First Community Bankshares Inc: Form 10-Q for the period ended Mar 31, 2018

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand our financial condition, changes in financial condition, and results of operations. MD&A contains forward-looking statements and should be read in conjunction with our consolidated financial statements, accompanying notes, and other financial information included in this report and our Annual Report on Form 10-K for the year ended December 31, 2017 (the “2017 Form 10-K”). Unless the context suggests otherwise, the terms “First Community,” “Company,” “we,” “our,” and “us” refer to First Community Bancshares, Inc. and its subsidiaries as a consolidated entity.

Executive Overview

First Community Bancshares, Inc. (the “Company”) is a financial holding company, headquartered in Bluefield, Virginia, that provides banking products and services through its wholly owned subsidiary First Community Bank (the “Bank”), a Virginia chartered bank institution. As of March 31, 2018, the Bank operated 44 branches as First Community Bank in Virginia, West Virginia, and North Carolina and as People’s Community Bank, a Division of First Community Bank, in Tennessee. Our primary source of earnings is net interest income, the difference between interest earned on assets and interest paid on liabilities, which is supplemented by fees for services, commissions on sales, and various deposit service charges. We fund our lending and investing activities primarily through the retail deposit operations of our branch banking network and, to a lesser extent, retail and wholesale repurchase agreements and Federal Home Loan Bank (“FHLB”) borrowings. We invest our funds primarily in loans to retail and commercial customers and various investment securities. Our common stock is traded on the NASDAQ Global Select Market under the symbol, FCBC.

The Bank offers trust management, estate administration, and investment advisory services through its Trust Division and wholly owned subsidiary First Community Wealth Management (“FCWM”). The Trust Division manages inter vivos trusts and trusts under will, develops and administers employee benefit and individual retirement plans, and manages and settles estates. Fiduciary fees for these services are charged on a schedule related to the size, nature, and complexity of the account. Revenues consist primarily of commissions on assets under management and investment advisory fees. As of March 31, 2018, the Trust Division and FCWM managed $945 million in combined assets under various fee-based arrangements as fiduciary or agent.

The Bank offers insurance products and services through its wholly owned subsidiary First Community Insurance Services (“FCIS”). FCIS provides in-branch commercial and insurance services in Virginia and West Virginia. Revenues are primarily derived from commissions paid by issuing companies on the sale of policies. As of March 31, 2018, FCIS operated 4 in-branch locations in Virginia and West Virginia.

We had no acquisition and divestiture activity during the three months ended March 31, 2018, and year ended December 31, 2017.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with generally accepted accounting principles (“GAAP”) in the U.S. and conform to general practices within the banking industry. Our financial position and results of operations may require management to make significant estimates and assumptions that have a material impact on our financial condition or operating performance. Due to the level of subjectivity and the susceptibility of such matters to change, actual results could differ significantly from management’s assumptions and estimates. Estimates, assumptions, and judgments, which are periodically evaluated, are based on historical experience and other factors, including expectations of future events believed reasonable under the circumstances. These estimates are generally necessary when assets and liabilities are required to be recorded at estimated fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or a valuation reserve, or when an asset or liability needs recorded based on the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices, when available, or third-party sources. When quoted prices or third-party information is not available, management estimates valuation adjustments primarily through the use of financial modeling techniques and appraisal estimates.

Our accounting policies are fundamental in understanding MD&A and the disclosures presented in Item 1, “Financial Statements,” of this report. Our accounting policies are described in detail in Note 1, “Basis of Presentation and Accounting Policies,” to the Consolidated Financial Statements in Part II, Item 8 of our 2017 Form 10-K and our critical accounting estimates are detailed in the “Critical Accounting Estimates” section in Part II, Item 7 of our 2017 Form 10-K.

Performance Overview

Highlights of our results of operations for the three months ended March 31, 2018, and financial condition as of March 31, 2018, include the following:

• Pre-tax income increased $2.18 million, or 23.54%, to $11.44 million for the first quarter of 2018 compared to the same quarter of 2017.
• Net income increased $2.67 million, or 42.99%, to $8.87 million and diluted earnings per share increased $0.16, or 44.44%, to $0.52 for the first quarter of 2018 compared to the same quarter of 2017.
• Net interest margin increased 21 basis points to 4.38%, and normalized net interest margin increased 8 basis points to 4.03% for the first quarter of 2018 compared to the same quarter of 2017.
• The Company repurchased 187,300 common shares during the first quarter of 2018 for $5.41 million.
• The Company significantly exceeds regulatory “well capitalized” targets as of March 31, 2018.
• The Company paid a one-time special cash dividend to common shareholders of $0.48 per common share on March 23, 2018. The special dividend was in addition to the regular cash dividend of $0.18 per common share paid on February 16, 2018.

