United Bancshares Inc: Form 10-Q for the period ended Jun 30, 2020

SELECTED FINANCIAL DATA

The following data should be read in conjunction with the unaudited consolidated financial statements and management’s discussion and analysis that follows:

(a) Some of the financial measures included in this table are not measures of financial performance recognized by U.S. Generally Accepted Accounting Principles, or GAAP. These non-GAAP financial measures include tangible book value, return on average tangible equity, net interest margin (tax-equivalent), and the efficiency ratio. Management uses these non-GAAP financial measures in its analysis of its performance, and believes financial analysts and investors frequently use these measures, and other similar measures, to evaluate capital adequacy. Reconciliations of non-GAAP disclosures used in this table to the comparable GAAP measures are provided in the accompanying table. Management, as well as regulators, financial analysts and other investors may use these measures in conjunction with more traditional bank capital ratios to compare the capital adequacy of banking organizations with significant amounts of goodwill or other intangible assets, which typically stem from the use of the purchase accounting method of accounting for mergers and acquisitions. These non-GAAP financial measures should not be considered in isolation or as a substitute for total shareholders’ equity, total assets, book value per share, return on average assets, return on average equity, or any other measure calculated in accordance with GAAP. Moreover, the manner in which we calculate these non-GAAP financial measures may differ from that of other companies reporting measures with similar names.

(b) Includes loans held for sale

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Introduction

United Bancshares, Inc. (the “Corporation”), an Ohio corporation, is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Corporation was incorporated and organized in 1985. The executive offices of the Corporation are located at 105 Progressive Drive, Columbus Grove, Ohio 45830. The Corporation is a one-bank holding company, as that term is defined by the Federal Reserve Board.

The Union Bank Company (the “Bank”), a wholly-owned subsidiary of the Corporation, is a full service community bank offering a full range of commercial and consumer banking services. The Bank is an Ohio state-chartered bank, which serves Allen, Delaware, Franklin, Hancock, Huron, Marion, Putnam, Sandusky, Van Wert and Wood counties in Ohio, with office locations in Bowling Green, Columbus Grove, Delaware, Delphos, Findlay, Gahanna, Gibsonburg, Kalida, Leipsic, Lima, Marion, Ottawa, Pemberville, Plymouth, Westerville and Worthington, Ohio.

Deposit services include checking accounts, savings and money market accounts; certificates of deposit and individual retirement accounts. Additional supportive services include online banking, bill pay, mobile banking, Zelle payment service, ATM’s and safe deposit box rentals. Treasury management and remote deposit capture products are also available to commercial deposit customers. Deposits of Union Bank are insured up to applicable limits by the Deposit Insurance Fund, which is administered by the FDIC.

Loan products offered include commercial and residential real estate loans, agricultural loans, commercial and industrial loans, home equity loans, various types of consumer loans and small business administration loans. Union Bank’s residential loan activities consist primarily of loans for purchasing or refinancing personal residences. The majority of these loans are sold to the secondary market.

Wealth management services are offered by Union Bank through an arrangement with LPL Financial LLC, a registered broker/dealer. Licensed representatives offer a full range of investment services and products, including financial needs analysis, mutual funds, securities trading, annuities and life insurance.

Union Bank has two subsidiaries: UBC Investments, Inc. (“UBC”), an entity formed to hold its securities portfolio, and UBC Property, Inc. (“UBC Property”), an entity formed to hold and manage certain property that is acquired in lieu of foreclosure.

When or if used in the Corporation’s Securities and Exchange Commission filings or other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases: “anticipate,” “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “is estimated,” “is projected,” or similar expressions are intended to identify “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Any such statements are subject to the risks and uncertainties that include but are not limited to: changes in economic conditions in the Corporation’s market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the Corporation’s market area, and competition. All or some of these factors could cause actual results to differ materially from historical earnings and those presently anticipated or projected.

The Corporation cautions readers not to place undue reliance on any such forward looking statements, which speak only as of the date made, and advises readers that various factors, including regional and national economic conditions, substantial changes in the levels of market interest rates, credit and other risks associated with lending and investing activities, and competitive and regulatory factors could affect the Corporation’s financial performance and could cause the Corporation’s actual results for future periods to differ materially from those anticipated or projected. The Corporation does not undertake, and specifically disclaims any obligation, to update any forward looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

The Corporation is registered as a Securities Exchange Act of 1934 reporting company.

The following discussion and analysis of the consolidated financial statements of the Corporation is presented to provide insight into management’s assessment of the financial results.

