Pathfinder Bancorp, Inc.: Form 10-Q for the period ended Mar 31, 2019

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 March 31, 2019, the Company and subsidiaries had total assets of $975.1 million, total liabilities of $908.6 million and shareholders' equity of $66.2 million plus noncontrolling interest of $258,000, which represents the 49% of FitzGibbons not owned by the Company.

The following discussion reviews the Company's financial condition at March 31, 2019 and the results of operations for the three month periods ended March 31, 2019 and 2018. Operating results for the three months ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.

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 2018 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 27, 2019 (“the consolidated annual financial statements”) as of December 31, 2018 and 2017 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;
• 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 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:

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. In the quarter ended March 31, 2019, the Company established, through a charge to earnings, a valuation allowance in the amount of $136,000 in order to reserve against deferred tax assets related to New York State income taxes. Effective in January 2018, the Company adopted a modification methodology, made available following changes to the New York State tax code, effecting how the Company’s state income tax liability is computed. Under this adopted methodology it is unlikely that the Company will pay income taxes to New York in future periods and it is therefore probable that the Company’s deferred tax assets related to New York State income taxes are unlikely to further reduce the Company’s state income tax rate in the future. Accordingly, a valuation allowance against the value of those deferred tax assets was established to reduce the net deferred tax asset related to New York income taxes to $-0- at March 31, 2019. At March 31, 2019, the Company had a valuation allowance of $33,000 established against the future projected benefits of deferred tax assets related to New York State income tax obligations. There were no valuation allowances against deferred tax assets at December 31, 2018. The Company’s effective tax rate typically differs from the 21% federal statutory tax rate due primarily to tax-exempt income from specific types of investment securities and loans, bank owned life insurance, and, to a much lesser degree, the utilization of low income housing tax credits. These factors, which typically lower the effective tax rate for the Company, were offset by the establishment of the valuation allowance described above in the quarter ended March 31, 2019, resulting in an effective tax rate of 33.8% for that period.

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 other-than-temporary impairment (“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 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 nationally recognized statistical rating organization (“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 available-for-sale and marketable equity investment securities, intangible assets, foreclosed real estate, and the value of loan collateral when valuing 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.

Management performs an annual evaluation of our goodwill for possible impairment at each of our reporting units. Based on the results of the December 31, 2018 evaluation, management has determined that the carrying value of goodwill was not impaired as of that date. The evaluation approach is described in Note 10 of the consolidated annual financial statements. Further information on the estimation of fair values can be found in Note 22 to the consolidated annual financial statements.

Recent Events

On March 29, 2019, the Company announced that its Board of Directors declared a quarterly cash dividend of $0.06 per common share. The dividend is payable on May 10, 2019 to shareholders of record on April 18, 2019.

On May 8, 2019, the Company entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”) with Castle Creek Capital Partners VII, L.P. (“Castle Creek”), pursuant to which the Company sold: (i) 37,700 shares of the Company’s common stock, par value $0.01 per share, at a purchase price of $14.25 per share (the “Common Stock”); (ii) 1,155,283 shares of a new series of preferred stock, Series B convertible perpetual preferred stock, par value $0.01 per share, at a purchase price of $14.25 per share (the “Series B Preferred Stock”); and (iii) a warrant, with an approximate fair value of $373,000, to purchase 125,000 shares of Common Stock at an exercise price equal to $14.25 per share (the “Warrant”), in a private placement transaction (the “Private Placement”) for gross proceeds of approximately $17.0 million. The Securities Purchase Agreement contains representations, warranties, and covenants of the Company and Castle Creek.

The Company also entered into subscription agreements dated as of May 8, 2019 (the “Subscription Agreements”) with certain directors and executive officers of the Company as well as other accredited investors. Pursuant to the Subscription Agreements, the investors purchased an aggregate of 269,277 shares of Common Stock at $14.25 per share for gross proceeds of approximately $3.8 million, before payment of placement fees and related costs and expenses. The Subscription Agreements contain representations, warranties, and covenants of the purchasers and the Company that are customary in private placement transactions.

