Fidelity D & D Bancorp Inc: Form 10-Q for the period ended Sep 30, 2023

The following is management's discussion and analysis of the significant changes in the consolidated financial condition of the Company as of September 30, 2023 compared to December 31, 2022 and a comparison of the results of operations for the three and nine months ended September 30, 2023 and 2022. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2022 Annual Report filed on Form 10-K.

Forward-looking statements

Certain of the matters discussed in this Quarterly Report on Form 10-Q may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. The words “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” and similar expressions are intended to identify such forward-looking statements.

The Company’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation:

• local, regional and national economic conditions and changes thereto;
• the short-term and long-term effects of inflation, and rising costs to the Company, its customers and on the economy;
• the risks of changes and volatility of interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities and interest rate protection agreements, as well as interest rate risks;
• securities markets and monetary fluctuations and volatility;
• disruption of credit and equity markets;
• impacts of the capital and liquidity requirements of the Basel III standards and other regulatory pronouncements, regulations and rules;
• governmental monetary and fiscal policies, as well as legislative and regulatory changes;
• effects of short- and long-term federal budget and tax negotiations and their effect on economic and business conditions;
• the costs and effects of litigation and of unexpected or adverse outcomes in such litigation;
• the impact of new or changes in existing laws and regulations, including laws and regulations concerning taxes, banking, securities and insurance and their application with which the Company and its subsidiaries must comply;
• the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters;
• the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in our market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet;
• the effects of economic conditions of any pandemic, epidemic or other health-related crisis such as COVID-19 and responses thereto on current customers and the operations of the Company, specifically the effect of the economy on loan customers’ ability to repay loans;
• the effects of bank failures, banking system instability, deposit fluctuations, loan and securities value changes;
• technological changes;
• the interruption or breach in security of our information systems, continually evolving cybersecurity and other technological risks and attacks resulting in failures or disruptions in customer account management, general ledger processing and loan or deposit updates and potential impacts resulting therefrom including additional costs, reputational damage, regulatory penalties, and financial losses;
• acquisitions and integration of acquired businesses;
• the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities;
• acts of war or terrorism; and
• the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

The Company cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document. The Company has no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.

Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

Executive Summary

The Company is a Pennsylvania corporation and a bank holding company, whose wholly-owned state chartered commercial bank and trust company is The Fidelity Deposit and Discount Bank. The Company is headquartered in Dunmore, Pennsylvania. We consider Lackawanna, Northampton, Lehigh and Luzerne Counties our primary marketplace.

As a leading Northeastern and Eastern Pennsylvania community bank, our goals are to enhance shareholder value while continuing to build a full-service community bank. We focus on growing our core business of retail and business lending and deposit gathering while maintaining strong asset quality and controlling operating expenses. We continue to implement strategies to diversify earning assets (see “Funds Deployed” section of this management’s discussion and analysis) and to increase the amount of relationship core deposits (see “Funds Provided” section of this management’s discussion and analysis). These strategies include a greater level of commercial lending and the ancillary business products and services supporting our commercial customers’ needs as well as residential lending strategies and an array of consumer products. We focus on developing a full banking relationship with existing, as well as new business prospects. The Bank has a personal and corporate trust department and also provides alternative financial and insurance products with asset management services. In addition, we explore opportunities to selectively expand and optimize our franchise footprint, consisting presently of our 21-branch network.

We are impacted by national, regional and market area economic factors, with commercial, commercial real estate and residential mortgage loans concentrated in Northeastern Pennsylvania, primarily in Lackawanna and Luzerne counties, and Eastern Pennsylvania, primarily Northampton and Lehigh counties. The Federal Open Market Committee (FOMC) increased interest rates by 425 basis points during 2022 and another 25 basis points each in February, March, May and July 2023. According to the U.S. Bureau of Labor Statistics, the national unemployment rate for September 2023 was 3.8%, up 0.3 percentage points from December 2022. The unemployment rates in the Scranton - Wilkes-Barre – Hazleton (market area north) and the Allentown – Bethlehem – Easton (market area south) Metropolitan Statistical Areas (local) were in line with the national unemployment rate. The local unemployment rates at September 30, 2023 were 3.5% in market area north and 3.4% in market area south, respectively, a decrease of 1.0 percentage points and 0.3 percentage points from the 4.5% and 3.7%, respectively, at December 31, 2022. The rising rate environment and historically low inventory has reduced the amount of home purchases below 2022 levels. The median home values in the Scranton-Wilkes-Barre-Hazleton metro and Allentown-Bethlehem-Easton metro increased 4.5% and 5.2%, respectively, from a year ago, according to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets, and values are expected to grow 1.7% and 2.6% in the next year. In light of these expectations, we are uncertain if real estate values could continue to increase at these levels with the current elevated rate environment, however we will continue to monitor the economic climate in our region and scrutinize growth prospects with credit quality as a principal consideration.

For the nine months ended September 30, 2023, net income was $17.7 million, or $3.11 diluted earnings per share, compared to $22.9 million, or $4.03 diluted earnings per share, for the nine months ended September 30, 2022.

As of September 30, 2023 and September 30, 2022, tangible common book value per share (non-GAAP) was $25.37 and $22.24, respectively. See reconciliation on page 39. The increase in tangible book value was due primarily to the improvement in retained earnings. These non-GAAP measures should be reviewed in connection with the reconciliation of these non-GAAP ratios. See “Non-GAAP Financial Measures” located below within this management’s discussion and analysis.

Branch managers, relationship bankers, mortgage originators and our business service partners are all focused on developing a mutually profitable full banking relationship with our clients. We understand our markets, offer products and services along with financial advice that is appropriate for our community, clients and prospects. The Company continues to focus on the trusted financial advisor model by utilizing the team approach of experienced bankers that are fully engaged and dedicated towards maintaining and growing profitable relationships.

In addition to the challenging economic environment in which we compete, the regulation and oversight of our business has changed significantly in recent years. As described more fully in Part II, Item 1A, “Risk Factors” below, as well as Part I, Item 1A, “Risk Factors,” and in the “Supervisory and Regulation” section of management’s discussion and analysis of financial condition and results of operations in our 2022 Annual Report filed on Form 10-K, certain aspects of the Dodd-Frank Wall Street Reform Act (Dodd-Frank Act) continue to have a significant impact on us.

Non-GAAP Financial Measures

The following are non-GAAP financial measures which provide useful insight to the reader of the consolidated financial statements but should be supplemental to GAAP used to prepare the Company’s financial statements and should not be read in isolation or relied upon as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Company’s tax rate used to calculate the fully-taxable equivalent (FTE) adjustment was 21% at September 30, 2023 and 2022.

The following table reconciles the non-GAAP financial measures of FTE net interest income:

(dollars in thousands)

The efficiency ratio is non-interest expenses as a percentage of FTE net interest income plus non-interest income. The following table reconciles the non-GAAP financial measures of the efficiency ratio to GAAP:

(dollars in thousands)

The following table provides a reconciliation of the tangible common equity (non-GAAP) and the calculations of tangible book value per share and tangible common equity ratio:

(dollars in thousands)

The following table provides a reconciliation of pre-provision net revenue (PPNR) to average assets (non-GAAP):

(dollars in thousands)

40

General

The Company’s earnings depend primarily on net interest income. Net interest income is the difference between interest income and interest expense. Interest income is generated from yields earned on interest-earning assets, which consist principally of loans and investment securities. Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is determined by the Company’s interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Interest rate spread is significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in the marketplace.

The Company’s earnings are also affected by the level of its non-interest income and expenses and by the provisions for credit losses and income taxes. Non-interest income mainly consists of: service charges on the Company’s loan and deposit products; interchange fees; trust and asset management service fees; increases in the cash surrender value of the bank owned life insurance and from net gains or losses from sales of loans and securities. Non-interest expense consists of: compensation and related employee benefit costs; occupancy; equipment; data processing; advertising and marketing; FDIC insurance premiums; professional fees; loan collection; net other real estate owned (ORE) expenses; supplies and other operating overhead.

Net interest income, net interest rate margin, net interest rate spread and the efficiency ratio are presented in the MD&A on a fully-taxable equivalent (FTE) basis. The Company believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.

Comparison of the results of operations

three and nine months ended September 30, 2023 and 2022

Overview

For the third quarter of 2023, the Company generated net income of $5.3 million, or $0.93 per diluted share, compared to $7.7 million, or $1.36 per diluted share, for the third quarter of 2022. The $2.4 million, or 31%, decrease in net income for the comparative quarters was primarily the result of $3.9 million lower net interest income partially offset by a $0.6 million decrease in the provision for income taxes, $0.4 million increase in non-interest income, $0.3 million net benefit in the provision for credit losses on unfunded commitments and $0.3 million lower non-interest expenses. In the year-to-date comparison, net income decreased by $5.1 million to $17.7 million, or $3.11 per diluted share, from $22.8 million, or $4.03 per diluted share for the comparative period. The decline was primarily caused by a reduction of $6.8 million in net interest income along with an increase of $0.6 million in non-interest expenses. These increases were partially offset by a $1.3 million decrease in the provision for income taxes, $0.3 million reduction in provision for credit losses on loans and unfunded commitments and $0.6 million higher non-interest income year-over-year.