Recent Developments

The progression of the COVID-19 pandemic in the United States began to have an adverse impact on the local and national economy during the latter part of the first quarter of 2020 and will likely have a complex and significant adverse impact on the economy, the banking industry and our Corporation in future fiscal periods, all subject to a high degree of uncertainty.

Our primary banking market area is Northwestern and Central Ohio. In Ohio, the Governor ordered individuals to stay at home and non-essential businesses to cease all activities, in each case subject to limited exceptions. This order went into effect on March 15, 2020, and was effective through May 1, 2020. In response to this order, the Bank continued to serve its customers through its drive-up windows at various branch locations and through online and mobile banking. Beginning July 13, 2020 all branch locations reopened to customers with protective measures in place. However, many of the Corporation's employees continue to work remotely.

Like most states, Ohio has experienced a dramatic and sudden increase in unemployment levels as a result of the curtailment of business activities, rising from an average of 4.1% in January 2020 to an average of 13.7 % in May 2020, according to the U.S. Bureau of Labor Statistics, which expects levels to rise further. To date, many of the public health and economic effects of COVID-19 have been concentrated in the largest U.S. cities, but it is possible that similar effects will occur on a more delayed basis in smaller cities and communities, where many of our banking operations are focused.

Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic, including the following:

• The Federal Reserve decreased the range for the Federal Funds Target Rate by 0.50% on March 3, 2020, and by another 1.0% on March 16, 2020, reaching a current range of 0.0 – 0.25%.
• On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief and Economic Security Act, or CARES Act, which established a $2.0 trillion economic stimulus package, including cash payments to individuals, supplemental unemployment insurance benefits and a $349 billion loan program administered through the U.S. Small Business Administration (SBA), referred to as the paycheck protection program, or PPP program. Under the PPP program, small businesses, sole proprietorships, independent contractors and self-employed individuals could apply for loans from existing SBA lenders and other approved regulated lenders who enrolled in the program, subject to limitations and eligibility criteria. The Bank participated as a lender in the PPP program, originating over 1,500 loans totaling $118.0 million during the second quarter of 2020. In addition, the CARES Act provides financial institutions the option to suspend certain requirements under GAAP related to TDRs for a limited period of time to account for the effects of COVID-19.
• On April 7, 2020, federal banking regulators issued a revised Interagency Statement on Loan Modifications and Reporting for Financial Institutions, which, among other things, encouraged financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19, and stated that institutions generally do not need to categorize COVID-19-related modifications as TDRs and that the agencies will not direct supervised institutions to automatically categorize all COVID-19 related loan modifications as TDRs.
• On April 9, 2020, the Federal Reserve announced additional measures aimed at supporting small and midsized business, as well as state and local governments impacted by COVID-19. The Federal Reserve announced the Main Street Business Lending Program, which establishes two new loan facilities intended to facilitate lending to small and midsized businesses: (1) the Main Street New Loan Facility, or MSNLF, and (2) the Main Street Expanded Loan Facility, or MSELF. MSNLF loans are unsecured term loans originated on or after April 8, 2020, while MSELF loans are provided as upsized tranches of existing loans originated before April 8, 2020. The program is designed for businesses with up to 10,000 employees or $2.5 billion in 2019 revenues. To obtain a loan, borrowers must confirm that they are seeking financial support because of COVID-19 and that they will not use proceeds from the loan to pay off debt. The Federal Reserve also stated that it would provide additional funding to banks offering PPP loans to struggling small businesses. Lenders participating in the PPP can exclude loans financed by the facility from their leverage ratio. In addition, the Federal Reserve created a Municipal Liquidity Facility to support state and local governments with up to $500 billion in lending, with the Treasury Department backing $35 billion for the facility using funds appropriated by the CARES Act. The facility makes short-term financing available to cities with a population of more than one million or counties with a population of greater than two million. The Federal Reserve expanded both the size and scope of its Primary and Secondary Market Corporate Credit Facilities to support up to $750 billion in credit to corporate debt issuers. The program expires August 8, 2020 unless extended by Congress.

We expect that the COVID-19 pandemic and the specific developments referred to above will have a significant impact on our business. In particular, we anticipate that a significant portion of the Bank’s borrowers in the retail, restaurants, and hospitality industries may endure significant economic distress, which will cause them to draw on their existing lines of credit and could adversely affect their ability and willingness to repay existing indebtedness, and could adversely impact the value of collateral. These developments, together with general economic conditions may also impact our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, our consumer loan business and loan portfolio, and the value of certain collateral securing our loans. We anticipate that our financial condition, capital levels and results of operations could be adversely affected going forward. The low interest rate environment during the second quarter of 2020 enabled the Corporation to originate a record number of mortgage loans resulting in $8.5 million of gains on sale of loans during the six month period ended June 30, 2020. The Corporation's second quarter operations were also bolstered by the aforementioned PPP loan origination activity, including the recovery of $1.0 million of non-interest expenses and amortization of $337,000 into interest income of PPP loan origination fees.

