First Community Bankshares Inc: Form 10-Q for the period ended Sep 30, 2023

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand our financial condition, changes in financial condition, and results of operations. MD&A contains forward-looking statements and should be read in conjunction with our consolidated financial statements, accompanying notes, and other financial information included in this report and our Annual Report on Form 10-K for the year ended December 31, 2022 (the “2022 Form 10-K”). Unless the context suggests otherwise, the terms “First Community,” “Company,” “we,” “our,” and “us” refer to First Community Bankshares, Inc. and its subsidiaries as a consolidated entity.

Executive Overview

First Community Bankshares, Inc. (the “Company”) is a financial holding company, headquartered in Bluefield, Virginia, that provides banking products and services through its wholly owned subsidiary First Community Bank (the “Bank”), a Virginia chartered bank institution. As of September 30, 2023, the Bank operated 53 branches in Virginia, West Virginia, North Carolina and Tennessee. As of September 30, 2023, full-time equivalent employees, calculated using the number of hours worked, totaled 628. Our primary source of earnings is net interest income, the difference between interest earned on assets and interest paid on liabilities, which is supplemented by fees for services, commissions on sales, and various deposit service charges. We fund our lending and investing activities primarily through the retail deposit operations of our branch banking network. We invest our funds primarily in loans to retail and commercial customers and various investment securities. Our common stock is traded on the NASDAQ Global Select Market under the symbol FCBC.

The Bank offers trust management, estate administration, and investment advisory services through its Trust Division and wholly owned subsidiary First Community Wealth Management Inc. (“FCWM”). The Trust Division manages inter vivos trusts and trusts under will, develops and administers employee benefit and individual retirement plans, and manages and settles estates. Fiduciary fees for these services are charged on a schedule related to the size, nature, and complexity of the account. Revenues consist primarily of investment advisory fees and commissions on assets under management and administration. As of September 30, 2023, the Trust Division and FCWM managed and administered $1.40 billion in combined assets under various fee-based arrangements as fiduciary or agent. The Bank also offers a full range of commercial and personal insurance products through its strategic partnership with Bankers Insurance, LLC.

On March 12, 2023, the Department of the Treasury, the Federal Reserve and the FDIC issued a joint statement relating to the resolution of Silicon Valley Bank and Signature Bank that stated that losses to support uninsured deposits of those banks would be recovered via a special assessment on banks. On May 11, 2023 the FDIC approved a notice of proposed rulemaking, which would impose the special assessment to recover the losses to the deposit insurance fund (“DIF”) resulting from protecting uninsured depositors following the closures of Silicon Valley Bank and Signature Bank. The FDIC stated that it currently estimates those assessed losses to total $15.8 billion and that the amount of the special assessments would be adjusted as the loss estimate changes. Under the proposed rule, the assessment base would be an insured depository institution’s (“IDI”) estimated uninsured deposits, as reported in the IDI’s December 31, 2022 Call Report, excluding the first $5 billion in estimated uninsured deposits. The special assessments would be collected at an annual rate of approximately 12.5 basis points per year (3.13 basis points per quarter) over eight quarters in 2024 and 2025, with the first assessment period beginning January 1, 2024 (with the first assessment payment due by June 28, 2024). Under the proposed rule, the estimated loss pursuant to the systemic risk determination would be periodically adjusted, and the FDIC would retain the ability to cease collection early, extend the special assessment collection period and impose a final shortfall special assessment on a one-time basis. Under the current provisions of this notice of proposed rulemaking, we believe that we would not be impacted by the special assessment associated with the most recent banking organization closures.

Critical Accounting Estimates

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

Allowance for Credit Losses or "ACL"

The ACL reflects management’s estimate of losses that will result from the inability of our borrowers to make required loan payments. Management uses a systematic methodology to determine its ACL for loans held for investment and certain off-balance-sheet credit exposures. Management considers the effects of past events, current conditions, and reasonable and supportable forecasts on the collectability of the loan portfolio. The Company’s estimate of its ACL involves a high degree of judgment; therefore, management’s process for determining expected credit losses may result in a range of expected credit losses. It is possible that others, given the same information, may at any point in time reach a different reasonable conclusion. The Company’s ACL recorded in the balance sheet reflects management’s best estimate of expected credit losses. The Company recognizes in net income the amount needed to adjust the ACL for management’s current estimate of expected credit losses. See Note 1 – "Basis of Presentation - Significant Accounting Policies" in this Quarterly Report on Form 10-Q for further detailed descriptions of our estimation process and methodology related to the ACL. See also Note 5 — "Allowance for Credit Losses" in this Quarterly Report on Form 10-Q, “Provision for Loan Losses and Nonperforming Assets” in this MD&A. Periods prior to the January 1, 2021 adoption of ASU 2016-13 follow prior accounting guidance for estimated loan losses and may not be comparable.

