Pathfinder Bancorp, Inc.: Form 10-Q for the period ended Jun 30, 2018

General

The Company is a Maryland corporation headquartered in Oswego, New York. The Company is 100% owned by public shareholders. The primary business of the Company is its investment in Pathfinder Bank (the "Bank"), a New York State chartered commercial bank, which is 100% owned by the Company. The Bank has two wholly owned operating subsidiaries, Pathfinder Risk Management Company, Inc. (“PRMC”) and Whispering Oaks Development Corp. All significant inter-company accounts and activity have been eliminated in consolidation. Although the Company owns, through its subsidiary PRMC, 51% of the membership interest in FitzGibbons Agency, LLC (“Agency”), the Company is required to consolidate 100% of FitzGibbons within the consolidated financial statements. The 49% of which the Company does not own is accounted for separately as noncontrolling interests within the consolidated financial statements. At June 30, 2018, the Company and subsidiaries had total consolidated assets of $903.5 million, total consolidated liabilities of $840.6 million and shareholders' equity of $62.6 million plus noncontrolling interest of $252,000, which represents the 49% of FitzGibbons not owned by the Company.

The following discussion reviews the Company's financial condition at June 30, 2018 and the results of operations for the three and six month periods ended June 30, 2018 and 2017. Operating results for the three and six months ended June 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018.

The following material under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" is written with the presumption that the users of the interim financial statements have read, or have access to, the Company's latest audited financial statements and notes thereto, together with Management's Discussion and Analysis of Financial Condition and Results of Operations included in the 2017 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 30, 2018 (“the consolidated annual financial statements”) as of December 31, 2017 and 2016 and for the two years then ended. Therefore, only material changes in financial condition and results of operations are discussed in the remainder of Item 2.

Statement Regarding Forward-Looking Statements

This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of the Company. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to:

• Credit quality and the effect of credit quality on the adequacy of our allowance for loan losses;
• Deterioration in financial markets that may result in impairment charges relating to our securities portfolio;
• Competition in our primary market areas;
• Changes in interest rates and national or regional economic conditions;
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• Changes in monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board;
• Significant government regulations, legislation and potential changes thereto;
• A reduction in our ability to generate or originate revenue-producing assets as a result of compliance with heightened capital standards;
• Increased cost of operations due to greater regulatory oversight, supervision and examination of banks and bank holding companies, and higher deposit insurance premiums;
• Cyberattacks, computer viruses and other technological threats that may breach the security of our websites or other systems;
• Technological changes that may be more difficult or expensive than expected;
• Limitations on our ability to expand consumer product and service offerings due to anticipated stricter consumer protection laws and regulations; and
• Other risks described herein and in the other reports and statements we file with the SEC.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

Application of Critical Accounting Policies

The Company's consolidated annual financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated annual financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain accounting policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by unaffiliated third-party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management.

The most significant accounting policies followed by the Company are presented in Note 1 to the annual audited consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated annual financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the allowance for loan losses, deferred income taxes, pension obligations, the evaluation of investment securities for other than temporary impairment, the estimation of fair values for accounting and disclosure purposes, and the evaluation of goodwill for impairment to be the accounting areas that require the most subjective and complex judgments. These areas could be the most subject to revision as new information becomes available.

The allowance for loan losses represents management's estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment on the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.

Our Allowance for Loan and Lease Losses policy establishes criteria for selecting loans to be measured for impairment based on the following:

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Residential and Consumer Loans:

• All loans rated substandard or worse, on nonaccrual, and above our total related credit (“TRC”) threshold balance of $300,000.
• All Troubled Debt Restructured Loans

Commercial Lines and Loans, Commercial Real Estate and Tax-exempt loans:

• All loans rated substandard or worse, on nonaccrual, and above our TRC threshold balance of $100,000.
• All Troubled Debt Restructured Loans

Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses as compared to the loan carrying value. For all other loans and leases, the Company uses the general allocation methodology that establishes an allowance to estimate the probable incurred loss for each risk-rating category.

Deferred income tax assets and liabilities are determined using the liability method. Under this method, the net deferred tax asset or liability is recognized for the future tax consequences. This is attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as net operating and capital loss carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. If current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established. The judgment about the level of future taxable income, including that which is considered capital, is inherently subjective and is reviewed on a continual basis as regulatory and business factors change. No valuation allowances were maintained at June 30, 2018 and December 31, 2017. The Tax Cuts and Jobs Act of 2017 (“Tax Act”), which was effective on January 1, 2018, reduced the Company’s corporate federal tax rate from 34% to 21%, starting on that date, and affected the valuation of its net deferred tax assets calculated under GAAP, at December 31, 2017. The Company’s effective tax rate differs from the federal statutory tax rate due primarily to tax-exempt income from specific types of investment securities and loans, and bank owned life insurance. The Company’s effective New York State tax rate differs from the state statutory tax rate of 6.5% due primarily to state tax-exempt income that can now be calculated under a newly-available modification of the state’s tax laws. This modification allows the Company to exclude up to 50% of interest income derived from qualified lending activities within the State from its state taxable income. The exclusion of this substantial portion of interest income from the Company’s New York State tax calculation significantly reduces the Company’s state income-based tax to a level where only immaterial capital-based or minimum franchise taxes apply.

We maintain a noncontributory defined benefit pension plan covering most employees. The plan provides defined benefits based on years of service and final average salary. On May 14, 2012, we informed our employees of our decision to freeze participation and benefit accruals under the plan, primarily to reduce some of the volatility in earnings that can accompany the maintenance of a defined benefit plan. Pension and post-retirement benefit plan liabilities and expenses are based upon actuarial assumptions of future events; including fair value of plan assets, interest rates, and the length of time the Company will have to provide those benefits. The assumptions used by management are discussed in Note 14 to the consolidated annual financial statements.

The Company carries all of its available-for-sale investments at fair value with any unrealized gains or losses reported, net of tax, as an adjustment to shareholders' equity and included in accumulated other comprehensive income (loss), except for the credit-related portion of debt securities impairment losses and OTTI of equity securities which are charged to earnings. The Company's ability to fully realize the value of its investments in various securities, including corporate debt securities, is dependent on the underlying creditworthiness of the issuing organization. In evaluating the debt securities (both available-for-sale and held-to-maturity) portfolio for other-than-temporary impairment losses, management considers (1) if we intend to sell the security; (2) if it is “more likely than not” we will be required to sell the security before recovery of its amortized cost basis; or (3) if the present value of expected cash flows is not sufficient to recover

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the entire amortized cost basis. When the fair value of a held-to-maturity or available-for-sale security is less than its amortized cost basis, an assessment is made as to whether OTTI is present. The Company considers numerous factors when determining whether a potential OTTI exists and the period over which the debt security is expected to recover. The principal factors considered are (1) the length of time and the extent to which the fair value has been less than the amortized cost basis, (2) the financial condition of the issue and (guarantor, if any) and adverse conditions specifically related to the security, industry or geographic area, (3) failure of the issuer of the security to make scheduled interest or principal payments, (4) any changes to the rating of the security by a NRSRO, and (5) the presence of credit enhancements, if any, including the guarantee of the federal government or any of its agencies.

The estimation of fair value is significant to several of our assets; including loans, available-for-sale and marketable equity investment securities, intangible assets, foreclosed real estate, and the value of loan collateral when valuing impaired loans. These are all recorded at either fair value, or the lower of cost or fair value. Fair values are determined based on third party sources, when available. Furthermore, accounting principles generally accepted in the United States require disclosure of the fair value of financial instruments as a part of the notes to the annual audited consolidated financial statements. Fair values on our available-for-sale securities may be influenced by a number of factors; including market interest rates, prepayment speeds, discount rates, and the shape of yield curves.