In total, therefore, the Company issued 306,977 shares of Common Stock, 1,155,283 shares of Series B Preferred Stock and the Warrant at the conclusion of the Private Placement offering period. The transaction raised $20.8 million in gross proceeds and it is anticipated that the final proceeds of the Private Placement, after all issuance expenses, including placement fees and all other issuance/due diligence costs of approximately $927,000 and $300,000, respectively, will be approximately $19.6 million. The Company intends to use the net proceeds of the Private Placement to strengthen the Company’s current balance sheet, improve the regulatory capital of the Bank, support organic growth opportunities and for general corporate purposes.

On May 8, 2019, the Company filed Articles Supplementary with the Maryland Department of Assessments and Taxation to issue 1,155,283 shares of Series B Preferred Stock to Castle Creek. Each share of the Series B Preferred Stock will be convertible on a one for one basis into either (i) Common Stock under certain circumstances or (ii) non-voting common stock, par value $0.01 per share (which will also be convertible into Common Stock), subject to approval of the creation of such class of non-voting common stock by the Company’s stockholders.

Pursuant to Nasdaq rules, Castle Creek may not convert the Series B Preferred Stock or, in the future the non-voting common stock into Common Stock, or exercise the Warrant if doing so would cause Castle Creek when combined with the purchases of certain directors and executive officers of the Company as well as other accredited investors in the Private Placement to own more than 19.99% of the Common Stock outstanding immediately prior to the execution of the Securities Purchase Agreement (the “Exchange Cap”). The Company must request stockholder approval to eliminate the Exchange Cap no later than at the 2021 annual meeting of Company shareholders. In addition, Castle Creek will need the approval or non-objection of the Board of Governors of the Federal Reserve System and the New York State Department of Financial Services if it seeks to increase its ownership of shares of Common Stock in excess of 9.9% of the outstanding shares of Common Stock.

Holders of the Series B Preferred Stock will be entitled to receive dividends if declared by the Company’s board of directors, in the same per share amount as paid on the Common Stock. No dividends would be payable on the Common Stock unless a dividend identical to that paid on the Common Stock is payable at the same time on the Series B Preferred Stock. The Series B Preferred Stock will rank, as to payments of dividends and distribution of assets upon dissolution, liquidation or winding up of the Company, pari passu with the Common Stock pro rata. Holders of Series B Preferred Stock will have no voting rights except as may be required by law. The Series B Preferred Stock will not be redeemable by either the Company or by the holder.

As discussed above, pursuant to the Securities Purchase Agreement, on May 8, 2019, the Company issued a Warrant to Castle Creek to purchase 125,000 shares of Common Stock at an exercise price equal to $14.25 per share. At the same time, the Company entered into a Warrant Agreement with Castle Creek, to, among other things, authorize and establish the terms of the Warrant. The Warrant is exercisable at any time after May 8, 2019, and from time to time, in whole or in part, until May 8, 2026. However, the exercise of such Warrant remains subject to certain contractual provisions and regulatory approval if Castle Creek’s ownership of Common Stock would exceed 9.9%. At May 8, 2019, Castle Creek owned 9.9% of the Company’s common stock.

Pursuant to the terms of the Securities Purchase Agreement, Castle Creek will be entitled to have one representative appointed to the Company’s board of directors for so long as Castle Creek, together with its respective affiliates, owns, in the aggregate, 4.9% or more of all of the outstanding shares of the Company’s Common Stock. If Castle Creek, together with its respective affiliates, owns, in the aggregate, 4.9% or more of all of the outstanding shares of the Company’s Common Stock and does not have a board representative appointed to the Company’s board of directors, the Company will invite a person designated by Castle Creek to attend meetings of the Company’s Board of Directors as an observer.

Overview and Results of Operations

The following represents the significant highlights of the Company’s operating results between the first quarter of 2019 and the first quarter of 2018.