Return on average assets (ROA) was 0.88% and 1.27% for the third quarters of 2023 and 2022, respectively, and 0.99% and 1.27% for the nine months ended September 30, 2023 and 2022, respectively. During the same time periods, return on average shareholders’ equity (ROE) was 11.96% and 18.23%, respectively, and 13.64% and 17.01%, respectively. ROA decreased due to the decline in net income for the quarter-over-quarter and year-over-year comparisons. ROE decreased primarily due to the net income decreases over the same time periods. Pre-provision net revenue to average assets (non-GAAP) was 1.02% and 1.55% for the three months ended September 30, 2023 and 2022, respectively, and 1.19% and 1.57% for the nine months ended September 30, 2023, respectively. See reconciliation on page 39. The decreases were due to a decline in income before taxes quarter-over-quarter and year-over-year.

Net interest income and interest sensitive assets / liabilities

For the third quarter of 2023, net interest income decreased $3.9 million, or 21%, to $14.6 million from $18.5 million for the third quarter of 2022 due to interest expense growing faster than interest income. The $3.5 million growth in interest income was produced by the addition of $19.0 million in average interest-earning assets and the effect of a 58 basis point increase in FTE yields earned on those assets. The loan portfolio contributed the most to this growth by providing $4.2 million more in FTE interest income, which absorbed $0.5 million less from fair value purchase accounting adjustment accretion, due to $129.1 million more in average loans and a 69 basis point increase in the FTE yields earned thereon. In the investment portfolio, the average balance of total securities declined $60.1 million from security sales and paydowns on mortgage-backed securities which produced $0.4 million less in FTE interest income. On the liability side, total interest-bearing liabilities grew $30.6 million, on average, with a 177 basis point increase in rates paid thereon. The 171 basis point increase in rates paid on deposits resulted in $6.9 million more interest expense for the third quarter of 2023 compared to the 2022 like period. The Company also utilized $37.6 million more in average short-term borrowings during the third quarter of 2023 which added $0.4 million in interest expense.

Net interest income decreased $6.8 million, or 13%, from $53.9 million for the nine months ended September 30, 2022 to $47.1 million for the nine months ended September 30, 2023, due to $18.4 million higher interest expense partially offset by the $11.6 million increase in interest income. Total average interest-earning assets increased $28.0 million and FTE yields earned on these assets rose 64 basis points resulting in $11.8 million of growth in FTE interest income. In the loan portfolio, the Company experienced average balance growth of $138.1 million and an additional 71 basis point in FTE yields which had the effect of producing $12.9 million more FTE interest income, despite $1.2 million less in fees earned under the Paycheck Protection Program (PPP) and $0.7 million less from fair value purchase accounting accretion during the first nine months of 2023. The average balance of the investment portfolio declined $62.9 million which resulted in $1.0 million lower FTE interest income. On the liability side, total interest-bearing liabilities grew $29.4 million on average with a 150 basis point increase in rates paid on these interest-bearing liabilities. The 139 basis point increase in rates paid on interest-bearing deposits resulted in interest expense growth of $16.4 million. An additional $1.8 million in interest expense was incurred from the utilization of $50.2 million more in average short-term borrowings.

The FTE net interest rate spread decreased by 119 and 86 basis points and margin decreased by 69 and 42 basis points, respectively, for the three and nine months ended September 30, 2023 compared to the same 2022 periods. In the quarter-over-quarter and year-over-year comparisons, the spread and margin decreased due to the rise in rates paid on interest-bearing liabilities which increased faster than the yields earned on interest-earning assets. The overall 163 and 133 basis points cost of funds for the three and nine months ended September 30, 2023, which includes the impact of non-interest bearing deposits, increased 134 and 112 basis points compared to the same 2022 periods. The primary reason for the increase was the higher rates paid on deposits compared to the same 2022 periods due to the increases in market interest rates during the periods.

For the remainder of 2023, the Company is uncertain about the expected interest rate environment. Management is primarily reliant on the Federal Open Market Committee's statements and forecast. The Company’s net interest income performance has been reduced by assetyields being outpaced by higher cost of funds compressing net interest spread. The risk to net interest income improvement is rapid acceleration of deposit rates in the Company's market area. The FOMC increased the federal funds rate by 425 basis points during 2022 and another 100 basis points in 2023, which had a disproportional effect on rates paid on interest-bearing liabilities in 2023. On the asset side, the Prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans was also increased 425 basis points during 2022 and another 100 basis points through September 2023. Consensus economic forecasts are predicting no change in short-term rates throughout the rest of 2023. For the remainder of 2023 into early 2024, the Company currently maintains a loan pipeline which we expect will grow the loan portfolio which will be funded by borrowing capacity until such time deposit growth will be able to pay down these short-term borrowings. The focus is to manage net interest income through an elevated forecasted rate cycle by exercising disciplined and proactive loan pricing and managing deposit costs to maintain a reasonable spread, to the extent possible, in order to mitigate further margin compression.

Due to volatility in the levels of borrowings during October 2023 and the increasing expected dependency on borrowing capacity from experiencing deposit fluctuations while funding loan growth, the Company evaluated a liquidity strategy to deleverage the reliance on short-term borrowings. As a result of this evaluation, in November 2023, the Company sold certain available-for-sale securities with a carrying value of $35.6 million for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities. This loss will be reflected in and adversely affect the Company’s fourth quarter 2023 operating results. The $29.1 million in proceeds received were used to pay down short-term borrowings that replenished available borrowing capacity at that time.

Continued growth in the loan portfolios is expected to boost interest income, and when coupled with a proactive relationship approach to deposit cost setting strategies should help mitigate spread compression and contain the interest rate margin, preventing further reductions below acceptable levels.

The Company’s cost of interest-bearing liabilities was 2.17% and 1.79% for the three and nine months ended September 30, 2023, or 177 and 150 basis points higher than the cost for the same 2022 periods. For the month of October 2023, the cost of interest-bearing liabilities was 50 basis points higher than the first nine months of 2023 at 2.29% which shows the higher costs are expected to continue. The increase in interest paid on deposits contributed to the higher cost of interest-bearing liabilities supplemented by the short-term borrowings utilized during the first nine months of 2023. The FOMC is expected to hold the federal funds rate in the immediate future, but the Company may continue to experience pressure to further increase rates paid on deposits. To help mitigate the impact of the imminent change to the economic landscape, the Company has successfully developed and will continue to strengthen its association with existing customers, develop new business relationships and generate new loan volumes. Strategically deploying relationship deposits into interest earning-assets is an effective margin-preserving strategy that the Company expects to continue to pursue and expand to help stabilize net interest margin.

The Company’s Asset Liability Management (ALM) team meets regularly to discuss among other things, interest rate risk and when deemed necessary adjusts interest rates. ALM is actively addressing the Company's sensitivity to a changing rate environment to ensure interest rate risks are contained within acceptable levels. ALM also discusses revenue enhancing strategies to help combat the potential for a decline in net interest income. The Company’s marketing department, together with ALM, and service-driven branch and relationship managers, continue to develop prudent strategies that will grow the loan portfolio and accumulate relationship driven deposits at costs lower than borrowing costs to improve net interest income performance.

The table that follows sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and rates for the periods indicated. Within the table, interest income was FTE adjusted, using the corporate federal tax rate of 21% for September 30, 2023 and 2022 to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. See “Non-GAAP Financial Measures” within this management’s discussion and analysis for the FTE adjustments. This treatment allows a uniform comparison among yields on interest-earning assets. Loans include loans held-for-sale (HFS) and non-accrual loans but exclude the allowance for credit losses. Home equity lines of credit (HELOC) are included in the residential real estate category since they are secured by real estate. Net deferred loan (cost amortization)/fee accretion of ($0.3 million) and ($0.2 million) during the third quarters of 2023 and 2022, respectively, and ($0.7 million) and $0.4 million for the nine months ended September 30, 2023 and 2022, respectively, are included in interest income from loans. Merchants Bank of Bangor and Landmark Community bank loan fair value purchase accounting adjustments of $0.5 million and $0.9 million are included in interest income from loans and $7 thousand and $13 thousand reduced interest expense on deposits and borrowings for the three months ended September 30, 2023 and 2022. Merchants Bank of Bangor and Landmark Community Bank loan fair value purchase accounting adjustments of $2.0 million and $2.8 million are included in interest income from loans and $27 thousand and $149 thousand reduced interest expense on deposits and borrowings for the nine months ended September 30, 2023 and 2022. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Residual values for direct finance leases are included in the average balances for consumer loans. Net interest margin is calculated by dividing net interest income-FTE by total average interest-earning assets. Cost of funds includes the effect of average non-interest bearing deposits as a funding source:

(dollars in thousands)

43

(dollars in thousands)

44

Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in volumes of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change. The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate. Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis:

(dollars in thousands)

Provision for credit losses

The provision for credit losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for credit losses to a level that represents management’s best estimate of expected credit losses in the Company’s loan portfolio. Loans determined to be uncollectible are charged off against the allowance. The required amount of the provision for credit losses, based upon the adequate level of the allowance, is subject to the ongoing analysis of the loan portfolio. The Company’s Special Assets Committee meets periodically to review problem loans. The committee is comprised of management, including credit administration officers, loan officers, loan workout officers and collection personnel.

Management continuously reviews the risks inherent in the loan portfolio. The determination of the amounts of the allowance for credit losses and the provision for credit losses is based on management’s current judgments about the credit quality of the Company’s financial assets and known and expected relevant internal and external factors that significantly affect collectability such as historical loss information. current conditions, and reasonable and supportable forecasts, including significant qualitative factors.

