First National Corp: Form 10-Q for the period ended Mar 31, 2024

Cautionary Statement Regarding Forward-Looking Statements

First National Corporation (the Company) makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding profitability, liquidity, adequacy of capital, allowance for credit losses, interest rate sensitivity, market risk, growth strategy, and the impact of the Company's acquisition (the Merger) of Touchstone Bankshares, Inc. (Touchstone), including the expected levels of merger related expenses to be incurred by the Company, the expected benefits of the Merger, and the potential impact of the Merger on the Company’s and First Bank’s (the Bank) liquidity and capital levels, as well as certain financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

• the ability of the Company and the Bank to realize the anticipated benefits of the Merger, including the ability to close the Merger within the expected time frame, or at all, and to successfully integrate Touchstone’s systems and processes into the Company’s systems and processes;
• expected revenue synergies and cost savings from the Merger that may not be fully realized or realized within the expected time frame;
• revenues following the Merger that may be lower than expected;
• general business conditions, as well as conditions within the financial markets;
• general economic conditions, including unemployment levels, inflation and slowdowns in economic growth;
• the Company’s branch and market expansions, technology initiatives and other strategic initiatives;
• the impact of competition from banks and non-banks, including financial technology companies (Fintech);
• the composition of the loan and deposit portfolio, including the types of accounts and customers, may change, which could impact the amount of net interest income and noninterest income in future periods, including revenue from service charges on deposits;
• limited availability of financing or inability to raise capital;
• reliance on third parties for key services;
• the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses;
• the quality of the loan portfolio and the value of the collateral securing those loans;
• prepayments of loans and securities could materially impact earnings through a reduction in interest income and fees on loans and interest income on securities
• demand for loan products;
• deposit flows;
• the level of net charge-offs on loans and the adequacy of the allowance for loan losses;
• the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets;
• the value of securities held in the Company's investment portfolio;
• legislative or regulatory changes or actions, including the effects of changes in tax laws;
• changes in accounting principles, policies and guidelines and elections made by the Company thereunder;
• cyber threats, attacks or events;
• the ability to maintain adequate liquidity by retaining deposit customers and secondary funding sources, especially if the Company’s or the industry's reputation were to become damaged;
• monetary and fiscal policies of the U.S. Government, including policies of the U.S. Department of the Treasury and the Federal Reserve Board, and the effect of those policies on interest rates and business in the Company's markets;
• changes in interest rates could have a negative impact on the value of the Company’s securities portfolio and its net interest income and an unfavorable impact on the Company’s customers’ ability to repay loans;
• geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad; and
• other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2023 and in this Form 10-Q.

Because of these and other uncertainties, actual results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at March 31, 2024 and statements of income of the Company for the three months ended March 31, 2024 and 2023 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2023. The statements of income for the three months ended March 31, 2024 may not be indicative of the results to be achieved for the year.

Executive Overview

The Company

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

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

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

Products, Services, Customers and Locations

The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank’s office locations are well-positioned in attractive markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in the Shenandoah Valley, the Roanoke Valley, central regions of Virginia, and the city of Richmond. Within these markets, there are diverse types of industry including medical and professional services, manufacturing, retail, warehousing, Federal and local government, hospitality, and higher education. The Bank’s products and services are delivered through 20 bank branch offices, a loan production office and customer service centers in two retirement villages. For the location and general character of each of these offices, see Item 2 of the Company's Form 10-K for the year ended December 31, 2023. Many of the Bank’s services are also delivered through the Bank’s mobile banking platform, its website, www.fbvirginia.com (http://www.fbvirginia.com), and a network of ATMs located throughout its market area.

Revenue Sources and Expense Factors

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

Primary expense categories are salaries and employee benefits, which comprised 59% of noninterest expenses for the three months ended March 31, 2024, followed by occupancy and equipment expense, which comprised 11% of noninterest expenses. The provision for credit losses is also typically a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for credit losses.

Acquisition of Touchstone Bankshares, Inc.

