National Bankshares Inc: Form 10-Q for the period ended Mar 31, 2022

$ in thousands, except per share data

The purpose of this discussion and analysis is to provide information about the financial condition and results of operations of the Company. Please refer to the financial statements and other information included in this report as well as the Company’s 2021 Annual Report on Form 10-K for an understanding of the following discussion and analysis. References in the following discussion and analysis to “we” or “us” refer to the Company unless the context indicates that the reference is to the Bank.

Cautionary Statement Regarding Forward-Looking Statements

We make forward-looking statements in this Form 10-Q that are subject to significant risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals, and are based upon our management’s views and assumptions as of the date of this report. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements.

These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, changes in:

• interest rates,
• general and local economic conditions,
• the legislative/regulatory climate,
• monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury, the Office of the Comptroller of the Currency, the Federal Reserve, the Consumer Financial Protection Bureau and the Federal Deposit Insurance Corporation (“FDIC”), and the impact of any policies or programs implemented pursuant to financial reform legislation,
• unanticipated increases in the level of unemployment in the Company’s market,
• the quality or composition of the loan and/or investment portfolios,
• demand for loan products,
• deposit flows,
• competition,
• demand for financial services in the Company’s market,
• the real estate market in the Company’s market,
• laws, regulations and policies impacting financial institutions,
• technological risks and developments, and cyber-threats, attacks or events,
• the Company’s technology initiatives,
• performance by the Company’s counterparties or vendors,
• applicable accounting principles, policies and guidelines,
• business disruption and/or impact due to the coronavirus or similar pandemic diseases, and
• the duration and severity of the COVID-19 pandemic, the uncertainty regarding new variants of COVID-19, the efficacy of vaccine and treatment developments, the impact of loosening or tightening of government restrictions, and the heightened impact it has on many of the risks described herein,
• geopolitical conditions, including acts or threats of terrorism and/or military conflicts, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, negatively impacting business and economic conditions in the U.S. and abroad.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report. This discussion and analysis should be read in conjunction with the description of our “Risk Factors” in Item 1A of the most recently filed Form 10-K.

Cybersecurity

The Company considers cybersecurity risk to be one of the greatest risks to its business. We have deployed a multi-faceted approach to limit the risk and impact of unauthorized access to customer accounts and to information relevant to customer accounts. We use digital technology safeguards, internal policies and procedures, and employee training to reduce the exposure of our systems to cyber-intrusions. The Company also requires assurances from key vendors regarding their cybersecurity.

We control functionalities of online and mobile banking to reduce risk. We do not offer online account openings or loan originations. We do not permit customers to submit address changes or wire requests through online banking, and we limit the dollar amount of online banking transfers to other banks. We require a special vetting process for commercial customers who wish to originate ACH transfers.

Further, the Company has a program to identify, mitigate and manage its cybersecurity risks. The program includes penetration testing and vulnerability assessment, technological defenses such as antivirus software, patch management, firewall management, email and web protections, an intrusion prevention system, a cybersecurity insurance policy which covers some but not all losses arising from cybersecurity breaches, as well as ongoing employee training. The cost of these measures was $94 for the three months ended March 31, 2022 and $98 for the three months ended March 31, 2021. These costs are included in various categories of noninterest expense.

However, it is not possible to fully eliminate exposure. The potential for financial and reputational losses due to cyber-breaches is increased by the possibility of human error, unknown system susceptibilities, and the rising sophistication of cyber-criminals to attack systems, disable safeguards and gain access to accounts and related information. We maintain insurance for these risks but insurance policies are subject to exceptions, exclusions and terms whose applications have not been widely interpreted in litigation. Accordingly, insurance can provide less than complete protection against the losses that result from cybersecurity breaches and pursuing recovery from insurers can result in significant expense. In addition, some risks such as reputational damage and loss of customer goodwill, which can result from cybersecurity breaches, cannot be insured against.

Response to COVID-19 Pandemic

The COVID-19 pandemic has affected the global economy since the first quarter of 2020. The Company has a robust business continuity plan, and partners with vendors whom we believe also have robust business continuity plans. In implementing its business continuity plan to address the COVID-19 pandemic, the Company has not incurred material expenditures and does not anticipate material expenditures. Further, all critical functions are cross-trained as part of our business continuity preparedness. Controls over cash and physical assets have remained in place and internal controls over financial reporting and disclosure have been maintained.

Non-GAAP Financial Measures

This report refers to certain financial measures that are computed under a basis other than U.S. GAAP ("non-GAAP"). Details on non-GAAP measures follow.

Return on Average Assets and Return on Average Equity

The return on average assets and return on average equity are measures of profitability. The return on average assets and return on average equity are calculated by annualizing net income and dividing by average year-to-date assets or equity, respectively. When net income includes larger nonrecurring items, the annualization magnifies their effect. In order to reduce distortion within the ratios, the Company adjusts net income for larger non-recurring items prior to annualization, and then nets the items against the annualized net income. The reconciliation of adjusted annualized net income, which is not a measurement under U.S. GAAP, is reflected in the table below.

(1) During the first quarter of each year, the Company adjusts its basis in partnership interests. During 2022 and 2021, the adjustment resulted in recognition of a gain. During 2022 and 2021, the Company also received a payout from a partnership interest. The gain and payout are recognized in other income. Partnership income is removed from income prior to annualization in order to avoid distortion, and added back to income after annualization.