Results of Operations

Net Income

The following table presents the changes in net income and related information for the periods indicated:

(Amounts in thousands, except per share data)

Three-Month Comparison. Net income increased in the first quarter of 2018 due to increases in noninterest and net interest income and a decrease in income tax. These changes were offset by a slight increase in noninterest expense.

Net Interest Income

Net interest income, our largest contributor to earnings, is analyzed on a fully taxable equivalent (“FTE”) basis, a non-GAAP financial measure. For additional information, see “Non-GAAP Financial Measures” below. The following tables present the consolidated average balance sheets and net interest analysis on a FTE basis for the dates indicated:

(Amounts in thousands)

(1) Fully taxable equivalent ("FTE") basis based on the federal statutory rate of 21% for periods after January 1, 2018, and 35% for periods prior to January 1, 2018

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

40

The following table presents the impact to net interest income on a FTE basis due to changes in volume (average volume times the prior year’s average rate), rate (average rate times the prior year’s average volume), and rate/volume (average volume times the change in average rate), for the periods indicated:

(Amounts in thousands)

(1) Fully taxable equivalent ("FTE") basis based on the federal statutory rate of 21% for periods after January 1, 2018, and 35% for periods prior to January 1, 2018

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

The following tables present the net interest analysis on a FTE basis excluding the impact of non-cash purchase accounting accretion from acquired loan portfolios for the periods indicated:

(Amounts in thousands)

(1) Fully taxable equivalent ("FTE") basis based on the federal statutory rate of 21% for periods after January 1, 2018, and 35% for periods prior to January 1, 2018

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

(3) Normalized totals are non-GAAP financial measures that exclude non-cash loan interest accretion related to PCI loans.

41

Three-Month Comparison. Net interest income comprised 77.64% of total net interest and noninterest income in the first quarter of 2018 compared to 80.52% in the same quarter of 2017. Net interest income on a GAAP basis increased $1.24 million, or 5.86%, and net interest income on a FTE basis increased $1.20 million, or 5.54%. Normalized net interest income on a FTE basis is a non-GAAP measure that excludes non-cash loan accretion income related to PCI loans. For additional information, see “Non-GAAP Financial Measures” below. Normalized net interest margin increased 8 basis points compared to an increase of 21 basis points on a FTE basis. Normalized net interest spread increased 7 basis points compared to an increase of 21 basis points on a FTE basis.

Average earning assets increased $10.59 million, or 0.50%, primarily due to an increase in interest-bearing deposits offset by decreases in loans and held-to-maturity securities. The normalized yield on earning assets increased 5 basis points compared to an increase of 19 basis points on a GAAP basis. Average loans decreased $33.00 million, or 1.79%, and the average loan to deposit ratio decreased to 94.67% from 99.52%. The normalized yield on loans increased 13 basis points compared to an increase of 30 basis points on a GAAP basis. Non-cash accretion income increased $711 thousand, or 62.70%.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, decreased $26.40 million, or 1.68%, primarily due to a decline in average borrowings. The yield on interest-bearing liabilities decreased 2 basis points, largely driven by a decrease in the average balance of borrowings. Average borrowings decreased $79.12 million, or 49.90%, largely due to a $62.50 million, or 93.36%, decrease in average retail repurchase agreements and a $16.62 million, or 24.95%, decrease in average FHLB advances. Average interest-bearing deposits increased $52.72 million, or 3.71%, which was driven by an $81.69 million, or 21.44%, increase in average interest-bearing demand deposits offset by a $21.96 million, or 4.26%, decrease in average time deposits, and a $7.01 million, or 1.33%, decrease in average savings deposits, which include money market and savings accounts.

Provision for Loan Losses

Three-Month Comparison. The provision charged to operations experienced a slight increase of $3 thousand to $495 thousand, which was attributed to the non-PCI provision. For additional information, see “Allowance for Loan Losses” in the “Financial Condition” section below.