On January 1, 2023, the Company adopted Accounting Standard Update 2016-13, Financial Instruments - Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments (CECL) and recorded an increase of $0.7 million in the allowance for credit losses on loans and an increase of $1.1 million in the allowance for credit losses on unfunded loan commitments. Results for reporting periods beginning after January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP.

For the three months ended September 30, 2023, the provision for credit losses on loans was $0.5 million due to growth and change in composition of the loan portfolio along with slower prepayment speeds and curtailment rates, which are key assumptions used in the estimate. The provision for credit losses on unfunded loan commitments was a net benefit of $0.3 million due to a reduction in unfunded commitments during the quarter along with lower loss rates related to an improved economic forecast and updated probability of default models used in the estimate.

For the nine months ended September 30, 2023, the provision for credit losses on loans was $1.4 million due to the growth and change in composition of the loan portfolio along with slower prepayment speeds and curtailment rates, which are key assumptions used in the estimate. The provision for credit losses on unfunded loan commitments was a net benefit of $0.1 million due to a reduction in unfunded commitments during the quarter along with lower loss rates related to an improved economic forecast and updated probability of default models used in the estimate.

Due to the Company’s adoption of ASU 2016-13 on January 1, 2023, comparability of the prior period provision is not considered relevant.

The provision for credit losses derives from the reserve required from the allowance for credit losses calculation. The Company continued provisioning for the three and nine ended September 30, 2023 to maintain an allowance level that management deemed adequate.

For a discussion on the allowance for credit losses, see “Allowance for credit losses,” located in the comparison of financial condition section of management’s discussion and analysis contained herein.

Other income

For the third quarter of 2023, non-interest income amounted to $4.3 million, an increase of $0.4 million, or 11%, compared to $3.9 million recorded for the same 2022 period. The increase was due to $0.2 million more trust fees, $0.1 million additional service charges on deposits and $0.1 million higher gains on loan sales.

Non-interest income totaled $13.3 million for the nine months ended September 30, 2023, an increase of $0.6 million, or 5%, from the $12.7 million recorded for the nine months ended September 30, 2022. The increase was primarily due to $0.4 million higher deposit service charges, $0.3 million higher trust fiduciary fees, $0.3 million in recoveries from acquired charged-off loans, $0.2 million in additional commercial loans fees from interest rate hedges, $0.2 million more debit card interchange fees and $0.1 million recorded for a death claim on BOLI. Partially offsetting these increases were $0.7 million lower gains on loan sales and $0.2 million less loan service charges due to scaled back demand for mortgages and less service fees recorded on commercial loans.

Operating expenses

For the quarter ended September 30, 2023, total non-interest expenses were $12.8 million, a decrease of $0.2 million, or 2%, compared to $13.0 million for the same 2022 quarter. Salary and employee benefits declined $0.5 million, or 8%, to $6.3 million for the third quarter of 2023 from $6.8 million for the third quarter of 2022. The decrease was primarily due to lower employee incentives and insurance expenses. Advertising and marketing expenses decreased $0.3 million due to a donation made to Fidelity D & D Charitable Foundation during the third quarter of 2022. Partially offsetting these decreases, premises and equipment expenses increased $0.4 million, or 23%, primarily due to higher equipment maintenance and rental expenses and depreciation from investments in new technology and infrastructure. The FDIC assessment expense increased $0.1 million due to the higher assessment rate for 2023. Other increases in non-interest expenses are as follows: $0.1 million in professional services and $0.1 million in data processing and communications expenses.

For the nine months ended September 30, 2023, non-interest expenses increased $0.6 million, or 1%, compared to the nine months ended September 30, 2022, from $38.5 million to $39.1 million. Premises and equipment expenses increased $1.0 million, or 17%, due primarily to higher expenses for equipment maintenance and rentals along with higher depreciation expense. Professional service expenses grew $0.6 million due to additional consulting, legal and audit expenses. Fraud losses increased $0.3 million due to more counterfeit checks. Partially offsetting these increases, salaries and employee benefit expenses declined $1.3 million, or 6%. The decrease was primarily due to less incentive expense. PA shares tax expense was also $0.5 million lower from declines in shareholders' equity.

The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, were 1.43% and 1.44% for the nine months ended September 30, 2023 and 2022. The expense ratio was relatively unchanged because the increase in non-interest expenses was offset by a similar increase in non-interest income. The efficiency ratio (non-GAAP) increased from 56.01% at September 30, 2022 to 62.33% at September 30, 2023 due to non-interest expenses increasing as net interest income declined. For more information on the calculation of the efficiency ratio, see “Non-GAAP Financial Measures” located within this management’s discussion and analysis.

Provision for income taxes

The provision for income taxes decreased $1.3 million for the nine months ended September 30, 2023 compared to the same 2022 period due to tax credits from plug-in hybrid electric vehicles and lower income before taxes. The Company's effective tax rate was 11.9% at September 30, 2023 compared to 14.0% at September 30, 2022. The difference between the effective rate and the enacted statutory corporate rate of 21% is due mostly to the effect of tax-exempt income in relation to the level of pre-tax income. The decrease in the effective tax rate was primarily due to lower pre-tax income and the aforementioned tax credits. Due to challenges relating to current market conditions, the Company may not have the ability to make a reliable estimate of all or part of its ordinary income which could cause volatility in the effective tax rate. If the federal corporate tax rate is increased, the Company’s net deferred tax liabilities and deferred tax assets will be re-valued upon adoption of the new tax rate. A federal tax rate increase will increase net deferred tax assets with a corresponding decrease to provision for income taxes.

Comparison of financial condition at

September 30, 2023 and December 31, 2022

Overview

Consolidated assets increased $98.4 million to $2.5 billion as of September 30, 2023 from $2.4 billion as of December 31, 2022. The increase in assets occurred primarily in the loan portfolio and cash and cash equivalents partially offset by a decline in the investment portfolio. The reduction in the investment portfolio was primarily caused by the sale of securities in order to pay down short-term borrowings. Loan portfolio increases were funded by growth in short-term borrowings.

Funds Deployed:

Investment securities

At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (AFS) or held-to-maturity (HTM). To date, management has not purchased any securities for trading purposes. Some of the securities the Company purchases are classified as AFS even though there is no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions. Debt securities AFS are carried at fair value on the consolidated balance sheets with unrealized gains and losses, net of deferred income taxes, reported separately within shareholders’ equity as a component of accumulated other comprehensive income (AOCI). Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity. For the nine months ended September 30, 2023, AOCI declined by $11.7 million due to the change in fair value of the Company's investment securities.

Effective April 1, 2022, the Company transferred agency and municipal bonds with a book value of $245.5 million from AFS to HTM in order to apply the accounting for securities HTM to mitigate the effect AFS accounting has on the balance sheet. The bonds that were transferred had the highest price volatility and consisted of fixed-rate securities representing 70% of the agency portfolio, 70% of the taxable municipal portfolio each laddered out on the short to intermediate part of the yield curve and 35% of the tax-exempt municipal portfolio on the long end of the yield curve were identified as the best candidates given the Company’s ability to hold those bonds to maturity. The market value of the securities on the date of the transfer was $221.7 million, after netting unrealized losses totaling $18.9 million. The $18.9 million, net of deferred taxes, will be accreted into other comprehensive income over the life of the bonds. As of September 30, 2023, the carrying value of held-to-maturity securities was $223.9 million, net of $16.2 million in remaining transferred after-tax unrealized losses.

The Company utilized a fair value hedge to designate and swap a portion of the fixed rate AFS portfolio. The Company has an approved Derivative Policy that requires Board pre-approval on such balance sheet hedging activates as well as ongoing reporting to its ALCO Committee. The Board has approved up to $200 million in notional amount of pay-fixed interest rate swap and the Company has executed on $100 million to date.

During September 2023, the Company entered into a $100 million interest rate swap with a third-party financial institution to limit the risk to the investment portfolio of rising interest rates. The interest rate swap was designated as a fair value hedge and utilized a pay fixed interest rate swap to hedge the change in fair value attributable to the movement in the Secured Overnight Financing Rate ("SOFR"). The Company designated $50 million of the swap's notional balance as a hedge against the closed portfolio of 20-year mortgage-backed securities and $50 million as a hedge against the closed portfolio of tax-free municipal bonds. As of September 30, 2023, the Company recorded the fair value of the swap of $104 thousand in accrued interest payable and other liabilities on the consolidated balance sheet offset by a $104 thousand increase to the carrying value of designated investment securities.

As of September 30, 2023, the carrying value of investment securities amounted to $576.7 million, or 23% of total assets, compared to $643.6 million, or 27% of total assets, as of December 31, 2022. On September 30, 2023, 32% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential or mortgage-backed securities) that amortize and provide monthly cash flow that the Company can use for reinvestment, loan demand, unexpected deposit outflow, facility expansion or operations. The mortgage-backed securities portfolio includes only pass-through bonds issued by Fannie Mae, Freddie Mac and the Government National Mortgage Association (GNMA).

The Company’s municipal (obligations of states and political subdivisions) portfolio is comprised of tax-free municipal bonds with a book value of $238.0 million and taxable municipal bonds with a book value of $92.1 million. The overall credit ratings of these municipal bonds was as follows: 38% AAA, 61% AA, and 1% A. For municipal securities HTM, the Company utilized a third-party model to analyze whether a credit loss reserve is needed for these bonds. The amount of the credit loss reserve calculated was immaterial because of the underlying strong credit quality of the municipal portfolio.