• Net income decreased $490,000, or 48.80%, to $514,000.
• Basic and diluted earnings per share both decreased $0.12 to $0.12 per share.
• Return on average assets decreased 23 basis points to 0.22% as the decrease in income outpaced the increase in average assets.
• Net interest income, after provision for loan losses, increased $623,000, or 10.8% to $6.4 million. This increase in earnings was primarily due to the increase in average balances of interest-earning assets, coupled with a decrease in the provision for loan losses, which is reflective of ongoing stable asset quality metrics.
• Net interest margin decreased by ten basis points to 2.92%, primarily as a result of a $97.9 million increase in the average balance of time deposits, coupled with an 84 basis points increase in the average interest rate paid on time deposits.
• Total interest-earning assets were $913.0 million, an increase of $68.4 million, or 8.1%.
• Total deposits increased $61.7 million, or 8.3%, to $805.5 million.
• The effective income tax rate increased 18.0% to 33.8% for the three months ended March 31, 2019 as compared to 15.8% for the same three month period in 2018. This increase was primarily related to the nonrecurring establishment, through a charge to earnings, of a $136,000 valuation allowance to reserve against deferred tax assets related to New York State income taxes.

The following reflects the significant changes in financial condition between March 31, 2018, December 31, 2018 and March 31, 2019.

• Total assets increased $42.0 million, or 4.5%, to $975.1 million primarily due to increases in loans. These increases were funded largely by increases in deposits.
• Asset quality metrics remained stable in comparison to recent reporting periods. 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. The annualized net loan charge-offs to average loans ratio was 0.10% for the first quarter of 2019, compared to 0.19% for the first quarter of 2018, and 0.22% for the fourth quarter of 2018. Nonperforming loans to total loans decreased 55 basis points to 0.51% at March 31, 2019, compared to 1.06% at March 31, 2018. Nonperforming loans to total loans increased 16 basis points to 0.51% at March 31, 2019, compared to 0.35% at December 31, 2018. Correspondingly, the ratio of the allowance for loan losses to nonperforming loans for first quarter 2019 was 215.18%, as compared to 115.45% at March 31, 2018, and 340.13% at December 31, 2018.

The Company had net income of $514,000 for the three months ended March 31, 2019 compared to net income of $1.0 million for the three months ended March 31, 2018. The $490,000 decrease in net income was due primarily to a $1.3 million increase in both interest and noninterest expense and a $69,000 increase in income tax expense. These increases were partially offset by a $1.5 million increase in interest income, a $469,000 decrease in the provision for loan losses, and a $198,000 increase in noninterest income.

Net interest income before the provision for loan losses increased $154,000 to $6.5 million for the three months ended March 31, 2019 as compared to $6.4 million for the same three month period in 2018. The increase was primarily the result of the increase in average interest-earning asset balances, primarily due to increases in average loans and average taxable investment securities. The increase in interest income that was derived from the increase in interest-earning asset balances was partially offset by increases in the average balance and average cost of interest-bearing liabilities between the year-over-year first quarter periods. The positive effects of increased average interest-earning assets for the three months ended March 31, 2019, as compared to the same three month period in 2018, were also enhanced by an increase in the average yield of those assets of 43 basis points to 4.31% for the three months ended March 31, 2019 from 3.88% for the same three month period of the previous year.

The $198,000 increase in noninterest income in the quarter ended March 31, 2019, as compared to the same quarterly period in 2018, was primarily the result of an increase of $186,000 in gains on the sales and redemptions of investment securities. Absent the effects of the quarter over quarter increase in gains on the sale of investment securities, all other noninterest income categories increased by $12,000, or 1.2%, to $1.0 million in the quarter ended March 31, 2019 as compared with $1.0 million in the same quarter of 2018.