Our accounting policies are fundamental in understanding MD&A and the disclosures presented in Item 1, “Financial Statements,” of this Quarterly Report on Form 10-Q. Our accounting policies are described in detail in Note 1, “Basis of Presentation,” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2023, and in Note 1, “Basis of Presentation and Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of our 2022 Form 10-K. Our critical accounting estimates are detailed in the “Critical Accounting Estimates” section in Part II, Item 7 of our 2022 Form 10-K.

Performance Overview

Highlights of our results of operations for the three and nine months ended September 30, 2023, and financial condition as of September 30, 2023, include the following:

• Net income of $14.64 million for the quarter was approximately 9.66%, or $1.29 million, higher compared to net income of $13.35 million in the same quarter of 2022. Adjusted for non-recurring items, third quarter net income increased $2.52 million to $14.72 million compared to third quarter 2022. The increase is primarily attributable to a significant increase in net interest income.
• Net interest income increased $4.01 million compared to the same quarter in 2022, as increases in benchmark interest rates have improved net interest margin.
• Net interest margin of 4.51% is an increase of 50 basis points over the same quarter of 2022. The yield on earning assets increased 82 basis points primarily driven by increased earnings on loans and securities.
• Interest and fees on loans increased $7.09 million from the same quarter of 2022 and is attributable to both an increase in yield and an increase in average balance compared to the yield and average balance of the prior year. Interest income from securities of $1.91 million was an increase of $127 thousand over the same quarter of 2022 and is attributable to an increase in yield from the same period of the prior year. Interest income on deposits in banks decreased $835 thousand to $697 thousand for the third quarter, primarily due to a significant decrease in the average balance compared to the third quarter of 2022.
• Annualized return on average assets was 1.74% for the third quarter and 1.49% for the first nine months of 2023 compared to 1.63% and 1.41% for the same periods, respectively of 2022. Annualized return on average common equity was 11.63% for the third quarter and 10.25% for the first nine months of 2023 compared to 12.60% and 10.73% for the same periods, respectively, of 2022.
• The Company’s loan portfolio increased by $193.28 million, or 8.05% from December 31, 2022. Excluding the Surrey transaction, the loan portfolio decreased approximately $45.81 million, or 1.91%.
• Deposits increased $67.32 million, or 2.51% from year-end 2022. Excluding the Surrey transaction, deposits decreased approximately $336.31 million, or 12.55% from December 31, 2022.
• The Company repurchased 299,012 common shares during the third quarter of 2023 for a total cost of $9.37 million. The Company repurchased 578,579 common shares year-to-date for a total cost of $17.06 million. The Company recently announced a new $2.7 million share repurchase program that replaces the small remainder of the prior program and expires December 31, 2026.
• Non-performing loans to total loans remained at 0.71% when compared with the prior quarter of June 30, 2023. The Company experienced net charge-offs for the third quarter of 2023 of $1.46 million or 0.22% of annualized average loans, compared to net charge-offs of $1.05 million, or 0.18% of annualized average loans for the same period in 2022.
• The allowance for credit losses to total loans was 1.39% at September 30, 2023 compared to 1.38% for the second quarter of 2023.
• Accumulated other comprehensive loss of $17.44 million at September 30, 2023, is primarily attributable to a relatively small decline in the market value of investment securities compared to book value after the significant increases in benchmark interest rates of the last seven quarters.
• Book value per share at September 30, 2023, was $26.55, an increase of $0.54 from year-end 2022.

Results of Operations

Net Income

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

(Amounts in thousands, except per

Three-Month Comparison.

Net income increased $1.29 million in the third quarter of 2023 compared to the same period in 2022. The increase is primarily attributable to an increase in net interest income of $4.01 million. Excluding the gain recorded in the third quarter of 2022 for the divestiture of the Emporia, Virginia branch of $1.66 million, non interest income increased $1.33 million. The increase was primarily driven by interchange fee income as well as a gain recorded from the sale of bank property in the third quarter of 2023. These increases were offset by a $1.77 million increase in noninterest expense. The increase in noninterest expense was primarily the result of increased salaries and benefits costs and increased service fees and are primarily attributable to the acquisition of Surrey Bancorp.

Nine - Month Comparison .