Net Interest Margin

The Company uses the net interest margin to measure profit on interest generating activities, as a percentage of total interest-earning assets. The net interest margin is calculated by dividing annualized taxable equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under U.S. GAAP, to net interest income, is reflected in the table below.

Efficiency Ratio

The efficiency ratio is computed by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding certain items management deems unusual or non-recurring. The tax rate used to calculate fully taxable equivalent basis is 21%. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. The components of the efficiency ratio calculation are summarized in the following table.

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Critical Accounting Policies

General

The Company’s consolidated financial statements are prepared in accordance with GAAP. The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value obtained when earning income, recognizing an expense, recovering an asset or satisfying a liability. Although the economics of the Company’s transactions may not change, the timing of events that would impact the transactions could change.

Presented below is a discussion of accounting policies that are the most important to the portrayal and understanding of the Company’s financial condition and results of operations. Critical accounting policies require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. If conditions occur that differ from our assumptions, depending upon the severity of such differences, the Company’s financial condition or results of operations may be materially impacted. The Company evaluates its critical accounting estimates and assumptions on an ongoing basis and updates them as needed. There have been no changes since December 31, 2021. Please refer to the Company’s 2021 Form 10-K, Note 1: Summary of Significant Accounting Policies for additional information on the Company’s accounting policies.

Allowance for Loan Losses

The Company evaluates the allowance each quarter through a methodology that estimates losses on individual impaired loans and evaluates the effect of numerous factors on the credit risk of groups of homogeneous loans (collectively-evaluated loans).

Impaired loans

Impaired loans are identified through the Company’s credit risk rating process. Generally, impaired loans have risk ratings that indicate higher risk, such as “classified” or “special mention.” Nonaccrual loan relationships that meet the Company’s balance threshold of $250 are designated impaired. The Company also designates as impaired other loan relationships that meet the Company’s balance threshold of $250 and for which a credit review identified a weakness that indicates principal and interest will not be collected according to the loan terms. All TDRs, regardless of size or past due status are designated impaired.

Troubled debt restructurings

Loan modifications are reviewed to determine whether, at the time of the modification, the borrower is experiencing financial difficulty and whether the Company provided a concession that it would not otherwise consider. Modified loans that meet this criteria are designated TDRs.

Individual evaluation

At the reporting date, the fair value of each impaired loan is estimated using either the cash flow method or the collateral method.

Cash flow method

The cash flow method is applied to loans that are not collateral dependent and for which cash flows may be estimated. The cash flow method measures fair value using assumptions specific to each loan, including expected amount and timing of cash flows and discount rate. For TDR loans, the discount rate is the rate immediately prior to the modification that resulted in a TDR. If an impaired loan evaluated under the cash flow method becomes 90 days or more past due, it is examined to determine whether the late payment indicates collateral dependency or cash flows below those that were used in the fair value measurement.

Collateral method

The collateral method is applied to impaired loans that are collateral-dependent, for which foreclosure is imminent or for which non-collateral repayment sources are determined not to be available or reliable. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Fair value is based upon the “as-is” value of independent appraisals or evaluations.

Impaired loans secured by residential 1-4 family properties with outstanding principal balances greater than $250 are valued using an appraisal. Appraisals are also used to value impaired loans secured by commercial real estate with outstanding principal balances greater than $500. Impaired loans secured by residential 1-4 family property with outstanding principal balances of $250 or less, or secured by commercial real estate with outstanding principal balances of $500 or less, are valued using a real estate evaluation prepared by a third party.

Appraisals must conform to the Uniform Standards of Professional Appraisal Practice and are prepared by an independent third-party appraiser who is certified and licensed and who is approved by the Company. Appraisals may incorporate market analysis, comparable sales analysis, cash flow analysis and market data pertinent to the property to determine market value.

Evaluations are prepared by third party providers and reviewed by employees of the Company who are independent of the loan origination, operation, management and collection functions. Evaluations provide a property’s market value based on the property’s current physical condition and characteristics and the economic market conditions that affect the collateral’s market value. Multiple sources of data contribute to the estimate of market value, including physical inspection, independent third-party automated tools, comparable sales analysis and local market information.

Updated appraisals or evaluations are ordered when a loan becomes impaired if the appraisal or evaluation on file is more than 24 months old. Appraisals and evaluations are reviewed for propriety and reasonableness and may be discounted if the Company determines that the value exceeds reasonable levels. If an updated appraisal or evaluation has been ordered but has not been received by a reporting date, the fair value may be based on the most recent available appraisal or evaluation, discounted for age. The appraisal or evaluation value is reduced by selling costs if recovery is expected solely from the sale of collateral.

Nonaccrual status of impaired loans

Nonaccrual status is applied to impaired loans that are not TDRs and for which fair value measurement indicates an impairment loss. Nonaccrual status is applied to TDRs that allow the borrower to discontinue payments of principal or interest for more than 90 days, unless the modification provides reasonable assurance of repayment performance and collateral value supports regular underwriting requirements. TDRs that maintain current status for at least a six-month period, including history prior to restructuring, may accrue interest. Impaired loans with partial charge-offs are maintained as impaired until the remaining balance is satisfied.

Collectively evaluated loans

Non-impaired loans are grouped by portfolio segments. Portfolio segments are further divided into smaller loan classes. Loans within a segment or class have similar risk characteristics. Credit loss on collectively-evaluated loans is estimated by applying to current class balances the class historical charge-off rates and percentages for qualitative factors that affect credit risk.