Noninterest Income

The following table presents the components of, and changes in, noninterest income for the periods indicated:

(Amounts in thousands)

Three-Month Comparison. Noninterest income comprised 22.36% of total net interest and noninterest income in the first quarter of 2018 compared to 19.48% in the same quarter of 2017. Noninterest income increased $1.33 million, or 26.02%, primarily due to the decrease in net negative amortization related to the FDIC indemnification asset as loss share coverage expired June 30, 2017, for commercial loans. Service charges on deposits and other service charges and fees increased $488 thousand, or 10.57%, primarily from increases in checking account fees and net interchange income. Other service charges and fees included the netting of interchange expense against income per the adoption of ASC 606. Net interchange income increased $82 thousand, or 8.00%, in the first quarter of 2018. Excluding the impact from net FDIC indemnification asset amortization, noninterest income increased $381 thousand, or 5.91%, to $6.83 million in the first quarter of 2018, from $6.45 million in the same quarter of 2017.

Noninterest Expense

The following table presents the components of, and changes in, noninterest expense for the periods indicated:

(Amounts in thousands)

Three-Month Comparison. Noninterest expense increased $387 thousand, or 2.34%, in the first quarter of 2018 compared to the same quarter of 2017, which was largely due to an increase in salaries and employee benefits. Full-time equivalent employees, calculated using the number of hours worked, decreased to 550 as of March 31, 2018, from 579 as of March 31, 2017. Other operating expense included a $510 thousand increase in property writedowns offset by a $157 thousand decrease in the net loss on sales and expenses related to other real estate owned (“OREO”) to $172 thousand from $328 thousand in the first quarter of 2017. Professional fees decreased largely due to a reduction in legal fees.

Income Tax Expense

Three-Month Comparison. The Company’s effective tax rate, income tax as a percent of pre-tax income, may vary significantly from the statutory rate due to permanent differences and available tax credits. Permanent differences are income and expense items excluded by law in the calculation of taxable income. The Company’s most significant permanent differences generally include interest income on municipal securities and increases in the cash surrender value of life insurance policies. Income tax expense decreased $487 thousand, or 15.94%, and the effective tax rate decreased to 22.46% compared to 33.00% in the same quarter of 2017. The decrease was largely due to the Tax Cuts and Jobs Act (“Tax Reform Act”) enacted on December 22, 2017, which reduced our federal statutory income tax rate from 35% to 21% beginning January 1, 2018.

Non-GAAP Financial Measures

In addition to financial statements prepared in accordance with GAAP, we use certain non-GAAP financial measures that management believes provide investors with important information useful in understanding our operational performance and comparing our financial measures with other financial institutions. The non-GAAP financial measures presented in this report include net interest income on a FTE basis and normalized net interest income on a FTE basis. While we believe these non-GAAP financial measures enhance understanding of our business and performance, they are supplemental and not a substitute for, or more important than, financial measures prepared on a GAAP basis. Our non-GAAP financial measures may not be comparable to those reported by other financial institutions. The reconciliations of these measures to GAAP measures are presented below.

We believe FTE basis is the preferred industry measurement of net interest income and provides better comparability between taxable and tax exempt amounts. We use this non-GAAP financial measure to monitor net interest income performance and to manage the composition of our balance sheet. The FTE basis adjusts for the tax benefits of income from certain tax exempt loans and investments using the federal statutory rate of 21% beginning January 1, 2018, and 35% prior to January 1, 2018. Normalized net interest income on a FTE basis is a non-GAAP measure that excludes non-cash loan accretion income related to PCI loans.

The following table reconciles net interest income and margin, as presented in our consolidated statements of income, to net interest income on a FTE basis for the periods indicated:

(Amounts in thousands)

(1) Fully taxable equivalent ("FTE") basis based on the federal statutory rate of 21% for periods after January 1, 2018, and 35% for periods prior to January 1, 2018

(2) Includes non-cash purchase accounting accretion income from acquired loan portfolios

Financial Condition

Total assets as of March 31, 2018, increased $39.85 million, or 1.67%, to $2.43 billion from $2.39 billion as of December 31, 2017. Total liabilities as of March 31, 2018, increased $48.52 million, or 2.38%, to $2.09 billion from $2.04 billion as of December 31, 2017.