Fair values for securities available-for-sale are obtained from unaffiliated third party pricing services. Where available, fair values are based on quoted prices on a nationally recognized securities exchange. If quoted prices are not available, fair values are measured using quoted market prices for similar benchmark securities. Management made no adjustments to the fair value quotes that were provided by the pricing sources. Fair values for marketable equity securities are based on quoted prices on a nationally recognized securities exchange for similar benchmark securities. The fair values of foreclosed real estate and the underlying collateral value of impaired loans are typically determined based on evaluations by third parties, less estimated costs to sell. When necessary, appraisals are updated to reflect changes in market conditions. On January 1, 2018, the Company adopted Accounting Standards Update (ASU) 2016-01: Financial Instruments – Overall [Subtopic 825-10]: Recognition and Measurement of Financial Assets and Financial Liabilities. The ASU requires the use of exit pricing in disclosures related to the fair value of financial instruments. Accordingly, at June 30, 2018, the financial assets and liabilities of the Company were valued at a price that represents the Company’s exit price or the price at which these instruments would be sold or transferred. The adoption of the ASU did not materially affect the fair value evaluations of the financial assets and financial liabilities of the Company at the adoption date. Further information on the estimation of fair values can be found in Note 22 to the consolidated annual financial statements.

Management performs an evaluation of our goodwill for possible impairment of the recorded value of goodwill for each of our reporting units at fiscal each year end or if events or circumstances warrant an evaluation. Based on the results of the December 31, 2017 evaluation, management has determined that the carrying value of goodwill was not impaired as of that date. No events or circumstances arose during the six months ended June 30, 2018 to adversely affect the Company’s recorded goodwill. The evaluation approach is described in Note 10 of the consolidated annual financial statements.

Recent Events

On June 29, 2018, the Company announced that the Board of Directors declared a quarterly cash dividend of $0.06 per common share. The dividend is payable on August 10, 2018 to shareholders of record on July 20, 2018.

Overview and Results of Operations

The following represents the significant highlights of the Company’s operating results between the second quarter of 2018 and the second quarter of 2017.

• Net income increased $25,000, or 2.7%, to $945,000.
• Basic and diluted earnings per share each remained unchanged at $0.23 and $0.22 per share, respectively.
• Return on average assets decreased three basis points to 0.43% as the increase in average assets outpaced the increase in net income.
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• Net interest income, after provision for loan losses, increased $1.0 million, or 19.6% to $6.2 million. This increase in earnings was primarily due to the increase in average balances of interest-earning assets and an increase in the average yield earned on those assets of 34 basis points.
• Net interest margin increased by 14 basis points to 3.07%, primarily as a result of a 34 basis point increase in the average yield earned on interest-earning assets.
• The effective income tax rate decreased 7.0% to 14.3% for the three months ended June 30, 2018 as compared to 21.3% for the same three month period in 2017. This eduction in the effective tax rate was primarily the result of the combined effects of the Tax Act and changes to the New York State tax code that became effective on January 1, 2018.

The following represents significant highlights of the Company’s operating results between the first six months of 2018 and the first six months of 2017.

• Net income improved by $229,000, or 13.3%, to $1.9 million.
• Basic and diluted earnings per share each improved by $0.05 to $0.47 and $0.46 per share, respectively.
• Return on average assets increased by one basis point to 0.44% as the increase in the Company’s net income slightly outpaced the increase in average assets.
• Net interest income, after provision for loan losses, increased by $1.7 million, or 16.4%, to $12.0 million. This increase in earnings was primarily due to the increase in average balances of interest earning assets, accompanied by an increase in the yield earned on interest-earning assets.
• Net interest margin increased by 10 basis points to 3.05%, primarily as a result of a 25 basis point increase in average yields earned on investments and loans in aggregate.
• The effective income tax rate decreased 7.5% to 15.1% for the six months ended June 30, 2018 as compared to 22.6% for the same six month period in 2017. This reduction in the effective tax rate was primarily the result of the combined effects of the Tax Act and changes to the New York State tax code that became effective on January 1, 2018.

The following reflects the significant changes in financial condition between the periods of December 31, 2017 and June 30, 2018. In addition, the following reflects significant changes in asset quality metrics between June 30, 2017 and June 30, 2018.

• Total assets increased $22.2 million, or 2.5% to $903.5 million at June 30, 2018, as compared to December 31, 2017, primarily due to increases in loans and cash and cash equivalents partially offset by a decrease in investment securities. These increases were funded largely by increases in long-term borrowing from the FHLB and increases in deposits, including brokered deposits, as well as the cash flow from the sale and maturity of investment securities.
• Asset quality metrics remained stable in comparison to recent reporting periods and are comparable to peer group averages. The Company’s consistent asset quality metrics are reflective of its disciplined risk management process, along with the relative economic stability of its Central New York State market area. During the first quarter of 2018, a single commercial real estate loan with an outstanding balance of $1.7 million was added to nonperforming assets. This loan currently is expected to be financed with a new borrower and no materially significant additional losses are anticipated beyond the specific reserves previously recorded during the fourth quarter of 2017 and the second quarter of 2018. Primarily as a result of this addition, nonperforming loans to total loans increased to 0.90% at June 30, 2018, compared to 0.84% at December 31, 2017, and 0.80% at June 30, 2017. Correspondingly, the ratio of the allowance for loan losses to nonperforming loans for second quarter 2018 was 139.7%, as compared to 145.6% at December 31, 2017 and 142.5% at June 30, 2017. Annualized net loan charge-offs to average loans ratio remained favorable and was 0.14% for the second quarter of 2018, compared to 0.16% for the fourth quarter of 2017 and 0.31% for the second quarter of 2017.

The Company had net income of $945,000 for the three months ended June 30, 2018 compared to net income of $920,000 for the three months ended June 30, 2017. The $25,000 increase in net income was due primarily to a $1.4 million increase in interest and dividend income, a decrease of $126,000 in provision for loan losses and a $72,000 decrease in

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income tax expense. These increases were partially offset by a $1.1 million increase in noninterest expense, a $546,000 increase in interest expense, and a decrease in noninterest income of $26,000.

Net interest income before the provision for loan losses increased $886,000, or 15.9%, to $6.5 million for the three months ended June 30, 2018 as compared to $5.6 million for the same three month period in 2017. The increase was primarily the result of the increase in average interest-earning asset balances due to increases in average loans, and average taxable and tax-exempt investment securities. The positive effects of increased average interest-earning assets for the three months ended June 30, 2018, as compared to the same three month period in 2017, were also enhanced by an increase in the average yield of those assets of 34 basis points to 4.05% for the three months ended June 30, 2018 from 3.71% for the same three month period of the previous year. This increase in net interest income was partially offset by an increase in the average balance and average cost of interest-bearing liabilities between the year-over-year second quarter periods.

The $26,000, or 2.5%, decrease in noninterest income in the quarter ended June 30, 2018, as compared to the same quarterly period in 2017, was primarily the result of a net decrease of $157,000 in the net gains on the sales and redemptions of investment securities from a gain of $135,000 for the three months ended June 30, 2017 to a net loss of $22,000 for the same quarter in 2018. The net gains on investment securities during the quarter ended June 30, 2017 were primarily the result of $94,000 in net gains recorded on short-term interest rate hedging activities in that period. There were no hedging activities of this type in the three months ended June 30, 2018. During the three months ended June 30, 2018, Company-initiated sales and issuer-initiated redemptions of investment securities in the amount of $11.4 million, generated a net loss of $22,000, or 0.19%. The investment securities sales were part of the Company’s portfolio optimization and liquidity management strategies. It is the intention of management to reinvest the proceeds of these investment securities transactions into potentially higher yielding interest-earning assets in future periods.