Qualitative factors include changes in national and local economic and business conditions, the nature and volume of classes within the portfolio, loan quality, loan officers’ experience, lending policies and the Company’s loan review system. The qualitative factor allocations are determined for pass-rated loans. To reflect the increased risk of criticized assets, qualitative factor allocations are multiplied by 150% for special mention loans, and multiplied by 200% for classified loans.

Loss rates

Loss rates are calculated for and applied to individual classes by averaging loss rates over the most recent eight quarters. Two loss rates for each class are calculated: total net charge-offs for the class as a percentage of average class loan balance (“class loss rate”), and total net charge-offs for the class as a percentage of average classified loans in the class (“classified loss rate”). Net charge-offs in both calculations include charge-offs and recoveries for all loans within the class, including classified and non-classified loans, as well as impaired and TDR loans. If the loss rate calculation results in a recovery, the loss rate applied is zero. Class historical loss rates are applied to collectively evaluated pass-rated loan balances and special mention rated loan balances, and classified historical loss rates are applied to collectively evaluated classified loan balances.

Qualitative factor allocations

The analysis of certain factors results in standard allocations to all classes. These factors include the risk from changes in lending policies, loan officers’ experience, changes in loan review, and economic factors including local unemployment levels, local bankruptcy rates, interest rate environment, and competition/legal/regulatory environments. Standard allocations for residential vacancy rates and housing inventory are applied to residential construction, investor-owned residential real estate, multifamily loans, other commercial real estate, state and political subdivision loans and all classes within the consumer real estate segment.

Qualitative factors incorporate economic data targeted to the Company’s market. If market–specific information is not available on a timely basis, regional or national information that historically shows a high degree of correlation to market data may be used.

Also applied to all segments and classes during 2021 was an economic factor implemented to address COVID-19 uncertainty: national unemployment filings. Local unemployment data lags the reporting date and the Company implemented analysis of national unemployment filings to capture current effects of the COVID-19 pandemic. Historical analysis determined that local unemployment filings were closely correlated to national unemployment filings. National unemployment filings returned to pre-pandemic levels during the fourth quarter of 2021 and no allocation was made as of March 31, 2022.

Factors analyzed for each class, with resultant allocations based upon the level of risk assessed for each class, include levels of past due loans, levels of nonaccrual loans, current class balance as a percentage of total loans and the percentage of high risk loans within the class. High risk loans include junior liens, interest only and high loan to value loans. High risk loans within each class are analyzed and allocated additional reserves based on current trends.

Nonaccrual status

The Company reviews loans with certain risk indicators to determine whether the loans should be placed on nonaccrual status, including loans that exceed 90 days past due, loans rated classified, and loans with a modification that provides relief from payments of interest or principle for more than 90 days.

Loans in nonaccrual are reviewed on an individual loan basis to determine whether they may return to accrual status. To return to accrual status, the Company’s analysis must determine that future payments are reasonably assured. To satisfy this criteria, the Company’s evaluation must determine that the underlying cause of the original delinquency or weakness that indicated nonaccrual status has been resolved, such as receipt of new guarantees, increased cash flows that cover the debt service or other resolution. Nonaccrual loans that demonstrate reasonable assurance of future payments and that have made at least six consecutive payments in accordance with repayment terms and timeframes may be returned to accrual status.

Sales, purchases and reclassification of loans

The Company finances consumer real estate mortgages under “best efforts” contracts with mortgage purchasers. The mortgages are designated as held for sale upon initiation. There have been no major reclassifications from portfolio loans to held for sale. Mortgages held for sale are not included in the calculation of the allowance for loan losses.

Occasionally, the Company purchases or sells participations in loans. All participation loans purchased met the Company’s normal underwriting standards at the time the participation was entered. Participation loans are included in the appropriate portfolio balances to which the allowance methodology is applied.

Unallocated Surplus

In addition to funding the allowance for loan losses based upon data analysis, the Company has the option to fund an unallocated surplus in excess to the calculated requirement, based upon management judgement. The Company’s policy permits an unallocated surplus of between 0% and 5% of the calculated requirement.

Estimation of the Allowance For Loan Losses

The estimation of the allowance involves analysis of internal and external variables, methodologies, assumptions and management’s judgment and experience. Key judgments used in determining the allowance for loan losses include internal risk rating determinations, market and collateral values, discount rates, loss rates, management’s assessment of current economic conditions, and management’s estimate of the impact of qualitative factors. These judgments are inherently subjective and actual losses could be greater or less than the estimate. Future estimates of the allowance could increase or decrease based on changes in the financial condition of individual borrowers, concentrations of various types of loans, economic conditions or the markets in which collateral may be sold. The estimate of the allowance accrual determines the amount of provision expense and directly affects our financial results.

The estimate of the allowance considered market conditions as of the reporting date where possible, and the most recent available information when data was not available as of the reporting date, portfolio conditions and levels of delinquencies at the reporting date, and net charge-offs in the eight quarters prior to the reporting date. For additional discussion of the allowance, see Note 3 to the consolidated financial statements and “Asset Quality,” and “Provision and Allowance for Loan Losses” of Management's Discussion and Analysis.

Goodwill

Goodwill is subject to at least an annual assessment for impairment by applying a fair value based test. The Company contracts with a third party valuation expert to perform impairment testing in the fourth quarter of each year. The Company’s most recent impairment test was performed using data from September 30, 2021. Accounting guidance provides the option of performing preliminary assessment of qualitative factors before performing more substantial testing for impairment. The Company opted not to perform the preliminary assessment. The Company’s goodwill impairment analysis considered three valuation techniques appropriate to the measurement. The first technique uses the Company’s market capitalization as an estimate of fair value; the second technique estimates fair value using current market pricing multiples for companies comparable to the Company; while the third technique uses current market pricing multiples for change-of-control transactions involving companies comparable to the Company. The analysis did not result in an impairment.

