-GAAP Financial Measurements.”

(6) Net interest margin represents net interest and dividend income as a percentage of average interest-earning assets.

(7) Net interest margin, on a tax-equivalent basis, represents tax-equivalent net interest and dividend income as a percentage of average interest-earning assets. See “Explanation of Use of Non-GAAP Financial Measurements.”

(8) Annualized.

Rate/Volume Analysis.

The following table shows how changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest and dividend income and interest expense during the periods indicated. Information is provided in each category with respect to: (1) interest income changes attributable to changes in volume (changes in volume multiplied by prior rate); (2) interest income changes attributable to changes in rate (changes in rate multiplied by prior volume); and (3) the net change.

The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

(In thousands)

(1) Securities, loan income and change in net interest and dividend income are presented on a tax-equivalent basis using a tax rate of 21%. The tax-equivalent adjustment is deducted from tax-equivalent net interest income to agree to the amount reported in the consolidated statements of net income. See “Explanation of Use of Non-GAAP Financial Measurements.”

Net interest income decreased $3.9 million, or 19.2%, to $16.4 million, for the three months ended September 30, 2023, from $20.3 million for the three months ended September 30, 2022. The decrease in net interest income was due to an increase in interest expense of $8.1 million, or 549.2%, partially offset by an increase in interest and dividend income of $4.1 million, or 19.1%. Interest expense on deposits increased $6.5 million and interest expense on borrowings increased $1.5 million. The increase in interest expense was a result of competitive pricing on deposits due to the continued higher interest rate environment and the unfavorable shift in the deposit mix from low cost core deposits to high cost time deposits.

The net interest margin was 2.70% for the three months ended September 30, 2023, compared to 3.35% for the three months ended September 30, 2022. The net interest margin, on a tax-equivalent basis, was 2.72% for the three months ended September 30, 2023, compared to 3.37% for the three months ended September 30, 2022. The decrease in the net interest margin was primarily due to an increase in the average cost of interest-bearing liabilities and the unfavorable shift in the deposit mix from low cost core deposits to high cost time deposits, which was partially offset with an increase in the average yield on interest-earning assets.

The average yield on interest-earning assets, without the impact of tax-equivalent adjustments, was 4.28% for the three months ended September 30, 2023, compared to 3.59% for the three months ended September 30, 2022. The average loan yield, without the impact of tax-equivalent adjustments, was 4.64% for the three months ended September 30, 2023, compared to 3.93% for the three months ended September 30, 2022. During the three months ended September 30, 2023, average interest-earning assets increased $1.5 million, or 0.1%, to $2.4 billion primarily due to an increase in average loans of $33.7 million, or 1.7%, an increase in average other investments of $2.1 million, or 21.1%, and an increase in average short-term investments, consisting of cash and cash equivalents, of $8.4 million, or 60.7%, partially offset by a decrease in average securities of $42.8 million, or 10.6%.

The average cost of total funds, including non-interest bearing accounts and borrowings, increased 139 basis points from 0.25% for the three months ended September 30, 2022 to 1.64% for the three months ended September 30, 2023. The average cost of core deposits, which the Company defines as all deposits except time deposits, increased 51 basis points to 0.70% for the three months ended September 30, 2023, from 0.19% for the three months ended September 30, 2022. The average cost of time deposits increased 316 basis points from 0.30% for the three months ended September 30, 2022 to 3.46% for the three months ended September 30, 2023. The average cost of borrowings, including subordinated debt, increased 69 basis points from 4.12% for the three months ended September 30, 2022 to 4.81% for the three months ended September 30, 2023. Average demand deposits, an interest-free source of funds, decreased $67.0 million, or 10.2%, from $658.9 million, or 29.0% of total average deposits, for the three months ended September 30, 2022, to $591.9 million, or 27.5% of total average deposits, for the three months ended September 30, 2023.

Provision for Credit Losses.

The provision for credit losses is reviewed by management based upon our evaluation of economic and business conditions affecting our key lending areas and other conditions, such as new loan products, credit quality trends (including trends in nonperforming loans expected to result from existing conditions), collateral values, loan volumes and concentrations, specific industry conditions using reasonable and supportable forecasts and the impact that such conditions were believed to have had on the collectability of the loan portfolio.