On March 25, 2024, the Company entered into an agreement to acquire Touchstone for an aggregate purchase price of approximately $47.0 million in stock (based on the Company's closing stock price as of March 25, 2024). The closing of the acquisition is subject to customary closing conditions, including shareholder and regulatory approvals, and the Company expects to complete the acquisition in the fourth quarter of 2024. At the time of closing of the acquisition, Touchstone is expected to have 12 retail bank offices serving south-central Virginia and northern North Carolina, and an administrative office in Prince George, Virginia. After the acquisition is completed, the former Touchstone branches will continue to operate as Touchstone Bank, a division of First Bank, until the systems conversion is completed, expected in the first quarter of 2025. As of March 31, 2024, Touchstone reported total assets of $673.2 million, gross loans of $506.0 million, and total deposits of $557.6 million. In connection with the transaction, the Company expects to issue approximately 2.7 million shares of its common stock to the shareholders of Touchstone. There were no merger related expenses incurred for the three months ended March 31, 2024 in connection with its acquisition of Touchstone. The Company estimates that it will incur aggregate pre-tax merger related expenses of approximately $3.3 million during 2024.

Overview of Quarterly Financial Performance

Net income decreased $640 thousand, or 17%, to $3.2 million, or $0.51 per diluted share, for the three months ended March 31, 2024, compared to $3.8 million, or $0.61 per diluted share, for the same period in 2023. Return on average assets was 0.90% and return on average equity was 11.07% for the first quarter of 2024, compared to 1.15% and 14.20%, respectively, for the same period in 2023.

The decrease in net income resulted from a $326 thousand, or 3%, decrease in net interest income, a $1.0 million increase in provision for credit losses, and a $687 thousand, or 8%, increase in total noninterest expense, which were partially offset by a $1.3 million, or 46%, increase in total noninterest income.

Net interest income decreased $326 thousand, or 1%, from a $3.1 million increase in total interest expense, which was partially offset by a $2.8 million increase in total interest income. Net interest income was negatively impacted by a 36-basis point contraction of the net interest margin to 3.24% and was partially offset by the positive impact of a $93.3 million, or 7%, increase in average earning assets.

The provision for credit losses increased to $1.0 million for the first quarter of 2024 compared to no provision for the same period one year ago. The allowance for credit losses on loans totaled $12.6 million, or 1.30% of total loans at March 31, 2024, which was a $3.9 million increase compared to $8.7 million, or 0.95% of total loans at March 31, 2023. The allowance for credit losses on loans individually evaluated increased $3.6 million compared to the same period in the prior year. The allowance for credit losses on loans collectively evaluated increased $318 thousand compared to the same period one year ago. Net charge-offs totaled $362 thousand in the first quarter of 2024 and $915 thousand in 2023.

Total noninterest income increased $1.3 million from an increase in other operating income, which was attributable to a recovery on a loan that was acquired through a business combination in 2021. Total noninterest expenses increased by $687 thousand, or 8%, and was primarily attributable to increases in salaries and employee benefits and legal and professional expenses.

Non-GAAP Financial Measures

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

This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for both 2024 and 2023 is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).

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Critical Accounting Policies

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

Critical accounting policies are most important to the portrayal of the Company’s financial condition or results of operations and require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. If conditions occur that differ from our assumptions, depending upon the severity of such differences, the Company’s financial condition or results of operations may be materially impacted. The Company evaluates its critical accounting estimates and assumptions on an ongoing basis and updates them as needed. The Company provides additional information on its critical accounting policies and estimates under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in its 2023 Form 10-K and in Note 1 “Significant Accounting Policies and Estimates” in Part I, Item 1 of this Quarterly Report.

Lending Policies

There have been no material changes in the Company’s lending policies disclosed in the Annual Report on Form 10-K for the year ended December 31, 2023.

Results of Operations

General

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

Net Income

Net income decreased $640 thousand, or 17%, to $3.2 million, or $0.51 per diluted share, for the three months ended March 31, 2024, compared to $3.8 million, or $0.61 per diluted share, for the same period in 2023. Return on average assets was 0.90% and return on average equity was 11.07% for the first quarter of 2024, compared to 1.15% and 14.20%, respectively, for the same period in 2023.

The decrease in net income resulted from a $326 thousand, or 3%, decrease in net interest income, a $1.0 million increase in provision for credit losses and a $687 thousand, or 8%, increase in total noninterest expense, which were partially offset by a $1.3 million, or 46%, increase in total noninterest income.

Net Interest Income

Net interest income decreased $326 thousand, or 3%, to $10.9 million for the first quarter of 2024 compared to the same period in the prior year. Total interest expense increased by $3.1 million and was partially offset by total interest income, which increased by $2.8 million. Net interest income was negatively impacted by a 36-basis point decrease in the net interest margin, which was partially offset by a $93.3 million, or 7%, increase in average earning assets.

