First National Corp: Form 10-Q for the period ended Sep 30, 2023

Cautionary Statement Regarding Forward-Looking Statements

First National Corporation (the Company) makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding profitability, liquidity, adequacy of capital, allowance for credit losses, interest rate sensitivity, market risk, growth strategy. 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 subject to significant uncertainties because they are based upon or are affected by factors including:

• general business conditions, as well as conditions within the financial markets;
• general economic conditions, including unemployment levels, inflation and slowdowns in economic growth;
• the Company’s branch and market expansions, technology initiatives and other strategic initiatives;
• the impact of competition from banks and non-banks, including financial technology companies (Fintech);
• the composition of the loan and deposit portfolio, including the types of accounts and customers, may change, which could impact the amount of net interest income and noninterest income in future periods, including revenue from service charges on deposits;
• limited availability of financing or inability to raise capital;
• reliance on third parties for key services;
• the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses;
• the quality of the loan portfolio and the value of the collateral securing those loans;
• demand for loan products;
• deposit flows;
• the level of net charge-offs on loans and the adequacy of the allowance for loan losses;
• the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets;
• the value of securities held in the Company's investment portfolio;
• legislative or regulatory changes or actions, including the effects of changes in tax laws;
• changes in accounting principles, policies and guidelines and elections made by the Company thereunder;
• cyber threats, attacks or events;
• the ability to maintain adequate liquidity by retaining deposit customers and secondary funding sources, especially if the Company’s or the industry's reputation were to become damaged;
• monetary and fiscal policies of the U.S. Government, including policies of the U.S. Department of the Treasury and the Federal Reserve Board, and the effect of those policies on interest rates and business in the Company's markets;
• changes in interest rates could have a negative impact on the value of the Company’s securities portfolio and its net interest income and an unfavorable impact on the Company’s customers’ ability to repay loans;
• geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad; and
• other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2022.

Because of these and other uncertainties, actual results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at September 30, 2023 and statements of income of the Company for the three and nine months ended September 30, 2023 and 2022 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2022. The statements of income for the three and nine months ended September 30, 2023 may not be indicative of the results to be achieved for the year.

Executive Overview

The Company

First National Corporation (the Company) is the bank holding company of:

• First Bank (the Bank). The Bank owns:
• First Bank Financial Services, Inc.
• Bank of Fincastle Services, Inc.
• ESF, LLC
• Shen-Valley Land Holdings, LLC
• First National (VA) Statutory Trust II (Trust II)
• First National (VA) Statutory Trust III (Trust III and, together with Trust II, the Trusts)

First Bank Financial Services, Inc. owns an interest in an entity that provides title insurance services. Bank of Fincastle Services, Inc. is no longer an active operating entity. Shen-Valley Land Holdings, LLC and ESF, LLC were formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities and are not included in the Company’s consolidated financial statements in accordance with authoritative accounting guidance because management has determined that the Trusts qualify as variable interest entities.

Products, Services, Customers and Locations

The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank’s office locations are well-positioned in attractive markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in the Shenandoah Valley, the Roanoke Valley, central regions of Virginia, and the city of Richmond. Within these markets, there are diverse types of industry including medical and professional services, manufacturing, retail, warehousing, Federal and local government, hospitality, and higher education. The Bank’s products and services are delivered through 20 bank branch offices, a loan production office and customer service centers in two retirement villages. For the location and general character of each of these offices, see Item 2 of the Company's Form 10-K for the year ended December 31, 2022. Many of the Bank’s services are also delivered through the Bank’s mobile banking platform, its website, www.fbvirginia.com (http://www.fbvirginia.com), and a network of ATMs located throughout its market area.

Revenue Sources and Expense Factors

The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services, and ATM and check card fees.

Primary expense categories are salaries and employee benefits, which comprised 57% of noninterest expenses for the nine months ended September 30, 2023, followed by occupancy and equipment expense, which comprised 12% of noninterest expenses. The provision for credit losses is also typically a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for credit losses.

Overview of Quarterly Financial Performance

Comparing the Three-Month Periods Ending September 30, 2023 and September 30, 2023

Net income decreased $1.3 million, or 30%, to $3.1 million, or $0.50 per diluted share, for the three months ended September 30, 2023, compared to $4.5 million, or $0.71 per diluted share, for the same period in 2022. Return on average assets was 0.91% and return on average equity was 10.96% for the third quarter of 2023, compared to 1.27% and 17.27%, respectively, for the same period in 2022.