We have taken numerous steps in response to the COVID-19 pandemic, including the following:

• We offered payment deferrals and interest only payment options for consumer, small business, and commercial customers for up to 90 days. We also offered payment extensions of up to 90 days for mortgage customers. As of June 30, 2020, we have modified or extended 138 loans, approximating $47.3 million.
• We formed a Business Continuity Planning COVID-19 Response team which meets regularly to manage the Corporation’s response to the pandemic and the effect on our business. In addition, cross functional task force teams meet as needed to address specific issues such as employee and client communications, facilities, and branch services and to discuss the effect on our business.
• We are participating in the SBA’s Paycheck Protection Program. As of June 30, 2020, we have secured funding for over 1,500 customers for loans approximating $118.0 million. The program expires August 8, 2020 unless extended by Congress.
• In response to the outbreak and business disruption, first and foremost, we have prioritized the safety, health and well-being of our employees, customers, and communities. We have implemented a work from home policy, we have implemented protective measures for customers who choose branch access and we continue to serve customers through our drive-up locations and digital platforms.

RESULTS OF OPERATIONS

Overview of the Income Statement

For the quarter ended June 30, 2020, the Corporation reported net income of $5,668,000, or $1.73 basic earnings per share. This compares to the second quarter of 2019 net income of $2,285,000, or $0.70 basic earnings per share. The increase in operating results for the second quarter of 2020 as compared to the same period in 2019 was primarily attributable to an increase in net interest income of $1,341,000, and an increase in non-interest income of $4,988,000, offset by an increase in the provision for loan losses of $750,000, an increase in non-interest expenses of $1,313,000, and an increase in the provision for income taxes of $883,000. For the quarter ended June 30, 2020, $1.0 million of fees received from the Small Business Administration was recorded as a reduction to non-interest expenses to cover PPP loan origination costs and $337,000 of deferred fees was amortized into interest income. The remaining $3.4 million of fees received from the SBA have been deferred and will be amortized into interest income over the two year life of the loans. The increase in net interest income resulted from additional interest and the $337,000 in loan fees generated through the PPP loan program, as well as a decrease in deposit interest rates. The increase in the provision for loan losses was due to loan growth and allocations of reserves for the uncertainties related to COVID-19.

Net income for the six months ended June 30, 2020 totaled $6,756,000, or $2.07 basic earnings per share, compared to $4,099,000, or $1.25 basic earnings per share for the same period in 2019, an increase of $2,657,000 (64.8%). The increase in operating results for the six month period ended June 30, 2020 as compared to the six month period ended June 30, 2019 was primarily attributable to increases in net interest income of $1,530,000, and non-interest income of $5,314,000, offset by an increase in the provision for loan losses of $1,200,000, an increase in non-interest expenses of $2,301,000, and an increase in the provision for income taxes of $686,000. Similar to the second quarter results, the increase in net interest income for the six month period resulted from interest and fees on PPP loans and lower deposit interest rates, and the increase in the provision for loan losses was attributable to loan growth and additional reserves in response to the COVID-19 uncertainties.

Net Interest Income

Net interest income is the amount by which income from interest-earning assets exceeds interest incurred on interest-bearing liabilities. Interest-earning assets consist principally of loans and investment securities while interest-bearing liabilities include interest-bearing deposit accounts and borrowed funds. Net interest income remains the primary source of revenue for the Corporation. Changes in market interest rates, as well as changes in the mix and volume of interest-bearing assets and interest-bearing liabilities impact net interest income. Net interest income was $8,586,000 for the second quarter of 2020, compared to $7,245,000 for the same period of 2019, an increase of $1.3 million (18.5%). Net interest income was $15,710,000 for the six months ended June 30, 2020 compared to $14,180,000 for the same period of 2019, an increase of $1.5 million (10.8%)

The increase in net interest income for the six months ended June 30, 2020 was attributable to an increase in interest income of $854,000 and a $676,000 decrease in interest expense. The increase in interest income was primarily attributable to interest and $337,000 in loan fees generated through PPP loan originations. The remaining $3.4 million of fees received from the SBA have been deferred and will be amortized into interest income over the two year life of the loans. The PPP program is set to expire on August 8, 2020 unless extended by Congress. The bulk of the income resulting from PPP loans is from the SBA fees payable in connection with the origination of the loans, and not from interest to be paid on such loans from the borrower, as management expects most of its PPP loan portfolio to be forgiven. The average loan balance was $631.2 million for the six months ended June 30, 2020 compared to $575.8 million for the same period of 2019. The yield on average earning assets was 4.61% for six months ended June 30, 2020 compared to 4.93% for the same period of 2019.