The increase in total interest income was attributable to a $2.0 million, or 17%, increase in interest income and fees on loans and a $944 thousand increase in interest income on interest-bearing deposits in banks. The increase in interest income on loans was attributable to a 49-basis point increase in yield and a 6% increase in average balances compared to the same period in the prior year. The increase in interest income on interest-bearing deposits in other banks was attributable to a 117-basis point increase in yield and a $65.8 million, or 187% increase in average balances compared to the same period in the prior year.

The increase in total interest expense was attributable to a $2.6 million increase in interest expense on deposits and a $576 thousand increase in interest expense on other borrowings. The higher interest expense on deposits resulted from a 110-basis point increase in the cost of interest-bearing deposits and a 7% increase in average interest-bearing deposit balances. The increase in the cost of deposits was also impacted by a change in the composition of the deposit portfolio as lower cost deposit balances decreased, while higher cost deposit balances increased. The higher interest expense on other borrowings resulted from a $49.8 million increase in average balances.

The net interest margin was 3.23% for the first quarter of 2024 compared to 3.60% for the same period in the prior year as the increase in the cost of funds exceeded the increase in yield on earning assets. Although the net interest margin in the first quarter of 2024 was 37-basis points lower than the same period one year ago, the net interest margin has been stable in recent quarterly periods. In December 2023, the Bank borrowed $50.0 million from the Federal Reserve Bank through its Bank Term Funding Program and invested the proceeds in interest-bearing deposit in other banks, which increased net interest income. Although net interest income increased, the transaction negatively impacted net interest margin by 9 basis points in the first quarter of 2024. The net interest margin was 3.35% for the linked fourth quarter of 2023, 3.35% for third quarter of 2023, and 3.36% for the second quarter of 2023. The net interest margin has been stable in recent quarterly periods as the rising cost of funds has been offset by an increase in earning asset yields.

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

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

(1) Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $102 and $82 thousand for the three months ended March 31, 2024 and 2023, respectively.

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

Provision for Credit Losses

The provision for credit losses totaled $1.0 million for the first quarter of 2024. There was no provision for credit losses for the same period of the prior year. The provision was comprised of a $991 thousand provision on loans, and a $9 thousand provision on held-to-maturity securities. The provision for credit losses on loans resulted primarily from net charge-offs totaling $362 thousand, and an increase in the specific reserve component of the allowance for credit losses.

Noninterest Income

Noninterest income increased $1.3 million, or 46%, to $4.0 million for the first quarter of 2024, compared to the same period of 2023. The increase resulted from an increase in other operating income and wealth management fees. Other operating income increased primarily from a recovery on a loan that was acquired through a business combination in 2021. Wealth management fees increased $107 thousand primarily from an increase in assets under management and from higher market values.

Noninterest Expense

Noninterest expenses increased $687 thousand, or 8%, to $9.9 million for the three-month period ended March 31, 2024, compared to the same period one year ago. The increase was attributable to a $525 thousand, or 10%, increase in salaries and employee benefits, a $109 thousand increase in legal and professional fees, and a $71 thousand increase in FDIC assessment, which were partially offset by a $73 thousand decrease in marketing expense.

Salaries and employee benefits increased primarily from an increase in the number of employees and annual increases in employee salaries and wages. Legal and professional fees increased from wealth management advisory expense. FDIC assessment increased from higher assessed rates during 2024.

Income Taxes

Income tax expense decreased $104 thousand for the first quarter of 2024, compared to the same period one year ago. The effective tax rate for the first quarter of 2024 was 20.1% compared to 19.0% for the same period in 2023.The increased effective tax rate for 2024 was the result of higher non-deductible expenses and lower nontaxable income in 2024 compared to 2023. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three months ended March 31, 2024, and 2023. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income, and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2023.

Financial Condition

General

Assets totaled $1.4 billion at March 31, 2024, which was an increase of $27.9 million or 8% (annualized) from December 31, 2023. The asset composition changed during the first three months of the year as interest-bearing deposits in banks increased by $54.3 million and loans, net of the allowance for credit losses, increased by $2.9 million, while total securities decreased by $27.6 million.