Certain key judgments were used in the valuation measurement. Goodwill is held by the Company’s bank subsidiary. The bank subsidiary is 100% owned by the Company, and no market capitalization is available. Because most of the Company’s assets are comprised of the subsidiary bank’s equity, the Company’s market capitalization was used to estimate the Bank’s market capitalization. Other judgments include the assumption that the companies and transactions used as comparables for the second and third technique were appropriate to the estimate of the Company’s fair value, and that the comparable multiples are appropriate indicators of fair value, and compliant with accounting guidance.

Pension Plan

The Company’s actuary determines plan obligations and annual pension plan expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated return on plan assets and the anticipated rate of compensation increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated, may impact pension assets, liabilities or expense.

Overview

National Bankshares, Inc. is a financial holding company that was organized in 1986 under the laws of Virginia and is registered under the Bank Holding Company Act of 1956. NBI common stock is listed on the Nasdaq Capital Market and is traded under the symbol “NKSH.”

NBI has two wholly-owned subsidiaries, the National Bank of Blacksburg and National Bankshares Financial Services, Inc. NBB is a community bank and does business as National Bank from 24 office locations and one loan production office. NBB is the source of nearly all of the Company’s revenue. NBFS does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future.

Performance Summary

The following table presents the Company’s key performance ratios for the periods indicated. The measures for March 31, 2022 and March 31, 2021 are annualized, except for basic and fully diluted earnings per share.

(1) Ratio is a non-GAAP financial measure that the Company believes provides investors with important information. Such information is not prepared in accordance with GAAP and should not be viewed as a substitute for GAAP. See “Non-GAAP Financial Measures” above.

(2) During the three months ended March 31, 2022, the Company repurchased 41,185 shares under its publicly announced stock repurchase plan. The repurchase reduced shareholders equity by $1,522. During the three months ended March 31, 2021, the Company repurchased 111,832 shares under its publicly announced stock repurchase plan. The repurchase reduced shareholders equity by $3,991.

Growth

NBI’s key growth indicators are shown in the following table.

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Asset Quality

Key indicators of the Company’s asset quality are presented in the following table.

The Company’s risk analysis at March 31, 2022 determined an allowance for loan losses of $7,788 or 0.95% of loans net of unearned income and deferred fees and costs. The allowance at March 31, 2021 was $8,536 or 1.10% of loans net of unearned income and deferred fees and costs. The allowance at December 31, 2021 was $7,674 or 0.96% of loans net of unearned income and deferred fees and costs. The determination of the appropriate level for the allowance for loan losses resulted in a provision of $134 for the three months ended March 31, 2022, compared with a provision of $50 for the three month period ended March 31, 2021, and a recovery of $398 for the 12 months ended December 31, 2021. To determine the appropriate level of the allowance for loan losses, the Company considers credit risk for certain loans designated as impaired and for non-impaired (“collectively evaluated”) loans.

Individually Evaluated Impaired Loans

Individually evaluated impaired loans at March 31, 2022 were $5,834 gross and $5,836 net of unearned income and deferred fees and costs. There were no specific allocations to the allowance for loan losses at March 31, 2022. Individually evaluated impaired loans at December 31, 2021 were $5,878 gross and $5,880 net of unearned income and deferred fees and costs. There were no specific allocations to the allowance for loan losses as of December 31, 2021. The specific allocation is determined based on criteria particular to each impaired loan.

Collectively Evaluated Loans

Collectively evaluated loans totaled $813,940 gross and $813,492 net of unearned income and deferred fees and costs, with an allowance of $7,788 or 0.95% of collectively-evaluated loans net of unearned income and deferred fees and costs at March 31, 2022. At December 31, 2021, collectively evaluated loans totaled $797,851 gross and $797,368 net of unearned income and deferred fees and costs, with an allowance of $7,674 or 0.96% of collectively-evaluated loans net of unearned income and deferred fees and costs.

Collectively evaluated loans are divided into classes based upon risk characteristics. In order to calculate the allowance for collectively evaluated loans, the Company applies to each loan class a historical net charge-off rate for the class, adjusted for qualitative factors that influence credit risk. Qualitative factors evaluated for impact to credit risk include economic measures, asset quality indicators, loan characteristics, and changes to internal Company policies and changes in management.

Net Charge-Offs

Increases in the net charge-off rate increase the required allowance for collectively-evaluated loans, while decreases in the net charge-off rate decrease the required allowance for collectively-evaluated loans. On a portfolio level, net charge-offs were $20 for the three months ended March 31, 2022, or 0.01% of average loans. For the three months ended March 31, 2021, a net recovery of $5 was recognized, or 0.00% of average loans. For the 12 months ended December 31, 2021, net charge-offs were $409 or 0.05% of average loans. The 8-quarter average historical loss rate was 0.05% for each of the three-month periods ended March 31, 2022 and March 31, 2021, and for the 12 months ended December 31, 2021.

Economic Factors

Economic factors influence credit risk and impact the allowance for loan loss. The Company considers economic indicators within its market area, including: unemployment, business and personal bankruptcy filings, the residential vacancy rate and the inventory of new and existing homes.