Excluding the effects of the quarter over quarter reduction in gains on the sale of investment securities, all other noninterest income categories increased in the aggregate by $131,000, or 14.3% to $1.0 million in the quarter ended June 30, 2018 as compared with $915,000 in the same quarter of 2017. This $131,000 quarter over quarter increase in noninterest income, excluding the effects of gains on the sales and redemptions of investment securities, was due primarily to increases of $46,000 in earnings and gains on bank owned life insurance, $34,000 net gains on sales of loans and foreclosed real estate, and $28,000 in other charges, commissions and fees.The $26,000 decrease in noninterest income in the quarter ended June 30, 2018, as compared to the same quarterly period in 2017, was primarily the result of a decrease of $157,000 in gains on the sales and redemptions of investment securities. Absent the effects of the quarter over quarter reduction in gains on the sale of investment securities, all other noninterest income categories increased by $131,000, or 14.3% to $1.0 million in the quarter ended June 30, 2018 as compared with $915,000 in the same quarter of 2017.

The $1.1 million increase in noninterest expense in the quarter ended June 30, 2018, as compared to the same quarterly period in 2017, was due primarily to an increase of $610,000, or 21.6%, in salaries and employee benefits expense that reflected an increase in staffing levels intended to meet increased loan demand and to better serve customers and potential customers as the Bank’s operations continue to expand primarily into Onondaga County, New York. In addition, professional and other services increased $186,000, advertising expenses increased $113,000, data processing increased $60,000, and FDIC assessments increased $54,000. All other noninterest expense categories increased $93,000, or 7.1%, in aggregate during the quarter ended June 30, 2018, as compared to the same three month period in 2017.

The $126,000 decrease in the provision for loan losses in the quarter ended June 30, 2018, as compared with the same quarter of 2017, was primarily due to improvements in the majority of credit quality metrics throughout the loan portfolio. The ratio of delinquent loans to total loans improved to 1.29% at June 30, 2018 as compared to 2.12% at December 31, 2017 as a result of a decrease in total delinquent loans to $7.8 million at June 30, 2018 as compared to $12.3 million at June 30, 2017. Partially offsetting the effects of these improvements in credit quality metrics was the increase in the estimable and probable loan losses inherent in the loan portfolio due to increases of $68.4 million, or 12.7%, in average loan balances in the second quarter of 2018 as compared with the same quarter of 2017.

In comparing the year-over-year second quarter periods, the return on average assets decreased three basis points to 0.43% due to the combined effects of the increase in net income (the numerator in the ratio) and the increase in average assets (the denominator in the ratio). Average assets increased due to increases in average loans, and average taxable and tax-

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exempt investment securities of $68.4 million and $8.1 million, respectively, in the second quarter of 2018 as compared to the same quarter of 2017. Average interest-bearing deposits increased $56.4 million in the second quarter of 2018, as compared with the same quarter in 2017, due to increased brokered and consumer deposits, and increased commercial deposits resulting in part from new loan account relationships, particularly in Onondaga County. These increases in average deposits were partially offset by decreases in municipal deposits that are considered to be seasonal in nature.

The Company had net income of $1.9 million for the six months ended June 30, 2018 compared to net income of $1.7 million for the six months ended June 30, 2017. The $229,000 increase in net income available to common shareholders was due primarily to a $2.8 million increase in interest and dividend income, and a $135,000 decrease in income tax expense, partially offset by an increase of $1.6 million in noninterest expense, a $989,000 increase in interest expense, an increase of $98,000 in provision for loan losses, and a $68,000 decrease in noninterest income.

Net interest income before the provision for loan losses increased $1.8 million, or 16.1%, to $12.9 million for the six months ended June 30, 2018 as compared to the same six month period in the previous year. The increase was a result of the increase in average balances on loans and taxable investment securities and an increase in the average yield earned on those balances, partially offset by an increase in the average balance and average cost of interest-bearing liabilities between the year-over-year six month periods.

The $68,000, or 3.4% decrease in noninterest income in the six months ended June 30, 2018, as compared to the same six month period in 2017, was primarily the result of a net decrease of $335,000 in the net gains on the sales and redemptions of investment securities from a gain of $206,000 for the six months ended June 30, 2017 to a net loss of $129,000 for the same six month period in 2018. The net gains on investment securities during the six months ended June 30, 2017 were primarily the result of $250,000 in net gains recorded on short-term interest rate hedging activities in that period. There were no hedging activities of this type in the six months ended June 30, 2018. During the six months ended June 30, 2018, Company-initiated sales and issuer-initiated redemptions of investment securities in the amount of $29.2 million, generated a net loss of $129,000, or 0.44%. The investment securities sales were part of the Company’s portfolio optimization and liquidity management strategies. It is the intention of management to reinvest the proceeds of these investment securities transactions into potentially higher yielding interest-earning assets in future periods.

Excluding the effects of the period over period reduction in gains on the sale of investment securities, all other noninterest income categories increased in the aggregate by $267,000, or 15.0% to $2.0 million in the six months ended June 30, 2018 as compared with $1.8 million in the same six month period of 2017. This $267,000 period over period increase in noninterest income, excluding the effects of gains on the sales and redemptions of investment securities, was due primarily to increases of $84,000 in other charges, commissions and fees, $61,000 net gains on sales of loans and foreclosed real estate, and $48,000 in earnings and gains on bank owned life insurance.

The $1.6 million increase in noninterest expense was due primarily to an increase of $844,000, or 14.9%, in salary and employee benefits expense that reflected in part an increase in staffing levels intended to meet increased loan demand and to better serve customers and potential customers as the Bank’s operations continue to expand into Onondaga County. In addition, professional and other services expense increased $326,000, advertising expense increased $128,000, FDIC assessments increased $118,000 and data processing expense increased $112,000. All other noninterest expense categories increased $74,000, or 2.9%, in aggregate for the six month period ended June 30, 2018, as compared to the same six month period in 2017.

For the three months ended June 30, 2018, we recorded $297,000 in provision for loan losses as compared to $423,000 in the same prior year three month period. This $126,000 decrease in the provision for loan losses was due principally to favorable changes to both the quantitative and environmental factors assigned to the Bank’s loan portfolio in aggregate, partially offset by $68.4 million, or 12.7%, increase in average loan balances in the first three months of 2018 as compared with the same three month period of 2017 and the resultant increase in the estimable and probable loan losses inherent in the loan portfolio.

For the first six months of 2018, we recorded $910,000 in provision for loan losses as compared to $812,000 in the same prior year six month period. This $98,000 increase in the provision for loan losses was due principally to the $77.5 million, or 14.8%, increase in average loan balances in the first six months of 2018 as compared with the same six month period of 2017 and the resultant increase in the estimable and probable loan losses inherent in the loan portfolio, partially

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offset by favorable changes to both the quantitative and environmental factors assigned to the Bank’s loan portfolio in aggregate.

Return on average assets increased one basis point to 0.44% between the year-over-year six month periods as the net income increases in the six month period ended June 30, 2018 (the numerator of the ratio) increased by a slightly higher percentage than did total average assets (the denominator of the ratio) during the period.

Net Interest Income

Net interest income is the Company's primary source of operating income for payment of operating expenses and providing for loan losses. It is the amount by which interest earned on loans, interest-earning deposits, and investment securities, exceeds the interest paid on deposits and other interest-bearing liabilities. Changes in net interest income and net interest margin result from the interaction between the volume and composition of interest-earning assets, interest-bearing liabilities, related yields, and associated funding costs.

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The following tables set forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. Interest income and resultant yield information in the tables has not been adjusted for tax equivalency. Averages are computed on the daily average balance for each month in the period divided by the number of days in the period. Yields and amounts earned include loan fees. Nonaccrual loans have been included in interest-earning assets for purposes of these calculations.