Investment Securities

Our investment securities are used to generate interest income through the employment of excess funds, to provide liquidity, to fund loan demand or deposit liquidation, and to pledge as collateral where required. The composition of our investment portfolio changes from time to time as we consider our liquidity needs, interest rate expectations, asset/liability management strategies, and capital requirements.

Available-for-sale debt securities as of March 31, 2018, decreased $1.39 million, or 0.84%, compared to December 31, 2017, primarily due to the maturity of certain U.S. Treasury securities offset by the purchase of U.S. Agency and mortgage-backed Agency securities coupled with an increase in net unrealized losses. The market value of debt securities available for sale as a percentage of amortized cost was 99.45% as of March 31, 2018, compared to 100.75% as of December 31, 2017. Held-to-maturity debt securities as of March 31, 2018, decreased $34 thousand, or 0.14%, compared to December 31, 2017, primarily due to an increase in net unrealized losses. The market value of debt securities held to maturity as a percentage of amortized cost was 99.49% as of March 31, 2018, compared to 99.74% as of December 31, 2017.

Investment securities are reviewed quarterly for possible other-than-temporary impairment (“OTTI”) charges. We recognized no OTTI charges in earnings associated with debt securities for the three months ended March 31, 2018 or 2017. For additional information, see Note 2, “Debt Securities,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

Loans Held for Investment

Loans held for investment, our largest component of interest income, are grouped into commercial, consumer real estate, and consumer and other loan segments. Each segment is divided into various loan classes based on collateral or purpose. Certain loans acquired in FDIC-assisted transactions are covered under loss share agreements (“covered loans”). Total loans held for investment, net of unearned income, as of March 31, 2018, decreased $24.08 million, or 1.32%, compared to December 31, 2017, primarily due to a $21.53 million, or 1.20%, decrease in non-covered loans, which was driven by declines in commercial construction, owner occupied construction, and multi-family residential segments. Covered loans decreased $2.54 million, or 9.10%, as the covered Waccamaw portfolio continues to run off. For additional information, see Note 3, “Loans,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

The following table presents loans, net of unearned income, with non-covered loans by loan class as of the dates indicated:

(Amounts in thousands)

The following table presents covered loans, by loan class, as of the dates indicated. The commercial loss share agreement expired June 30, 2017.

(Amounts in thousands)

45

Risk Elements

We seek to mitigate credit risk by following specific underwriting practices and by ongoing monitoring of our loan portfolio. Our underwriting practices include the analysis of borrowers’ prior credit histories, financial statements, tax returns, and cash flow projections; valuation of collateral based on independent appraisers’ reports; and verification of liquid assets. We believe our underwriting criteria are appropriate for the various loan types we offer; however, losses may occur that exceed the reserves established in our allowance for loan losses. We track certain credit quality indicators that include: trends related to the risk rating of commercial loans, the level of classified commercial loans, net charge-offs, nonperforming loans, and general economic conditions. The Company’s loan review function generally analyzes all commercial loan relationships greater than $4.0 million annually and at various times during the year. Smaller commercial and retail loans are sampled for review during the year.

Nonperforming assets consist of nonaccrual loans, accrual loans contractually past due 90 days or more, unseasoned troubled debt restructurings (“TDRs”), and OREO. Ongoing activity in the classification and categories of nonperforming loans include collections on delinquencies, foreclosures, loan restructurings, and movements into or out of the nonperforming classification due to changing economic conditions, borrower financial capacity, or resolution efforts. Loans acquired with credit deterioration, with a discount, continue to accrue interest based on expected cash flows; therefore, PCI loans are not generally considered nonaccrual. For additional information, see Note 4, “Credit Quality,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

The following table presents the components of nonperforming assets and related information as of the periods indicated:

(Amounts in thousands)

(1) TDRs restructured within the past six months and nonperforming TDRs exclude nonaccrual TDRs of $115 thousand, $169 thousand, and $24 thousand for the periods ended March 31, 2018, December 31, 2017, and March 31, 2017, respectively.

(2) TDRs with six months or more of satisfactory payment performance exclude nonaccrual TDRs of $1.89 million, $1.76 million, and $1.40 million for the periods ended March 31, 2018, December 31, 2017, and March 31, 2017, respectively.

(3) Total TDRs exclude nonaccrual TDRs of $2.01 million, $1.93 million, and $1.43 million for the periods ended March 31, 2018, December 31, 2017, and March 31, 2017, respectively.