The Company sources economic data pertinent to its market from the most recently available publications. Most economic indicators lag the report date by one to three months. In periods of low volatility, lagging indicators are accepted as reasonably representative of current conditions. The COVID-19 pandemic introduced significant uncertainty and beginning in 2020, the Company implemented a qualitative factor for national unemployment filings to represent current economic data. Unemployment filings for the Company’s market area are not available on a timely basis, however national data is available on a timely basis and historical analysis shows a strong correlation between national and local unemployment filings. National unemployment claims escalated sharply beginning in the latter half of March 2020 and the Company reacted by substantially increasing the allowance for loan losses. During the 19 weeks prior to March 31, 2022, national unemployment claims have consistently been reported at pre-pandemic levels, allowing the Company to reduce the allocation for this factor to $0 as of March 31, 2022.

The Company continues to monitor the most recently available economic indicators for its market and their effect on credit risk. As of March 31, 2022, the unemployment rate for the Company’s market area was measured as of January 31, 2022 and increased from the measurement available at December 31, 2021, increasing the allocation to the allowance for loan losses.

Business and personal bankruptcy filing data was available as of December 2021. Higher bankruptcy filings indicate heightened credit risk and increase the allowance for loan losses, while lower bankruptcy filings have a beneficial impact on credit risk. Compared with data available at December 31, 2021, business bankruptcy filings and personal bankruptcy filings decreased. The Company estimates that bankruptcy filings are artificially low due to a backlog in the court system and prolonged government aid. When the pandemic began, precautions for COVID-19 slowed the work of the court system. The federal government also implemented a foreclosure moratorium, provided direct payments to qualifying recipients and PPP loans to small businesses, and encouraged banks to work with borrowers who were impacted by the pandemic, all of which had a minimizing effect on bankruptcy filings. All of these measures expired by the end of 2021. Management believes bankruptcy filings will normalize and currently available data does not reflect credit risk. The allocation was based on an average of pre-pandemic filings from 2017 through 2020, which was higher than the current reported level and the level incorporated to the allowance at December 31, 2021.

Residential vacancy rates and housing inventory impact the Company’s residential construction customers and the consumer real estate market. Higher levels increase credit risk. The residential vacancy rate at March 31, 2022 was measured as of the fourth quarter of 2021 and improved slightly from the data incorporated into the December 31, 2021 calculation, resulting in a lower allocation. Housing inventory data was available as of March 31, 2022. Levels are historically low and are lower than those at December 31, 2021, resulting in a lower allocation.

Asset Quality Indicators

Asset quality indicators, including past due levels, nonaccrual levels and internal risk ratings, are evaluated at the class level. Loans past due and loans designated nonaccrual indicate heightened credit risk. Increases in past due and nonaccrual loans increase the required level of the allowance for loan losses and decreases in past due and nonaccrual loans reduce the required level of the allowance for loan losses.

Accruing loans past due 30-89 days were 0.11% of total loans net of unearned income and deferred fees and costs at March 31, 2022, a decrease from 0.12% at December 31, 2021. Accruing loans past due 90 days or more were 0.05% of total loans, net of unearned income and deferred fees and costs at March 31, 2022, compared with 0.01% at December 31, 2021. Nonaccrual loans at March 31, 2022 were 0.35% of total loans net of unearned income and deferred fees and costs, slightly lower than 0.36% at December 31, 2021.

Loans rated special mention and classified (together, “criticized assets”) indicate heightened credit risk. Higher levels of criticized assets increase the required level of the allowance for collectively-evaluated loans, while lower levels of criticized assets reduce the required level of the allowance for collectively-evaluated loans. There were no collectively evaluated loans rated special mention at March 31, 2022, compared with $3,728 at December 31, 2021. Collectively evaluated loans rated classified were $1,259 at March 31, 2022 and $1,064 at December 31, 2021.

Other Factors

The Company considers other factors that impact credit risk, including the interest rate environment, the competitive, legal and regulatory environments, changes in lending policies and loan review, changes in management, and high risk loans.

The interest rate environment impacts variable rate loans. If interest rates increase, the payment on variable rate loans increases, which may increase credit risk. The Federal Reserve increased the target Fed Funds rate in March 2022, resulting in an increased allocation for March 31, 2022.

The competitive, legal and regulatory environments were evaluated for changes that would impact credit risk. Higher competition for loans increases credit risk, while lower competition decreases credit risk. Competition remained at similar levels to those at December 31, 2021. The legal and regulatory environments remain in a similar posture to that at December 31, 2021.

Lending policies, loan review procedures and management’s experience influence credit risk. Since December 31, 2021, there have been no changes that affect credit risk to the Company’s lending policies or loan review procedures. During the first quarter of 2022, the Company filled the Chief Credit Officer position vacated during the last quarter of 2021, and maintained the same allocation.

Levels of high risk loans are considered in the determination of the level of the allowance for loan loss. A decrease in the level of high risk loans within a class decreases the required allocation for the loan class, and an increase in the level of high risk loans within a class increases the required allocation for the loan class. Total high risk loans increased $3,742 or 4.15% from the level at December 31, 2021, resulting in an increased allocation.

Unallocated Surplus

The unallocated surplus at March 31, 2022 is $171 or 2.24% in excess of the calculated requirement. The unallocated surplus at December 31, 2021 was $361 or 4.94% in excess of the calculated requirement. The surplus provides some mitigation of the uncertainty surrounding the impact of COVID-19.