The decrease in net income resulted from a $1.0 million, or 9%, decrease in net interest income and a $701 thousand, or 8%, increase in total noninterest expense, which were partially offset by a $26 thousand, or 1%, increase in total noninterest income, a $100 thousand decrease in the provision for credit losses, and a $286 thousand decrease in income tax expense.

Net interest income decreased from a 23-basis point decrease in the net interest margin and a 1% decrease in average earning assets. The net interest margin was impacted by changes in market interest rates, including the Federal funds target rate, which averaged 5.43% in the third quarter of 2023, compared to 2.35% for the same period one year ago. The rise in the Federal funds rate had an impact on the Company’s cost of funds, which increased 94 basis points. The higher cost of funds was partially offset by a 68-basis point increase in the yield on earning assets.

The net interest margin decreased by 1 basis point in the third quarter of 2023 compared to the linked second quarter of 2023, which was an improvement compared to a 24-basis point decrease in the second quarter of 2023 compared to the linked first quarter of 2023, and a 10-basis point decrease in the first quarter of 2023 compared to the linked fourth quarter of 2022.

Total noninterest expenses increased by $701 thousand, or 8%, and was primarily attributable to increases in salaries and employee benefits, legal and professional expenses, ATM and check card expenses, and FDIC assessment costs.

Comparing the Nine-Month Periods Ending September 30, 2023 and September 30, 2023

Net income decreased $1.5 million, or 13%, to $10.5 million, or $1.67 per diluted share, for the nine months ended September 30, 2023, compared to $12.0 million, or $1.92 per diluted share, for the same period in 2022. Return on average assets was 1.03% and return on average equity was 12.57% for the nine months ending 2023, compared to 1.14% and 15.12%, respectively, for the same period in 2022.

The decrease in net income resulted from a $961 thousand, or 3%, decrease in net interest income and a $1.5 million, or 6%, increase in total noninterest expense, which were partially offset by a $197 thousand, or 2%, increase in total noninterest income, a $400 thousand decrease in the provision for credit losses, and a $318 thousand decrease in income tax expense.

Net interest income decreased from a 13-basis point decrease in the net interest margin, which was partially offset by a 1% increase in average earning assets. The net interest margin was impacted by changes in market interest rates, including the Federal funds target rate, which averaged 5.09% for the nine months ending September 30, 2023, compared to 1.20% for the same period one year ago. The rise in the Federal funds rate had an impact on the Company’s cost of funds, which increased 85 basis points. The higher cost of funds was partially offset by a 68 basis point increase in the yield on earning assets.

Total noninterest expense increased by $1.5 million, or 6%, and was primarily attributable to increases in salaries and employee benefits, marketing expense, ATM and check card expenses, and other operating expenses.

For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income,” “Provision for Credit Losses,” "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.

Non-GAAP Financial Measures

This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding amortization of intangibles, net gains (loss) on disposal of premises and equipment, other real estate owned (income) expense, net, and merger related expenses, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding securities gains. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The methodology for determining this measurement may differ among companies. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).

This report also refers to net interest margin, which is calculated by dividing tax 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 for both 2023 and 2022 is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).

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Critical Accounting Policies

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 relieving a liability. Although the economics of the Company’s transactions may not change, the timing of events that would impact the transactions could change.

Critical accounting policies are most important to the portrayal of the Company’s financial condition or results of operations and 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. The Company provides additional information on its critical accounting policies and estimates under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in its 2022 Form 10-K and in Note 1 “Significant Accounting Policies and Estimates” in Part I, Item 1 of this Quarterly Report.

Lending Policies

There have been no material changes in the Company’s lending policies disclosed in the Annual Report on Form 10-K for the year ended December 31, 2022.

Results of Operations

General

Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for credit losses, noninterest income, and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consist of income from service charges on deposit accounts, revenue from wealth management services, ATM and check card income, revenue from other customer services, income from bank owned life insurance, general and administrative expenses, amortization expense, and other real estate owned expense.