Total liabilities increased by $26.4 million during the three-month period ended March 31, 2024, primarily from a $25.4 million or 8% (annualized) increase in total deposits from December 31, 2023. The composition of deposits was consistent during the first quarter as noninterest-bearing deposits, savings and interest-bearing deposits, and time deposits increased $4.9 million, $15.3 million, and $5.2 million, respectively from December 31, 2023.

Total shareholders’ equity increased by $1.5 million during the first three months of 2024, primarily from a $2.3 million increase in retained earnings, which was partially offset by an $811 thousand increase in accumulated other comprehensive loss. The increase in accumulated other comprehensive loss was attributable to higher unrealized losses in the available-for-sale securities portfolio. Retained earnings increased as $3.2 million of net income was partially offset by $941 thousand of cash dividends on common stock. The Bank's capital ratios continued to exceed the minimum capital requirements for regulatory purposes.

Loans

Loans totaled $973.0 million at March 31, 2024, which was a $3.5 million or 2% (annualized) increase from December 31, 2023, and a $55.0 million, or 6%, increase over March 31, 2023. The growth in loans over the periods did not have a significant impact on the composition of the loan portfolio. The loan portfolio was primarily comprised of loans secured by one-to-four family residential real estate, loans secured by commercial real estate, and commercial and industrial loans, which totaled 36%, 46%, and 12% of the loan portfolio, respectively, at March 31, 2024.

The loan portfolio includes loans that were acquired through business combinations and loans that were purchased through a third-party loan originator. Loans acquired through business combinations included unamortized discounts, net of unamortized premiums totaling $1.8 million and $1.9 million, as of March 31, 2024 and December 31, 2023, respectively. Loans purchased from a third-party that originated and serviced loans to health care professionals totaled $23.6 million as of March 31, 2024, which included unamortized premiums totaling $7.4 million, compared to loans totaling $24.6 million as of December 31, 2023, which included unamortized premiums totaling $7.9 million.

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

A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled $175 thousand and $524 thousand at March 31, 2024 and 2023, respectively. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.

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

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

Asset Quality

Management classifies non-performing assets as non-accrual loans and OREO. Non-performing assets totaled $8.0 million and $6.8 million at March 31, 2024 and December 31, 2023, representing approximately 0.55% and 0.48% of total assets, respectively. Nonaccrual loans totaled $8.0 million and $6.8 million at March 31, 2024 and December 31, 2023, respectively. There was no OREO at March 31, 2024 and December 31, 2023, respectively. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for, or used in bank operations, but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank did not have any consumer mortgage loans secured by real estate properties for which formal foreclosure proceedings were in process as of March 31, 2024

On March 31, 2024 commercial and industrial loans comprised 90% of non-performing assets and residential real estate loans comprised 10%. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $1.7 million and $287 thousand at March 31, 2024 and December 31, 2023, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.

The Company purchased commercial and industrial loans between October 2021 and October 2023 from a third-party finance company that originated and serviced loans to health care professionals. The finance company operated a program that historically provided credit support to the Company through, among other things, the repurchase of their loans and unamortized loan premiums when loans did not pay according to the loan agreements. On March 31, 2024, loans purchased from the finance company totaled $23.6 million, which was comprised of $16.2 million of loan balances and unamortized premiums totaling $7.4 million. As of March 31, 2024, $3.4 million of these loans were non-accrual including premiums totaling $1.0 million and thus were individually evaluated. Specific reserves on these individually evaluated loans totaled $2.4 million and were included in the Company’s allowance for credit losses on loans. The remaining $20.2 million of loans with premiums of $6.4 million were considered performing and were included in the calculation of the general reserve component of the allowance for credit losses. Premiums are amortized over the life of the loans using the effective interest method. On March 31, 2024, there was a total of 171 loans purchased from the finance company included in the Company’s loan portfolio with a weighted average maturity of 7.3 years.

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

Securities

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

On March 31, 2024 securities totaled $275.6 million, a decrease of $27.6 million, or 9.1%, from $303.2 million at December 31, 2023. Investment securities are comprised of U.S. Treasury securities, U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of March 31, 2024, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $51 thousand and $61 thousand at March 31, 2024 and December 31, 2023, respectively. Gross unrealized losses in the available for sale portfolio totaled $22.2 million and $20.7 million at March 31, 2024 and December 31, 2023, respectively. Gross unrealized gains in the held to maturity portfolio totaled $40 thousand and $107 thousand at March 31, 2024 and December 31, 2023, respectively. Gross unrealized losses in the held to maturity portfolio totaled $11.9 million and $10.8 million at March 31, 2024 and December 31, 2023, respectively. The change in the unrealized gains and losses of investment securities from December 31, 2023 to March 31, 2024 was related to changes in market interest rates and was not related to credit concerns of the issuers.