Conclusion

The calculation of the appropriate level for the allowance for loan losses incorporates analysis of multiple factors and requires management’s prudent and informed judgment. The most recently available data showed improvements that decreased the required level of the allowance for loan losses at March 31, 2022 from December 31, 2021 including residential vacancy, housing inventory, and criticized loans. Other indicators, including accruing loans past due 90 days or more, the unemployment rate, and loans considered high risk, showed worsening from levels at December 31, 2021 and increased the required level of the allowance for loan losses.

The Company augmented the calculated requirement with an unallocated surplus of 2.24% to mitigate some of the uncertainty caused by the lingering pandemic. Based on analysis of historical indicators, asset quality and economic factors, management believes the level of allowance for loan losses is reasonable for the credit risk in the loan portfolio as of March 31, 2022.

Please refer to Note 3: Allowance for Loan Losses, Nonperforming Assets and Impaired Loans for further information on collectively evaluated loans, individually evaluated impaired loans and the unallocated portion of the allowance for loan losses.

Other Real Estate Owned

The following table discloses the OREO in physical possession and in process at each reporting date:

(1) Net of valuation allowance.

As of March 31, 2022, loans in various stages of foreclosure totaled $407, of which $87 are secured by residential real estate. Loans currently in the process of foreclosure may increase OREO in future quarters. It is not possible to accurately predict the future total of OREO because property sold at foreclosure may be acquired by third parties and OREO properties are regularly marketed and sold.

The Company continues to monitor risk levels within the loan portfolio. If the Company’s market experiences an economic downturn, real estate values could decline and foreclosure activity could increase. A decline in value may result in loss recognition for OREO, while an increase in foreclosures may increase the number of OREO properties.

Modifications and TDRs

Modifications

In the ordinary course of business the Company modifies loan terms on a case-by-case basis for a variety of reasons. Modifications may include rate reductions, payment extensions of varying lengths of time, a change in amortization term or method or other arrangements. Please refer to the Company’s 2021 Form 10-K, Note 1: Summary of Significant Accounting Policies for information on TDR designation. If the modified terms are consistent with competitive market conditions and representative of terms the borrower could otherwise obtain in the open market, the modified loan is not categorized as a TDR.

Modifications to consumer loans generally involve short-term payment extensions to accommodate specific, temporary circumstances. Payment extensions provide short-term payment relief to borrowers who have demonstrated a willingness and ability to repay their loan but who are experiencing consequences of a specific unforeseen temporary hardship. If the temporary event is not expected to impact a borrower’s ability to repay the debt, and if the Company expects to collect all amounts due including interest accrued at the contractual interest rate for the extension period at contractual maturity, the modification is not designated a TDR. Modifications to commercial loans may include, but are not limited to, changes in interest rate, maturity, amortization and financial covenants. The Company codes modifications to assist in identifying TDRs.

Modifications Made for Competitive Purposes

During the three months ended March 31, 2022, the Company provided 235 modifications for competitive reasons to loans totaling $39,182. The modifications were not TDRs and were not related to COVID-19. For the three months ended March 31, 2021, the Company provided non-TDR modifications for competitive reasons to 244 loans totaling $27,978.

Modifications Related to COVID-19

During 2021, the Company provided modifications related to COVID-19 financial difficulty, including payment extensions and interest only periods. The modifications met the criteria under the CARES Act, the CAA and regulatory guidance and were not designated as TDRs. The provisions of the CARES Act and the CAA expired on January 1, 2022. All loans that received payment extensions have returned to normal payment terms.

The following tables provide information regarding COVID-19 related modifications for the periods indicated.

Three Months Ended March 31, 2021

Twelve Months Ended December 31, 2021

TDRs

The Company’s TDRs, by delinquency status, are presented below:

Please refer to Note 3: Allowance for Loan Losses, Nonperforming Assets and Impaired Loans for information on TDRs.

Net Interest Income

The following table shows the major categories of interest‑earning assets and interest‑bearing liabilities, the interest earned or paid, the average yield or rate on the daily average balance outstanding, net interest income and net yield on average interest‑earning assets for the periods indicated.

(1) Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 21%.

(2) Included in interest income are loan fees of $88 and $558 for the three months ended March 31, 2022 and 2021, respectively.

(3) Nonaccrual loans are included in average balances for yield computations.

(4) Includes loans held for sale.

(5) Daily averages are shown at amortized cost.

(6) Includes restricted stock.

The yield on loans in 2021 benefitted from PPP interest and fees of $650, without which the net interest margin for the three months ended March 31, 2021 would have been 2.71%. The yield on earning assets decreased when the three months ended March 31, 2022 are compared with the three months ended March 31, 2021, due to high levels of loan refinance activity throughout 2021 and a shift in the mix of assets to a higher percentage of taxable securities, which provide lower yields than loans. The Company reduced offering rates on interest-bearing liabilities to partially offset the decline in asset yield. The Company’s yield on earning assets and cost of funds are largely dependent on the interest rate environment.

Provision and Allowance for Loan Losses

The calculation of the allowance for loan losses resulted in a provision for loan losses of $134 for the three month period ended March 31, 2022, compared with $50 for the three month period ended March 31, 2021. The provision for loan losses is the result of a detailed analysis to estimate an adequate allowance for loan losses. See “Asset Quality” for additional information.

Noninterest Income

Service charges on deposit accounts increased when the three month period ended March 31, 2022 is compared the three month period ended March 31, 2021, primarily due to increased nonsufficient funds and overdraft charges. Service charges on deposit accounts include account maintenance fees, fees for nonsufficient funds, ATM and wire transfer fees.