Net income increased $2.16 million in the first nine months of 2023 compared to the same period in 2022. The increase was primarily attributable to an increase in net interest income of $13.58 million compared to the same period in 2022. Net interest income totaled $95.62 million for the first nine months of 2023 compared to $82.04 million for the same period of 2022. The increase in net interest income was offset by an increase in the provision for credit losses of $3.80 million, an increase in noninterest expense of $6.01 million, and a decrease in noninterest income of $1.01 million over the same period in 2022. The increase in provision for credit losses was partly due to $1.61 million recorded for the day two provision for the Surrey loan portfolio. The increase in noninterest expense included $2.39 million in merger expenses and an increase in salaries and benefits costs of $1.68 million both due to the second quarter acquisition of Surrey Bancorp. The decrease in noninterest income was primarily attributable to a gain of $1.66 million recorded in 2022 for the divestiture of the Emporia, Virginia branch.

Net Interest Income

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

AVERAGE BALANCE SHEETS AND NET INTEREST INCOME ANALYSIS (Unaudited)

(Amounts in thousands)

(1) Interest income and average yield/rate are presented on a FTE, non-GAAP, basis using the federal statutory income tax rate of 21%.

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

(3) Interest on loans includes non-cash and accelerated purchase accounting accretion of $874 thousand and $487 thousand for the three months ended September 30, 2023 and 2022, respectively.

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AVERAGE BALANCE SHEETS AND NET INTEREST INCOME ANALYSIS (Unaudited)

(Amounts in thousands)

(1) Interest income and average yield/rate are presented on a FTE, non-GAAP, basis using the federal statutory income tax rate of 21%.

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

(3) Interest on loans includes non-cash and accelerated purchase accounting accretion of $1.95 million and $2.22 million the first nine months ended September 30, 2023 and 2022, respectively.

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

(Amounts in thousands)

(1) FTE basis based on the federal statutory rate of 21%.

Three-Month Comparison. Net interest income comprised 77.61% of total net interest and noninterest income in the third quarter of 2023 compared to 74.68% in the same quarter of 2022. Net interest income on a GAAP basis increased $4.01 million, or 13.65%, compared to an increase of $4.00 million, or 13.58%, on a FTE basis. The net interest margin on a FTE basis increased 50 basis points and the net interest spread on a FTE basis increased 30 basis points. The increase was primarily driven by increase in the average balance for loans as well as an increase in the yield on loans. The average balance for loans increased $270.29 million, while the yield increased 61 basis points resulting in a tax effected increase in interest on loans of $7.09 million compared to 2022. The tax effected interest on securities available for sale increased $119 thousand and is primarily attributable to the increase in yield of 31 basis points. These increases were offset by a decrease in the tax effected interest on interest-bearing deposits of $834 thousand. The decrease in interest was primarily driven by a decrease in the average balance for interest-bearing deposits of $224.44 million compared to the same quarter of 2022.

Average earning assets increased $29.15 million, or 1.00%, primarily due to an increase in average loans as noted above. The increase in average loans was offset by a decrease in average interest-bearing deposits with banks of $224.44 million and securities available for sale of $16.70 million. The yield on earning assets increased 82 basis points, or 20.15% primarily due an increase in benchmark rates as compared to the same period of 2022. The average loan to deposit ratio increased to 93.39% from 84.11% reported in the same quarter of 2022. Non-cash accretion income increased to $874 thousand from $487 thousand reported in the same quarter of 2022 and is primarily due to the Surrey Bancorp acquisition.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, decreased $70.12 million, or 3.70%, primarily due to a decrease in deposits. Time deposits decreased $53.35 million, or 16.82% and savings deposits decreased $25.33 million or 2.85%. The decreases were offset by an increase in interest-bearing demand deposits of $9.69 million, or 1.41%. The yield on interest-bearing liabilities increased 52 basis points and is primarily due to increases in benchmark rates throughout 2022 and 2023.

Nine-Month Comparison.

Net interest income comprised 77.99% of total net interest and noninterest income for the nine months ended September 30, 2023 compared to 74.56% in the same period of 2022. Net interest income on a GAAP basis increased $13.58 million, or 16.55%, compared to an increase of $13.58 million, or 16.49%, on a FTE basis. The net interest margin on a FTE basis increased 67 basis points and the net interest spread on a FTE basis increased 55 basis points. The increase was primarily driven by increases in both average balances and rates for loans and securities available for sale. The average balance for loans increased $253.84 million, while the yield increased 41 basis points resulting in a tax effected increase in interest on loans of $16.38 million compared to 2022. The average balance for securities available for sale increased $64.80 million and the yield increased 36 basis points resulting in a tax effected increase to interest on securities available for sale of $1.96 million compared to 2022.