Non-covered nonperforming assets as of March 31, 2018, increased $4.85 million, or 22.52%, from December 31, 2017, primarily due to an increase in non-covered nonaccrual loans and non-covered OREO. Non-covered nonaccrual loans as of March 31, 2018, increased $2.65 million, or 13.97%, from December 31, 2017. As of March 31, 2018, non-covered nonaccrual loans were largely attributed to single family owner occupied (58.85%) and non-farm, non-residential (22.35%) loans. As of March 31, 2018, approximately $2.07 million, or 9.58%, of non-covered nonaccrual loans were attributed to performing loans acquired in business combinations. Certain loans included in the nonaccrual category have been written down to estimated realizable value or assigned specific reserves in the allowance for loan losses based on management’s estimate of loss at ultimate resolution.

Non-covered delinquent loans, comprised of loans 30 days or more past due and nonaccrual loans, totaled $29.81 million as of March 31, 2018, a decrease of $900 thousand, or 2.93%, compared to $30.71 million as of December 31, 2017. Non-covered delinquent loans as a percent of total non-covered loans totaled 1.66% as of March 31, 2018, which includes past due loans (0.45%) and nonaccrual loans (1.21%).

When restructuring loans for borrowers experiencing financial difficulty, we generally make concessions in interest rates, loan terms, or amortization terms. Certain TDRs are classified as nonperforming when modified and are returned to performing status after six months of satisfactory payment performance; however, these loans remain identified as impaired until full payment or other satisfaction of the obligation occurs. Accruing TDRs as of March 31, 2018, decreased $437 thousand, or 5.65%, to $7.30 million from December 31, 2017. Nonperforming accruing TDRs as of March 31, 2018, decreased $43 thousand, or 35.83%, to $77 thousand compared to December 31, 2017. Nonperforming accruing TDRs as a percent of total accruing TDRs totaled 1.06% as of March 31, 2018, compared to 1.55% as of December 31, 2017. Specific reserves on TDRs totaled $648 thousand as of March 31, 2018, compared to $642 thousand as of December 31, 2017.

Non-covered OREO, which is carried at the lesser of estimated net realizable value or cost, increased $2.21 million, or 91.78%, as of March 31, 2018, compared to December 31, 2017. Non-covered OREO consisted of 24 properties with an average holding period of 7 months as of March 31, 2018. The net loss on the sale of OREO totaled $103 thousand for the three months ended March 31, 2018, compared to $241 thousand for the same period of the prior year. The following table presents the changes in OREO during the periods indicated:

(Amounts in thousands)

Allowance for Loan Losses

The allowance for loan losses is maintained at a level management deems sufficient to absorb probable loan losses inherent in the loan portfolio. The allowance is increased by the provision for loan losses and recoveries of prior loan charge-offs and decreased by loans charged off. The provision for loan losses is calculated and charged to expense to bring the allowance to an appropriate level using a systematic process of measurement that requires significant judgments and estimates. As of March 31, 2018, our qualitative risk factors reflect a stable risk of loan losses due to consistent asset quality metrics and relatively stable business and economic conditions in our primary market areas. The loan portfolio is continually monitored for deterioration in credit, which may result in the need to increase the allowance for loan losses in future periods. Management considered the allowance adequate as of March 31, 2018; however, no assurance can be made that additions to the allowance will not be required in future periods. For additional information, see Note 5, “Allowance for Loan Losses,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

The allowance for loan losses as of March 31, 2018, increased $224 thousand, or 1.16%, from December 31, 2017. The increase was largely attributed to a $336 thousand increase in specific reserves on impaired loans. The non-PCI allowance as a percent of non-covered loans totaled 1.10% as of March 31, 2018, compared to 1.08% as of December 31, 2017. PCI loans were aggregated into five loan pools as of March 31, 2018, and December 31, 2017: Waccamaw commercial, Waccamaw serviced home equity lines, Waccamaw residential, Peoples Bank of Virginia (“Peoples”) commercial, and Peoples residential. The cash flow analysis identified no impaired PCI loan pools as of March 31, 2018, or December 31, 2017. Net charge-offs increased $289 thousand for the three months ended March 31, 2018, compared to the same period of the prior year, largely due to an increase in charge-offs in the consumer loan segment.