In response to the COVID-19 pandemic, the Federal Reserve decreased the targeted federal funds rate by a total of 150 basis points (1.5%) in March 2020. This decrease impacts the comparability of net interest income between 2019 and 2020, especially for the second quarter. Our interest income could be significantly adversely affected in future periods as a result of the COVID-19 pandemic, including the impact of decreases in the size of our loan portfolio, the effects of lower interest rates and possible increases of non-accrual loans.

The decrease in interest rates by the Federal Reserve resulted in a decrease in the cost of average interest bearing liabilities to 1.04% for the six months ended June 30, 2020 compared to 1.39% for the same period of 2019. This decrease more than offset the $79.8 million increase in average interest bearing deposits at June 30, 2020 compared to June 30, 2019.

Net interest margin is calculated by dividing net interest income (adjusted to reflect tax-exempt interest income on a taxable equivalent basis) by average interest-earning assets. The resulting percentage serves as a measurement for the Corporation in comparing its results with those of past periods as well as those of peer institutions. For the quarter and six months ended June 30, 2020 the net interest margin (on a taxable equivalent basis) was 3.87% and 3.74% compared with 3.80% and 3.77% for the same period in 2019. Loans and leases comprised 73.8% of interest-earning assets at June 30, 2020 compared to 75.0% of interest-earning assets at June 30, 2019. Interest-bearing deposits comprised 90.3% of average interest-bearing liabilities at June 30, 2020, compared to 89.3% for the same period in 2019.

As a result of the recent reductions in the target federal funds interest rate, as well as the impact of the COVID-19 pandemic and related future loan charge-offs and increases in non-accrual loans which we believe may occur, we expect that our net interest income and net interest margin will decrease in future periods. These decreases will be offset to some degree through recognition of deferred loan fees received from the SBA for PPP loan financing, but we cannot determine at this time what the scope of such losses or offsets might be. The SBA loan fees are deferred and being recognized as an adjustment to interest income over the life of the loans. The timing of such will be impacted by the timing and level of loan forgiveness granted by the SBA.

Provision for Loan and Lease Losses

The Corporation’s provision for loan and lease losses is determined based upon management’s calculation of the allowance for loan and lease losses and is reflective of management’s assessment of the quality of the portfolio and overall management of the inherent credit risk of the loan and lease portfolio. Changes in the provision for loan and lease losses are dependent, among other things, on loan and lease delinquencies, collateral position, portfolio risks and general economic conditions in the Corporation’s lending markets. In assessing the adequacy of the allowance, management considers the size and quality of the loan portfolio measured against prevailing economic conditions, regulatory guidelines, and historical loan loss experience. However, there is no assurance that loan credit losses will not exceed the allowance, and any growth in the loan portfolio and the uncertainty of the general economy may require additional provisions in future periods.

A $1,450,000 provision for loan and lease losses was recognized during the six month period ended June 30, 2020 compared to a $250,000 provision during the six month period ended June 30, 2019 due to the economic uncertainty related to COVID-19.

We are preparing for the possibility that the provision for loan losses could increase in future periods based on our belief that the credit quality of our loan portfolio may decline and loan defaults may increase as a result of economic conditions created by the COVID-19 pandemic. See “Allowance for Loan and Lease Losses” under Financial Condition for further discussion relating to the provision for loan and lease losses.

Non-Interest Income

The Corporation’s non-interest income is largely generated from activities related to the origination, servicing and gain on sales of fixed rate mortgage loans; customer deposit account fees; earnings on life insurance policies; income arising from sales of investment products to customers; and occasional security sale transactions. Income related to customer deposit accounts and life insurance policies provides a relatively steady flow of income while the other sources are more volume or transaction related and consequently can vary from quarter to quarter.

For the quarter ended June 30, 2020, non-interest income was $8,121,000, compared to $3,133,000 for the second quarter of 2019, a $4,988,000 (159.2%) increase, which was attributable to increases in gain on sales of loans of $3,779,000, gain on sales of securities of $287,000, and other non-interest income of $921,000 (97.3%).

For the six months ended June 30, 2020, non-interest income was $10,955,000 compared to $5,641,000 for the same period in 2019, an increase of $5,314,000 (94.2%), which was attributable to increases in gain on sales of loans of $4,924,000, gain on sales of securities of $287,000, and other non-interest income of $103,000. In response to possible liquidity concerns at the the time, the Corporation sold certain investment securities during the second quarter of 2020 resulting in the aforementioned gains of $287,000.