Average earning assets decreased $27.93 million, or 0.96%, primarily due to a decrease in interest-bearing deposits with banks of $346.57 million, or 87.01%. This decrease was offset by an increase in average loans and average securities available for sale as noted above. The yield on earning assets increased 87 basis points, or 22.66%, primarily due to significant increase in benchmark rates as compared to the same period of 2022. The average loan to deposit ratio increased to 92.44% from 81.85% in the same period of 2022. Non-cash accretion income decreased $272 thousand, or 12.24% to $1.95 million.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, decreased $100.39 million, or 5.25%, primarily due to a decrease in deposits. Time deposits decreased $59.37 million, or 17.89%, savings deposits decreased $37.65 million or 4.24%, and demand deposits decreased $6.41 million or 0.93%. The yield on interest-bearing liabilities increased 32 basis points and is primarily due to increases in benchmark rates throughout 2022 and 2023.

Provision for Credit Losses

Three-Month Comparison. The provision charged to operations increased $424 thousand, in the third quarter of 2023 compared to the same quarter of 2022. Provision for credit losses for loans of $1.32 million was recorded in the third quarter of 2023 compared to the provision of $685 thousand recorded in the same period of 2022. The increase in provision is commensurate with changes in economic forecasts and changes in the loan portfolio. There was a recovery of provision recorded for loan commitments during the third quarter of $206 thousand. The provision for loan commitments of $459 thousand in 2022 was included in other operating expenses.

Nine-Month Comparison. The provision charged to operations increased $3.80 million, in the nine months ended of September 30, 2023 compared to the nine months ended of September 30, 2022. The provision expense of $6.96 million was comprised of $7.39 million related to loans and a recovery of provision of $438 thousand for loan commitments. Provision for credit losses for loans of $7.39 million was recorded in the nine months ended of September 30, 2023 compared to the provision of $3.16 million recorded in the nine months ended of September 30, 2022. The increase in provision is commensurate with changes in economic forecasts and growth in the loan portfolio associated with the acquisition of Surrey Bancorp on April 21, 2023. $1.61 million of the provision is attributable to day two provision for the Surrey portfolio. A provision of $737 thousand was recorded for loan commitments in 2022 and was included in other operating expense.

Noninterest Income

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

(Amounts in thousands)

Three-Month Comparison. Noninterest income comprised 22.39% of total net interest and noninterest income in the third quarter of 2023 compared to 25.32% in the same quarter of 2022. Noninterest income decreased $328 thousand or 3.30%. The decrease is primarily driven by the gain recorded in the third quarter of 2022 for the divestiture of the Emporia, Virginia branch of $1.66 million. Other service charges and fees increased $576 thousand and was primarily driven by an increase in interchange income. Other operating income increased $501 thousand partially driven by a gain recorded in the third quarter for the sale of bank-owned property. In addition, Wealth Management increased $213 thousand over the same period of 2022.

Nine-Month Comparison. Noninterest income comprised 22.01% of total net interest and noninterest income in the nine months ended of September 30, 2023 compared to 25.44% in the nine months ended of September 30, 2022. Noninterest income decreased $1.01 million or 3.60%. As noted above, the decrease is primarily driven by the gain recorded in the third quarter of 2022 for the divestiture of the Emporia, Virginia branch of $1.66 million. Additionally, there was decrease in service charges on deposits of $500 thousand compared to the same period of 2022. The decrease was primarily the result of a decrease in the volume of overdraft fees. The decreases were offset by an increase in other service charges of $804 thousand and an increase in wealth management income of $230 thousand compared to the nine months ended of September 30, 2022. The increase in other service charges was primarily driven by an increase in interchange income.

Noninterest Expense

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

(Amounts in thousands)

Three-Month Comparison. Noninterest expense increased $1.77 million, or 8.36%, in the third quarter of 2023 compared to the same quarter of 2022. The increase is primarily attributable to an increase in service fees of $715 thousand as well as an increase of $592 thousand in salaries and employee benefits. The increase in both costs can be attributable to the addition of Surrey branches and staff.

Nine-Month Comparison. Noninterest expense increased $6.01 million, or 9.64%, in the nine months ended of September 30, 2023 compared to the nine months ended of September 30, 2022. The Company recorded merger expenses of $2.39 million in 2023 related to the Surrey Bancorp acquisition. Also, contributing to the overall increase, was an increase in salaries and benefits of $1.68 million, or 4.77%. In addition, increases occurred in services fees of $952 thousand, advertising and public relations of $622 thousand, and other operating expense of $592 thousand. The increases are partially driven by the addition of Surrey branches and staff.

Income Tax Expense

The Company’s effective tax rate, income tax as a percent of pre-tax income, may vary significantly from the statutory rate due to permanent differences and available tax credits. Permanent differences are income and expense items excluded by law in the calculation of taxable income. The Company’s most significant permanent differences generally include interest income on municipal securities and increases in the cash surrender value of life insurance policies.

Three-Month Comparison. Income tax expense increased $196 thousand, or 4.77% and was primarily due to the increase in pre-tax income. The effective tax rate decreased to 22.73% in the third quarter of 2023 from 23.54% in the same quarter of 2022.