During the three months ended September, 30, 2023, the Company recorded a provision for credit losses of $354,000, under the CECL model, compared to a provision for credit losses of $675,000 during the three months ended September 30, 2022, under the incurred loss model. The decrease was primarily due to changes in the economic environment and related adjustments to the quantitative components of the CECL methodology. The provision for credit losses was determined by a number of factors: the continued strong credit performance of the Company’s loan portfolio, changes in the loan portfolio mix and Management’s consideration of existing economic conditions and the economic outlook from the Federal Reserve’s actions to control inflation. Management continues to monitor macroeconomic variables related to increasing interest rates, inflation and the concerns of an economic downturn, and believes it is appropriately provisioned for the current economic environment and supportable forecast period.

The Company recorded net charge-offs of $78,000 for the three months ended September 30, 2023, as compared to net charge-offs of $27,000 for the three months ended September 30, 2022.

Although we believe that we have established and maintained the allowance for credit losses at adequate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment. If the high interest rate environment and inflation precipitated by the COVID-19 pandemic has a long-term adverse effect on the ability of our borrowers to satisfy their obligations to us, the demand for our loans or our other products and services, other aspects of our business operations, or on financial markets, real estate markets, or economic growth, this could, depending on the extent of the loan defaults, materially and adversely affect our liquidity and financial condition and our results of operations could be materially and adversely affected.

Non-interest Income.

Non-interest income increased $1.0 million, or 39.5%, to $3.6 million for the three months ended September 30, 2023, from $2.6 million for the three months ended September 30, 2022. During the three months ended September 30, 2023, the Company recorded a non-taxable gain of $778,000 in BOLI death benefits. Service charges and fees decreased $78,000, or 3.5%, from the three months ended September 30, 2022 to $2.1 million for the three months ended September 30, 2023, primarily due to changes in the Company’s overdraft program that were implemented in the first quarter of 2023. Income from BOLI increased $63,000, or 16.1%, for the three months ended September 30, 2022 to $454,000 for the three months ended September 30, 2023. During the three months ended September 30, 2023, the Company reported a gain of $238,000 on non-marketable equity investments compared to a gain of $211,000 during the three months ended September 30, 2022. During the three months ended September 30, 2022, the Company reported unrealized losses on marketable equity securities of $235,000. During the three months ended September 30, 2023, the Company did not have comparable gains or losses. During the three months ended September 30, 2023, the Company reported a loss on the disposal of premises and equipment of $3,000. The Company did not have a comparable gain or loss during the same period in 2022.

Non-interest Expense.

For the three months ended September 30, 2023, non-interest expense decreased $225,000, or 1.6%, to $14.1 million from $14.3 million for the three months ended September 30, 2022. The decrease in non-interest expense was due to a decrease in professional fees of $160,000, or 19.9%, a decrease in salaries and benefits of $70,000, or 0.9%, a decrease in occupancy expense of $67,000, or 5.5%, a decrease in advertising expense of $57,000, or 13.6%, and a decrease in other non-interest expense of $73,000, or 3.0%. These decreases were partially offset by an increase in data processing of $117,000, or 16.5%, an increase in FDIC insurance expense of $68,000, or 24.9%, and an increase in furniture and equipment of $17,000, or 3.7%.

For the three months ended September 30, 2023, the efficiency ratio was 70.6%, compared to 62.7% for the three months ended September 30, 2022. For the three months ended September 30, 2023, the adjusted efficiency ratio, a non-GAAP financial measure, was 74.4% compared to 62.6% for the three months ended September 30, 2022. The efficiency ratio increase was driven by decreased revenues, defined as net interest income and non-interest income, during the three months ended September 30, 2023 compared to the three months ended September 30, 2022. See “Explanation of Use of Non-GAAP Financial Measurements” for the related efficiency ratio calculation and a reconciliation of GAAP to non-GAAP financial measures.

Income Taxes.

Income tax expense for the three months ended September 30, 2023 was $1.0 million, representing an effective tax rate of 18.7%, compared to $1.9 million, representing an effective tax rate of 23.7%, for three months ended September 30, 2022. The decrease in the Company’s effective tax rate was primarily due to BOLI death benefits recognized during the three months ended September 30, 2023.

COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2023 AND SEPTEMBER 30, 2022

General.

For the nine months ended September 30, 2023, the Company reported net income of $12.6 million, or $0.58 per diluted share, compared to $16.9 million, or $0.77 per diluted share, for the nine months ended September 30, 2022. Return on average assets and return on average equity were 0.66% and 7.19% for the nine months ended September 30, 2023, respectively, compared to 0.88% and 10.26% for the nine months ended September 30, 2022, respectively.