During the first nine months of 2023, the carrying value of total investments decreased $66.9 million, or 10%. During January 2023 with the 10-year U.S. Treasury yield declining, $31.2 million of securities were able to be sold yielding 3.62% (FTE yield of 4.33%) at a breakeven level. These proceeds were used to pay down FHLB overnight borrowings costing 4.80% at that time. Additionally, principal reductions during the first nine months of 2023 totaled $19.4 million and there was a decline in the unrealized loss position of $14.8 million in the AFS portfolio. The Company attempts to maintain a well-diversified and proportionate investment portfolio that is structured to complement the strategic direction of the Company. Its growth typically supplements the lending activities but also considers the current and forecasted economic conditions, the Company’s liquidity needs and interest rate risk profile, to the extent possible.

A comparison of investment securities at September 30, 2023 and December 31, 2022 is as follows:

(dollars in thousands)

The investment securities portfolio contained no private label mortgage-backed securities, collateralized mortgage obligations, collateralized debt obligations, or trust preferred securities. The portfolio had no adjustable-rate instruments as of September 30, 2023 and December 31, 2022.

Investment securities were comprised of AFS and HTM securities as of September 30, 2023 and December 31, 2022. The AFS securities were recorded with a net unrealized loss of $82.7 million and a net unrealized loss of $67.9 million as of September 30, 2023 and December 31, 2022, respectively. Of the $14.8 million net decline; $7.7 million was attributable to municipal securities; $6.9 million was attributable to mortgage-backed securities and $0.2 million was attributable to agency securities. During the second quarter of 2022, securities with net unrealized losses totaling $23.9 million were transferred to HTM and for the nine months ended September 30, 2023 $1.7 million was accreted against other comprehensive income. The direction and magnitude of the change in value of the Company’s investment portfolio is attributable to the direction and magnitude of the change in interest rates along the treasury yield curve. Generally, the values of debt securities move in the opposite direction of the changes in interest rates. As interest rates along the treasury yield curve rise, especially at the intermediate and long end, the values of debt securities tend to decline. Whether or not the value of the Company’s investment portfolio will change above or below its amortized cost will be largely dependent on the direction and magnitude of interest rate movements and the duration of the debt securities within the Company’s investment portfolio. Management does not consider the reduction in value attributable to changes in credit quality. Correspondingly, when interest rates decline, the market values of the Company’s debt securities portfolio could be subject to market value increases.

As of September 30, 2023, the Company had $307.1 million in public deposits, or 14% of total deposits. As of September 30, 2023, trust deposits were $102.7 million, or 5% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on public and trust deposits or otherwise obtain a FHLB letter of credit or FDIC insurance for these customers. As of September 30, 2023, the balance of pledged securities required for public and trust deposits was $415.9 million, or 72% of total securities.

Quarterly, management performs a review of the investment portfolio to determine the causes of declines in the fair value of each security. The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio. Inputs provided by the third parties are reviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed to determine whether credit losses on debt securities exist. Considerations such as the Company’s intent and ability to hold the securities until or sell prior to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, the receipt of amounts contractually due and whether or not there is an active market for the securities, for example, are applied, along with an analysis of the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security has credit losses. If a decline in value is deemed to be credit losses, a contra-asset is recorded on both HTM and AFS securities, limited by the amount that the fair value is less than the amortized cost basis. During the quarter ended September 30, 2023, the Company did not incur any credit losses on debit securities from its investment securities portfolio.

Due to volatility in the levels of borrowings during October 2023 and the increasing expected dependency on borrowing capacity from experiencing deposit fluctuations while funding loan growth, the Company evaluated a liquidity strategy to deleverage the reliance on short-term borrowings. As a result of this evaluation, in November 2023, the Company sold longer term available-for-sale general market tax-free municipal securities with a carrying value of $35.6 million as part of a liquidity and net interest margin enhancement strategy for a $6.5 million loss recognized in gain (loss) on sale of available-for-sale debt securities. This loss will be reflected in and adversely affect the Company’s fourth quarter 2023 operating results. The $29.1 million in proceeds received were used to retire short-term borrowings with a cost of approximately 5.50%. Management made the decision to sell these particular securities because they had a weighted average yield of 1.28% with a 13.5 year weighted average maturity. While the Company has ample funding sources available, management felt it prudent to create additional capacity for the borrowings over the near term should the banking industry again experience funding pressures as it did in March of this year. In addition, since the municipal securities sold were purchased in a much lower rate environment, there is an immediate improvement in net interest margin (NIM) of over 5 bps as a result of paying down the borrowing with the sale proceeds. The sale removes a 422 basis point negative spread and will incrementally improve net interest income, earnings per share and NIM every year starting in 2024. The cost savings from paying down the advances with the sale of low yielding bonds will also allow the pre-tax loss of $6.5 million realized on the sale to be fully recouped prior to the term of the bonds sold. The effect of the security sales is expected to reduce regulatory ratios by 25-30 basis points for 2023.

Restricted investments in bank stock

Investment in Federal Home Loan Bank (FHLB) stock is required for membership in the organization and is carried at cost since there is no market value available. The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB of Pittsburgh. Excess stock is repurchased from the Company at par if the amount of borrowings decline to a predetermined level. In addition, the Company earns a return or dividend based on the amount invested. Atlantic Community Bankers Bank (ACBB) stock totaled $82 thousand as of September 30, 2023 and December 31, 2022. The balance in FHLB stock was $3.7 million and $5.2 million as of September 30, 2023 and December 31, 2022, respectively. The dividends received from the FHLB totaled $229 thousand and $109 thousand for the nine months ended September 30, 2023 and 2022, respectively.

Loans held-for-sale (HFS)

Upon origination, most residential mortgages and certain Small Business Administration (SBA) guaranteed loans may be classified as held-for-sale (HFS). In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In declining interest rate environments, the Company would be exposed to prepayment risk as rates on fixed-rate loans decrease, and customers look to refinance loans. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as HFS. Occasionally, residential mortgage and/or business loans may be transferred from the loan portfolio to HFS. The carrying value of loans HFS is based on the lower of cost or estimated fair value. If the fair values of these loans decline below their original cost, the difference is written down and charged to current earnings. Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.

As of September 30, 2023 and December 31, 2022, loans HFS consisted of residential mortgages with carrying amounts of $2.3 million and $1.6 million, respectively, which approximated their fair values. During the nine months ended September 30, 2023, residential mortgage loans with principal balances of $37.9 million were sold into the secondary market and the Company recognized net gains of $0.7 million, compared to $68.0 million and $1.4 million, respectively, during the nine months ended September 30, 2022.

The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market. MSRs are retained so that the Company can foster personal relationships. At September 30, 2023 and December 31, 2022, the servicing portfolio balance of sold residential mortgage loans was $473.0 million and $465.7 million, respectively, with mortgage servicing rights of $1.5 million and $1.6 million for the same periods, respectively.

Loans and leases

As of September 30, 2023, the Company had gross loans and leases totaling over $1.6 billion, an increase of $81.2 million, or 5%, compared to almost $1.6 billion at December 31, 2022.

During the nine months ended September 30, 2023, the growth in the portfolio was primarily attributed to a $31.8 million increase in the commercial portfolio and a $48.0 million increase in the residential portfolio, the result of a higher percentage of adjustable rate mortgages recorded as held-for-investment during this period.

As management continues to identify ways to optimize the Company’s balance sheet, the focus is to lend in areas that provide better risk-adjusted returns and improved opportunities to deepen relationships with our customers. This could result in a change in the composition of the loan portfolio in future periods.

The composition of the loan portfolio at September 30, 2023 and December 31, 2022 is summarized as follows:

(dollars in thousands)

Commercial & industrial (C&I) and commercial real estate (CRE)

As of September 30, 2023, the commercial portfolio increased by $31.8 million, or 4%, to $872.9 million compared to the December 31, 2022 balance of $841.1 million due to growth of $13.1 million in total commercial and industrial loans and $18.7 million in growth in commercial real estate loans.

Commercial and industrial loans are generally secured with short-term assets; however, in many cases, additional collateral such as real estate is provided as additional security for the loan. Loan-to-value maximum values have been established by the Company and are specific to the type of collateral. Collateral values may be determined using invoices, inventory reports, accounts receivable aging reports, independent collateral appraisals, etc.

For the nine months ended September 30, 2023, commercial and industrial loans increased $4.1 million, or 3%, from $141.1 million at December 31, 2022 to $145.2 million at September 30, 2023, which was the result of originations and line advances outpacing scheduled payments and line pay-downs/offs.

Municipal loans are secured by the full faith and credit of respective local government units located in the Commonwealth of Pennsylvania authorized in accordance with the Local Government Unit Debt Act. These loans have a long history of performance within contractual terms with no defaults noted.

For the nine months ended September 30, 2023, municipal loans increased $9.1 million, or 12%, from $73.0 million at December 31, 2022 to $82.1 million at September 30, 2023, which was attributed to $6.6 million in originations during the year along with advances on loan commitments.

Commercial real estate loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions and the complexities involved in valuing the underlying collateral whose values tend to move inversely with interest rates. These loans are generally secured with mortgages, or commercial real estate mortgages (CREM) against the subject property. In underwriting commercial real estate construction loans, the Company performs a robust analysis of the financial condition of the borrower, the borrower’s credit history, and the reliability and predictability of the cash flow generated by the project using feasibility studies, market data, etc. Appraisals on properties securing commercial real estate loans originated by the Company are performed by independent appraisers consistent with Uniform Standards of Professional Appraisal Practice (USPAP) standards and compliant with Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).