Net Income

Three Month Period Ended September 30, 2023

Net income decreased $1.3 million, or 30%, to $3.1 million, or $0.50 per diluted share, for the three months ended September 30, 2023, compared to $4.5 million, or $0.71 per diluted share, for the same period in 2022. Return on average assets was 0.91% and return on average equity was 10.96% for the third quarter of 2023, compared to 1.27% and 17.27%, respectively, for the same period in 2022.

The decrease in net income resulted from a $1.0 million, or 9%, decrease in net interest income, and a $701 thousand, or 8%, increase in total noninterest expense, which were partially offset by a $26 thousand, or 1%, increase in total noninterest income, a $100 thousand decrease in the provision for credit losses, and a $286 thousand decrease in income tax expense.

Nine Month Period Ended September 30, 2023

Net income decreased $1.5 million, or 13%, to $10.5 million, or $1.67 per diluted share, for the nine months ended September 30, 2023, compared to $12.0 million, or $1.92 per diluted share, for the same period in 2022. Return on average assets was 1.03% and return on average equity was 12.57% for the nine months ended September 30, 2023, compared to 1.14% and 15.12%, respectively, for the same period in 2022.

The decrease in net income was attributable to a $1.5 million, or 6%, increase in noninterest expenses, and a $961 thousand decrease in net interest income. These changes were partially offset by a $197 thousand increase in noninterest income, and a $400 thousand decrease in the provision for credit losses, and a $318 thousand decrease in income tax expense.

Net Interest Income

Three Month Period Ended September 30, 2023

Net interest income decreased from a 23-basis point decrease in the net interest margin and a 1% decrease in average earning assets. The net interest margin was impacted by changes in market interest rates, including the Federal funds target rate, which averaged 5.43% in the third quarter of 2023, compared to 2.35% for the same period one year ago. The rise in the Federal funds rate had an impact on the Company’s cost of funds, which increased 94 basis points. The higher cost of funds was partially offset by a 68-basis point increase in the yield on earning assets.

The net interest margin decreased by 1 basis point in the third quarter of 2023 compared to the linked second quarter of 2023, which was an improvement compared to a 24-basis point decrease in the second quarter of 2023 compared to the linked first quarter of 2023, and a 10-basis point decrease in the first quarter of 2023 compared to the linked fourth quarter of 2022.

Net interest income decreased by $1.0 million as total interest income increased by $1.8 million, which was offset by a $2.9 million increase in total interest expense. Although both interest income and interest expense increased as a result of the higher interest rate environment in 2023, interest expense increased more than interest income, comparing the third quarter of 2023 with the same period of the prior year.

Total interest income increased primarily from interest and fees on loans, which resulted from both higher yields and higher average balances, while interest on deposits in banks increased solely from higher yields, as their average balances decreased compared to the same period of the prior year. The yield on loans increased by 52 basis points to 5.31% and the average balance of loans increased to 74% of average earning assets, compared to 68% for the same period one year ago. The yield on interest-bearing deposits in banks increased by 344 basis points to 5.39%, while the average balance decreased to 2% of average earning assets, compared to 6% for the same period of the prior year.

Net accretion of discounts on purchased loans totaled $61 thousand in the third quarter of 2023 compared to $295 thousand for the third quarter of 2022.

The increase in interest expense was attributable to higher interest expense on deposits. Deposit costs increased from higher interest rates paid on deposit accounts in 2023, as well as a change in the deposit portfolio composition, as interest-bearing deposits increased as a percentage of total deposits, while noninterest-bearing deposits decreased. Additionally, within the interest-bearing deposit portfolio, higher cost time deposit balances and money market balances increased, while lower cost checking and savings balances decreased. The average balance of time deposits increased to 22% of average interest-bearing deposits, compared to 16% for the same period of the prior year. The cost of interest-bearing deposits increased by 139 basis points to 1.82% for the current period, compared to 0.43% for the same period of the prior year. The total cost of funds increased 94-basis points to 1.27% for the current period compared to 0.33% for the same period of the prior year.

Nine Month Period Ended September 30, 2023

Net interest income decreased from a 13-basis point decrease in the net interest margin, which was partially offset by a 1% increase in average earning assets. The net interest margin was impacted by changes in market interest rates, including the Federal funds target rate, which averaged 5.09% for the nine months ending September 30, 2023, compared to 1.20% for the same period one year ago. The rise in the Federal funds rate had an impact on the Company’s cost of funds, which increased 85 basis points. The higher cost of funds was partially offset by a 68-basis point increase in the yield on earning assets.