Nine-Month Comparison. Income tax expense increased $603 thousand, or 5.79% and was primarily due to the increase in pre-tax income. The effective tax rate decreased to 23.32% in the nine months ended of September 30, 2023 from 23.41% in the nine months ended of September 30, 2022.

Non-GAAP Financial Measures

In addition to financial statements prepared in accordance with GAAP, we use certain non-GAAP financial measures that management believes provide investors with important information useful in understanding our operational performance and comparing our financial measures with other financial institutions. The non-GAAP financial measure presented in this report includes net interest income on a FTE basis. We believe FTE basis is the preferred industry measurement of net interest income and provides better comparability between taxable and tax exempt amounts. We use this non-GAAP financial measure to monitor net interest income performance and to manage the composition of our balance sheet. The FTE basis adjusts for the tax benefits of income from certain tax exempt loans and investments using the federal statutory rate of 21%. While we believe certain non-GAAP financial measures enhance understanding of our business and performance, they are supplemental and not a substitute for, or more important than, financial measures prepared on a GAAP basis. Our non-GAAP financial measures may not be comparable to those reported by other financial institutions. The reconciliations of non-GAAP to GAAP measures are presented below.

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

(Amounts in thousands)

(1) FTE basis of 21%.

Financial Condition

Total assets as of September 30, 2023, increased $148.65 million, or 4.74%, from December 31, 2022. Total liabilities increased $74.97 million, or 2.76%, and stockholders' equity increased $73.68 million or 17.46%. The primary driver for the change in the balance sheet components was the acquisition of Surrey Bancorp on April 21, 2023. Total assets of $466.25 million were acquired in the transaction. In addition, the Company issued 2.99 million common shares in the purchase resulting in an increase in capital of $71.35 million. The purchase transaction created $14.38 million in goodwill and $12.7 million in other intangible assets.

Excluding the Surrey transaction, total assets decreased $317.59 million primarily due to a decrease in cash and cash equivalents of $234.15 million excluding the Surrey transaction. Total liabilities decreased $334.29 million excluding the Surrey transaction primarily due to a decrease in deposits of $336.31 million.

Investment Securities

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

Available-for-sale debt securities as of September 30, 2023, decreased $25.02 million, or 8.33%, compared to December 31, 2022. The decrease is due to $75.90 million in maturities, prepayments, and calls, as well as sales of $38.98 million in securities available for sale. Included in the sale of securities was the entire portfolio of Surrey with an acquired fair value of $20.93 million comprised primarily of U. S. Treasury securities. A loss of $28 thousand was recognized in the sale of the portfolio. The decreases were offset by purchases of $68.87 million and $20.93 million in investments acquired in the Surrey acquisition. The market value of debt securities available for sale as a percentage of amortized cost was 92.61% as of September 30, 2023, compared to 93.82% as of December 31, 2022.

Management evaluates securities for impairment where there has been a decline in fair value below the amortized cost basis of a security to determine whether there is a credit loss associated with the decline in fair value on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Credit losses are calculated individually, rather than collectively, using a discounted cash flow method, whereby Management compares the present value of expected cash flows with the amortized cost basis of the security. The credit loss component would be recognized through the provision for credit losses and the creation of an allowance for credit losses. Consideration is given to (1) the financial condition and near-term prospects of the issuer including looking at default and delinquency rates, (2) the outlook for receiving the contractual cash flows of the investments, (3) the length of time and the extent to which the fair value has been less than cost, (4) our intent and ability to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value or for a debt security whether it is more-likely-than-not that we will be required to sell the debt security prior to recovering its fair value, (5) the anticipated outlook for changes in the general level of interest rates, (6) credit ratings, (7) third party guarantees, and (8) collateral values. In analyzing an issuer’s financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the results of reviews of the issuer’s financial condition, and the issuer’s anticipated ability to pay the contractual cash flows of the investments. U.S. Treasury Securities, Agency-Backed Securities including GNMA, FHLMC, FNMA, FHLB, FFCB and SBA. All of the U.S. Treasury and Agency-Backed Securities have the full faith and credit backing of the United State Government or one of its agencies. Municipal securities and all other securities that do not have a zero expected credit loss are evaluated quarterly to determine whether there is a credit loss associated with a decline in fair value. All debt securities available for sale in an unrealized loss position as of September 30, 2023 continue to perform as scheduled and we do not believe that a provision for credit losses is necessary.

Loans Held for Investment

Loans held for investment, which generates the largest component of interest income, are grouped into commercial, consumer real estate, and consumer and other loan segments. Each segment is divided into various loan classes based on collateral or purpose.