Net Interest and Dividend Income.

The following tables set forth the information relating to our average balance and net interest income for the nine months ended September 30, 2023 and 2022, and reflect the average yield on interest-earning assets and average cost of interest-bearing liabilities for the periods indicated. Yields and costs are derived by dividing interest income by the average balance of interest-earning assets and interest expense by the average balance of interest-bearing liabilities for the periods shown. The interest rate spread is the difference between the total average yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin represents tax-equivalent net interest and dividend income as a percentage of average interest-earning assets. Average balances are derived from actual daily balances over the periods indicated. Interest income includes fees earned when the real estate loans are prepaid or refinanced. For analytical purposes, the interest earned on tax-exempt assets is adjusted to a tax-equivalent basis to recognize the income tax savings which facilitates comparison between taxable and tax-exempt assets.

(Dollars in thousands)

(1) Loans, including nonaccrual loans, are net of deferred loan origination costs and unadvanced funds.

(2) Loan and securities income are presented on a tax-equivalent basis using a tax rate of 21%. The tax-equivalent adjustment is deducted from tax-equivalent net interest and dividend income to agree to the amount reported on the consolidated statements of net income.

(3) Short-term investments include federal funds sold.

(4) Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.

(5) Net interest rate spread, on a tax-equivalent basis, represents the difference between the tax-equivalent weighted average yield on interest-earning assets and the tax-equivalent weighted average cost of interest-bearing liabilities. See “Explanation of Use of Non-GAAP Financial Measurements.”

(6) Net interest margin represents net interest and dividend income as a percentage of average interest-earning assets.

(7) Net interest margin, on a tax-equivalent basis, represents tax-equivalent net interest and dividend income as a percentage of average interest-earning assets. See “Explanation of Use of Non-GAAP Financial Measurements.”

(8) Annualized.

Rate/Volume Analysis.

The following table shows how changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest and dividend income and interest expense during the periods indicated. Information is provided in each category with respect to: (1) interest income changes attributable to changes in volume (changes in volume multiplied by prior rate); (2) interest income changes attributable to changes in rate (changes in rate multiplied by prior volume); and (3) the net change.

The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

(In thousands)

(1) Securities, loan income and change in net interest and dividend income are presented on a tax-equivalent basis using a tax rate of 21%. The tax-equivalent adjustment is deducted from tax-equivalent net interest income to agree to the amount reported in the consolidated statements of net income. See “Explanation of Use of Non-GAAP Financial Measurements.”

During the nine months ended September 30, 2023, net interest income decreased $6.7 million, or 11.4%, to $51.7 million, compared to $58.4 million for the nine months ended September 30, 2022. The decrease in net interest income was due to an increase in interest expense of $18.7 million, or 470.4%, partially offset by an increase in interest and dividend income of $12.0 million, or 19.3%. The increase in interest expense was due to an increase in interest expense on deposits of $14.7 million, or 468.2%, and an increase in interest expense on borrowings of $3.9 million, or 478.6%. For the nine months ended September 30, 2023, interest and dividend income included $52,000 in Paycheck Protection Program (“PPP Income”), compared to $710,000 during the nine months ended September 30, 2022.

The net interest margin for the nine months ended September 30, 2023 was 2.88% compared to 3.26% during the nine months ended September 30, 2022. The net interest margin, on a tax-equivalent basis, was 2.90% for the nine months ended September 30, 2023, compared to 3.28% for the nine months ended September 30, 2022. The decrease in the net interest margin was primarily due to an increase in the average cost of interest-bearing liabilities and the unfavorable shift in the deposit mix from low cost core to high cost time deposits, which was partially offset with an increase in the average yield on interest-earning assets.

The average yield on interest-earning assets, without the impact of tax-equivalent adjustments, was 4.14% for the nine months ended September 30, 2023, compared to 3.48% for the nine months ended September 30, 2022. The average loan yield, without the impact of tax-equivalent adjustments, was 4.49% for the nine months ended September 30, 2023, compared to 3.86% for the nine months ended September 30, 2022. During the nine months ended September 30, 2023, average interest-earning assets increased $5.2 million, or 0.2% to $2.4 billion, primarily due to an increase in average loans of $62.9 million, or 3.2%, and an increase in average other investments of $2.4 million, or 23.2%, partially offset by a decrease in average securities of $41.2 million, or 10.0%, and a decrease in average short-term investments, consisting of cash and cash equivalents, of $18.9 million, or 59.4%.