(Dollars in thousands)

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(Dollars in thousands)

As indicated in the above tables, net interest income, before provision for loan losses, increased $886,000, or 15.9%, to $6.5 million for the three months ended June 30, 2018 as compared to $5.6 million for the same prior year period. This increase was due principally to the $78.7 million, or 10.3%, increase in the average balance of interest-earning assets, and an increase of 34 basis points on the average interest yield earned on those assets. These positive factors on net interest income were partially offset by an increase in the average balance of interest-bearing liabilities of $62.8 million, or 9.55%, and an increase of 23 basis points on the average interest rate paid on those liabilities. In total, net interest margin increased 14 basis points to 3.07% due largely to the increase in yields earned on average interest-earning assets, as noted above. The following analysis should also be viewed in conjunction with the table below which reports the changes in net interest income attributable to rate and volume.

Interest and dividend income increased $1.4 million, or 20.2%, to $8.5 million for the three months ended June 30, 2018 compared to $7.1 million for the same three month period in 2017. The increase in interest income was due principally to the increase in average interest-earning assets (primarily loans, and taxable and tax-exempt investment securities) which increased between the year-over-year second quarter periods by 10.2%. The increase in the average balances of loans reflects the Company’s continued success in its expansion within the greater Syracuse, New York market. Further supporting the quarter-over-quarter increase in interest income, the average yield on the loans and taxable investment portfolio improved 26 basis points to 4.62% and 73 basis points to 2.65%, respectively. This increase in the average yield

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on loans was the result of new loan production being added to the loan portfolio at rates slightly higher than the average rates of the previously existing portfolio. The increase in the average yield on taxable investment securities was the result of an increase in book yields on adjustable-rate securities and the purchase of new securities, often with longer durations or more credit risk exposure, at rates higher than the average yields of securities within the previously-existing portfolio whose balances continue to be reduced by amortization and maturities.

Interest expense for the three months ended June 30, 2018 increased $546,000, or 36.3%, to $2.0 million when compared to the same prior year period. Deposit interest expense increased $671,000, or 75.0%, to $1.6 million due to a $56.4 million increase in the average balance of interest-bearing deposits accompanied by a 37 basis point increase in the average annualized rate paid on these deposits to 0.98% for the three months ended June 30, 2018, as compared with the same three month period in 2017. This increase in average rates was primarily due to 45 and 43 basis points increases in the average rates paid on time deposits and money market deposit accounts (“MMDA”), respectively, during the three months ended June 30, 2018 as compared to the same three month period in 2017. These increases in the average rates paid on time deposits and MMDA deposits reflected the competitive environment for such deposits within the Company’s marketplace as well as a general increase in short-term interest rates nationally. Partially offsetting the increase in interest expense on deposits in the three months ended June 30, 2018, as compared with the same three month period in 2017, was a decrease of $138,000 in interest expense on borrowed funds, primarily due to the Bank’s use of certain interest rate risk hedging strategies in the second quarter of 2017 that added $222,000 to interest expense in the second quarter of that year. The Bank did not engage in those activities during 2018.

For the six month period ended June 30, 2018, net interest income, before the provision for loan losses, increased $1.8 million, or 16.1%, to $12.9 million compared to $11.1 million for the six months ended June 30, 2017. Interest and dividend income increased $2.8 million, or 19.9%, to $16.7 million for the six months ended June 30, 2018 from $14.0 million for the same six month period in 2017. The increase in interest income was due principally to the increase in average balances of loans, and the aggregate balances of taxable and tax-exempt investment securities, which increased 14.8% and 11.5%, respectively, between the year-over-year six month periods. The increase in the average balances of loans reflects the Company’s continued success in its expansion within the greater Syracuse market. These increases were also positively affected by the increase in the average yield on loans and taxable investment securities of 13 basis points to 4.57% and 59 basis points to 2.51%, respectively. This increase in the average yield on loans was the result of new loan production being added to the loan portfolio at rates slightly higher than the average rates of the previously existing portfolio. The increase in the average yield on taxable investment securities was the result of an increase in book yields on adjustable-rate securities and the purchase of new securities, often with longer durations or more credit risk exposure, at rates higher than the average rates of securities within the previously-existing portfolio whose balances continue to be reduced by amortization, maturities and sales.

Interest expense for the six months ended June 30, 2018 increased $989,000, or 34.4%, to $3.9 million as compared to $2.9 million for the six months ended June 30, 2017. The increase in interest expense was due principally to the increase in average interest-bearing liabilities of $77.1 million, along with a 17 basis point increase in the average rate paid on these liabilities to 1.06%. The increase in average rates paid on interest-bearing liabilities was due to a $1.3 million increase in deposit interest expense, partially offset by a $285,000 decrease in interest expense paid on borrowed funds. The average balances of interest-bearing deposits, which include brokered deposits, increased $73.2 million between the year-over-year six month periods. Deposit interest expense increased 32 basis points to 0.90% for the six months ended June 30, 2018 as compared with the same six month period in 2017. This increase was primarily due to a 44 and 36 basis point increase in the average rate paid on time deposits and MMDA deposits, respectively, during the six months ended June 30, 2018 as compared to the same time period in 2017. The increases in rates paid on those deposits reflected the competitive environment for such deposits within the Company’s marketplace and a general increase in short-term interest rates nationally.

The $285,000 decrease in interest expense related to borrowings between the year-over-year six month periods was primarily due to a reduction of $430,000 in pretax interest expense paid that was related to the Bank’s short-term interest rate risk hedging activities in 2017. This reduction in interest expense paid on borrowings was partially offset by an increase of $145,000 in interest expense related to non-hedge related borrowings. There were no hedging activities in the first six months of 2018. During the six months of 2017, the Bank paid $430,000 in net interest on a $40 million U.S. Treasury security that it had received from an unrelated entity as collateral for a short term loan. The U.S. Treasury security was sold by the Bank which placed the Bank in what is commonly referred to as a “short” position with respect to

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that security. During the period of time that the Bank was in a short position with respect to the security, short-term interest rates generally rose and the Bank reacquired the security with a realized gain, net of tax benefits, of $346,000. The $145,000 increase in non-hedge related borrowings interest expense was primarily due to a 36 basis point increase in the average rate paid on non-hedge related borrowings to 1.62% in the six months ended June 30, 2018 from 1.26% in the same six month period of 2017. This increase in the average rate paid on non-hedge related borrowings was primarily due to a general year-over-year increase in short-term interest rates.

Rate/Volume Analysis

Net interest income can also be analyzed in terms of the impact of changing interest rates on interest-earning assets and interest-bearing liabilities and changes in the volume or amount of these assets and liabilities. The following table represents the extent to which changes in interest rates and changes in the volume 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: (i) changes attributable to changes in volume (change in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) total increase or decrease. Changes attributable to both rate and volume have been allocated ratably.

(In thousands)

Provision for Loan Losses

We establish a provision for loan losses, which is charged to operations, at a level management believes is appropriate to absorb probable incurred credit losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events change. The provision for loan losses represents management’s estimate of the amount necessary to maintain the allowance for loan losses at an adequate level.

Management extensively reviews recent trends in historical losses, qualitative factors and specific reserve needs on loans individually evaluated for impairment in its determination of the adequacy of the allowance for loan losses. We recorded $297,000 in provision for loan losses for the three month period ended June 30, 2018, as compared to $423,000 for the three month period ended June 30, 2017. The $126,000 decrease in the provision for loan losses was primarily due to favorable changes to both the quantitative and environmental factors deemed to be appropriate for the Bank’s loan

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portfolio in aggregate, partially offset by the effects of an increase in the estimable and probable loan losses inherent in the loan portfolio that resulted from the $68.4 million, or 12.7%, increase in average loan balances in the second quarter of 2018, as compared with the same quarter of 2017.