Total noninterest expense in the first quarter of 2019 was $6.7 million, an increase of $1.3 million, or 22.9%, compared to $5.5 million for the prior year quarter. The $1.3 million increase in noninterest expense in the quarter ended March 31, 2019, as compared to the same quarterly period in 2018, was primarily due to an increase of $696,000, or 22.6%, 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, foreclosed real estate expenses increased $211,000, which was related to the final disposition of a single foreclosed commercial property. Further, data processing expenses increased $114,000, building and occupancy costs increased $65,000, and advertising expenses increased $53,000. The increases in these operating costs were partially due to expenses related to our two new banking locations in Oneida and Onondaga counties. All other noninterest expenses increased $113,000, or 10.4%, in aggregate during the quarter ended March 31, 2019, as compared to the same three-month period in 2018.

The $469,000 decrease in the provision for loan losses in the quarter ended March 31, 2019, as compared with the same quarter of 2018, was reflective of favorable changes to both the quantitative and environmental factors deemed to be appropriate for the Bank’s loan portfolio, as well as ongoing stable asset quality metrics. These factors were partially offset by an increase in the provision for loan losses recorded due to an increase of $40.5 million, or 6.8%, in the average loan balances in the first quarter of 2019 as compared with the same quarter of 2018 and the corresponding increase in the estimable and probable loan losses inherent in the loan portfolio. The provision for loan losses in the quarter ended March 31, 2019 was further increased, as compared to the same quarter in 2018, by the effects of an increase in the ratio of delinquent loans to total loans, which increased to 2.75% at March 31, 2019 as compared to 2.31% at March 31, 2018, offset by a decrease in nonaccrual loans that decreased $3.1 million to $3.4 million at March 31, 2019 as compared to $6.5 million at March 31, 2018.

In comparing the year-over-year first quarter periods, the return on average assets decreased 23 basis points to 0.22% due to the combined effects of the decrease 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 investment securities of $40.5 million and $8.3 million, respectively in the first quarter of 2019 as compared to the same quarter of 2018. Average deposits increased $27.8 million in the first quarter of 2019, as compared with the same quarter in 2018, due to strong growth in retail deposits, along with the seasonally-normal strong deposit inflows related to the Bank’s municipal depositor relationships.

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.

The following table sets 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 table 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)

As indicated in the above table, net interest income, before provision for loan losses, increased $154,000, or 2.4%, to $6.5 million for the three months ended March 31, 2019 as compared to $6.4 million for the same prior year period. This increase was due principally to the $51.2 million, or 6.1%, increase in the average balance of interest-earning assets, and an increase of 43 basis points on the average interest rate 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 $46.1 million, or 6.3%, and an increase of 62 basis points on the average interest rate paid on those liabilities. In total, net interest margin decreased 10 basis points to 2.92% due largely to the increase in average rates paid on average interest-bearing liabilities, as noted above, which was primarily due to a $97.9 million increase in the average balance of time deposits, coupled with an 84 basis points increase in the interest rate paid on those deposits. 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 $1.5 million, or 17.8%, to $9.7 million for the three months ended March 31, 2019 compared to $8.2 million for the same three-month period in 2018. The increase in interest income was due principally to the increase in average balances of loans and taxable investment securities which increased 6.8% and 3.9%, respectively, between the year-over-year first quarter periods. The average balance of loans increased by $40.5 million and the average yield on that portfolio improved 25 basis points to 4.78%. The increase in the average balance of loans reflected 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 balance of taxable investment securities increased by $8.3 million and the average yield on that portfolio improved 99 basis points to 3.20%. The increase in the average yield on taxable investment securities was the result of an increase the rates received 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 March 31, 2019 increased $1.3 million, or 71.9%, to $3.1 million when compared to the same prior year period. Deposit interest expense increased $1.0 million, or 74.4%, to $2.3 million due to a $27.8 million increase in the average balance of interest-bearing deposits accompanied by a 56 basis points increase in the average annualized rate paid on these deposits to 1.39% for the three months ended March 31, 2019, as compared with the same three-month period in 2018. This increase was primarily due to 84 and 20 basis points increases in the average rates paid on time deposits and money market deposit accounts (“MMDA”), respectively, during the three months ended March 31, 2019 as compared to the same time period in 2018. These increases in the average rates paid on time deposits and MMDA accounts reflected the competitive environment for such deposits within the Company’s marketplace as well as a general increase in short-term interest rates nationally. In addition, interest expense on borrowed funds increased by $306,000 in the three months ended March 31, 2019, as compared with the same three-month period in 2018 primarily due to general increases in the short-term interest rate environment.