The significant increase in gain on sale of loans was attributable to increased loan origination and sales activities within the residential mortgage and governmental lending operations along with an increase in the average gain on sale per loan. Loan sales for the second quarter of 2020 were 516 loans closed totaling $138.0 million compared to 220 loans closed totaling $52.7 million for the second quarter of 2019, resulting in gains on sale of loans of $5,965,000 for the quarter ended June 30, 2020 compared to $2,186,000 for the quarter ended June 30, 2019. Loan sales year to date in 2020 were 784 loans closed totaling $201.2 million compared to 385 loans closed totaling $89.6 million for the same period in 2019, resulting in gains on sale of loans of $8,548,000 for the six months ended June 30, 2020 compared to $3,624,000 for the six months ended June 30, 2109. The average gain on sale approximated $10,000 per loan during the first six months of 2020 compared to $8,000 for the same period of 2019.

Gain on sales of securities amounted to $287,000 for the quarter ended June 30, 2020. There were no gains or losses for the quarter or six month period ended June 30, 2019. In response to possible liquidity concerns at the time, the Corporation sold certain investment securities during the second quarter of 2020 resulting in the aforementioned gains of $287,000.

Other non-interest income was $1,869,000 for the quarter ended June 30, 2020 compared to $947,000 for the comparable period in 2019, an increase of $922,000. This was due to a $1.0 million increase in mortgage banking hedge income. For the six months ended June 30, 2020 other non-interest income was $2,120,000 compared to $2,017,000.

We anticipate that our non-interest income may be adversely affected in future periods as a result of the COVID-19 pandemic. Increased unemployment and recessionary concerns may adversely affect mortgage originations and mortgage banking revenue in future periods.

Non-Interest Expenses

For the quarter ended June 30, 2020, non-interest expenses were $8,805,000, compared to $7,492,000 for the second quarter of 2019, a $1,313,000 (17.5%) increase. The significant quarter-over-quarter increases included salaries and benefits expense of $844,000 (19.5%), loan fees of $217,000, data processing expenses of $118,000, and consultant fees of $172,000.

For the six month period ended June 30, 2020, non-interest expenses were $17,015,000 compared to $14,714,000 for the same period of 2019, a $2,301,000 (15.6%) increase, which was attributable to increases in salaries and benefits expense of $1,495,000, loan fees of $312,000, data processing expenses of $143,000, and an increase in consultant fees of $170,000.

Maintaining acceptable levels of non-interest expenses and operating efficiency are key performance indicators for the Corporation in its strategic initiatives. The financial services industry uses the efficiency ratio (total non-interest expense as a percentage of the aggregate of fully-tax equivalent net interest income and non-interest income) as a key indicator of performance. For the quarter ended June 30, 2020, the Corporation’s efficiency ratio was 51.82%, compared to 71.25% for the same period of 2019. For the six months ended June 30, 2020 the Corporation's efficiency ratio was 63.14% compared to 73.36% for the same period of 2019

Provision for Income Taxes

The provision for income taxes for the quarter ended June 30, 2020 was $1,334,000 (effective rate of 19.1%), compared to $451,000 (effective rate of 16.5%) for the comparable 2019 period. The provision for the six month period ended June 30, 2020 was $1,444,000 (effective rate of 17.6%) compared to $758,000 (effective rate of 15.6%) for the comparable 2019 period.

FINANCIAL CONDITION

Overview of Balance Sheet

Total assets amounted to $1.0 billion at June 30, 2020, compared to $880.0 million at December 31, 2019, an increase of $137.4 million (15.6%). The increase in total assets was primarily the result of increases of $96.7 million (16.9%) in net loans, $42.4 million (160.7%) in cash and cash equivalents due to deposit growth, $8.5 million (55.7%) in loans held for sale, offset by a decrease of $9.4 million (5.1%) in securities available-for-sale, and a decrease of $1.0 million (10.1%) in other assets (including accrued interest receivable). Deposits during this same period increased $124.0 million (17.6%).

Shareholders’ equity increased from $94.8 million at December 31, 2019 to $104.8 million at June 30, 2020. This increase was primarily the result of net income during the six month period ended June 30, 2020 of $6,756,000 and an increase in unrealized securities gains, net of tax of $3,756,000, offset by dividends paid of $687,000. The increase in unrealized securities gains during the six month period ended June 30, 2020, was attributable to the Federal Reserve decreasing the Federal Funds Target Rate by 150 basis points (1.50%) during March 2020, in response to the COVID-19 pandemic. Net unrealized gains and losses on securities are reported as accumulated other comprehensive income (loss) in the consolidated balance sheets.