Non-owner occupied CRE loans are commercial loans not occupied by their owners and thus rely on income from third parties, including multi-family residential tenants and commercial tenants representing various industries. Underwriting on non-owner occupied CRE loans evaluates cash flow derived from the respective tenants and the industries they occupy. As such, management considers non-owner occupied CRE loans as having a higher risk profile than owner occupied CRE loans. In keeping with its risk appetite and relationship management strategy, the Company avoids speculative commercial office space and prefers loans to projects that have sufficient equity, or loan to value, and have either S&P rated tenants with long term leases, loans structured with personal guarantees of owners whose personal financial strength provides meaningful cash flow support to supplement rental income volatility, residential projects with stable rents in desirable locations, or projects with sufficient diversity and industries proven to provide lower risk over the long term.

For the nine months ended September 30, 2023, non-owner occupied commercial real estate decreased $7.0 million, or 2%, from $318.3 million at December 31, 2022 to $311.3 million at September 30, 2023, which was attributed to scheduled monthly payments.

Owner occupied commercial real estate loans are occupied by their owners which rely on income generated from the respective owners’ businesses. Therefore, underwriting on owner occupied CRE loans emphasizes the owner’s cash flow and financial conditions while the real estate typically represents the owners' primary business location. As such, management considers owner occupied CRE loans as having a lower risk profile than non-owner occupied CRE loans.

For the nine months ended September 30, 2023, owner occupied commercial real estate increased $6.9 million, or 2%, from $284.7 million at December 31, 2022 to $291.6 million at September 30, 2023, which was attributed to a $10 million CRE loan originated during the second quarter.

Construction lending consists of commercial and residential site development loans, as well as commercial building construction and residential housing construction loans. Management prefers lending to well-established developers with a proven track record and strong business and guaranteed with owners’ personal financial conditions.

For the nine months ended September 30, 2023, commercial construction increased $18.8 million, or 78%, from $24.0 million at December 31, 2022 to $42.8 million at September 30, 2023, which was primarily attributable to $12.4 million in fundings on four large construction loans originated prior to December 31, 2022 and $7.6 million commercial construction loans originated during 2023.

Consumer

The consumer loan portfolio consisted of home equity installment, home equity line of credit, non-recourse auto loans, recourse auto loans, direct finance leases and other consumer loans.

As of September 30, 2023, the consumer loan portfolio increased by $1.5 million, or 1%, to $285.9 million compared to the December 31, 2022 balance of $284.4 million, primarily due to growth in the non-recourse auto portfolio from continued demand for higher priced automobiles and new dealer relationships.

Residential

As of September 30, 2023, the residential loan portfolio increased by $47.9 million, or 11%, to $488.3 million compared to the December 31, 2022 balance of $440.4 million. The increase was due to a shift from mortgage loans sold to loans held-for-investment due to increased jumbo loans, the pricing of loans in the secondary market and $28.9 million more adjustable-rate mortgages which are not being sold in the secondary market.

The residential loan portfolio consisted primarily of held-for-investment residential loans for primary residences, including approximately $372 million in fixed-rate and $73 million in adjustable-rate mortgages as of September 30, 2023. Management expects the sudden historic rise in interest rates to impact demand for residential mortgages for the remainder of 2023.

The Company considers its portfolio segmentation, including the real estate secured portfolio, to be normal and reasonably diversified. The banking industry is affected by general economic conditions including, among other things, the effects of real estate values. The Company ensures that its mortgage lending adheres to standards of secondary market compliance. Furthermore, the Company’s credit function strives to mitigate the negative impact of economic conditions by maintaining strict underwriting principles for all loan types.

Allowance for credit losses

Management continually evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for credit losses (ACL) on a quarterly basis. The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio. When estimating the net amount expected to be collected, Management considers the effects of past events, current conditions, and reasonable and supportable forecasts of the collectability of the Company’s financial assets. Those estimates may be susceptible to significant change. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.

The methodology to analyze the adequacy of the ACL is based on seven primary components:

• Data: The quality of the Company’s data is critically important as a foundation on which the ACL estimate is generated. For its estimate, the Company uses both internal and external data with a preference toward internal data where possible. Data is complete, accurate, and relevant, and subjected to appropriate governance and controls.
• Segmentation: Financial assets are segmented based on similar risk characteristics.
• Contractual term of financial assets: The contractual term of financial assets is a significant driver of ACL estimates. Financial assets or pools of financial assets with shorter contractual maturities typically result in a lower reserve than those with longer contractual maturities. As the average life of a financial asset or pool of assets increases, there generally is a corresponding increase to the ACL estimate because the likelihood of default is considered over a longer time frame. As such, pool-based assumptions for a pool’s contractual term (i.e., average life) are based on the contractual maturity of the financial assets within the pool and adjusted in accordance with GAAP, if appropriate.
• Credit loss measurement method: Multiple measurement methods for estimating ACLs are allowable per ASC Topic 326. The Company applies different estimation methods to different groups of financial assets. The discounted cash flow method is used for the commercial & industrial, commercial real estate non-owner occupied, commercial real estate owner occupied, commercial construction, home equity installment loan, home equity line of credit, residential real estate, and residential construction pools. The weighted average remaining maturity (WARM) method is used for the municipal, non-recourse auto, recourse auto, direct finance lease, and consumer other pools.
• Reasonable and supportable forecasts: ASC Topic 326 requires management to consider reasonable and supportable forecasts that affect expected collectability of financial assets. As such, the Company’s forecasts incorporate anticipated changes in the economic environment that may affect credit loss estimates over a time horizon when management can reasonably support and document expectations. Forward-looking information may reflect positive or negative expectations relative to the current environment. As of the reporting date, management is using the median Federal Open Market Committee (FOMC) National Gross Domestic Product (GDP) and unemployment rate forecasts as well as the Federal Housing Finance Agency (FHFA) House Price Index (HPI) for its reasonable and supportable forecasts. The Company currently uses a 12-month (4 quarter) reasonable and supportable forecast period.
• Reversion period: ASC Topic 326 does not require management to estimate a reasonable and supportable forecast for the entire contractual life of financial assets. Management may apply reversion techniques for the contractual life remaining after considering the reasonable and supportable forecast period, which allows management to apply a historical loss rate to latter periods of the financial asset’s life. The Company currently uses a 12 month (4 quarter) straight-line reversion period.
• Qualitative factor adjustments: The Company’s ACL estimate considers all significant factors relevant to the expected collectability of its financial assets as of the reporting date; Qualitative factors reflect the impact of conditions not captured elsewhere, such as the historical loss data or within the economic forecast. The qualitative considerations can be captured directly within measurement models or as additional components in the overall ACL methodologies. Currently, the Company uses the following qualitative factors:
• levels of and trends in delinquencies and non-accrual loans;
• levels of and trends in charge-offs and recoveries;
• trends in volume and terms of loans;
• changes in risk selection and underwriting standards;
• changes in lending policies and legal and regulatory requirements;
• experience, ability and depth of lending management;
• national and local economic trends and conditions;
• changes in credit concentrations; and
• changes in underlying collateral.

A key control related to the allowance is the Company’s Special Assets Committee. This committee meets quarterly, and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount, if applicable, based on current accounting guidance. The Special Assets Committee’s focus is on ensuring the pertinent facts are considered regarding not only loans considered for specific reserves, but also the collectability of loans that may be past due in payment. The assessment process also includes the review of all loans on a non-accruing basis as well as a review of certain loans to which the lenders or the Company’s Credit Administration function have assigned a criticized or classified risk rating.

The following tables set forth the activity in the allowance for credit losses and certain key ratios for the period indicated:

(dollars in thousands)

For the nine months ended September 30, 2023, the allowance increased $1.6 million, or 9%, to $18.7 million from $17.1 million at December 31, 2022. The increase in the allowance was based on a $0.7 million adjustment related to the adoption of CECL on January 1, 2023 including a $0.1 million initial allowance on Purchase Credit Deteriorated (PCD) loans related to the reclassification of Purchase Credit Impaired (PCI) loans to PCD along with provisioning of $1.4 million partially offset by net charge-offs of $0.5 million.

The allowance for credit losses as a percentage of total loans increased to 1.14% as of September 30, 2023 compared to 1.10% at December 31, 2022 as the increase in the allowance (9%) outpaced the growth in the loan portfolio (5%).

Management believes that the current balance in the allowance for credit losses is sufficient to meet the identified potential credit quality issues that may arise and other issues unidentified but inherent to the portfolio. Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more.

Although key loss driver assumptions used in the ACL estimate remained largely stable from the day one estimate to the estimate as of September 30, 2023, the ACL estimate increased based on growth in the loan and lease portfolio and changes in the composition of the portfolio along with slower prepayment and curtailment rates. Key loss driver assumptions included the median Federal Open Market Committee (FOMC) National Gross Domestic Product (GDP) and unemployment rate forecasts, the Federal Housing Finance Agency (FHFA) House Price Index (HPI), prepayment and curtailment rates, and estimated remaining loan lives.

Qualitative factors for the ACL estimate as of September 30, 2023 were largely unchanged compared to the day one estimate as an increase related to higher delinquency in the HELOC portfolio during the second quarter was offset by a reduction related to improvement in the experience, depth, and ability of lending management. average risk rating in the commercial portfolio during the first quarter.