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 $144,000 in provision for loan losses for the three-month period ended March 31, 2019, as compared to $613,000 for the three-month period ended March 31, 2018. The decrease in the provision for loan losses was reflective of favorable changes to both the quantitative and environmental factors deemed to be appropriate for the Bank’s loan portfolio, as well as ongoing stable asset quality metrics. These factors were partially offset by an increase in the provision for loan losses recorded due to an increase of $40.5 million, or 6.8%, in the average loan balances in the first quarter of 2019 as compared with the same quarter of 2018 and the corresponding increase in the estimable and probable loan losses inherent in the loan portfolio.

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 increased to 2.75% at March 31, 2019 as compared to 1.81% at December 31, 2018.

Delinquent loans increased at a rate that was modestly more than the rate of increase in total loan balances, primarily driven by an increase of $4.5 million in loans delinquent 30-59 days, an increase of $1.2 million in loans 60-89 days past due, and an increase of $1.2 million in loans delinquent more than 90 days. At March 31, 2019, there were $18.1 million in loans past due including $12.6 million in loans 30-59 days past due, $2.3 million in loans 60-89 days past due and $3.2 million in loans 90 or more days past due. At December 31, 2018, there were $11.2 million in loans past due including $8.1 million in loans 30-59 days past due, $1.1 million in loans 60-89 days past due and $2.0 million in loans 90 or more days past due.

The increase of $6.8 million in total loans past due at March 31, 2019, as compared to December 31, 2018, was primarily due to an increase of $4.5 million in loans 30-59 days past due. The increase in loans 30-59 days past due at March 31, 2019 as compared to December 31, 2018 was primarily due to the addition of one commercial line of credit with an outstanding balance of $2.0 million and three commercial and industrial loans with a total outstanding balance of $2.9 million. Total loans with delinquent balances 60-89 days past due increased in aggregate primarily due to the addition of one commercial real estate loan in the amount of $875,000. The increase in loans 90 days or more past due was primarily a result of three commercial real estate loans with an outstanding balance of $510,000 and three commercial and industrial loans with a total outstanding balance of $559,000.

The determination of the overall adequacy of the allowance for loan losses is also influenced by individual loan and borrower analyses that include reviews of such factors as the delinquency status of loans, assessments of underlying collateral sufficiency and/or the borrower’s documented resources outside of the specific loan relationship (referred to as the borrower’s “global” capacity to repay), personal or corporate guarantees, and the conclusions drawn from detailed discussions with borrowers. Therefore, the level of loan delinquencies, while generally indicative of the potential levels of future loan charge-offs, are not wholly-definitive in making that determination. Management believes that the allowance for loan losses was adequate at March 31, 2019 based on its analyses of the totality of factors related to making that determination, notwithstanding the increased levels of delinquent loans at March 31, 2019, as compared to December 31, 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.

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

(Dollars in thousands)

The $198,000, or 22.1%, increase in noninterest income in the quarter ended March 31, 2019, as compared to the same quarterly period in 2018, was primarily the result of an increase of $186,000 in gains on the sales and redemptions of investment securities. Security sales were completed in the first quarter of 2019 primarily to provide additional liquidity for loan purchases and originations. Absent the effects of the quarter over quarter increase in gains on the sale of investment securities, all other noninterest income categories increased by $12,000, or 1.2%, to $1.0 million in the quarter ended March 31, 2019 as compared with the same quarter of 2018. This $12,000 quarter over quarter increase in noninterest income, excluding the effects of gains on the sales and redemptions of investment securities, was due primarily to an increase of $48,000 in earnings and gain on bank owned life insurance and a $28,000 increase in gains on marketable equity securities. These increases were offset by a decrease in other charges, commissions and fees of $62,000, which was the result of a nonrecurring recovery in the first quarter of 2018 of an escrowed balance in the amount of $57,000 that had been established to settle claims related to a previously disposed of ORE property upon the statutory expiration of all potential claimants rights.