On September 1, 2022, the Bank transferred 24 securities designated as available for sale with a combined book value of $82.2 million, market value of $74.4 million, and an unrealized loss of $7.8 million, to securities designated held to maturity. The unrealized loss is being amortized monthly over the life of the securities with an increase to the carrying value of securities and a decrease to the related accumulated other comprehensive loss, which is included in the shareholders’ equity section of the Company’s balance sheet. The amortization of the unrealized loss on the transferred securities totaled $367 thousand, or $290 thousand net of tax, for the first three months of 2024. Securities designated as held to maturity are carried on the balance sheet at amortized cost, while securities designated as available for sale are carried at fair market value.

Deposits

Deposits totaled $1.3 billion on March 31, 2024, which was a $25.4 million or 8% (annualized) increase from December 31, 2023. Noninterest-bearing deposits increased $4.8 million, savings and interest-bearing deposits increased $15.3 million, and time deposits increased $5.2 million. The composition of the deposit portfolio remained consistent with the prior period.

Liquidity

Liquidity sources available to the Bank, including interest-bearing deposits in banks, unpledged securities available for sale, at fair value, unpledged securities held-to-maturity, at par, eligible to be pledged to the Federal Reserve Bank through its Bank Term Funding Program, and available lines of credit totaled $554.8 million on March 31, 2024 and $562.3 million on March 31, 2023.

The Bank maintains liquidity to fund loan growth and to meet potential demand from deposit customers, including potential volatile deposits. The estimated amount of uninsured customer deposits totaled $391.9 on March 31, 2024, $368.2 million on December 31, 2023, and $407.5 million on March 31, 2023. Excluding municipal deposits, the estimated amount of uninsured customer deposits totaled $308.6 on March 31, 2024, $293.7 million on December 31, 2023, and $330.4 million on March 31, 2023.

Capital Resources

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

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

The minimum capital level requirements applicable to the Bank under the final rules are as follows: a common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. There is also a capital conservation buffer, which is 2.5% above the regulatory minimum capital requirements. If capital levels fall below the required minimum ratios plus the buffer, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. This results in the following minimum capital ratios required to exceed the buffer: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Management believes, as of March 31, 2024 and December 31, 2023, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.

The following table shows the Bank’s regulatory capital ratios at March 31, 2024:

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

The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The Bank met the requirements to qualify as "well capitalized" as of March 31, 2024 and December 31, 2023.

Contractual Obligations

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2023.

Off-Balance Sheet Arrangements

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

Commitments to extend credit, which amounted to $214.7 million at March 31, 2024, and $170.2 million at March 31, 2023, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.

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

Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At March 31, 2024 and December 31, 2023, the Bank had $17.0 million and $17.6 million in outstanding standby letters of credit, respectively.

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

The interest rate swaps qualified and are designated as cash flow hedges. The Company’s cash flow hedges effectively modify the Company’s exposure to interest rate risk by converting variable rates of interest on $9.0 million of the Company’s junior subordinated debt to fixed rates of interest. The cash flow hedges end and the junior subordinated debt matures between June 2034 and October 2036. The cash flow hedges’ total notional amount is $9.0 million. At March 31, 2024, the cash flow hedges had a fair value of $2.7 million, which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive (loss) income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 10 to the Consolidated Financial Statements.

The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of March 31, 2024 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.

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

Except for the following risks related to the acquisition of Touchstone, there were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2023.

Risks Related to the Acquisition of Touchstone

Combining Touchstone into the Company may be more difficult, costly or time-consuming than we expect.

The success of the Merger will depend, in part, on the Company’s ability to realize the anticipated benefits and cost savings from combining the business of Touchstone into the business of the Company without materially disrupting the existing customer relationships of Touchstone or the Company. If the Company is not able to achieve these objectives, the anticipated benefits and cost savings of the Merger may not be realized fully, or at all, or may take longer to realize than expected.