The allocation of net charge-offs among major categories of loans are as follows for the periods indicated:

(dollars in thousands)

For the nine months ended September 30, 2023, net charge-offs against the allowance totaled $516 thousand compared with net charge-offs of $420 thousand for the nine months ended September 30, 2022, representing a $96 thousand, or 23%, increase due to an increase in commercial real estate and consumer net charge-offs. Net charge-offs were unchanged as a percentage of the total loan portfolio at 0.04% for the nine months ended September 30, 2023 compared to 0.04% for the nine months ended September 30, 2022.

For a discussion on the provision for credit losses, see the “Provision for credit losses,” located in the results of operations section of management’s discussion and analysis contained herein.

The allowance for credit losses can generally absorb losses throughout the loan portfolio. However, in some instances an allocation is made for specific loans or groups of loans. Allocation of the allowance for credit losses for different categories of loans is based on the methodology used by the Company, as previously explained. The changes in the allocations from period-to-period are based upon quarter-end reviews of the loan portfolio.

Allocation of the allowance among major categories of loans for the periods indicated, as well as the percentage of loans in each category to total loans, is summarized in the following table. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends. When present, the portion of the allowance designated as unallocated is within the Company’s guidelines:

(dollars in thousands)

As of September 30, 2023, the commercial loan portfolio, consisting of CRE and C&I loans, comprised 57% of the total allowance for credit losses compared with 59% on December 31, 2022. The commercial loan allowance allocation decreased based on the adoption of CECL and changes in how reserves are estimated compared to the previous incurred loss methodology.

As of September 30, 2023, the consumer loan portfolio comprised 11% of the total allowance for credit losses compared with 17% on December 31, 2022. The consumer loan allowance allocation decreased based on the adoption of CECL and changes in how reserves are estimated compared to the previous incurred loss methodology.

As of September 30, 2023, the residential loan portfolio comprised 32% of the total allowance for credit losses compared with 24% on December 31, 2022. The residential loan allowance allocation increased based on the adoption of CECL and changes in how reserves are estimated compared to the previous incurred loss methodology.

As of September 30, 2023, the unallocated reserve, representing the portion of the allowance not specifically identified with a loan or groups of loans, was less than 1% of the total allowance for credit losses, unchanged from December 31, 2022.

Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, other real estate owned (ORE) and repossessed assets. Based on the Company’s adoption of ASU 2022-02, Financial Instruments-Credit Losses (Topic 326) Troubled Debt Restructurings and Vintage Disclosures, the recognition and measurement guidance related to troubled debt restructurings (TDR) has been eliminated. As such, TDRs were removed from non-performing assets at September 30, 2023, December 31, 2022, and September 30, 2022 in the following table to adhere to this standard and provide better comparability.

The following table sets forth non-performing assets data as of the period indicated:

(dollars in thousands)

Management continually monitors the loan portfolio to identify loans that are either delinquent or are otherwise deemed by management unable to repay in accordance with contractual terms. Generally, loans of all types are placed on non-accrual status if a loan of any type is past due 90 or more days or if collection of principal and interest is in doubt. Further, unsecured consumer loans are charged-off when the principal and/or interest is 90 days or more past due. Uncollected interest income accrued on all loans placed on non-accrual is reversed and charged to interest income.

Non-performing assets represented 0.14% of total assets at September 30, 2023 compared with 0.12% at December 31, 2022. The increase resulted from a $0.6 million, or 23%, increase in non-performing assets which outpaced the growth in total assets (4%) during this period. Non-performing assets increased due to a $0.2 million increase in loans past due 90 days or more and accruing along with the recognition of $1.5 million in Purchase Credit Deteriorated (PCD) loans, now classified as non-accrual loans, consistent with the changes in financial reporting under ASC Topic 326 (CECL). This was partially offset by a $1.0 million decrease in non-PCD non-accrual loans as well as a $0.1 million decrease in other real estate owned.

At September 30, 2023, there were a total of 31 non-accrual loans to 26 unrelated borrowers with balances that ranged from less than $1 thousand to $1.3 million, or $3.0 million in the aggregate. At December 31, 2022, there were a total of 39 non-accrual loans to 29 unrelated borrowers with balances that ranged from less than $1 thousand to $0.6 million, or $2.5 million in the aggregate.

Loans past due 90 days or more accruing totaled $275 thousand, which was comprised of one direct finance lease for $15 thousand, one indirect recourse auto loan for $12 thousand, and one residential real estate loan for $248 thousand as of September 30, 2023 compared to one direct finance lease and one non-recourse auto loan totaling $33 thousand as of December 31, 2022. All loans were well secured and in the process of collection.

The Company seeks payments from all past due customers through an aggressive customer communication process. Unless well-secured and in the process of collection, past due loans will be placed on non-accrual at the 90-day point when it is deemed that a customer is non-responsive and uncooperative to collection efforts.

The composition of non-performing loans as of September 30, 2023 is as follows:

(dollars in thousands)

*Net of unearned lease revenue of $2.0 million.

Payments received from non-accrual loans are recognized on a cost recovery method. Payments are first applied to the outstanding principal balance, then to the recovery of any charged-off loan amounts. Any excess is treated as a recovery of interest income. If the non-accrual loans that were outstanding as of September 30, 2023 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $228 thousand.

Foreclosedassets held-for-sale

From December 31, 2022 to September 30, 2023, foreclosed assets held-for-sale (ORE) declined from $168 thousand to $87 thousand, an $81 thousand decrease, which was attributed to one ORE property being transferred to non-accrual due to administrative error during the first quarter. One property totaling $86 thousand was added to ORE during 2023.

The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale:

(dollars in thousands)

As of September 30, 2023, ORE consisted of two properties securing loans to two unrelated borrowers totaling $87 thousand. One property ($86 thousand) was added in 2023 and one property ($1 thousand) was added in 2017. Both properties are listed for sale.

As of September 30, 2023 and December 31, 2022, the Company had no other repossessed assets held-for-sale.

Cash surrender value of bank owned life insurance

The Company maintains bank owned life insurance (BOLI) for a chosen group of employees at the time of purchase, namely its officers, where the Company is the owner and sole beneficiary of the policies. BOLI is classified as a non-interest earning asset. Increases in the cash surrender value are recorded as components of non-interest income. The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance and its tax-free advantage to the Company. This profitability is used to offset a portion of current and future employee benefit costs. The BOLI cash surrender value build-up can be liquidated if necessary, with associated tax costs. However, the Company intends to hold this pool of insurance, because it provides income that supports employee benefit cost increases which enhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value. The Company received a death benefit claim on two owned policies and received $0.8 million in return of cash surrender value and $0.1 million in other income during the first quarter of 2023.

Premises and equipment

Net of depreciation, premises and equipment increased $1.3 million during the first nine months of 2023. The Company purchased $1.1 million in fixed assets and added $3.4 million in construction in process during the first nine months of 2023. These increases were partially offset by $1.9 million in depreciation expense. The Company closed the Hazle Township branch on March 31, 2023 and listed it for sale during the second quarter of 2023 resulting in a transfer of $0.7 million from premises and equipment to other assets held-for-sale. The Company opened a new branch in Wilkes-Barre in 2023. The Company has recently begun remodeling the Main Branch located in Dunmore, PA and remaining estimated costs for the project are approximately $2.0 million and construction is expected to be completed in early 2024. The Company began corporate headquarters construction which may continue to increase construction in process and is evaluating its branch network looking for consolidation that makes sense for more efficient operations. The Company recently entered into a branch relocation lease and is currently negotiating a land lease for a de novo branch in the Lehigh Valley. Construction on these leased properties over the upcoming year is expected to increase bank premises and equipment by approximately $2.6 million.

On December 23, 2020, the Commonwealth of Pennsylvania authorized the release of $2.0 million in Redevelopment Assistance Capital Program (RACP) funding for the Company’s headquarters project in Lackawanna County. On December 2, 2021, the Company announced it would be receiving an additional $2.0 million in RACP funding in support of the project. The $4.0 million in total RACP grant funds will be allocated to the renovation and rehabilitation of the historic building located in downtown Scranton which will be used for the new corporate headquarters. The Company currently estimates net remaining costs for the corporate headquarters could range from $15 million to $20 million. This range estimate may expand because it is subject to supply chain issues, commodities pricing and results of final planning over approximately two years through early 2025. In addition, the Company currently is in the process of pursuing a federal historic preservation tax credit which would provide a 20% tax credit on qualified improvements on the historic property.

Other assets

During the first nine months of 2023, the $4.1 million increase in other assets was due mostly to a $3.4 million increase in deferred tax assets primarily from higher net unrealized losses in the investment portfolio and a $0.6 million increase in other assets held-for-sale.

Funds Provided:

Deposits

The Company is a community based commercial depository financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Generally, deposits are obtained from consumers, businesses and public entities within the communities that surround the Company’s 21 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law. Deposit products consist of transaction accounts including: savings; clubs; interest-bearing checking; money market and non-interest bearing checking (DDA). The Company also offers short- and long-term time deposits or certificates of deposit (CDs). CDs are deposits with stated maturities which can range from seven days to ten years. Cash flow from deposits is influenced by economic conditions, changes in the interest rate environment, pricing and competition. To determine interest rates on its deposit products, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as short-term borrowings and FHLB advances.