For the three months ended June 30, 2018, we recorded $297,000 in provision for loan losses as compared to $423,000 in the same prior year three month period. This $126,000 decrease in the provision for loan losses was due principally to favorable changes to both the quantitative and environmental factors assigned to the Bank’s loan portfolio in aggregate, partially offset by $68.4 million, or 12.7%, increase in average loan balances in the first three months of 2018 as compared with the same three month period of 2017 and the resultant increase in the estimable and probable loan losses inherent in the loan portfolio.

For the first six months of 2018, we recorded $910,000 in provision for loan losses as compared to $812,000 in the same prior year six month period. This $98,000 increase in the provision for loan losses was due principally to the $77.5 million, or 14.8%, increase in average loan balances in the first six months of 2018 as compared with the same six month period of 2017 and the resultant increase in the estimable and probable loan losses inherent in the loan portfolio, partially offset by favorable changes to both the quantitative and environmental factors assigned to the Bank’s loan portfolio in aggregate.

The Company measures delinquency based on the amount of past due loans as a percentage of total loans. The ratio of delinquent loans to total loans decreased to 1.29% at June 30, 2018 as compared to 2.12% at December 31, 2017. Delinquent loans (numerator) decreased $4.5 million while total loan balances (denominator) increased $26.1 million at June 30, 2018, as compared to December 31, 2017. The decline in past due loans was primarily driven by a decrease of $2.7 million in loans delinquent 30-59 days and $2.4 million in loans delinquent 60-89, partially offset by an increase of $551,000 in loans delinquent more than 90 days. At June 30, 2018, there were $7.8 million in loans past due including $1.6 million in loans 30-59 days past due, $812,000 in loans 60-89 days past due and $5.4 million in loans 90 or more days past due. At December 31, 2017, there were $12.3 million in loans past due, including $4.3 million in loans 30-59 days past due, $3.2 million in loans 60-89 days past due and $4.9 million in loans 90 or more days past due.

The decrease of $4.5 million in total loans past due at June 30, 2018, as compared to December 31, 2017, was primarily due to a decrease of $2.7 million in loans 30-59 days past due and a decrease of $2.4 million in loans 60-89 days past due. The decrease in loans 30-59 days past due at June 30, 2018 as compared to December 31, 2017 was primarily due to a decrease in the commercial lines of credit that were delinquent 30-59 days. At December 31, 2017, there were four commercial lines of credit with an outstanding balance of $1.5 million (outstanding loan balances of $600,000, $450,000, $400,000, and $32,000, respectively) that were 30-59 days past due, while at June 30, 2018, there were only two commercial lines of credit with an outstanding balance of $161,000 (outstanding loan amounts of $71,000 and $90,000, respectively) that were 30-59 days past due. Total loans with delinquent balances 60-89 days past due decreased by $2.4 million in aggregate, primarily as a result of one commercial real estate loan with an outstanding balance of $1.7 million that was 60-89 days delinquent at December 31, 2017 and was over 90 days past due at June 30, 2018.

Noninterest Income

The Company's noninterest income is primarily comprised of fees on deposit account balances and transactions, loan servicing, commissions, including insurance agency commissions, and net gains on sales of securities, loans, and foreclosed real estate.

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The following table sets forth certain information on noninterest income for the periods indicated:

(Dollars in thousands)

The $26,000, or 2.5%, decrease in noninterest income in the quarter ended June 30, 2018, as compared to the same quarterly period in 2017, was primarily the result of a net decrease of $157,000 in the net gains on the sales and redemptions of investment securities from a gain of $135,000 for the three months ended June 30, 2017 to a net loss of $22,000 for the same quarter in 2018. The net gains on investment securities during the quarter ended June 30, 2017 were primarily the result of $94,000 in net gains recorded on short-term interest rate hedging activities in that period. There were no hedging activities of this type in the three months ended June 30, 2018. During the three months ended June 30, 2018, Company-initiated sales and issuer-initiated redemptions of investment securities in the amount of $11.4 million, generated a net loss of $22,000, or 0.19%. The investment securities sales were part of the Company’s portfolio optimization and liquidity management strategies. It is the intention of management to reinvest the proceeds of these investment securities transactions into potentially higher yielding interest-earning assets in future periods.

Excluding the effects of the quarter over quarter reduction in gains on the sale of investment securities, all other noninterest income categories increased in the aggregate by $131,000, or 14.3% to $1.0 million in the quarter ended June 30, 2018 as compared with $915,000 in the same quarter of 2017. This $131,000 quarter over quarter increase in noninterest income, excluding the effects of gains on the sales and redemptions of investment securities, was due primarily to increases of $46,000 in earnings and gains on bank owned life insurance, $34,000 net gains on sales of loans and foreclosed real estate, and $28,000 in other charges, commissions and fees.

The $68,000, or 3.4% decrease in noninterest income in the six months ended June 30, 2018, as compared to the same six month period in 2017, was primarily the result of a net decrease of $335,000 in the net gains on the sales and redemptions of investment securities from a gain of $206,000 for the six months ended June 30, 2017 to a net loss of $129,000 for the same six month period in 2018. The net gains on investment securities during the six months ended June 30, 2017 were primarily the result of $250,000 in net gains recorded on short-term interest rate hedging activities in that period. There were no hedging activities of this type in the six months ended June 30, 2018. During the six months ended June 30, 2018, Company-initiated sales and issuer-initiated redemptions of investment securities in the amount of $29.2 million, generated a net loss of $129,000, or 0.44%. The investment securities sales were part of the Company’s portfolio optimization and liquidity management strategies. It is the intention of management to reinvest the proceeds of these investment securities transactions into potentially higher yielding interest-earning assets in future periods.

Excluding the effects of the period over period reduction in gains on the sale of investment securities, all other noninterest income categories increased in the aggregate by $267,000, or 15.0% to $2.0 million in the six months ended June 30, 2018 as compared with $1.8 million in the same six month period of 2017. This $267,000 period over period increase in noninterest income, excluding the effects of gains on the sales and redemptions of investment securities, was due primarily to increases of $84,000 in other charges, commissions and fees, $61,000 net gains on sales of loans and foreclosed real estate, and $48,000 in earnings and gains on bank owned life insurance.

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Noninterest Expense

The following table sets forth certain information on noninterest expense for the periods indicated:

(Dollars in thousands)

The $1.1 million, or 22.3%, increase in noninterest expense between the year-over-year second quarter periods was principally due to an increase in salaries and employee benefits expense of $610,000, or 21.6%. All other noninterest expenses in aggregate increased $506,000, or 23.1%, for the three months ended June 30, 2018 as compared to the same three month period in 2017. The detail of the components of the overall increase in noninterest expense is as follows:

• The $610,000 increase in salaries and employee benefits expense in the second quarter of 2018, as compared to the same three month period in 2017, was primarily due to increases of $221,000 in salary expense, increases of $185,000 in commissions expense, increases of $109,000 in employee benefits expense, including employee payroll tax expenses, and the establishment of a $100,000 reserve, through expense recognition, for the potential acceleration of postemployment benefits related to the earlier than originally planned retirement of a senior officer. Partially offsetting these increases was a net decrease in all other salaries and employee benefits expenses of $5,000. Salaries expense increased primarily as the result of the addition of staff members supporting current and planned asset growth and risk management activities. Commissions expense increased primarily due to $113,000 in additional accruals in the second quarter of 2018 that related to the timing of commissions payments, primarily to the senior management team of the Agency under a revised compensation formula established at the end of 2017. These timing factors are expected to partially reverse themselves in the remainder of 2018. The increases in employee benefits expenses for the three months ended June 30, 2018, as compared to the same three-month period in 2017, were also affected by certain timing factors and were consistent with the salary and commissions expense increases discussed above.
• The $60,000 increase in data processing costs was primarily due to an additional $28,000 in processing fees paid by the Bank that were based on increased levels of customer activity primarily transacted through its electronic delivery channels and $22,000 of additional equipment depreciation expenses.
• The $186,000 increase in professional and other services fees was primarily due to fees paid to an unaffiliated consulting firm during the quarter for assistance with operational and strategic planning.
• Advertising expense increased $113,000 primarily as the result of increases in the level of brand awareness advertising expenditures primarily focused on the Onondaga County market.
• FDIC assessments increased $54,000 due to an increase in the Bank’s risk-weighted assessment resulting from the phase-out of a benefit the Bank received in the FDIC’s risk-weighting methodology as a result of the dissolution of Pathfinder Commercial Bank.
• All other noninterest expenses decreased in aggregate in the year-over-year three month periods by a total of $93,000, or 7.1%, due to a broad range of individually immaterial variances.
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The $1.6 million, or 16.0%, increase in noninterest expenses between the six month period ended June 30, 2018 and the same six month period in the prior year was principally due to an increase in salaries and employee benefits expense, data processing expense, professional and other service fees, advertising expense, FDIC assessments, and other expenses. The detail of the components of the overall increase in noninterest expense is as follows:

• The $844,000 increase in salaries and employee benefits expense in the first six months of 2018, as compared to the same six month period in 2017, was primarily due to $447,000 in salary expense increases, increases of $151,000 in employee benefits expense, including employee payroll tax expenses, the establishment of a $150,000 reserve, through expense recognition, for the potential acceleration of postemployment benefits related to the earlier than originally planned retirement of a senior officer, and increases of $134,000 in commissions expense, partially offset by a net decrease in all other salaries and employee benefits expenses of $38,000. Salaries expense increased as the result of the additions of staff members supporting current and planned asset growth and risk management activities. Commissions expense increased primarily due to $113,000 in additional accruals in the second quarter of 2018 that related to the timing of commissions payments, primarily to the senior management team of the Agency under a revised compensation formula established at the end of 2017. These timing factors are expected to partially reverse themselves in the remainder of 2018. The increases in employee benefits expenses for the six months ended June 30, 2018, as compared to the same six-month period in 2017, were consistent with the salary and commissions expense increases discussed above.
• The $112,000 increase in data processing expenses was primarily related to increases of $42,000, $32,000 and $31,000 in third-party processing charges, equipment depreciation and equipment maintenance expenses, respectively, for the six months ended June 30, 2018, as compared with the same six month period in 2017.
• The $326,000 increase in professional and other services fees was primarily due to fees paid to an unaffiliated consulting firm for the six months ended June 30, 2018 for assistance with operational and strategic planning.
• Advertising expense increased $128,000 primarily as the result of increases in the level of brand awareness advertising expenditures primarily focused on the Onondaga County market.
• FDIC assessments increased $118,000 due to an increase in the Bank’s risk-weighted assessment resulting from the phase-out of a benefit the Bank received in the FDIC’s risk-weighting methodology as a result of the dissolution of Pathfinder Commercial Bank.
• All other noninterest expenses decreased in aggregate in the year-over-year six month periods by a total of $74,000, or 2.9%, due to a broad range of individually immaterial variances.

At June 30, 2018, the Bank serviced 220 residential mortgage loans in the aggregate amount of $31.2 million that have been sold on a non-recourse basis to FNMA. FNMA is the only unrelated third-party that has acquired loans originated by the Bank. On an infrequent basis, loans previously sold to FNMA that subsequently default may be found to have underwriting defects that place the loans out of compliance with the representations and warranties made by the Bank. This can occur at any time while the loan is outstanding. In such cases, the Bank is required to repurchase the defaulted loans from FNMA. Repurchase losses sustained by the Bank include all costs incurred by FNMA as part of the foreclosure process, including items such as delinquent property taxes and legal fees. Management continues to monitor the underwriting standards applied to all residential mortgage loan originations and subsequent sales through its quality control processes and considers these occurrences and their related expenses to be isolated instances.

Income Tax Expense

Income tax expense decreased $72,000 to $166,000, with an effective tax rate of 14.3% for the quarter ended June 30, 2018 as compared to $238,000, with an effective tax rate of 21.3%, for the same three month period in 2017. The reduction in income tax expense was primarily the result of a reduction in statutory tax rates applicable to the Company and, to a lesser extent, a reduction in net income before income taxes of $130,000. The reduction in the second quarter 2018 effective tax rate, compared to the effective tax rate in the same quarter of 2017, was primarily the result of the enactment of the Tax Act, which reduced the federal statutory corporate tax rate applicable to the Company from 34% to 21%, and favorable changes to the New York State tax code. During both the second quarters of 2018 and 2017, the Company derived tax benefits from its investments in tax-exempt securities issued by municipalities and political subdivisions, and from its investments in bank owned life insurance. In the second quarter of 2018, these benefits reduced the effective tax rate to 18.9%. In addition, the Company recognized tax benefits of $52,000 and $19,000 related to the

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nonqualified redemption of employee incentive stock options and the utilization of low-income housing tax credits, respectively, that further reduced the overall effective tax rate for the first half of 2018 to the reported 14.3%.

During the second quarter of 2017, the sale of certain U.S. Treasury assets, positioned as part of the Company’s short-term interest rate hedge strategies, resulted in realized capital gains in the amount of $156,000. These gains enabled the partial utilization of previously reserved-for capital loss carryforwards resulting in a reduction in income tax expense of $60,000 during that quarter. Absent this capital loss carryforward utilization effect in the second quarter of 2017, the Company’s income tax expense would have been $298,000 and its effective tax rate for that quarter would have been 26.7%.

Income tax expense decreased $135,000 to $348,000, with an effective tax rate of 15.1% for the six months ended June 30, 2018 as compared to $483,000, with an effective tax rate of 22.6%, for the same six month period in 2017. The reduction in the first half 2018 effective tax rate, compared to the effective tax rate in the same six month period in 2017, was primarily the result of the enactment of the Tax Act, which reduced the federal statutory corporate tax rate applicable to the Company from 34% to 21%, and favorable changes to the New York State tax code. During both the first six months of 2018 and 2017, the Company derived effective tax rate benefits from its investments in tax-exempt securities issued by municipalities and political subdivisions, and from its investments in bank owned life insurance. In the first six months of 2018, these benefits reduced the effective tax rate to 19.0%. In addition, the Company recognized tax benefits of $74,000 and $19,000 related to the nonqualified redemption of employee incentive stock options and the utilization of low-income housing tax credits, respectively, reducing the overall effective tax rate for the first half of 2018 to the reported 15.1%.

During the first six months of 2017, the sale of certain U.S. Treasury assets, positioned as part of the Company’s short-term interest rate hedge strategies, resulted in realized capital gains in the amount of $250,000. These gains enabled the partial utilization of previously reserved-for capital loss carryforwards resulting in a reduction in income tax expense of $96,000 during the six months ended June 30, 2018. Absent this capital loss carryforward utilization effect in the first half of 2017, the Company’s income tax expense would have been $298,000 and its effective tax rate for that six month period would have been 27.1%.

Earnings per Share

Basic and diluted earnings per share were unchanged at $0.23 and $0.22, respectively, for the second quarters of 2018 and 2017.

Basic and diluted earnings per share were $0.47 and $0.46, respectively, for the six month period ended June 30, 2018 as compared to $0.42 and $0.41, respectively, for the same prior year period. The increase in earnings per share between these two periods was due to the increase in net income between these two time periods. Further information on earnings per share can be found in Note 3 of this Form 10-Q.

Changes in Financial Condition

Assets

Total assets increased $22.2 million, or 2.5%, to $903.5 million at June 30, 2018 as compared to $881.3 million at December 31, 2017. This increase was due primarily to an increase in loans and cash and cash equivalents, partially offset by decreases in investment securities.