Net interest income decreased $961 thousand as total interest income increased $6.8 million and was offset by a $7.8 million increase in total interest expense. Although both interest income and interest expense increased as a result of the higher interest rate environment in 2023, the increase in interest income was offset by the increase in interest expense, comparing the nine-month period of 2023 with the same period of the prior year.

Total interest income increased from interest and fees on loans and from interest on deposits in banks. Interest and fees on loans increased from higher yields and higher average balances. Interest on deposits in banks increased solely from higher yields, as their average balances decreased compared to the same period of the prior year. The yield on loans increased by 49 basis points to 5.19% and the average balance increased to 73% of total average earning assets, compared to 68% for the same period of the prior year. The yield on interest-bearing deposits in banks increased by 420 basis points to 4.95%, while the average balance of interest-bearing deposits decreased to 3% of average earning assets, compared to 10% for the same period of the prior year.

Accretion of PPP income, net of costs, and accretion of discounts on purchased loans, net of premiums, were included in interest and fees on loans. There was no accretion of PPP income for the nine months ended September 30, 2023, compared to $358 thousand for the same period of 2022. Net accretion of discounts on purchased loans totaled $510 thousand for the nine-month period ended September 30, 2023, compared to $1.0 million for the same period of 2022.

The increase in interest expense was attributable to higher interest expense on deposits and a change in the deposit portfolio composition. Interest expense on deposits increased from higher interest rates paid on deposit accounts in 2023, as well as an increase in the average balances of higher cost deposits and a decrease in the average balances of lower cost deposits. The average balance of time deposits balances increased to 20% of total average interest-bearing deposits, compared to 16% for the same period one year ago. The cost of interest-bearing deposits increased by 126 basis points to 1.52% for the current period, compared to 0.26% for the same period of the prior year. The total cost of funds increased 85-basis points to 1.06% for the current period compared to 0.21% for the same period of the prior year.

The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):

Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis)

(1) Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $81 and $82 thousand for the three months ended September 30, 2023 and 2022, respectively.

(2) Loans on non-accrual status are reflected in the balances.

(1) Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $244 and $245 thousand for the six months ended September 30, 2023 and 2022, respectively.

(2) Loans on non-accrual status are reflected in the balances.

Provision for Credit Losses

Three Month Period Ended September 30, 2023

The provision for credit losses totaled $100 thousand for the third quarter of 2023, compared to $200 thousand for the same period of the prior year. The provision was comprised of a $120 thousand provision on loans, an $8 thousand recovery on unfunded commitments, and a $12 thousand recovery on held-to-maturity securities. The provision for credit losses on loans resulted from growth of the loan portfolio, net charge-offs, and an increase in the specific reserve component of the allowance for credit losses, which were partially offset by a decrease in the general reserve component from lower expected loss rates and an adjustment to a qualitative factor.

Nine Month Period Ended September 30, 2023

The provision for credit losses totaled $200 thousand for the nine-months ended September 30, 2023, compared to $600 thousand for the same period of the prior year. The provision was comprised of a $165 thousand provision on loans, a $36 thousand provision on unfunded commitments, and a $1 thousand net recovery on held-to-maturity securities. The provision for credit losses on loans resulted from growth of the loan portfolio, net charge-offs, and an increase in the specific reserve component of the allowance for credit losses, which were partially offset by a decrease in the general reserve component from lower expected loss rates and an adjustment to a qualitative factor.

Noninterest Income

Three Month Period Ended September 30, 2023

Noninterest income increased $26 thousand, or 1%, to $3.1 million for the third quarter of 2023, compared to the same period of 2022. ATM and check card fees increased $61 thousand, or 7%, and wealth management fees increased $72 thousand, or 10%. These increases were partially offset by a $58 thousand, or 32%, decrease in fees for other customer services, and a $34 thousand, or 47%, decrease in brokered mortgage fees.

The increases in ATM and check card fees were favorably impacted by an increase in customer transactions. The increase in wealth management fees resulted primarily from an increase in assets under management from higher market values.