Other service charges and fees include charges for official checks, income from the sale of checks to customers, safe deposit box rent, fees from letters of credit and income from commissions on the sale of credit life, accident and health insurance. Fee income from letters of credit was the primary driver of growth when the three month period ended March 31, 2022 is compared with the three month period ended March 31, 2021.

Increased transactions improved credit card fees when the three months ended March 31, 2022 is compared with the three months ended March 31, 2021. Credit and debit card fees are presented net of interchange expense.

Trust fees increased when the three months ended March 31, 2022 is compared with the three months ended March 31, 2021. Trust fees are generated from a number of different types of accounts, including estates, personal trusts, employee benefit trusts, investment management accounts, attorney-in-fact accounts and guardianships. Trust income varies depending on the number and type of accounts under management and financial market conditions.

The Company purchased an additional $5,000 in bank-owned life insurance (“BOLI”) during the second quarter of 2021, contributing to increased income when the three month period ended March 31, 2022 is compared with the three month period ended March 31, 2021.

Gain on sale of mortgage loans decreased when the three month period ended March 31, 2022 is compared with the three month period ended March 31, 2021, due to lower refinance activity and higher interest rates. The Company originates consumer real estate mortgage loans to be kept in portfolio and to be sold on the secondary market under best efforts contracts.

Other income decreased when the three month period ended March 31, 2022 is compared with the three month period ended March 31, 2021 due to lower commissions on securities and insurance sales, partially offset by a higher gain on partnership interests.

Noninterest Expense

Salaries and employee benefits increased for the three month period ended March 31, 2022 when compared with the same period in 2021 due to normal staffing and compensation decisions. This expense category includes employee salaries, payroll taxes, insurance and fringe benefits, employee stock ownership plan contribution accruals, the service component of net periodic pension cost, and salary continuation expenses.

When the three month period ended March 31, 2022 is compared with the three month period ended March 31, 2021, occupancy, furniture and fixtures expense as well as data processing and ATM expense increased slightly.

Federal Deposit Insurance (“FDIC”) assessment expense increased when the three month period ended March 31, 2022 is compared with the same period of 2021. The FDIC assessment is accrued based on a method provided by the FDIC. The calculation is based on average assets reduced by average tangible equity and incorporates risk-based factors to determine the amount of the assessment.

Net costs of OREO decreased for the three month period ended March 31, 2022, compared with the same period in 2021. The cost of OREO includes maintenance costs as well as valuation write-downs and gains and losses on the sale of properties. The expense varies with the number of properties, the maintenance required and changes in the real estate market. There were no write downs on OREO properties during the three months ended March 31, 2022 or March 31, 2021. The Company recognized a loss on the sale of OREO of $26 for the three months ended March 31, 2021.

Franchise tax expense increased when the three month period ended March 31, 2022 is compared with the three month period ended March 31, 2021. Franchise taxes are levied by the states in which NBB operates and are based upon NBB’s total equity at the prior year-end, adjusted for real estate taxes and certain other items.

The category of other operating expenses includes noninterest expense items such as professional services, stationery and supplies, telephone costs, postage, charitable donations, losses and other expenses. Other operating expense decreased for the three month period ended March 31, 2022, compared with the same period of 2021, primarily due to decreased pension non-service cost.

Income Tax

Income tax expense for the first three months of 2022 was $1,053, compared with $1,009 for the first three months of 2021. The Company’s federal statutory corporate tax rate is 21%. The Company’s effective tax rate for the three month period ended March 31, 2022 was 17.73%, compared with 17.47% for the three month period ended March 31, 2021.

Balance Sheet

Year-to-date daily averages for the major balance sheet categories are as follows:

Securities

Securities available for sale are measured at fair value on a recurring basis. Market conditions at March 31, 2022 are reflected in the presentation of securities available for sale. During the three months ended March 31, 2022, purchases of securities resulted in an increase of $56,092 in the book value of securities available for sale, while the fair value adjustment for unrealized gains and losses decreased from a net unrealized gain of $3,613 at December 31, 2021 to a net unrealized loss of $39,205 at March 31, 2022. Change in the fair value of bonds is inversely related to interest rate movement. An increase in the Federal Reserve's target interest rate, as well as expected future increases, contributed to the decline in fair value of the securities portfolio. While we do not expect significant changes in future judgements or methodologies used to determine the fair value of the securities portfolio, future rate increases or market volatility associated with the COVID-19 pandemic or any future national or global concern, could impact the value of securities. Management regularly monitors the quality of the securities portfolio and closely follows the uncertainty in the economy and the volatility of financial markets. The value of individual securities will be written down if the decline in fair value is considered to be other than temporary based upon the totality of circumstances. See Note 4: Securities for additional information.

Loans

Loan fluctuations from December 31, 2021 to March 31, 2022 are primarily due to normal activity within the Company's markets. Real estate construction loan growth also benefitted from an increase in participation loans.

Deposits

Time deposits decreased while all other categories increased. The Company’s deposits do not include any brokered deposits.

Liquidity

Liquidity measures the Company’s ability to meet its financial commitments at a reasonable cost. Demands on the Company’s liquidity include funding additional loan demand and accepting withdrawals of existing deposits. The Company has diverse liquidity sources, including customer and purchased deposits, customer repayments of loan principal and interest, sales, calls and maturities of securities, Federal Reserve discount window borrowing, short-term borrowing, and FHLB advances. At March 31, 2022, the Bank did not have discount window borrowings, short-term borrowings, or FHLB advances. To assure that short-term borrowing is readily available, the Company tests accessibility annually.