Noninterest Expense

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

(Dollars in thousands)

The $1.3 million, or 22.9%, increase in noninterest expense between year-over-year first quarter periods was principally due to an increase in salaries and employee benefits expense which increased by $696,000. All other noninterest expenses in aggregate increased $556,000, or 23.4%, for the three months ended March 31, 2019 as compared to the same three-month period in 2018. The detail of the components of the overall increase in noninterest expense follows:

• The $696,000 increase in salaries and employee benefits expense in the first quarter of 2019, as compared to the same three-month period in 2018, was primarily due to $421,000 in salary expense increases, $239,000 in employee benefits expense increases, including employee payroll tax expenses, and a $36,0000 net increase in all other salaries and employee benefit expenses. Salaries expense increased primarily as the result of additional staff members supporting current and planned asset growth and risk management activities as well as increased customer service and other operating costs reflecting the ramp-up period for our two new banking locations in Oneida and Onondaga counties. The year-over-year increases in employee benefit expenses were consistent with the salary increases discussed above.
• The $65,000 increase in building and occupancy expenses was primarily due to $17,000 in additional depreciation expense related to recently completed building modernization and refurbishment projects, a $16,000 increase in utilities, a $14,000 increase in building and machine maintenance, and $18,000 of additional expenses in all other building and occupancy expenses.
• The $114,000 increase in data processing costs was primarily due to $65,000 in additional depreciation related to recently completed projects, an additional $27,000 in processing fees paid by the Bank that were based on increased levels of customer activity transacted through its electronic delivery channels and $22,000 of additional expenses in all other data processing expenses.
• Advertising expense increased $53,000 primarily as the result of increases in the level of brand awareness advertising expenditures primarily focused on the Onondaga County market.
• Foreclosed real estate expenses increased $211,000 as a result of a foreclosed property that the Bank paid taxes on. This foreclosed property was sold in February 2019 and is no longer in foreclosed real estate at March 31, 2019.
• All other noninterest expenses increased in aggregate in the year-over-year three-month periods by a total of $113,000, or 10.4%, due primarily to an increase in community service activities and insurance agency expenses of $51,000 and $35,000, respectively.

Income Tax Expense

Income tax expense increased $69,000 to $251,000, with an effective tax rate of 33.8% for the quarter ended March 31, 2019 as compared to $182,000, with an effective tax rate of 15.8%, for the same three month period in 2018. In the quarter ended March 31, 2019, the Company established, through a charge to earnings, a valuation allowance in the amount of $136,000, increasing the Company’s effective tax rate by 18.3%, in order to establish a reserve against deferred tax assets related to New York State income taxes. Effective in January 2018, the Company adopted a modification methodology, made available following changes to the New York State tax code, effecting how the Company’s state income tax liability is computed. Under this adopted methodology, it is unlikely that the Company will pay income taxes to New York in future periods and it is therefore probable that the Company’s deferred tax assets related to New York State income taxes are unlikely to further reduce the Company’s State tax rate in the future. Accordingly, a valuation allowance against the recorded value of those deferred tax assets was established in order to reduce the net deferred tax asset related to New York income taxes to $-0- at March 31, 2019. There were no valuation allowances against deferred tax assets at December 31, 2018.