The following table presents the changes in the allowance for loan losses, by loan class, during the periods indicated:

(Amounts in thousands)

Deposits

Total deposits as of March 31, 2018, increased $50.73 million, or 2.63%, compared to December 31, 2017. Noninterest-bearing deposits increased $6.34 million; interest-bearing deposits increased $45.19 million; and savings deposits, which include money market accounts and savings accounts, increased $11.10 million; while time deposits, which include certificates of deposit and individual retirement accounts, decreased $11.90 million as of March 31, 2018, compared to December 31, 2017.

Borrowings

Total borrowings as of March 31, 2018, decreased $971 thousand, or 1.21%, compared to December 31, 2017. Short-term borrowings consisted of retail repurchase agreements, which decreased $971 thousand, or 19.09%, while the weighted average rate increased 2 basis points to 0.09% as of March 31, 2018, compared to December 31, 2017.

Long-term borrowings consisted of a wholesale repurchase agreement and a convertible FHLB advance as of March 31, 2018. The wholesale repurchase agreement totaled $25.00 million with a weighted average contractual rate of 3.18% as of March 31, 2018, and December 31, 2017. Long-term FHLB borrowings totaled $50.00 million with a weighted average contractual rate of 4.00% as of March 31, 2018, and December 31, 2017.

Liquidity and Capital Resources

Liquidity

Liquidity is a measure of our ability to convert assets to cash or raise cash to meet financial obligations. We believe that liquidity management should encompass an overall balance sheet approach that draws together all sources and uses of liquidity. Poor or inadequate liquidity risk management may result in a funding deficit that could have a material impact on our operations. We maintain a liquidity risk management policy and contingency funding policy (“Liquidity Plan”) to detect potential liquidity issues and protect our depositors, creditors, and shareholders. The Liquidity Plan includes various internal and external indicators that are reviewed on a recurring basis by our Asset/Liability Management Committee (“ALCO”) of the Board of Directors. ALCO reviews liquidity risk exposure and policies related to liquidity management; ensures that systems and internal controls are consistent with liquidity policies; and provides accurate reports about liquidity needs, sources, and compliance. The Liquidity Plan involves ongoing monitoring and estimation of potentially credit sensitive liabilities and the sources and amounts of balance sheet and external liquidity available to replace outflows during a funding crisis. The liquidity model incorporates various funding crisis scenarios and a specific action plan is formulated, and activated, when a financial shock that affects our normal funding activities is identified. Generally, the plan will reflect a strategy of replacing liability outflows with alternative liabilities, rather than balance sheet asset liquidity, to the extent that significant premiums can be avoided. If alternative liabilities are not available, outflows will be met through liquidation of balance sheet assets, including unpledged securities.

As a financial holding company, the Company’s primary source of liquidity is dividends received from the Bank, which are subject to certain regulatory limitations. Other sources of liquidity include cash, investment securities, and borrowings. As of March 31, 2018, the Company’s cash reserves totaled $33.90 million and availability on an unsecured, committed line of credit with an unrelated financial institution totaled $15.00 million. There was no outstanding balance on the line of credit as of March 31, 2018. The Company’s cash reserves and investments provide adequate working capital to meet obligations, projected dividends to shareholders, and anticipated debt repayments for the next twelve months.

In addition to cash on hand and deposits with other financial institutions, we rely on customer deposits, cash flows from loans and investment securities, and lines of credit from the FHLB and the Federal Reserve Bank (“FRB”) Discount Window to meet potential liquidity demands. These sources of liquidity are immediately available to satisfy deposit withdrawals, customer credit needs, and our operations. Secondary sources of liquidity include approved lines of credit with correspondent banks and unpledged available-for-sale securities. As of March 31, 2018, our unencumbered cash totaled $205.14 million, unused borrowing capacity from the FHLB totaled $392.85 million, available credit from the FRB Discount Window totaled $6.15 million, available lines from correspondent banks totaled $90.00 million, and unpledged available-for-sale securities totaled $122.75 million.

Cash Flows

The following table summarizes the components of cash flow for the periods indicated:

(Amounts in thousands)

Cash and cash equivalents increased $47.19 million for the three months ended March 31, 2018, compared to an increase of $76.54 million for the same period of the prior year. The $29.36 million decrease was primarily due to a $23.11 million reduction in net cash provided by investing activities from the purchase of available-for-sale securities. Net cash provided by financing activities decreased $6.39 million largely due to a net decrease in deposit accounts and an increase in cash dividends offset by the absence of repayments of FHLB and other borrowings that occurred during the first quarter of 2017. Net cash provided by operating activities increased $145 thousand.