Cash and Cash Equivalents

Cash and cash equivalents totaled $68.8 million at June 30, 2020 and $26.4 million at December 31, 2019, including interest-bearing deposits in other banks of $58.8 million at June 30, 2020 and $17.2 million at December 31, 2019. The increase in cash and cash equivalents was due to the PPP loans as they increased both deposits and cash. Management believes the current level of cash and cash equivalents is sufficient to meet the Corporation’s present liquidity and performance needs especially considering the availability of other funding sources, as described below. Total cash and cash equivalents fluctuate on a daily basis due to transactions in process and corresponding liquidity sources and uses. Management believes the Corporation’s liquidity needs in the near term will be satisfied by the current level of cash and cash equivalents, readily available access to traditional and non-traditional funding sources, and the portions of the investment and loan portfolios that will mature within one year. These sources of funds should enable the Corporation to meet cash obligations and off-balance sheet commitments as they come due. In addition, the Corporation has access to various sources of additional borrowings by virtue of long-term assets that can be used as collateral for such borrowings.

Securities

Management monitors the earnings performance and liquidity of the securities portfolio on a regular basis through Asset/Liability Committee (ALCO) meetings. As a result, all securities, except FHLB stock, have been designated as available-for-sale and may be sold if needed for liquidity, asset-liability management or other reasons. Such securities are reported at fair value, with any net unrealized gains or losses reported as a separate component of shareholders’ equity, net of related incomes taxes.

The amortized cost and fair value of available-for-sale securities as of June 30, 2020 totaled $165.8 million and $174.2 million, respectively, resulting in net unrealized gain before tax of $8.4 million and a corresponding after-tax increase in shareholders’ equity of $6.6 million.

Loans and Leases

The Corporation’s primary lending areas are Northwestern, West Central, and Central Ohio. Gross loans and leases totaled $671.2 million at June 30, 2020, compared to $576.4 million at December 31, 2019, an increase of $94.8 million (16.4%). As compared to December 31, 2019, commercial loans increased $104.6 million due to PPP loan originations, commercial and multi-family real estate loans increased $4.1 million. All other loan categories experienced decreases aggregating $13.9 million with the largest decrease of $13.0 million (10.5%) coming from the residential 1-4 family real estate loan portfolio.

There are also unrecognized financial instruments at June 30, 2020 and December 31, 2019 which relate to commitments to extend credit and letters of credit. The contract amount of such financial instruments approximated $153.3 million at June 30, 2020 and $133.2 million at December 31, 2019.

It's likely that loan demand will decline for the remainder of the 2020 fiscal year and into 2021 as a result of COVID-19 and the related decline in economic conditions in our market areas, leading to reductions in the growth of for our commercial and industrial loan, commercial real estate loan, residential real estate loan and consumer loan portfolios. The PPP loan program expires August 8, 2020 unless extended by Congress. Existing PPP loan balances could decrease significantly by year end as forgiveness guidelines are formalized. We are also anticipating that we could see increased line of credit utilization and a reduction in our unused commitments.

Allowance for Loan and Lease Losses

The following table presents a summary of activity in the allowance for loan and lease losses for the six month periods ended June 30, 2020 and 2019:

(in thousands)

The allowance for loan and lease losses as a percentage of gross loans and leases was 0.83% at June 30, 2020, 0.72% at December 31, 2019, and 0.67% at June 30, 2019. Excluding PPP loans and the related allocation of allowance, the allowance for loan losses as a percentage of gross loans and leases was 0.99% at June 30, 2020. Based on current economic indicators, the Corporation increased the economic factors within the allowance for loan losses evaluation. We expect that the allowance for loan losses as a percent of total loans may increase in future periods based on our belief that the credit quality of our loan portfolio may decline, and loan defaults may increase as a result of COVID-19.

Regular provisions are made in amounts sufficient to maintain the balance in the allowance for loan and lease losses at a level considered by management to be adequate for losses within the portfolio. Even though management uses all available information to assess possible loan and lease losses, future additions or reductions to the allowance may be required as changes occur in economic conditions and specific borrower circumstances. The regulatory agencies that periodically review the Corporation’s allowance for loan and lease losses may also require additions to the allowance or the charge-off of specific loans and leases based upon the information available to them at the time of their examinations.