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

(Amounts in thousands)

Total loans as of September 30, 2023, increased $193.28 million, or 8.05%, compared to December 31, 2022, and was primarily due to the Surrey acquisition with loans acquired totaling $239.08 million. The largest components of Surrey's portfolio included approximately $98.89 million in non-farm, non-residential loans, $61.47 million in commercial and industrial loans, and $23.03 million in non-owner occupied single family loans.

Risk Elements

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

Nonperforming assets consist of nonaccrual loans, accrual loans contractually past due 90 days or more, and modified loans past due 90 days or more, and OREO. Prior to the adoption of ASU 2022-02, unseasoned troubled debt restructurings ("TDRs") were included in nonperforming assets. Ongoing activity in the classification and categories of nonperforming loans include collections on delinquencies, foreclosures, loan restructurings, and movements into or out of the nonperforming classification due to changing economic conditions, borrower financial capacity, or resolution efforts.

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

(Amounts in thousands)

(1) ASU 2022-02, Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures. ASU adopted effective January 1, 2023.

(2) TDRs restructured within the past six months and nonperforming TDRs exclude nonaccrual TDRs of $1.22 million and $2.09 million for the periods ended December 31, 2022, and September 30, 2022, respectively. They are included in nonaccrual loans as reported prior to the adoption of ASU 2022-02.

(3) Total accruing TDRs exclude nonaccrual TDRs of $1.32 million and $1.48 million for the periods ended December 31, 2022, and September 30, 2022, respectively. They are included in nonaccrual loans as reported prior to the adoption of ASU 2022-02.

Nonperforming assets as of September 30, 2023, increased $1.27 million, or 7.29%, from December 31, 2022, with the largest increase due to an increase in nonaccrual loans of $3.16 million. The increase was offset by a decrease of $1.35 million in nonaccrual TDRs that was reported in December 31, 2022. The adoption of ASU 2022-02, Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures, on January 1, 2023, eliminated the accounting guidance for troubled debt restructurings by creditors as provided in ASC 310-40, Receivables - Troubled Debt Restructurings by Creditors. Therefore, the guidance applied prior to January 1, 2023, is no longer applicable. OREO decreased $460 thousand, or 65.43% and accruing loans past due 90 days or more decreased $83 thousand from year-end. As of September 30, 2023, nonaccrual loans were largely attributed to single family owner occupied (53.66%), consumer loans (11.64%), and agricultural (8.03%). Certain loans included in the nonaccrual category have been written down to estimated realizable value or assigned specific reserves in the allowance for loan losses based on management’s estimate of loss at ultimate resolution.

Delinquent loans, comprised of loans 30 days or more past due and nonaccrual loans, totaled $31.46 million as of September 30, 2023, a increase of $1.78 million, or 5.98%, compared to $29.68 million as of December 31, 2022. Delinquent loans as a percent of total loans totaled 1.21% as of September 30, 2023, which includes past due loans (0.50%) and nonaccrual loans (0.71%).

When restructuring loans for borrowers experiencing financial difficulty, we generally make concessions in interest rates, loan terms, or amortization terms. As noted above, ASU 2022-02, eliminated and replaced the accounting guidance for borrowers experiencing financial difficulties previously applied under ASC 310-40, Receivables - Troubled Debt Restructurings by Creditors. ASU 2022-02, Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures, discloses loans for borrowers experiencing financial difficulty as modified loans. Total loans modified as of September 30, 2023, were $642 thousand. As of September 30, 2023, the payment status of these loans were all current.

OREO, which is carried at the lesser of estimated net realizable value or cost, decreased $460 thousand, or 65.43%, as of September 30, 2023, compared to December 31, 2022, and consisted of 7 properties with an average holding period of approximately 15 months. The net loss on the sale of OREO totaled $94 thousand for the nine months ended September 30, 2023, compared to a net loss of $423 thousand for the same period of the prior year. The following table presents the changes in OREO during the periods indicated:

(Amounts in thousands)

Allowance for Credit Losses

The ACL reflects management’s estimate of losses that will result from the inability of our borrowers to make required loan payments. Management uses a systematic methodology to determine its ACL for loans held for investment and certain off-balance-sheet credit exposures. The ACL is a valuation account that is deducted from the amortized cost basis to present the net amount expected to be collected on the loan portfolio. Management considers the effects of past events, current conditions, and reasonable and supportable forecasts on the collectability of the loan portfolio. The Company’s estimate of its ACL involves a high degree of judgment; therefore, management’s process for determining expected credit losses may result in a range of expected credit losses. It is possible that others, given the same information, may at any point in time reach a different reasonable conclusion. The Company’s ACL recorded in the balance sheet reflects management’s best estimate of expected credit losses. The Company recognizes in net income the amount needed to adjust the ACL for management’s current estimate of expected credit losses. The Company’s measurement of credit losses policy adheres to GAAP as well as interagency guidance. The Company's ACL is calculated using collectively evaluated and individually evaluated loans.