The success of the Merger will depend, in part, on the Company’s ability to successfully combine the businesses of the Company and Touchstone. To realize these anticipated benefits, the Company will integrate Touchstone’s business into its own. The integration process in the Merger could result in the disruption of ongoing business, inconsistencies in standards, controls, procedures, and policies that affect adversely the Company’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the Merger. If the Company experiences difficulties with the integration process, the anticipated benefits of the Merger may not be realized, fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be disruptions that cause the Company to lose customers or cause customers to withdraw their deposits from Touchstone or the Bank, or other unintended consequences that could have a material adverse effect on the Company’s results of operations or financial condition after the Merger. These integration matters could have an adverse effect on the Company for an indeterminate period after consummation of the Merger.

The Company may not be able to effectively integrate the operations of Touchstone into the Bank.

The future operating performance of the Company and the Bank will depend, in part, on the success of the merger of Touchstone with and into the Bank. The success of the subsidiary bank merger will, in turn, depend on a number of factors, including the Company’s ability to (i) integrate the operations and branches of Touchstone and the Bank, (ii) retain the deposits and customers of Touchstone and the Bank, (iii) control the incremental increase in noninterest expense arising from the Merger in a manner that enables the combined bank to improve its overall operating efficiencies, and (iv) retain and integrate the appropriate personnel of Touchstone into the operations of the Bank, and reduce overlapping bank personnel. The integration of Touchstone and the Bank will require the dedication of the time and resources of the Bank’s management and may temporarily distract management’s attention from the day-to-day business of the Bank. If the Bank is unable to successfully integrate Touchstone, the Bank may not be able to realize expected operating efficiencies and eliminate redundant costs.

Regulatory approvals may not be received, may take longer than expected, or may impose conditions that are not presently anticipated or that could have an adverse effect on the combined company following the Merger.

Before the Merger may be completed, the Company and the Bank must obtain approvals from the Federal Reserve and the Virginia Bureau of Financial Institutions. Other approvals, waivers or consents from regulators may also be required. These regulators may impose conditions on the completion of the Merger or require changes to the terms of the Merger. Such conditions or changes and the process of obtaining regulatory approvals could have the effect of delaying completion of the Merger and the subsidiary bank merger, imposing additional costs on the combined company or limiting the revenues of the combined company, any of which might have an adverse effect on the combined company following the Merger.

A significant delay in the completion of the Merger could have a material adverse effect on the Company and Touchstone as a combined company.

The merger agreement with Touchstone is subject to a number of conditions that must be fulfilled in order to complete the Merger. Those conditions include, among others: (1) approval of the Merger by the Company’s and Touchstone’s shareholders, (2) receipt of all required approvals from bank regulatory authorities and expiration of all applicable waiting periods, (3) absence of any law or order prohibiting or restricting the completion of the Merger, and (4) effectiveness of the Company’s registration statement filed with the SEC. Certain costs relating to the Merger, such as legal, accounting and financial advisory fees, must be paid even if the Merger is not completed. If the Merger is not completed, the Company would have to recognize these expenses and its management would have committed substantial time and resources without realizing the expected benefits of the Merger.

If these conditions to the completion of the Merger are not fulfilled when expected and, as a result, the completion of the Merger is delayed, the diversion of management attention from pursuing other opportunities, the constraints in the merger agreement on the ability to make significant changes to each company’s ongoing business during the pendency of the Merger, the incurrence of additional merger related expenses, and other market and economic factors could have a material adverse effect on the combined company's business, financial condition and results of operations.

The Company and Touchstone will be subject to business uncertainties and contractual restrictions while the Merger is pending.

Uncertainty about the effect of the Merger on employees and customers may have an adverse effect on the Company and Touchstone. These uncertainties may impair the Company’s and Touchstone’s ability to attract, retain and motivate key personnel until the Merger is completed, and could cause customers and others that deal with the Company and Touchstone to seek to change existing business relationships with the Company and Touchstone. Retention of certain employees by the Company and Touchstone may be challenging while the Merger is pending, as certain employees may experience uncertainty about their future roles with the Company or Touchstone. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company or Touchstone, the Company’s or Touchstone’s business, or the business of the combined company following the Merger, could be harmed. In addition, subject to certain exceptions, the Company and Touchstone have each agreed to operate its business in the ordinary course prior to closing and refrain from taking certain specified actions until the Merger occurs, which may prevent the Company from pursuing attractive business opportunities that may arise prior to the completion of the Merger.