The following table represents the components of deposits as of the date indicated:

(dollars in thousands)

Total deposits decreased $15.2 million, or 1%, to $2.2 billion at September 30, 2023 from $2.2 billion at December 31, 2022. Non-interest bearing checking accounts decreased $52.9 million primarily due to declines in personal and business checking accounts from shifts to interest-bearing products and increased spending. Interest-bearing checking accounts decreased $31.4 million during the first nine months of 2023 primarily from outflow of public funds from municipalities withdrawing American Rescue Plan Act funds and seasonal decline in public accounts along with personal and business account decreases. Savings and club accounts also decreased $27.4 million primarily due to personal savings declines and shifts to CDs and money market accounts. Partially offsetting these decreases, money market accounts increased $11.0 million primarily due to a $28.6 million increase in trust sweep accounts and a new large business relationship. The Company focuses on obtaining a full-banking relationship with existing checking account customers as well as forming new customer relationships. The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop targeted programs for its customers to maintain and grow core deposits. For the first nine months of 2023, the Company experienced deposit balance declines as clients transferred their deposits to investments to earn higher interest and pay down debts and consumer spending. We currently expect this trend of cash usage due to the impact of inflation on consumer and business spending and deposit mix shifts due to the high interest rate environment to continue throughout the last quarter of 2023. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset future deposit growth.

Partially offsetting these non-maturing deposit decreases, CDs increased $85.6 million, or 73%, during the first nine months of 2023. CD balances started to increase as promotional rate offerings expanded. Some maturing CDs were closed as customers could earn higher yields by investing the money into other products. The Company will continue to pursue strategies to grow and retain retail and business customers with an emphasis on deepening and broadening existing and creating new relationships.

The Company uses the Certificate of Deposit Account Registry Service (CDARS) reciprocal program and Insured Cash Sweep (ICS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum insured amount of $250,000. The Company had $1.4 million in CDARs as of September 30, 2023 and no CDARs as of December 31, 2022. As of September 30, 2023 and December 31, 2022, ICS reciprocal deposits represented $78.7 million and $26.3 million, or 4% and 1%, of total deposits which are included in interest-bearing checking accounts in the table above. The $52.4 million increase in ICS deposits is primarily due to one large business relationship that transferred deposits to ICS accounts from other interest-bearing checking accounts.

As of September 30, 2023, total uninsured deposits were estimated to be $896.4 million, or 42% of total deposits. The estimate of uninsured deposits is based on the same methodologies and assumptions used for regulatory reporting requirements. The Company aggregates deposit products by taxpayer identification number and classifies into ownership categories to estimate amounts over the FDIC insurance limit. As of September 30, 2023, the ratio of uninsured and non-collateralized deposits to total deposits was approximately 22%. Collateralized deposits totaled $415.9 million, or 19%, of total deposits as of September 30, 2023.

The maturity distribution of certificates of deposit that meet or exceed the FDIC limit, by account, at September 30, 2023 is as follows:

(dollars in thousands)

Approximately 11% of the CDs, with a weighted-average interest rate of 1.39%, are scheduled to mature in the last quarter of 2023 and an additional 71%, with a weighted-average interest rate of 3.51%, are scheduled to mature in 2024. Renewing CDs are currently expected to re-price to higher market rates depending on the rate on the maturing CD, the pace and direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative, non-term products. The Company plans to continue to address repricing CDs in the ordinary course of business on a relationship pricing basis and is prepared to match rates when prudent to maintain relationships. Growth in CD accounts is challenged by the current and expected rate environment and clients’ preference for short-term rates. The Company will continue to develop CD promotional programs when the Company deems that it is economically feasible to do so or when demand exists. The Company will consider the needs of the customers and simultaneously be mindful of the liquidity levels, borrowing rates and the interest rate sensitivity exposure of the Company.

Short-term borrowings

Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Company will borrow under advances from the FHLB of Pittsburgh and other correspondent banks for asset growth and liquidity needs.

Short-term borrowings may include overnight balances with FHLB's line of credit and/or correspondent bank’s federal funds lines which the Company may require to fund daily liquidity needs such as deposit outflow, loan demand and operations. The Company used $124.0 million in short-term borrowings to fund loan growth and an increase in interest-bearing cash balances for the first nine months of 2023. The short-term borrowings included $32.0 million borrowed through the Federal Reserve Bank Term Funding Program (BTFP) up to one year costing 4.38% by pledging $32.0 million in securities. As of September 30, 2023, the Company had the ability to borrow an additional $36.5 million from the Federal Reserve borrower-in-custody program, $145.9 million in overnight borrowings with the FHLB open-repo line of credit and $20.0 million from lines of credit with correspondent banks.

In November 2023, the Company sold securities and used $29.1 million in proceeds received to pay down short-term borrowings that replenished available borrowing capacity at that time.

Secured borrowings

As of September 30, 2023 and December 31, 2022, the Company had 8 secured borrowing agreements with third parties with a fair value of $7.4 million and $7.6 million, respectively, related to certain sold loan participations that did not qualify for sales treatment acquired from Landmark. Secured borrowings are expected to decrease for 2023 from scheduled amortization and, when possible, early pay-offs.

FHLB advances

The Company had no FHLB advances as of September 30, 2023 and December 31, 2022. As of September 30, 2023, the Company had the ability to borrow an additional $647.4 million from the FHLB, including any overnight borrowings. The Company does not expect to have any FHLB advances in the last quarter of 2023.

Management of interest rate risk and market risk analysis.

The adequacy and effectiveness of an institution’s interest rate risk management process and the level of its exposures are critical factors in the regulatory evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy. Management believes the Company’s interest rate risk measurement framework is sound and provides an effective means to measure, monitor, analyze, identify and control interest rate risk in the balance sheet.

The Company is subject to the interest rate risks inherent in its lending, investing and financing activities. Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity. Interest rate risk management is an integral part of the asset/liability management process. The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position. Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations. The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.

Asset/Liability Management. One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income. The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and members of the board of directors. ALCO meets quarterly to monitor the relationship of interest sensitive assets to interest sensitive liabilities. The process to review interest rate risk is a regular part of managing the Company. Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect. In addition, there is an annual process to review the interest rate risk policy with the board of directors which includes limits on the impact to earnings from shifts in interest rates.

Interest Rate Risk Measurement. Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation. While each of the interest rate risk measurements has limitations, collectively, they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.

Static Gap. The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.

To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or re-price within given time intervals. A positive gap (asset sensitive) indicates that more assets will re-price during a given period compared to liabilities, while a negative gap (liability sensitive) indicates the opposite effect. The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions. The use of this model assists the ALCO in gauging the effects of interest rate changes on interest-sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread. At September 30, 2023, the Company maintained a one-year cumulative gap of negative (liability sensitive) $177.0 million, or -7%, of total assets. The effect of this negative gap position provided a mismatch of assets and liabilities which may expose the Company to interest rate risk during periods of rising interest rates. Conversely, in a decreasing interest rate environment, net interest income could be positively impacted because more liabilities than assets will re-price downward during the one-year period.

Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table. Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table amounts. The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.

The following table reflects the re-pricing of the balance sheet or “gap” position at September 30, 2023:

(dollars in thousands)

(1) Includes restricted investments in bank stock and the net unrealized gains/losses on available-for-sale securities.

(2) Investments and loans are included in the earlier of the period in which interest rates were next scheduled to adjust or the period in which they are due. In addition, loans were included in the periods in which they are scheduled to be repaid based on scheduled amortization. For amortizing loans and MBS – GSE residential, annual prepayment rates are assumed reflecting historical experience as well as management’s knowledge and experience of its loan products.

(3) The Company’s demand and savings accounts were generally subject to immediate withdrawal. However, management considers a certain amount of such accounts to be core accounts having significantly longer effective maturities based on the retention experiences of such deposits in changing interest rate environments. The effective maturities presented are the recommended maturity distribution limits for non-maturing deposits based on historical deposit studies.

Earnings at Risk and Economic Value at Risk Simulations. The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.

Earnings at Risk. An earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.

Economic Value at Risk. An earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.

The following table illustrates the simulated impact of an immediate 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity). This analysis assumed that the adjusted interest-earning asset and interest-bearing liability levels at September 30, 2023 remained constant. The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the September 30, 2023 levels:

In the scenarios in the above table, the Board-approved policy has the following guidelines: net interest income within +/- 10%, net income within +/- 25%, economic value of equity within +/- 25%, economic value of equity as a percent of total assets within +/-5%.

Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%. At September 30, 2023, the Company’s risk-based capital ratio was 14.76%.

Given the existing economic and interest rate conditions along with the recent increase in earnings at risk exposure to rising rates, management is evaluating to pursue balance sheet hedging opportunities on both sides of balance sheet with an independent third-party vendor with derivative expertise in response to mitigate these interest rate risks on net interest income. The Company has a derivative policy in place and any balance sheet hedges require Board pre-approval along with quarterly monitoring requirements by the Company's ALCO Committee.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning October 1, 2023, under alternate interest rate scenarios using the income simulation model described above:

(dollars in thousands)

Simulation models require assumptions about certain categories of assets and liabilities. The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity. MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Company uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and interest-bearing checking accounts do not have stated maturities or re-pricing terms and can be withdrawn or re-price at any time. This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates. As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.