​For collectively evaluated loans, the Company in general uses two modeling approaches to estimate expected credit losses. The Company projects the contractual run-off of its portfolio at the segment level and incorporates a prepayment assumption in order to estimate exposure at default. Financial assets that have been individually evaluated can be returned to a pool for purposes of estimating the expected credit loss insofar as their credit profile improves and that the repayment terms were not considered to be unique to the asset.

In addition to its own loss experience, management also includes peer bank historical loss experience in its assessment of expected credit losses to determine the ACL. The Company utilized call report data to measure historical credit loss experience with similar risk characteristics within the segments. For the majority of segment models for collectively evaluated loans, the Company incorporated at least one macroeconomic driver either using a statistical regression modeling methodology or simple loss rate modeling methodology.

Included in its systematic methodology to determine its ACL for loans held for investment and certain off-balance-sheet credit exposures. Management considers the need to qualitatively adjust expected credit losses for information not already captured in the loss estimation process. These qualitative adjustments either increase or decrease the quantitative model estimation (i.e. formulaic model results). Each period the Company considers qualitative factors that are relevant within the qualitative framework. For further discussion of our Allowance for Credit Losses - See Note 1 - "Basis of Presentation - Significant Accounting Policies".

With the adoption of ASU 2016-13 effective January 1, 2021, the Company changed its method for calculating it allowance for loans from an incurred loss method to a life of loan method. As of September 30, 2023, the balance of the ACL for loans was $36.03 million, or 1.39% of total loans. The ACL at September 30, 2023, increased $5.48 million from the balance of $30.56 million recorded at December 31, 2022. This increase included a $7.39 million provision offset by net charge-offs for the nine months of $3.93 million. Included in the $7.39 million provision was a day two provision of $1.61 million for Surrey loans. In addition, $2.01 million was added to the reserve for Surrey's purchased credit deteriorated loans.

At September 30, 2023, the Company also had an allowance for unfunded commitments of $758 thousand which was recorded in Other Liabilities on the Balance Sheet. During the first nine months of 2023, the Company recorded a recovery for credit losses on unfunded commitments of $438 thousand compared to a provision of $737 thousand recorded in the same period of 2022.

Deposits

Total deposits as of September 30, 2023, increased $67.32 million, or 2.51%, compared to December 31, 2022. The increase was primarily attributable to the acquisition of Surrey Bancorp. The Company acquired $403.64 million in deposits in the transaction; acquiring $158.39 million in demand accounts, $99.32 million in interest-bearing demand, $102.70 million in savings, and $43.23 million in time deposit accounts. Excluding the Surrey acquisition, deposits decreased $336.31 million with the largest decreases occurring in savings of $104.15 million, demand deposits of $86.26 million, and interest-bearing demand of $76.92 million. Deposit attrition related to Surrey post-merger totaled $59.80 million, with attrition of $37.99 million in interest-bearing demand, $13.92 million in savings, and $12.21 million in time deposits.

Total borrowings in the form of retail repurchase agreements as of September 30, 2023, decreased $845 thousand, or 45.09%, compared to December 31, 2022.

Liquidity and Capital Resources

Liquidity

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

As a financial holding company, the Company’s primary source of liquidity is dividends received from the Bank, which are subject to certain regulatory limitations. Other sources of liquidity include cash, investment securities, and borrowings. As of September 30, 2023, the Company’s cash reserves and short-term investment securities totaled $12.92 million and $22.76 million, respectively. The Company’s cash reserves and investments provide adequate working capital to meet obligations for the next twelve months.

In addition to cash on hand and deposits with other financial institutions, we rely on customer deposits, cash flows from loans and investment securities, and lines of credit from the FHLB and the Federal Reserve Bank (“FRB”) Discount Window to meet potential liquidity demands. These sources of liquidity are immediately available to satisfy deposit withdrawals, customer credit needs, and our operations. Secondary sources of liquidity include approved lines of credit with correspondent banks and unpledged available-for-sale securities. As of September 30, 2023, our unencumbered cash totaled $113.40 million, unused borrowing capacity from the FHLB totaled $382.39 million, available credit from the FRB Discount Window totaled $6.08 million, available lines from correspondent banks totaled $100.00 million, and unpledged available-for-sale securities totaled $129.95 million.