Total loans receivable increased $26.4 million, or 4.5%, to $607.2 million at June 30, 2018 from $580.8 million at December 31, 2017. Commercial loans and residential loans recorded increases between these two dates, with increases of $20.6 million, and $6.8 million, respectively. These increases were partially offset by a decrease of $1.3 million in consumer loans.

Investment securities decreased $26.1 million, or 11.0%, to $211.2 million at June 30, 2018, as compared to $237.3 million at December 31, 2017, due principally to sales and maturities of securities during the first six months of 2018.

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Cash and cash equivalents increased $14.7 million, or 67.1%, to $36.7 million at June 30, 2018, as compared to $22.0 million at December 31, 2017. The $14.7 million increase in cash and cash equivalents was primarily due to a strategic increase in short-term liquidity in anticipation of continued high levels of demand for loan fundings in the second half of 2018. The Bank considers its statutorily required cash reserve balances held at the Federal Reserve Bank to be restricted cash. Total restricted cash was $4.4 million and $6.3 million at June 30, 2018 and December 31, 2017, respectively.

Liabilities

Total liabilities increased $21.5 million, or 2.6%, to $840.6 million at June 30, 2018 compared to $819.1 million at December 31, 2017. Deposits increased $9.6 million, or 1.3%, to $733.2 million at June 30, 2018, compared to $723.6 million at December 31, 2017. This increase was the result of an increase in brokered deposits of $10.4 million, partially offset by a decrease in deposits obtained directly from customers within the Bank’s marketplace of $792,000. The net decrease in customer deposits during the six months ended June 30, 2018 was due primarily to decreases in municipal deposits of $18.7 million, partially offset by growth in consumer and business deposit categories of $17.9 million in aggregate. The Bank utilizes the Certificates of Deposit Account Registry Service (“CDARS”) provided by Promontory Interfinancial Network as a form of brokered deposits. At June 30, 2018, deposits obtained through the use of this service increased $10.4 million to $69.9 million as compared to $59.5 million at December 31, 2017. Borrowed funds balances at June 30, 2018 increased $10.2 million, or 13.8%, to $84.1 million from $73.9 million at December 31, 2017.

Shareholders’ Equity

The Company’s shareholders’ equity, exclusive of the noncontrolling interest, increased $806,000, or 1.3%, to $62.6 million at June 30, 2018 from $61.8 million at December 31, 2017. This increase was principally due to an increase of $1.5 million in retained earnings, a $459,000 increase in additional paid-in capital, resulting from activity within the Company’s stock-based compensation programs, and a $90,000 increase in ESOP shares earned. In addition, the Company adopted ASU 2017-12: Derivatives and Hedging [Topic 815]: Targeted Improvements to Accounting for Hedging Activities, effective January 1, 2018, in the second quarter of 2018. As a result of the adoption of this guidance, the Company transferred investment securities from HTM to AFS with an amortized historical cost before transfer of $35.2 million. This transfer resulted in the addition of $359,000 to accumulated other comprehensive income as of the effective date. Partially offsetting these increases in shareholders’ equity was an increase of $1.3 million in accumulated other comprehensive loss. The increase in retained earnings primarily resulted from $1.9 million in net income recorded in the first six months of 2018 and a $53,000 one-time adjustment related to the cumulative effect of an unrealized gain on marketable equity securities based on the adoption of ASU 2016-01 - Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Liabilities in the first quarter of 2018. Partially offsetting these increases in retained earnings was a reduction of $497,000 for cash dividends declared on our common stock. The increase in accumulated comprehensive loss was primarily the result of the decline in the fair market value of our available-for-sale investment securities during the six months ended June 30, 2018.

Capital

Capital adequacy is evaluated primarily by the use of ratios which measure capital against total assets, as well as against total assets that are weighted based on defined risk characteristics. The Company’s goal is to maintain a strong capital position, consistent with the risk profile of its banking operations. This strong capital position serves to support growth and expansion activities while at the same time exceeding regulatory standards. At June 30, 2018, the Bank met the regulatory definition of a “well-capitalized” institution, i.e. a leverage capital ratio exceeding 5%, a Tier 1 risk-based capital ratio exceeding 8%, Tier 1 common equity exceeding 6.5%, and a total risk-based capital ratio exceeding 10%.

In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions and certain discretionary bonus payments to management if the institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above the amount necessary to meet its minimum risk-based capital requirements. The buffer is separate from the capital ratios required under the Prompt Corrective Actions (“PCA”) standards. In order to avoid these restrictions, the capital conservation buffer effectively increases the minimum levels of the following capital to risk-weighted assets ratios: (1) Core Capital, (2) Total Capital and (3) Common Equity. The capital conservation buffer requirement began being phased in beginning January 1, 2016 at 0.625% of risk-weighted assets and is increasing each year until fully implemented at 2.5% on January 1, 2019. For

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2018, the capital buffer is 1.875% of risk-weighted assets. At June 30, 2018, the Bank exceeded all current and projected regulatory required minimum capital ratios, including the maximum capital buffer level that will be required on January 1, 2019.

As a result of the recently enacted Economic Growth, Regulatory Relief, and Consumer Protection Act, the federal banking agencies are required to develop a “Community Bank Leverage Ratio” (the ratio of a bank’s tangible equity capital to average total consolidated assets) for financial institutions with assets of less than $10 billion. A “qualifying community bank” that exceeds this ratio will be deemed to be in compliance with all other capital and leverage requirements, including the capital requirements to be considered “well capitalized” under Prompt Corrective Action statutes. The federal banking agencies may consider a financial institution’s risk profile when evaluating whether it qualifies as a community bank for purposes of the capital ratio requirement. The federal banking agencies must set the minimum capital for the new Community Bank Leverage Ratio at not less than 8% and not more than 10%. A financial institution can elect to be subject to this new definition.

Pathfinder Bank’s capital amounts and ratios as of the indicated dates are presented in the following tables:

(Dollars in thousands)

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Non-GAAP Financial Measures

Regulation G, a rule adopted by the Securities and Exchange Commission (SEC), applies to certain SEC filings, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” GAAP is generally accepted accounting principles in the United States of America. Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure (if a comparable GAAP measure exists) and a statement of the Company’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. Financial institutions like the Company and its subsidiary bank are subject to an array of bank regulatory capital measures that are financial in nature but are not based on GAAP. The Company follows industry practice in disclosing its financial condition under these various regulatory capital measures, including period-end regulatory capital ratios for its subsidiary bank, in its periodic reports filed with the SEC. The Company provides, below, an explanation of the calculations, as supplemental information, for non-GAAP measures included in the consolidated annual financial statements. In addition, the Company provides a reconciliation of its subsidiary bank’s disclosed regulatory capital measures, below.

(Dollars in thousands)

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Loan and Asset Quality and Allowance for Loan Losses

The following table represents information concerning the aggregate amount of non-performing assets at the indicated dates:

(Dollars In thousands)

Nonperforming assets include nonaccrual loans, nonaccrual troubled debt restructurings (“TDR”), and foreclosed real estate (‘‘FRE”). The Company generally places a loan on nonaccrual status and ceases accruing interest when loan payment performance is deemed unsatisfactory and the loan is past due 90 days or more. There are no loans that are past due 90 days or more and still accruing interest. Loans are considered modified in a TDR when, due to a borrower’s financial difficulties, the Company makes a concession(s) to the borrower that it would not otherwise consider. These modifications may include, among others, an extension of the term of the loan, and granting a period when interest-only payments can be made, with the principal payments made over the remaining term of the loan or at maturity. TDRs are included in the above table within the categories of nonaccrual loans or accruing TDRs. There were two nonaccruing TDR loans, with an aggregate carrying value of $69,000 included among the nonaccrual loans detailed in the table above at June 30, 2018.