Capital Resources

We are committed to effectively managing our capital to protect our depositors, creditors, and shareholders. Failure to meet certain capital requirements may result in actions by regulatory agencies that could have a material impact on our operations. Total stockholders’ equity as of March 31, 2018, decreased $8.68 million, or 2.47%, to $342.04 million from $350.71 million as of December 31, 2017. The change in stockholders’ equity was largely due to dividends declared on our common stock of $11.18 million, which includes the one-time special dividend, and repurchase of 187,300 shares of our common stock totaling $5.41 million offset by net income of $8.87 million. In accordance with current regulatory guidelines, accumulated other comprehensive income/(loss) is largely excluded from stockholders' equity in the calculation of our capital ratios. The accumulated other comprehensive loss increased $1.64 million to $2.48 million as of March 31, 2018, compared to December 31, 2017, primarily due to net unrealized losses on securities. Our book value per common share decreased $0.33, or 1.60%, to $20.30 as of March 31, 2018, from $20.63 as of December 31, 2017.

Capital Adequacy Requirements

Risk-based capital guidelines, issued by state and federal banking agencies, include balance sheet assets and off-balance sheet arrangements weighted by the risks inherent in the specific asset type. Our current risk-based capital requirements, based on the international capital standards known as Basel III, became effective on January 1, 2015, subject to a four-year phase-in period. Basel III’s capital conservation buffer became effective on January 1, 2016, at 0.625%, and will be phased in over a four-year period (increasing by an additional 0.625% each year until it reaches 2.5% on January 1, 2019). A description of the Basel III capital rules is included in Part I, Item 1 of the 2017 Form 10-K. Our current required capital ratios are as follows:

• 4.5% Common Equity Tier 1 capital to risk-weighted assets (effectively 5.75% including the capital conservation buffer)
• 6.0% Tier 1 capital to risk-weighted assets (effectively 7.25% including the capital conservation buffer)
• 8.0% Total capital to risk-weighted assets (effectively 9.25% including the capital conservation buffer)
• 4.0% Tier 1 capital to average consolidated assets (“Tier 1 leverage ratio”)

The following table presents our capital ratios as of the dates indicated:

Our risk-based capital ratios as of March 31, 2018, decreased from December 31, 2017, due to a decrease in Tier 1 and total risk-based capital. As of March 31, 2018, we continued to meet all capital adequacy requirements and were classified as well-capitalized under the regulatory framework for prompt corrective action. Management believes there have been no conditions or events since those notifications that would change the Bank’s classification. Additionally, our capital ratios were in excess of the minimum standards under the Basel III capital rules on a fully phased-in basis, if such requirements were in effect, as of March 31, 2018.

Off-Balance Sheet Arrangements

We extend contractual commitments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. Our exposure to credit loss in the event of nonperformance by other parties to financial instruments is the same as the contractual amount of the instrument.

The following table presents our off-balance sheet arrangements as of the dates indicated:

(Amounts in thousands)

(1) Includes FHLB letters of credit

Market Risk and Interest Rate Sensitivity

Market risk represents the risk of loss due to adverse changes in current and future cash flows, fair values, earnings, or capital due to movements in interest rates and other factors. Our profitability is largely dependent upon net interest income, which is subject to variation due to changes in the interest rate environment and unbalanced repricing opportunities. We are subject to interest rate risk when interest-earning assets and interest-bearing liabilities reprice at differing times, when underlying rates change at different levels or in varying degrees, when there is an unequal change in the spread between two or more rates for different maturities, and when embedded options, if any, are exercised. ALCO reviews our mix of assets and liabilities with the goal of limiting exposure to interest rate risk, ensuring adequate liquidity, and coordinating sources and uses of funds while maintaining an acceptable level of net interest income given the current interest rate environment. ALCO is also responsible for overseeing the formulation and implementation of policies and strategies to improve balance sheet positioning and mitigate the effect of interest rate changes.