The average cost of total funds, including non-interest bearing accounts and borrowings, increased 109 basis points from 0.23% for the nine months ended September 30, 2022 to 1.32% for the nine months ended September 30, 2023. The average cost of core deposits, which the Company defines as all deposits except time deposits, increased 46 basis points to 0.62% for the nine months ended September 30, 2023, from 0.16% for the nine months ended September 30, 2022. The average cost of time deposits increased 239 basis points from 0.33% for the nine months ended September 30, 2022 to 2.72% for the nine months ended September 30, 2023. The average cost of borrowings, including subordinated debt, increased 60 basis points from 4.24% for the nine months ended September 30, 2022 to 4.84% for the nine months ended September 30, 2023. Average demand deposits, an interest-free source of funds, decreased $35.3 million, or 5.5%, from $642.6 million, or 28.4% of total average deposits, for the nine months ended September 30, 2022, to $607.3 million, or 28.0% of total average deposits, for the nine months ended September 30, 2023.

Provision for Credit Losses.

During the nine months ended September 30, 2023, the Company recorded a provision for credit losses of $386,000, under the CECL model, compared to a provision for credit losses of $550,000 during the nine months ended September 30, 2022 under the incurred loss model. The $386,000 provision for credit losses during the nine months ended September 30, 2023 was comprised of a $768,000 provision for loan losses, which was partially offset by a $382,000 reversal of credit losses for unfunded commitments. The increase in loan loss reserves was primarily due to changes in the economic environment and related adjustments to the quantitative components of the CECL methodology. The Company recorded net charge-offs of $1.9 million for the nine months ended September 30, 2023, as compared to net charge-offs of $129,000 for the nine months ended September 30, 2022.

Although we believe that we have established and maintained the allowance for credit losses at adequate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment. If the high interest rate environment and inflation precipitated by the COVID-19 pandemic has a long-term adverse effect on the ability of our borrowers to satisfy their obligations to us, the demand for our loans or our other products and services, other aspects of our business operations, or on financial markets, real estate markets, or economic growth, this could, depending on the extent of the loan defaults, materially and adversely affect our liquidity and financial condition and our results of operations could be materially and adversely affected.

Non-interest Income.

For the nine months ended September 30, 2023, non-interest income increased $504,000, or 6.6%, from $7.7 million during the nine months ended September 30, 2022 to $8.2 million. During the nine months ended September 30, 2023, the Company recorded a $1.1 million final termination expense related to the DB Plan termination and also recorded a non-taxable gain of $778,000 on BOLI death benefits. During the same period, service charges and fees decreased $170,000, or 2.5%, primarily due to changes in the Company’s overdraft program that were implemented in 2023 and income from BOLI increased $91,000, or 7.0%. Other income from loan-level swap fees on commercial loans decreased $25,000 for the nine months ended September 30, 2023 compared to the nine months ended September 30, 2022. During the nine months ended September 30, 2023, the Company reported a gain of $590,000 on non-marketable equity investments compared to a gain of $352,000 during the nine months ended September 30, 2022. During the nine months ended September 30, 2022, the Company reported unrealized losses on marketable equity securities of $736,000 and realized losses on the sale of securities of $4,000. The Company did not have comparable investment activity in 2023. During the nine months ended September 30, 2023, the Company reported a loss on the disposal of premises and equipment of $3,000. The Company did not have a comparable gain or loss during the same period in 2022.

Non-interest Expense.

For the nine months ended September 30, 2023, non-interest expense increased $333,000, or 0.8%, to $43.6 million, compared to $43.2 million for the nine months ended September 30, 2022. The increase in non-interest expense was primarily due to an increase in data processing of $208,000, or 9.6%, and increase in FDIC insurance expense of $190,000, or 24.0%, an increase in professional fees of $104,000, or 5.0%, and an increase in other non-interest expense of $111,000, or 1.6%. These increases were partially offset by a decrease in advertising expense of $112,000, or 9.1%, a decrease in furniture and equipment expense of $87,000, or 5.6%, a decrease in occupancy expense of $56,000, or 1.5%, and decrease in salaries and employee benefits of $25,000, or 0.1%. During the nine months ended September 30, 2023, other non-interest expense included $154,000 in expense related to the DB Plan termination.