Loans and leases on non-accrual status amounted to $1.7 million and $1.0 million at June 30, 2020 and December 31, 2019, respectively. Non-accrual loans and leases as a percentage of outstanding loans amounted to 0.26% at June 30, 2020 and 0.17% at December 31, 2019.

The Corporation considers a loan or lease to be impaired when it becomes probable that the Corporation will be unable to collect under the contractual terms of the loan or lease, as the case may be, based on current information and events. The Corporation had impaired loans totaling $2.1 million with $574,000 of specific reserves at June 30, 2020 and impaired loans of $1.9 million with $435,000 of specific reserves as of December 31, 2019. The Corporation had $775,000 and $848,000, respectively, of impaired loans without specific reserves at June 30, 2020 and December 31, 2019.

The Corporation had other potential problem credits, consisting of loans graded substandard or special mention, as well as loans over 90 days past due, loans on non-accrual, and TDR loans, amounting to $5.4 million at June 30, 2020 and $4.9 million at December 31, 2019. The Corporation’s credit administration department continues to closely monitor these credits. The corporation has also modified or extended 138 loans, approximating $47.3 million in response to the COVID-19 pandemic.

The Corporation provides pooled reserves for potential problem loans and leases using loss rates calculated considering historic net loan charge-off experience, as well as other environmental and qualitative factors. The Corporation experienced $22,000 of loan charge-offs during the first six months of 2020 compared to $29,000 during the first six months of 2019 with the charge-offs coming from the residential 1-4 family, commercial and consumer loan portfolios. The Corporation also provides pooled general reserves for the remaining portion of its loan portfolio not considered to be problem or potential problem loans. These general reserves are also calculated considering, among other things, the historic net charge-off experience for the related loan type.

Funding Sources

The Corporation considers a number of alternatives, including but not limited to, deposits, as well as short-term and long-term borrowings when evaluating funding sources. Deposits, including customer deposits, brokered certificates of deposit, and public funds deposits continue to be the most significant source of funds for the Corporation, totaling $831.2 million, or 91.1% of the Corporation’s outstanding funding sources at June 30, 2020, compared to $707.1 million at December 31, 2019. The significant increase in deposits during the six month period is somewhat attributable to customer deposits from PPP loan proceeds.

Non-interest bearing deposits comprised 20.0% of total deposits at June 30, 2020 and 16.5% at December 31, 2019. We expect that deposit levels may decrease in future periods if the conditions in our market areas become distressed relating to the COVID-19 pandemic.

In addition to traditional deposits, the Corporation maintains both short-term and long-term borrowing arrangements. Other borrowings consisted of FHLB borrowings totaling $50.0 million at June 30, 2020 and December 31, 2019, as well as $8,250,000 and $8,750,000 of term borrowings from the United Bankers’ Bank (UBB) at June 30, 2020 and December 31, 2019, respectively. The Corporation also has outstanding junior subordinated deferrable interest debentures of $12,925,000 and $12,908,000 at June 30, 2020 and December 31, 2019, respectively. Management plans to maintain access to various borrowing alternatives as an appropriate funding source.

Regulatory Capital

The Corporation and Bank met all regulatory capital requirements as of June 30, 2020, and the Bank is considered “well capitalized” under regulatory and industry standards of risk-based capital.

Cash Flow from Operations

As part of the Bank's hedging program, loans held for sale are accumulated into larger blocks before being sold. Depending on the timing of the sales of these blocks, there could be a positive or negative impact to net income and cash flow from operations. As of June 30, 2020, loans held for sale amounted to $23,817,000 compared to $15,301,000 as of December 31, 2019 resulting in a negative impact to cash flow from operations for the six month period ended June 30, 2020 of $8,516,000. Similarly, there was a negative impact on cash flow from operations for the six month period ended June 30, 2019 of $2,298,000 from the increase in loans held for sale. Excluding these changes in loans held for sale, cash flow from operations for the six months ended June 30, 2020 and 2019 would have been a positive $6,845,000 and $3,936,000, respectively.

Liquidity and Interest Rate Sensitivity

The objective of the Corporation’s asset/liability management function is to maintain consistent growth in net interest income through management of the Corporation’s balance sheet liquidity and interest rate exposure based on changes in economic conditions, interest rate levels, and customer preferences.

The Corporation manages interest rate risk to minimize the impact of fluctuating interest rates on earnings. The Corporation uses simulation techniques that attempt to measure the volatility of changes in the level of interest rates, basic banking interest rate spreads, the shape of the yield curve, and the impact of changing product growth patterns. The primary method of measuring the sensitivity of earnings of changing market interest rates is to simulate expected cash flows using varying assumed interest rates while also adjusting the timing and magnitude of non-contractual deposit re-pricing to more accurately reflect anticipated pricing behavior. These simulations include adjustments for the lag in prime loan re-pricing and the spread and volume elasticity of interest-bearing deposit accounts, regular savings and money market deposit accounts.