Nine Month Period Ended September 30, 2023

Total noninterest income increased $197 thousand, or 2%, for the nine months ended September 30, 2023, compared to the same period of 2022. The increase resulted primarily from a $162 thousand, or 7%, increase in ATM and check card fees, a $150 thousand increase in other operating income, and a $47 thousand, or 2%, increase in service charges on deposit accounts, which were partially offset by a $151 thousand decrease in income from brokered mortgage fees. An increase in customer transactions favorably impacted ATM and check card fees. The increase in other operating income was attributable to a death benefit payment received from a bank-owned life insurance policy in 2023.

Noninterest Expense

Three Month Period Ended September 30, 2023

Noninterest expenses increased $701 thousand, or 8%, to $9.8 million for the three-month period ended September 30, 2023, compared to the same period one year ago. The increase was primarily attributable to a $331 thousand, or 6%, increase in salaries and employee benefits, a $78 thousand increase in legal and professional fees, a $108 thousand increase in ATM and check card expense, a $52 thousand increase in FDIC assessment, and a $52 thousand increase in equipment expense.

Salaries and employee benefits increased primarily from annual increases in employee salaries and wages. Legal and professional fees increased from wealth management advisory expense. ATM and check expenses increased from higher volume of customer transactions. FDIC assessment increased from higher assessed rates during 2023. The increase in equipment expense resulted primarily from higher depreciation expense on software.

Nine Month Period Ended September 30, 2023

Noninterest expense increased $1.5 million, or 6%, to $28.1 million for the nine-month period ended September 30, 2023, compared to the same period one year ago. The increase was primarily attributable to a $656 thousand, or 4% increase in salaries and employee benefits, a $135 thousand, or 23%, increase in marketing, a $283 thousand, or 29%, increase in ATM and check card expense, and a $387 thousand, or 13%, increase in other operating expenses. These increases were partially offset by a $284 thousand decrease in OREO expense, net, which resulted from gains on the sale of other real estate during 2023.

Salaries and employee benefits increased primarily from an annual increase in employee salaries and wages. Marketing expenses increased from additional advertising and active promotion initiatives. ATM and check card expense increased primarily from a higher volume of customer transactions. Other operating expenses increased primarily from higher recruiting expense, education and training expense, loan collection expense, and courier and armored services.

Income Taxes

Three Month Period Ended September 30, 2023

Income tax expense decreased $286 thousand for the third quarter of 2023, compared to the same period one year ago. The effective tax rate for the second quarter of 2023 was 19.0% compared to 18.6% for the same period in 2022. The increased effective tax rate for 2023 was the result of higher non-deductible expenses and lower nontaxable income in 2023 compared to 2022. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three months ended September 30, 2023, and 2022. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income, and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

Nine Month Period Ended September 30, 2023

Income tax expense decreased $318 thousand, or 11.3%, for the first nine months of 2023 compared with the same period in 2022. The effective tax rate for the first nine months of 2023 was 19.3% compared with 19.0% for the same period in 2022. Like the three month period ended September 30, 2023, the increased effective tax rate for 2023 was also the result of lower non-deductible expenses in 2023 compared to 2022.

Financial Condition

General

Assets totaled $1.4 billion on September 30, 2023, which was a slight decrease of $3.2 million from December 31, 2022. The asset composition changed during the first nine months of the year as cash and due from banks decreased by $3.6 million, interest-bearing deposits in banks decreased by $13.2 million, and total securities decreased by $14.7 million, while loans, net of the allowance for credit losses, increased by $30.5 million.

Total liabilities decreased by $6.8 million during the nine-month period ended September 30, 2023, primarily from a $6.2 million decrease in total deposits. Although total deposits decreased slightly, the composition of deposits changed as noninterest-bearing deposits and savings and interest-bearing deposits decreased $23.6 million and $30.2 million, respectively, while time deposits increased $47.6 million. The change in composition of the deposit portfolio during the period was attributable to customers shifting deposits into products with higher interest rates.

Total shareholders’ equity increased by $3.6 million during the first nine months of 2023, primarily from a $5.7 million increase in retained earnings, which was partially offset by a $2.2 million increase in accumulated other comprehensive loss. The increase in accumulated other comprehensive loss was attributable to higher unrealized losses in the available-for-sale securities portfolio. Retained earnings increased from $10.5 million of net income, which was partially offset by $2.8 million of cash dividends on common stock and a $2.0 million decrease from the adoption of CECL on January 1, 2023. The Bank's capital ratios continued to exceed the minimum capital requirements for regulatory purposes.