For the nine months ended September 30, 2023, the efficiency ratio was 72.7%, compared to 65.5% for the nine months ended September 30, 2022. For the nine months ended September 30, 2023, the adjusted efficiency ratio, a non-GAAP financial measure, was 73.0%, compared to 65.1% for the nine months ended September 30, 2022. The adjusted efficiency ratio is a non-GAAP measure. The adjusted efficiency ratio is a non-GAAP measure. See “Explanation of Use of Non-GAAP Financial Measurements” for the related efficiency ratio calculation and a reconciliation of GAAP to non-GAAP financial measures.

Income Taxes.

Income tax expense for the nine months ended September 30, 2023 was $3.4 million, representing an effective tax rate of 21.3%, compared to $5.4 million, representing an effective tax rate of 24.3%, for nine months ended September 30, 2022. The decrease in the Company’s effective tax rate was primarily due to BOLI death benefits recognized during the three months ended September 30, 2023.

Explanation of Use of Non-GAAP Financial Measurements.

We believe that it is common practice in the banking industry to present interest income and related yield information on tax-exempt loans and securities on a tax-equivalent basis, as well as presenting tangible book value per share and adjusted efficiency ratio, and that such information is useful to investors because it facilitates comparisons among financial institutions. However, the adjustment of interest income and yields on tax-exempt loans and securities to a tax-equivalent amount, as well as the presentation of tangible book value per share and adjusted efficiency ratio, may be considered to include financial information that is not in compliance with GAAP. A reconciliation from GAAP to non-GAAP is provided below.

(In thousands)

(1) The tax equivalent adjustment is based upon a 21% tax rate.

(In thousands)

50

(In thousands)

(In thousands)

Liquidity and Capital Resources.

The term “liquidity” refers to our ability to generate adequate amounts of cash to fund loan originations, loan purchases, deposit withdrawals and operating expenses. Our primary sources of liquidity are deposits, scheduled amortization and prepayments of loan principal and mortgage-backed securities, maturities and calls of investment securities and funds provided by our operations. We can also borrow funds from the FHLB and the FRB based on eligible collateral of loans and securities. Our material cash commitments include funding loan originations, fulfilling contractual obligations with third-party service providers, maintaining operating leases for certain of our Bank properties and satisfying repayment of our long-term debt obligations.

Primary Sources of Liquidity

At September 30, 2023 and December 31, 2022, the Company’s outstanding borrowings with the FHLB were $31.2 million and $36.2 million, respectively. At September 30, 2023, the Company had $542.0 million in available borrowing capacity with the FHLB. The Company can increase its borrowing capacity with the FHLB by pledging additional investments or loans. At September 30, 2023, the Company had $90.0 million in outstanding borrowings under the FRB’s BTFP, with $25.3 million in additional borrowing capacity.

The Company also has a borrowing relationship with the FRB through its primary credit program offered through its Discount Window with a borrowing capacity up to $48.4 million. In addition, the Company also has an available overnight Ideal Way line of credit with the FHLB of $9.5 million. At September 30, 2023 and at December 31, 2022, the Company did not have any outstanding balances under either of these lines. The Company has agreements with approved brokers-dealers to participate in the brokered deposit market to support liquidity. At September 30, 2023, the Company had $1.7 million in brokered deposits included within time deposits on the balance sheet. At December 31, 2022, the Company did not have any brokered deposits.

The Company also has available lines of credit of $15.0 million and $10.0 million with other correspondent banks. Interest rates on these lines are determined and reset on a daily basis by each respective bank. At September 30, 2023 and December 31, 2022, we did not have an outstanding balance under either of these lines of credit. In addition, we may enter into reverse repurchase agreements with approved broker-dealers. Reverse repurchase agreements are agreements that allow us to borrow money using our securities as collateral.

We also have outstanding at any time, a significant number of commitments to extend credit and provide financial guarantees to third parties. These arrangements are subject to strict credit control assessments. Guarantees specify limits to our obligations. Because many commitments and almost all guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows. We are also obligated under agreements with the FHLB to repay borrowed funds, under leases for certain of our branches and equipment and for our core processing agreement.

Maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of securities and prepayments of loans and mortgage-backed securities are strongly influenced by interest rates, general and local economic conditions and competition in the marketplace. These factors reduce the predictability of the timing of these sources of funds.

The Company’s primary activities are the origination of commercial real estate loans, commercial and industrial loans and residential real estate loans, as well as and the purchase of mortgage-backed and other investment securities. At September 30, 2023, the Company had approximately $136.7 million in loan commitments and letters of credit to borrowers and approximately $349.4 million in available home equity and other unadvanced lines of credit.