The Company considers its security portfolio for typical liquidity needs, within accounting, legal and strategic parameters. Portions of the securities portfolio are pledged to meet state requirements for public funds deposits. Discount window borrowings also require pledged securities. Increased/decreased liquidity from public funds deposits or discount window borrowings results in increased/decreased liquidity from pledging requirements. The Company monitors public funds pledging requirements and unpledged available-for-sale securities accessible for liquidity needs.

Regulatory capital levels at the subsidiary bank determine the Bank’s ability to use purchased deposits and the Federal Reserve discount window. At March 31, 2022, the Bank is considered well capitalized and does not have any restrictions on purchased deposits or borrowing ability at the Federal Reserve discount window.

The Company monitors factors that may increase its liquidity needs. Some of these factors include deposit trends, large depositor activity, maturing deposit promotions, interest rate sensitivity, maturity and repricing timing gaps between assets and liabilities, the level of unfunded loan commitments, loan growth and share repurchase activity within the Company’s own stock. At March 31, 2022, the Company’s liquidity is sufficient to meet projected trends in these areas.

To monitor and estimate liquidity levels, the Company performs stress testing under varying assumptions on credit sensitive liabilities and the sources and amounts of balance sheet and external liquidity available to replace outflows. The Company’s Contingency Funding Plan sets forth avenues for rectifying liquidity shortfalls. At March 31, 2022, the analysis indicated adequate liquidity under the tested scenarios.

The Company utilizes several other strategies to maintain sufficient liquidity. Loan and deposit growth are managed to keep the loan to deposit ratio within the Company’s own target range of 65% to 75%. At March 31, 2022, the loan to deposit ratio was 53.07%. The investment strategy takes into consideration the term of the investment, and securities in the available for sale portfolio are laddered based upon projected funding needs.

The Company’s liquidity position was strong prior to the COVID-19 pandemic and has expanded due to increased customer deposits fueled by federal stimulus payments.

Capital Resources

Total stockholders’ equity at March 31, 2022 was $161,289, a decrease of $30,462 or 15.89%, from the $191,751 at December 31, 2021. The decrease reflects the decline in the fair value of securities available for sale, which impacted accumulated other comprehensive loss.

On May 12, 2021, the Company’s Board of Directors approved the repurchase of up to 1,000,000 shares of the Company’s common stock. The authorization began June 1, 2021 and expires May 31, 2022. During the first three months of 2022, the Company repurchased 41,185 shares under the program. The repurchases reduced shareholders equity by $1,522. The Company repurchased 111,832 shares during the quarter ended March 31, 2021.

The Company qualifies as a small bank holding company under the Federal Reserve’s Small Bank Holding Company Policy Statement, which exempts bank holding companies with less than $3 billion in assets from reporting consolidated regulatory capital ratios and from minimum regulatory capital requirements. NBB is subject to various capital requirements administered by banking agencies, including an additional capital conservation buffer in order to make capital distributions or discretionary bonus payments. Risk-based capital ratios are calculated in compliance with OCC rules based on the Basel III Capital Rules. The Bank’s ratios are well above the required minimums. Risk based capital ratios for the Bank are shown in the following tables.

Off-Balance Sheet Arrangements

In the normal course of business, NBB extends lines of credit and letters of credit to its customers. Depending on their needs, customers may draw upon lines of credit at any time in any amount up to a pre-approved limit. Standby letters of credit are issued for two purposes. Financial letters of credit guarantee payments to facilitate customer purchases. Performance letters of credit guarantee payment if the customer fails to complete a specific obligation.

Historically, the full approved amount of letters and lines of credit has not been drawn at any one time. The Company has developed plans to meet a sudden and substantial funding demand. These plans include accessing a line of credit with a correspondent bank, borrowing from the FHLB, selling available for sale investments or loans and raising additional deposits.

The Company sells mortgages on the secondary market. Our agreement with the purchaser provides for strict underwriting and documentation requirements. Violation of the representations and warranties of the agreement would entitle the purchaser to recourse provisions. The Company has determined that its risk in this area is not significant because of a low volume of secondary market mortgage loans and high underwriting standards. The Company estimates a potential loss reserve for recourse provisions that is not material as of March 31, 2022. To date, no recourse provisions have been invoked. If funds were needed, the Company would access the same sources as noted above for funding lines and letters of credit. There were no material changes in off-balance sheet arrangements during the three months ended March 31, 2022.

Contractual Obligations

The Company had no finance lease or purchase obligations and no long-term debt at March 31, 2022.

The Company considers interest rate risk to be a significant market risk and has systems in place to measure the exposure of net interest income to adverse movement in interest rates. Interest rate shock analyses provide management with an indication of potential economic loss due to future rate changes. There have not been any changes which would significantly alter the results disclosed as of December 31, 2021 in the Company’s 2021 Form 10-K.

The Company’s management evaluated, with the participation of the Company’s principal executive officer and principal financial officer, the effectiveness of the Company’s 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 report. Based on that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective as of March 31, 2022 to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the Company's management, including the Company's principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the three months ended March 31, 2022 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Because of the inherent limitations in all control systems, the Company believes that no system of controls, no matter how well designed and operated, can provide absolute assurance that all control issues have been detected.

Part II

Other Information

Please refer to the “Risk Factors” previously disclosed in Item 1A of our 2021 Annual Report on Form 10-K and the factors discussed under “Cautionary Statement Regarding Forward-Looking Statements” in Part I. Item 2 of this Form 10-Q.