Liquidity

Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities, facility expansion and normal operating expenses. Sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans HFS, investments AFS, growth of core deposits, utilization of borrowing capacities from the FHLB, correspondent banks, IntraFi's ICS and One-Way Buy program, the Discount Window of the Federal Reserve Bank of Philadelphia (FRB), Atlantic Community Bankers Bank (ACBB) and proceeds from the issuance of capital stock. Though regularly scheduled investment and loan payments are dependable sources of daily liquidity, sales of both loans HFS and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions including the interest rate environment. During low and declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity that can be used to invest in other interest-earning assets but at lower market rates. Conversely, in periods of high or rising interest rates, prepayments from interest-sensitive assets tend to decelerate causing prepayment cash flows from mortgage loans and mortgage-backed securities to decrease. Rising interest rates may also cause deposit inflow but priced at higher market interest rates or could also cause deposit outflow due to higher rates offered by the Company’s competition for similar products. The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.

The Company’s contingency funding plan (CFP) sets a framework for handling liquidity issues in the event circumstances arise which the Company deems to be less than normal. The Company established guidelines for identifying, measuring, monitoring and managing the resolution of potentially serious liquidity crises. The CFP outlines required monitoring tools, acceptable alternative funding sources and required actions during various liquidity scenarios. Thus, the Company has implemented a proactive means for the measurement and resolution for handling potentially significant adverse liquidity conditions. At least quarterly, the CFP monitoring tools, current liquidity position and monthly projected liquidity sources and uses are presented and reviewed by the Company’s Asset/Liability Committee. As of September 30, 2023, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.

During the nine months ended September 30, 2023, the Company generated $81.4 million of cash. During the period, the Company’s operations provided approximately $21.4 million mostly from $50.2 million of net cash inflow from the components of net interest income partially offset by net non-interest expense/income related payments of $25.5 million and $2.6 million in quarterly estimated tax payments. Cash inflow from interest-earning assets, the sale of securities, short-term borrowings and loan payments were used to fund the loan portfolio, invest in bank premises and equipment and make net dividend payments. The Company received a large amount of public deposits over the past six years. The seasonal nature of deposits from municipalities and other public funding sources requires the Company to be prepared for the inherent volatility and the unpredictable timing of cash outflow from this customer base, including maintaining the requirements to pledge investment securities. Accordingly, the use of short-term overnight borrowings could be used to fulfill funding gap needs. The CFP is a tool to help the Company ensure that alternative funding sources are available to meet its liquidity needs.

During January 2023, the Company sold $31.2 million in AFS securities at breakeven to generate liquidity in order to pay down overnight borrowings which will result in interest expense savings. Management will continue to execute strategies to generate liquidity when it makes sense for the Company's operations.

During 2021 and 2022, the Company also experienced deposit inflow resulting from businesses and municipalities that received relief from the CARES Act, American Rescue Plan Act ("ARPA") and other government stimulus. There is uncertainty about the length of time that these deposits will remain which could require the Company to maintain elevated cash balances. During the first nine months of 2023, the Company experienced an outflow of $66.1 million in ARPA funds, or approximately 68% of the balance of these funds from the end 2022. The Company will continue to monitor deposit fluctuations for other significant changes.

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy. These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk. In accordance with GAAP, these instruments are either not recorded in the consolidated financial statements or are recorded in amounts that differ from the notional amounts. Such instruments primarily include lending commitments.

Lending commitments include commitments to originate loans and commitments to fund unused lines of credit. Commitments to extend credit 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. Unfunded commitments of existing loan facilities totaled $365.3 million, standby letters of credit totaled $19.0 million and the level of uninsured and non-collateralized deposits was $480.5 million at September 30, 2023. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

As of September 30, 2023, the Company maintained $110.5 million in cash and cash equivalents and $355.2 million of investments AFS and loans HFS. Also as of September 30, 2023, the Company had approximately $647.4 million available to borrow from the FHLB, $20.0 million from correspondent banks, $36.5 million from the FRB and $371.5 million from the IntraFi Network One-Way Buy program. The combined total of $1,541.1 million represented 62% of total assets at September 30, 2023. The Company also has the ability to pledge securities to borrow at par from the Federal Reserve Bank Term Funding Program to gain liquidity. Management believes this level of liquidity to be strong and adequate to support current operations.

Capital

During the nine months ended September 30, 2023, total shareholders' equity increased $2.5 million, or 2%, due principally to $17.7 million in net income added into retained earnings. Capital was enhanced by $0.3 million from investments in the Company’s common stock via the Employee Stock Purchase Plan (ESPP), $1.3 million from stock-based compensation expense from the ESPP and restricted stock and $1.2 million from the re-issuance of treasury stock for the dividend reinvestment plan. Partially offsetting these increases were a $10.4 million after tax decline in the net unrealized loss position in the Company’s investment portfolio. $6.2 million of cash dividends declared on the Company’s common stock, a $1.3 million cumulative effect adjustment for adoption of CECL and $0.2 million in treasury stock purchases to cover employee withholdings. The Company’s dividend payout ratio, defined as the rate at which current earnings are paid to shareholders, was 34.9% for the nine months ended September 30, 2023. The balance of earnings is retained to further strengthen the Company’s capital position.

As of September 30, 2023, the Company reported a net unrealized loss position of $81.5 million, net of tax, from the securities portfolio compared to a net unrealized loss of $71.2 million as of December 31, 2022. The $10.4 million decline during the first nine months of 2023 was from the $11.7 million decline in net unrealized losses on AFS securities, net of tax, and $1.3 million in accretion of net unrealized losses on HTM securities transferred from AFS, net of tax. Higher unrealized losses on all types of securities contributed to the decline in the investment portfolio. Management believes that changes in fair value of the Company’s securities are due to changes in interest rates and not in the creditworthiness of the issuers.

Generally, when U.S. Treasury rates rise, investment securities’ pricing declines and fair values of investment securities also decline. Volatility has existed in the yield curve within the past twelve months and the Company is uncertain about the expected rate environment. There is no assurance that future realized and unrealized losses will not be recognized from the Company’s portfolio of investment securities.

The tangible common equity (TCE) ratio (non-GAAP) was 5.89% and 5.19% for the nine months ended September 30, 2023 and 2022, respectively. At September 30, 2023 and 2022, the held-to-maturity securities portfolio had $36.2 million and $31.7 million in unrealized losses, net of deferred taxes. If the TCE ratio was adjusted to include the unrealized losses on held-to-maturity securities, the adjusted TCE ratio (non-GAAP) would have been 4.41% and 3.87% at September 30, 2023 and 2022. See reconciliation on page 39.

To help maintain a healthy capital position, the Company can issue stock to participants in the DRP and ESPP plans. The DRP affords the Company the option to acquire shares in open market purchases and/or issue shares directly from the Company to plan participants. During the first nine months of 2023, the Company re-issued treasury shares to fulfill the needs of the DRP. Both the DRP and the ESPP plans have been a consistent source of capital from the Company’s loyal employees and shareholders and their participation in these plans will continue to help strengthen the Company’s balance sheet.

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets. The guidelines require all banks and bank holding companies to maintain a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I common equity to total risk-weighted assets (Tier I Common Equity) of 4.5%, Tier I capital to total risk-weighted assets (Tier I Capital) of 6% and Tier I capital to average total assets (Leverage Ratio) of at least 4%. A capital conservation buffer, comprised of common equity Tier I capital, is also established above the regulatory minimum capital requirements of 2.50%. As of September 30, 2023 and December 31, 2022, the Company and the Bank exceeded all capital adequacy requirements to which it was subject.

The Company continues to closely monitor and evaluate alternatives to enhance its capital ratios as the regulatory and economic environments change. The following table depicts the capital amounts and ratios of the Company, on a consolidated basis, and the Bank as of September 30, 2023 and December 31, 2022:

(dollars in thousands)

(dollars in thousands)

The Company advises readers to refer to the Supervision and Regulation section of Management’s Discussion and Analysis of Financial Condition and Results of Operation, of its 2022 Form 10-K for a discussion on the regulatory environment and recent legislation and rulemaking.

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company’s management, with the participation of its President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934. Based on such evaluation, the President and Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations, and are effective. The Company made no changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended September 30, 2023.

Negative Developments Affecting the Banking Industry, Including Bank Failures or Concerns Regarding Liquidity, Have Eroded Customer Confidence in the Banking System and May Have a Material Adverse Effect on the Company.

During March and April 2023, three significant bank failures occurred (Silicon Valley Bank, Signature Bank, and First Republic Bank). These failures continue to be accompanied by financial instability at various additional banks. These bank failures and bank instabilities have created and may continue to create market and other risks, for all financial institutions and banks, including the Corporation. These risks include, but are not limited to:

1. market risk and a loss of confidence in the financial services sector, and/or specific banks;

2. Deterioration of securities and loan portfolios;

3. Deposit volatility and reductions with higher volumes and occurring over shorter periods of time;

4. Increased liquidity demand and utilization of sources of liquidity; and

5. Interest rate volatility and abrupt, sudden and greater than usual rate changes.

These factors individually, or in any combination, could materially and adversely affect our:

1. Financial condition;

2. Operations and results thereof; and

3. Stock price.

In addition, the previously mentioned bank failures and instabilities, or future bank failures and instability, may result in an increase of FDIC deposit insurance premiums and/or result in special FDIC deposit insurance assessments, which also may adversely affect the Company’s financial condition, operations, results thereof or stock price.

The Company cannot predict the impact, timing or duration of such events.

Management of the Company does not believe there have been any other material changes to the risk factors that were disclosed in the 2022 Form 10-K filed with the Securities and Exchange Commission on March 20, 2023.