Deposit inflows and outflows are affected by the level of interest rates, the products and interest rates offered by competitors and by other factors. At September 30, 2023, time deposit accounts scheduled to mature within one year totaled $567.3 million. Based on the Company’s deposit retention experience and current pricing strategy, we anticipate that a significant portion of these time deposits will remain on deposit. We monitor our liquidity position frequently and anticipate that it will have sufficient funds to meet our current funding commitments for the next 12 months and beyond.

At September 30, 2023, the Company and the Bank exceeded each of the applicable regulatory capital requirements (See Note 13, Regulatory Capital, to our consolidated financial statements in our 2022 Annual Report on Form 10-K for further information on our regulatory requirements).

Material Cash Commitments

The Company entered into a long-term contractual obligation with a vendor for use of its core provider and ancillary services beginning in 2016. Total remaining contractual obligations outstanding with this vendor as of September 30, 2023 were estimated to be $12.0 million, with $5.0 million expected to be paid within one year and the remaining $7.0 million to be paid within the next three years. Further, the Company has operating leases for certain of its banking offices and ATMs. Our leases have remaining lease terms of less than one year to fifteen years, some of which include options to extend the leases for additional five-year terms up to ten years. Undiscounted lease liabilities totaled $10.3 million as of September 30, 2023. Principal payments expected to be made on our lease liabilities during the twelve months ended September 30, 2024 were $1.5 million. The remaining lease liability payments totaled $8.8 million and are expected to be made after September 30, 2024.

In addition, the Company completed an offering of $20 million in aggregate principal amount of its 4.875% fixed-to-floating rate subordinated notes (the “Notes”) to certain qualified institutional buyers in a private placement transaction on April 20, 2021. Unless earlier redeemed, the Notes mature on May 1, 2031. At September 30, 2023, $19.7 million aggregate principle amount of the Notes was outstanding. The Notes will bear interest from the initial issue date to, but excluding, May 1, 2026, or the earlier redemption date, at a fixed rate of 4.875% per annum, payable quarterly in arrears on May 1, August 1, November 1 and February 1 of each year, beginning August 1, 2021, and from and including May 1, 2026, but excluding the maturity date or earlier redemption date, equal to the benchmark rate, which is the 90-day average secured overnight financing rate, plus 412 basis points, determined on the determination date of the applicable interest period, payable quarterly in arrears on May 1, August 1, November 1 and February 1 of each year. The Company may also redeem the Notes, in whole or in part, on or after May 1, 2026, and at any time upon the occurrence of certain events, subject in each case to the approval of the Board of Governors of the Federal Reserve.

We do not anticipate any material capital expenditures during the calendar year 2023, except in pursuance of the Company’s strategic initiatives. The Company does not have any balloon or other payments due on any long-term obligations or any off-balance sheet items other than the commitments and unused lines of credit noted above.

At September 30, 2023, we exceeded each of the applicable regulatory capital requirements. As of September 30, 2023, the most recent notification from the Office of Comptroller of the Currency categorized the Bank as “well-capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well-capitalized,” the Bank must maintain minimum total risk-based, Tier 1 risk-based, Common Equity Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes would change our category.

(Dollars in thousands)

53

We also have outstanding, at any time, a significant number of commitments to extend credit and provide financial guarantees to third parties. These arrangements are subject to strict credit control assessments. Guarantees specify limits to our obligations. Because many commitments and almost all guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows.

OFF-BALANCE SHEET ARRANGEMENTS.

The Company does not have any off-balance sheet arrangements, other than noted above under Material Cash Commitments, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

There have been no material changes in our assessment of our sensitivity to market risk since our presentation in our 2022 Annual Report and our update on Form 10-Q for the quarter ended June 30, 2023. Please refer to Item 7A of the 2022 Annual Report for additional information.

Disclosure Controls and Procedures.

Management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a‑15(e) and 15d‑15(e)), as of the end of the period covered by this report. Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective, to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934, as amended, is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussion regarding required disclosure.

Changes in Internal Control Over Financial Reporting.

There have been no changes in our internal control over financial reporting identified in connection with the evaluation that occurred during our last fiscal quarter that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

For a summary of risk factors relevant to our operations, see Part 1, Item 1A, “Risk Factors” in our 2022 Annual Report. There are no additional material changes in the risk factors relevant to our operations since December 31, 2022 and our update on Form 10-Q for the quarter ended March 31, 2023.