Loans

Loans totaled $952.5 million at September 30, 2023, which was a $32.0 million, or 5% annualized, increase from December 31, 2022, and a $46.0 million, or 5%, increase over September 30, 2023. The growth in loans over the periods did not have a significant impact on the composition of the loan portfolio. The loan portfolio was primarily comprised of loans secured by one-to-four family residential real estate, loans secured by commercial real estate, and commercial and industrial loans, which totaled 36%, 46%, and 12% of the loan portfolio, respectively, at September 30, 2023.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for credit losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Interest income includes amortization of purchase premiums and discounts, recognized evenly over the life of the loans.

A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled $368 thousand at September 30, 2023 There were no loans greater than 90 days past due and still accruing at December 31, 2022. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.

Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.

Asset Quality

Management classifies non-performing assets as non-accrual loans and OREO. Non-performing assets totaled $3.1 million and $2.9 million at September 30, 2023 and December 31, 2022, representing approximately 0.23% and 0.21% of total assets, respectively. Nonaccrual loans totaled $3.1 million and $2.7 million at September 30, 2023 and December 31, 2022, respectively. OREO totaled $0 and $185 thousand at September 30, 2023 and December 31, 2022, respectively. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for, or used in bank operations, but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank did not have any consumer mortgage loans secured by real estate properties for which formal foreclosure proceedings were in process as of September 30, 2023

On September 30, 2023 17.5% of non-performing assets were comprised of residential real estate loans. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $1.7 million and $2.3 million at September 30, 2023 and December 31, 2022, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.

Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for credit losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical losses, past due percentages, internally generated loan quality reports, and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for credit losses will not be required in the future, including as a result of changes in the qualitative factors underlying management’s estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company’s market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for credit losses, see “Critical Accounting Policies” above.

Securities

The securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity and serves as a source of liquidity. The portfolio is used as needed to meet collateral requirements, such as those related to secure public deposits and balances with the Reserve Bank. The investment portfolio consists of held to maturity, available for sale, and restricted securities. Securities are classified as available for sale or held to maturity based on the Company’s investment strategy and management’s assessment of the intent and ability to hold the securities until maturity. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Restricted securities, including Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock, are generally viewed as long-term investments because there is minimal market for the stock and are carried at cost.

On September 30, 2023 securities totaled $300.2 million, a decrease of $17.8 million, or 5.6%, from $318.0 million at December 31, 2022. Investment securities are comprised of U.S. Treasury securities, U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of September 30, 2023, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $64 thousand and $99 thousand at September 30, 2023 and December 31, 2022, respectively. Gross unrealized losses in the available for sale portfolio totaled $28.4 million and $24.0 million at September 30, 2023 and December 31, 2022, respectively. There were no gross unrealized gains in the held to maturity portfolio at September 30, 2023 and December 31, 2022, respectively. Gross unrealized losses in the held to maturity portfolio totaled $15.2 million and $11.4 million at September 30, 2023 and December 31, 2022, respectively. The change in the unrealized gains and losses of investment securities from December 31, 2022 to September 30, 2023 was related to changes in market interest rates and was not related to credit concerns of the issuers.

On September 1, 2022, the Bank transferred 24 securities designated as available for sale with a combined book value of $82.2 million, market value of $74.4 million, and an unrealized loss of $7.8 million, to securities designated held to maturity. The unrealized loss is being amortized monthly over the life of the securities with an increase to the carrying value of securities and a decrease to the related accumulated other comprehensive loss, which is included in the shareholders’ equity section of the Company’s balance sheet. The amortization of the unrealized loss on the transferred securities totaled $1.2 million, or $972 thousand net of tax, for the first nine months of 2023. Securities designated as held to maturity are carried on the balance sheet at amortized cost, while securities designated as available for sale are carried at fair market value.