In order to manage our exposure to interest rate risk, we periodically review third-party and internal simulation models that project net interest income at risk, which measures the impact of different interest rate scenarios on net interest income, and the economic value of equity at risk, which measures potential long-term risk in the balance sheet by valuing our assets and liabilities at fair value under different interest rate scenarios. Simulation results show the existence and severity of interest rate risk in each scenario based on our current balance sheet position, assumptions about changes in the volume and mix of interest-earning assets and interest-bearing liabilities, and estimated yields earned on assets and rates paid on liabilities. The simulation model provides the best tool available to us and the industry for managing interest rate risk; however, the model cannot precisely predict the impact of fluctuations in interest rates on net interest income due to the use of significant estimates and assumptions. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes; changes in market conditions and customer behavior; and changes in our strategies that management might undertake in response to a sudden and sustained rate shock.

During the first quarter of 2018, the Federal Open Market Committee increased the benchmark federal funds rate to a range of 150 to 175 basis points. The following table presents the sensitivity of net interest income from immediate and sustained rate shocks in various interest rate scenarios over a twelve-month period for the periods indicated. Due to the current target rate, we do not reflect a decrease of more than 100 basis points from current rates in our analysis.

(Dollars in thousands)

We have established policy limits for tolerance of interest rate risk in various interest rate scenarios and exposure limits to changes in the economic value of equity. As of March 31, 2018, exposure to interest rate risk is within our defined policy limits.

The Company primarily uses derivative instruments to manage exposure to market risk and meet customer financing needs. As of March 31, 2018, we maintained interest rate swap agreements with notional amounts totaling $5.73 million to modify our exposure to interest rate risk caused by changes in the LIBOR curve in relation to certain designated fixed rate loans. The fair values of the swap agreements, which are accounted for as fair value hedges, were recorded as a derivative asset totaling $45 thousand as of March 31, 2018, and a derivative liability totaling $90 thousand as of December 31, 2017. For additional information, see Note 9, “Derivative Instruments and Hedging Activities,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

Inflation and Changing Prices

Our consolidated financial statements and related notes are presented in accordance with GAAP, which requires the measurement of results of operations and financial position in historical dollars. Inflation may cause a rise in price levels and changes in the relative purchasing power of money. These inflationary effects are not reflected in historical dollar measurements. The primary effect of inflation on our operations is increased operating costs. In management’s opinion, interest rates have a greater impact on our financial performance than inflation. Interest rates do not necessarily fluctuate in the same direction, or to the same extent, as the price of goods and services; therefore, the effect of inflation on businesses with large investments in property, plant, and inventory is generally more significant than the effect on financial institutions. The U.S. inflation rate continues to be relatively stable, and management believes that any changes in inflation will not be material to our financial performance.

The information required in this item is incorporated by reference to “Market Risk and Interest Rate Sensitivity” in Item 1 of this report.

Evaluation of Disclosure Controls and Procedures

In connection with this report, we conducted an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures under the Exchange Act Rule 13a-15(b). Based upon that evaluation, the CEO and CFO concluded that, as of March 31, 2018, our disclosure controls and procedures were effective.

Disclosure controls and procedures are our Company’s controls and other procedures that are designed to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including the CEO and CFO, as appropriate, to allow timely decisions about required disclosure.

Management, including the CEO and CFO, does not expect that our disclosure controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, collusion of two or more people, or management’s override of the controls.

Changes in Internal Control over Financial Reporting

We assess the adequacy of our internal control over financial reporting quarterly and enhance our controls in response to internal control assessments and internal and external audit and regulatory recommendations. There were no changes in our internal control over financial reporting during the quarter ended March 31, 2018, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Our risk factors discuss potential events, trends, or other circumstances that could adversely affect our business, financial condition, results of operations, cash flows, liquidity, access to capital resources, and, consequently, cause the market value of our common stock to decline. These risks could cause our future results to differ materially from historical results and expectations of future financial performance. If any of the risks occur and the market price of our common stock declines significantly, individuals may lose all, or part, of their investment in our Company. Individuals should carefully consider our risk factors and information included, or incorporated by reference, in this report before making an investment decision. There may be risks and uncertainties that we have not identified or that we have deemed immaterial that could adversely affect our business; therefore, the following risk factors are not intended to be an exhaustive list of all risks we face. There have been no material changes to the risk factors included in Part I, Item 1A, “Risk Factors,” of our 2017 Form 10-K.