The principal function of interest rate risk management is to maintain an appropriate relationship between those assets and liabilities that are sensitive to changing market interest rates. The Corporation closely monitors the sensitivity of its assets and liabilities on an ongoing basis and projects the effect of various interest rate changes on its net interest margin. Interest sensitive assets and liabilities are defined as those assets or liabilities that mature or re-price within a designated time frame.

Management believes the Corporation’s current mix of assets and liabilities provides a reasonable level of risk related to significant fluctuations in net interest income and the resulting volatility of the Corporation’s earning base. The Corporation’s management reviews interest rate risk in relation to its effect on net interest income, net interest margin, and the volatility of the earnings base of the Corporation.

Effects of Inflation on Financial Statements

All of the Corporation’s assets relate to commercial banking operations and are generally monetary in nature. Therefore, they are not impacted by inflation to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in loss of purchasing power and conversely a net monetary liability position results in an increase in purchasing power. In the commercial banking industry, monetary assets typically exceed monetary liabilities. The Corporation has not experienced a significant level of inflation or deflation during the six month period ended June 30, 2020. However, because of the depressed national real estate market and sluggish local economy, the Corporation has experienced declines in the value of collateral securing commercial and non-commercial real estate loans. Management continues to closely monitor these trends in calculating the Corporation’s allowance for loan and lease losses.

There have been no material changes in the quantitative and qualitative information about market risk from the information provided in the Corporation’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.

Evaluation of Controls and Procedures.

With the participation of our management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this Quarterly Report on Form 10-Q.

Based on that evaluation, the Corporation's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Corporation's disclosure controls and procedures were effective as of June 30, 2020.

Changes in Internal Control over Financial Reporting.

There were no significant changes during the period covered by this Quarterly Report on Form 10-Q in our internal control over financial reporting (as defined in Rules 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In addition to the risk factors set forth under Part I, Item 1A “Risk Factors” in the Company’s Form 10-K for the fiscal year ended December 31, 2019, the following risk factor applies to the Corporation

The outbreak of Coronavirus Disease 2019 (“COVID-19”), or an outbreak of other highly infectious or contagious diseases, could adversely impact certain industries in which the Corporation’s customers operate and impair their ability to fulfill their obligations to the Corporation. Further, the spread of the outbreak could lead to an economic recession or other severe disruptions in the U.S. economy and may disrupt banking and other financial activity in the areas in which the Corporation operates and could potentially create widespread business continuity issues for the Corporation.

COVID-19 has caused severe disruptions in the U.S. economy at large, and for small businesses in particular, which has disrupted the Corporation’s operations. We are starting to see the impact from COVID-19 on our business, and we believe that it will be significant, adverse and potentially material. Currently, COVID-19 infections continue throughout the United States. The ongoing concerns on the part of the U.S. have created continued risk of a recession, reduced economic activity and significant volatility in the U.S. stock markets. We expect continued disruption across our business due to these effects, very likely leading to decreased earnings and significant slowdowns in our loan collections or loan defaults. Anticipated increases in unemployment and recessionary concerns will also likely adversely affect mortgage originations and mortgage banking revenue in future periods.

COVID-19 may impact the financial ability of businesses and consumers to borrow money, which would negatively impact loan volumes. In addition, certain of our borrowers are in or have exposure to the retail, restaurants, and hospitality industries and/or are located in areas that are mandating reduced capacity requirements or other types of operating restrictions, and COVID-19 may also have an adverse effect on our commercial real estate and consumer loan portfolios. Any additional prolonged quarantine or stay-at-home order would have a negative adverse impact on these borrowers and their revenue streams, which consequently impacts their ability to meet their financial obligations and could result in loan defaults.

The Corporation relies upon its third-party vendors to conduct business and to process, record, and monitor transactions. If any of these vendors are unable to continue to provide the Corporation with these services, it could negatively impact the Corporation’s ability to serve its customers. Furthermore, the continued outbreak could negatively impact the ability of the Corporation’s employees and customers to engage in banking and other financial transactions in the geographic area in which the Corporation operates and could create widespread business continuity issues for the Corporation. The Corporation also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of a COVID-19 outbreak in our market area. Although the Corporation has business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.

We continue to believe that the extended economic impact from COVID-19 will be severe and could have a material and adverse impact on our business and that it could result in significant losses in our loan portfolio in future periods, all of which would adversely and materially impact our earnings and capital.