As indicated in the table above, nonperforming assets at June 30, 2018 were $5.5 million and were $180,000 higher than the $5.4 million reported at December 31, 2017, due primarily to an increase of $709,000 in nonperforming commercial and commercial real estate loans, partially offset by a decrease of $371,000 in FRE and $160,000 in nonperforming consumer loans.

As indicated in the nonperforming asset table above, FRE balances decreased $371,000 to $97,000 at June 30, 2018 from $468,000 at December 31, 2017, following five sales from the portfolio and four additions to the portfolio during the six-month period ended June 30, 2018. More information regarding foreclosed real estate can be found in Note 8 of this Form 10-Q.

Fair values for commercial FRE are initially recorded based on market value evaluations by third parties, less costs to sell (“initial cost basis”). On a prospective basis, residential FRE assets will be initially recorded at the lower of the net amount of loan receivable or the real estate’s fair value less costs to sell. Any write-downs required when the related loan receivable is exchanged for the underlying real estate collateral at the time of transfer to FRE are charged to the allowance for loan losses. Values are derived from appraisals, similar to impaired loans, of underlying collateral or discounted cash flow analysis. Subsequent to foreclosure, valuations are updated periodically and assets are marked to current fair value, not to exceed the initial cost basis for the FRE property.

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The allowance for loan losses represents management’s estimate of the probable losses inherent in the loan portfolio as of the date of the statement of condition. The allowance for loan losses was $7.6 million and $7.1 million at June 30, 2018 and December 31, 2017, respectively. The ratio of the allowance for loan losses to total loans increased two basis points to 1.25% at June 30, 2018 from 1.23% at December 31, 2017. Management performs a quarterly evaluation of the allowance for loan losses based on quantitative and qualitative factors and has determined that the current level of the allowance for loan losses is adequate to absorb the losses in the loan portfolio as of June 30, 2018.

The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan. The measurement of impaired loans is generally based upon the fair value of the collateral, with a portion of the impaired loans measured based upon the present value of future cash flows discounted at the historical effective interest rate. A specific reserve is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral. For loans secured by real estate, estimated fair values are determined primarily through third-party appraisals or broker price opinions. When a loan is determined to be impaired, the Bank will reevaluate the collateral which secures the loan. For real estate, the Company will obtain a new appraisal or broker’s opinion whichever is considered to provide the most accurate value in the event of sale. An evaluation of equipment held as collateral will be obtained from a firm able to provide such an evaluation. Collateral will be inspected not less than annually for all impaired loans and will be reevaluated not less than every two years. Appraised values and broker opinion values are discounted due to the market’s perception of a reduced price of Bank-owned property and the Bank’s desire to sell the property more quickly to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

At June 30, 2018 and December 31, 2017, the Company had $7.8 million and $9.2 million in loans, respectively, which were deemed to be impaired, having established specific reserves of $1.2 million and $1.1 million, respectively, on these loans. The decrease in impaired loans between these two dates was primarily driven by decreases of $970,000 and $348,000 in impaired commercial real estate and other commercial loans, respectively. The $68,000 increase in specific reserves for impaired loans at June 30, 2018, as compared to December 31, 2017 was primarily due to a $276,000 increase in specific reserves for commercial real estate loans, partially offset by a $208,000 decrease in reserves for all other loans in aggregate.

Management has identified potential credit problems which may result in the borrowers not being able to comply with the current loan repayment terms and which may result in those loans being included in future impaired loan reporting. Potential problem loans totaled $3.8 million as of June 30, 2018, a decrease of $138,000, or 3.5%, as compared to $3.9 million at December 31, 2017. These loans have been internally classified as special mention, substandard, or doubtful, yet are not currently considered impaired.

Appraisals are obtained at the time a real estate secured loan is originated. For commercial real estate held as collateral, the property is inspected every two years.

In the normal course of business, the Bank has infrequently sold residential mortgage loans and participation interests in commercial loans. As is typical in the industry, the Bank makes certain representations and warranties to the buyer. The Bank maintains a quality control program for closed loans and considers the risks and uncertainties associated with potential repurchase requirements to be minimal.

Liquidity

Liquidity management involves the Company’s ability to generate cash or otherwise obtain funds at reasonable rates to support asset growth, meet deposit withdrawals, maintain reserve requirements, and otherwise operate the Company on an ongoing basis. The Company's primary sources of funds are deposits, borrowed funds, amortization and prepayment of loans and maturities of investment securities and other short-term investments, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company manages the pricing of deposits to maintain a desired deposit composition and balance. In addition, the Company invests excess funds in short-term interest-earning and other assets, which provide liquidity to meet lending requirements.

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The Company's liquidity has been enhanced by its ability to borrow from the Federal Home Loan Bank of New York (“FHLBNY”), whose competitive advance programs and lines of credit provide the Company with a safe, reliable, and convenient source of funds. A significant decrease in deposits in the future could result in the Company having to seek other sources of funds for liquidity purposes. Such sources could include, but are not limited to, additional borrowings, brokered deposits, negotiated time deposits, the sale of "available-for-sale" investment securities, the sale of securitized loans, or the sale of whole loans. Such actions could result in higher interest expense and/or losses on the sale of securities or loans.

Through the first six months of 2018, as indicated in the consolidated statement of cash flows, the Company reported net cash flows from operating activities of $5.1 million and net cash outflows of $9.7 million related to investing activities. The net cash outflows from investing activities primarily was due to a net $27.0 million increase in loan balances, partially offset by a $17.3 million decrease in all other investing activities in aggregate. The Company reported net cash flows from financing activities of $19.4 million generated principally by increased balances of long-term borrowings of $14.2 million and brokered deposits of $10.4 million, partially offset by an aggregate decrease in net cash of $5.2 million from all other financing sources, including dividends paid to common shareholders of $502,000.

In June 2018, the Company renewed for the period ended June 12, 2019, a $12.0 million portion of an expiring $26.0 million Irrevocable Stand-By Letter of Credit (“LOC”), first established in June 2016, with the FHLBNY as an alternative means of collateralizing certain public funds deposits. A LOC is a conditional commitment issued by the FHLBNY to guarantee the performance of the Bank with respect to large public funds deposits. These deposits are placed with the Bank by entities, such as municipalities and other political subdivisions within the Bank’s market area, and typically exceed the statutory FDIC deposit insurance limits for individual accounts. As a matter of statute, these depositors require that collateral be directly deposited by the Bank with an independent safekeeping agent, or in certain cases, that LOCs be issued by a third party that is acceptable to the depositor. The Bank finds that, with certain depositor relationships, this method of collateralization for the benefit of the municipal depositors is more economically efficient than posting specific securities with a safekeeping agent. The Bank committed a portion of its mortgage loan portfolio as pledged collateral to the FHLBNY for the LOC. Loans encumbered as collateral for letters of credit reduce the Bank’s available liquidity position in that available borrowing capacity with the FHLBNY is decreased substantially on a dollar-for-dollar basis.

The Company has a number of existing credit facilities available to it. At June 30, 2018, total credit available to the Company under the existing lines of credit was approximately $194.4 million at FHLBNY, the Federal Reserve Bank, and two other correspondent banks. As of June 30, 2018, the Company had $96.1 million of the available lines of credit utilized, including encumbrances supporting outstanding letters of credit, described above, on its existing lines of credit with $98.3 million available.

The Asset Liability Management Committee of the Company is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity. As of June 30, 2018, management reported to the Board of Directors that the Company is in compliance with its liquidity policy guidelines.

Off-Balance Sheet Arrangements

The Company is also a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. At June 30, 2018, the Company had $108.8 million in outstanding commitments to extend credit and standby letters of credit.

Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure

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controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this quarterly report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. There has been no change in the Company’s internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonable likely to materially affect, the Company’s internal control over financial reporting.

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