Deposits

Deposits totaled $1.2 billion on September 30, 2023, which was a $6.2 million decrease from December 31, 2022, and a $30.3 million, or 2%, decrease from September 30, 2022. The composition of the deposit portfolio has changed compared to prior periods. Noninterest-bearing deposits, savings and interest-bearing deposits, and time deposits, totaled 33%, 52%, and 15%, of total deposits, respectively on September 30, 2023, compared to 34%, 55%, and 11% on December 31, 2022, and 34%, 55%, and 11%, on September 30, 2022. The change in deposit composition was attributable to deposits that shifted into products paying higher interest rates.

Liquidity

Liquidity sources available to the Bank, including interest-bearing deposits in banks, unpledged securities available for sale, at fair value, unpledged securities held-to-maturity, at par, eligible to be pledged to the Federal Reserve Bank through its Bank Term Funding Program, and available lines of credit totaled $532.1 million on September 30, 2023, and $417.2 million on December 31, 2022.

The Bank maintains liquidity to fund loan growth and meet the potential demand from its deposit customers, including potential volatile deposits. The estimated amount of uninsured customer deposits totaled $346.9 million on September 30, 2023, and $261.7 million on December 31, 2022. Excluding municipal deposits, the estimated amount of uninsured customer deposits totaled $268.4 million on September 30, 2023, and $185.3 million on December 31, 2022.

The Bank also has access to off-balance sheet liquidity through its available lines of credit from other institutions, which totaled $347.1 million at September 30, 2023, $287.3 million at December 31, 2022, and $379.0 million at September 30, 2023. The available lines of credit were comprised of secured and unsecured lines of credit. The Bank had no borrowings on the lines of credit at September 30, 2023, December 31, 2022, or September 30, 2023.

Capital Resources

The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board’s Small Bank Holding Company Policy Statement and is not obligated to report consolidated regulatory capital.

The Bank is subject to capital rules adopted by federal bank regulators that implemented the Basel III regulatory capital reforms adopted by the Basel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act.

The minimum capital level requirements applicable to the Bank under the final rules are as follows: a common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. There is also a capital conservation buffer, which is 2.5% above the regulatory minimum capital requirements. If capital levels fall below the required minimum ratios plus the buffer, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. This results in the following minimum capital ratios required to exceed the buffer: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Management believes, as of September 30, 2023 and December 31, 2022, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.

The following table shows the Bank’s regulatory capital ratios at September 30, 2023:

(1) Calculated by subtracting the regulatory minimum capital ratio requirements from the Company’s actual ratio for Common equity Tier 1, Tier 1, and Total risk based capital. The lowest of the three measures represents the Bank’s capital conservation buffer ratio.

The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The Bank met the requirements to qualify as "well capitalized" as of September 30, 2023 and December 31, 2022.

During the fourth quarter of 2022, the Board of Directors of the Company authorized a stock repurchase plan pursuant to which the Company could repurchase up to $5.0 million of its outstanding common stock through December 31, 2023. The Company repurchased 37,532 shares under this plan during the first nine months of 2023 at an average price of $15.14 per share.

Contractual Obligations

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

Off-Balance Sheet Arrangements

The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.

Commitments to extend credit, which amounted to $171.9 million at September 30, 2023, and $158.3 million at December 31, 2022, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.

Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed.

On January 1, 2023, the Company recorded an adjustment for unfunded commitments of $153 thousand for the adoption of ASC Topic 326. The Company recorded an additional provision for credit losses for unfunded commitments of $36 thousand during the nine months ended September 30, 2023. At September 30, 2023, the liability for credit losses on off-balance sheet exposures included in other liabilities was $189 thousand.

Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At September 30, 2023 and December 31, 2022, the Bank had $12.1 million and $18.0 million in outstanding standby letters of credit, respectively.

On April 21, 2020, the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. The Company uses derivatives to manage exposure to interest rate risk through the use of interest rate swaps. Interest rate swaps involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date with no exchange of underlying principal amounts.

The interest rate swaps qualified and are designated as cash flow hedges. The Company’s cash flow hedges effectively modify the Company’s exposure to interest rate risk by converting variable rates of interest on $9.0 million of the Company’s junior subordinated debt to fixed rates of interest. The cash flow hedges end and the junior subordinated debt matures between June 2034 and October 2036. The cash flow hedges’ total notional amount is $9.0 million. At September 30, 2023, the cash flow hedges had a fair value of $3.1 million, which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive (loss) income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 10 to the Consolidated Financial Statements.

The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of September 30, 2023 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2022.