Capital Resources

We are committed to effectively managing our capital to protect our depositors, creditors, and shareholders. Failure to meet certain capital requirements may result in actions by regulatory agencies that could have a material impact on our operations. Total stockholders’ equity as of September 30, 2023, increased $73.68 million, or 17.46%, to $495.67 million from $421.99 million as of December 31, 2022. The change in stockholders’ equity was largely due to the acquisition of Surrey Bancorp. The Company issued 2.99 million shares of common stock in the transaction resulting in an increase to capital of $71.35 million. In addition, capital increased due to net income of $36.24 million. The increases were offset by the repurchase of our common stock totaling $17.06 million and dividends declared on our common stock of $15.72 million. Book value per share at September 30, 2023, was $26.55, an increase of $0.54 from year-end 2022.

Capital Adequacy Requirements

Risk-based capital guidelines, issued by state and federal banking agencies, include balance sheet assets and off-balance sheet arrangements weighted by the risks inherent in the specific asset type. Our current risk-based capital requirements are based on the international capital standards known as Basel III. A description of the Basel III capital rules is included in Part I, Item 1 of the 2022 Form 10-K. Our current required capital ratios are as follows:

• 4.5% Common Equity Tier 1 capital to risk-weighted assets (effectively 7.00% including the capital conservation buffer)
• 6.0% Tier 1 capital to risk-weighted assets (effectively 8.50% including the capital conservation buffer)
• 8.0% Total capital to risk-weighted assets (effectively 10.50% including the capital conservation buffer)
• 4.0% Tier 1 capital to average consolidated assets (“Tier 1 leverage ratio”)

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

Our risk-based capital ratios as of September 30, 2023, increased from December 31, 2022, primarily due to an increase in capital. The increase in capital was primarily due to the acquisition of Surrey and the issuance of 2.99 million shares of common stock in the transaction resulting in an increase to capital of $71.35 million. As of September 30, 2023, we continued to meet all capital adequacy requirements and were classified as well-capitalized under the regulatory framework for prompt corrective action. Management believes there have been no conditions or events since those notifications that would change the Bank’s classification. Additionally, our capital ratios were in excess of the minimum standards under the Basel III capital rules as of September 30, 2023.

Off-Balance Sheet Arrangements

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

(Amounts in thousands)

(1) Includes FHLB letters of credit

Market Risk and Interest Rate Sensitivity

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

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

As of September 30, 2023, the Federal Open Market Committee had set the benchmark federal funds rate to a range of 525 to 550 basis points. In the downward rate shock presented, benchmark interest rates were assumed at levels with floors near 0%. The following table presents the sensitivity of net interest income from immediate and sustained rate shocks in various interest rate scenarios over a twelve-month period for the periods indicated.

(Dollars in thousands)

Inflation and Changing Prices

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

Astronomic federal government spending, growth in economic activity and demand for goods and services, alongside labor shortages and supply chain complications, have contributed to rising inflation. In response, the Federal Reserve Bank has begun raising interest rates and signaled that it will continue to raise rates, taper its purchase of mortgage and other bonds and reduce the size of the balance sheet over time. The timing and impact of inflation and rising interest rates on our business and related financial results will depend on future developments, which are highly uncertain and difficult to predict.

Most LIBOR settings ceased to be published after June 30, 2023. The Company had discontinued originating LIBOR-based variable rate loans in 2018 in favor of U. S. Treasury rates. The Company has substituted an alternative reference rate published by the U. S. Treasury for any remaining loans tied to LIBOR.

The information required in this item is incorporated by reference to “Market Risk and Interest Rate Sensitivity” in Item 2 of this Quarterly Report on Form 10-Q.

Evaluation of Disclosure Controls and Procedures

In connection with this report, we conducted an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures under the Exchange Act Rule 13a-15(b). Based upon that evaluation, the CEO and CFO concluded that, as of September 30, 2023, our disclosure controls and procedures were effective.

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

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

Changes in Internal Control over Financial Reporting

We assess the adequacy of our internal control over financial reporting quarterly and enhance our controls in response to internal control assessments and internal and external audit and regulatory recommendations. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2023, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

The risk factors set forth in our annual report on Form 10-K for the year ended December 31, 2022, discuss potential events, trends, or other circumstances that could adversely affect our business, financial condition, results of operations, cash flows, liquidity, access to capital resources, and, consequently, cause the market value of our common stock to decline. These risks could cause our future results to differ materially from historical results and expectations of future financial performance. If any of the risks occur and the market price of our common stock declines significantly, individuals may lose all, or part, of their investment in our Company. Individuals should carefully consider our risk factors and information included in our annual report on Form 10-K for the year ended December 31, 2022 before making an investment decision. There may be risks and uncertainties that we have not identified or that we have deemed immaterial that could adversely affect our business; therefore, such risk factors are not intended to be an exhaustive list of all risks we face. There have been no material changes to the risk factors included in Part I, Item 1A, “Risk Factors,” of our annual report on Form 10-K for the year ended December 31, 2022.