The Company’s effective tax rate differs from the statutory federal tax rate of 21% due primarily to tax-exempt income from specific types of investment securities and loans, bank owned life insurance, and, to a much lesser degree, the utilization of low income housing credits. In addition, the tax effects of certain incentive stock option activity may also reduce the Company’s effective tax rate on a sporadic basis. During the quarter ended March 31, 2019 these effects reduced the Company’s effective tax rate by 5.4%. Excluding the nonrecurring charge related to the deferred tax asset valuation allowance, income tax expense in 2019 would have been $67,000 less than the prior year, and the effective tax rate would have been 15.5%. The reduction in income tax expense and the effective tax rate in 2019, as compared to the previous year, was primarily attributable to the year-over-year first quarter reduction in pre-tax net income.

Earnings per Share

Basic and diluted earnings per share were $0.12 for the first quarter of 2019, as compared to $0.24 per basic and diluted share for the same quarter of 2018. These $0.12 decreases in basic and fully diluted earnings per share, respectively, were driven principally by the decrease in net income between these two 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 $42.0 million, or 4.5%, to $975.1 million at March 31, 2019 as compared to $933.1 million at December 31, 2018. This increase was due primarily to an increase in loans and investment securities, partially offset by decreases in cash and cash equivalents.

Total net loans receivable increased $37.3 million, or 6.1%, to $650.3 million at March 31, 2019 from $613.0 million at December 31, 2018. Consumer loans, commercial lines of credit, commercial and industrial loans, and residential loans recorded increases between these two dates, with increases of $24.0 million, $11.0 million, $4.2 million, and $2.1 million, respectively. These increases were partially offset by a decrease of $3.9 million in commercial real estate loans. The increase in consumer loans was primarily the result of the March 2019 acquisition of $23.4 million in automobile loans from an unrelated financial institution.

Investment securities increased $2.6 million, or 1.1%, to $234.7 million at March 31, 2019, as compared to $232.0 million at December 31, 2018, due principally to purchases of securities during the first quarter of 2019.

Cash and cash equivalents decreased $1.5 million, or 5.7%, to $24.8 million at March 31, 2019, as compared to $26.3 million at December 31, 2018. The $1.5 million decrease in cash and cash equivalents was primarily due to deployment of cash balances at December 31, 2018 into loan fundings during the quarter ended March 31, 2019. The Bank considers its statutorily required cash reserve balances held at the Federal Reserve Bank to be restricted cash. Total restricted cash was $4.6 million and $4.0 million at March 31, 2019 and December 31, 2018, respectively.

Liabilities

Total liabilities increased $40.0 million to $908.6 million at March 31, 2019 compared to $868.7 million at December 31, 2018. Deposits increased $78.5 million, or 10.8%, to $805.5 million at March 31, 2019, compared to $727.1 million at December 31, 2018. This increase was the result of an increase in deposits obtained directly from customers within the Bank’s marketplace of $35.6, primarily due to increases in time deposits. This increase was further enhanced by the seasonally-normal strong deposit inflows related to the Bank’s municipal depositor relationships, which increased $25.4 million. The increase in these customer deposits during the three months ended March 31, 2019 was partially offset by a decrease in business deposits of $16.6 million. In March 2019, the Bank took on additional brokered time deposits through an unrelated financial institution in the amount of $24.0 million. The Bank utilizes the Certificates of Deposit Account Registry Service (“CDARS”) provided by Promontory Interfinancial Network and other deposits acquired through unaffiliated financial institutions as forms of brokered deposits. At March 31, 2019, deposits obtained through the use of this service increased $9.1 million to $50.5 million as compared to $41.4 million at December 31, 2018. Borrowed funds balances from the FHLB-NY decreased $41.1 million, or 34.7%, to $77.4 million at March 31, 2019 from $118.5 million at December 31, 2018.

Shareholders’ Equity

The Company’s shareholders’ equity, exclusive of the noncontrolling interest, increased $2.0 million to $66.2 million at March 31, 2019 from $64.2 million at December 31, 2018. This increase was principally due to the $1.6 million increase in comprehensive income, a $315,000 increase in additional paid-in capital, a $45,000 increase in ESOP shares earned, and a $19,000 increase in retained earnings. Comprehensive income was primarily the result of the appreciation in the fair market value of our available-for-sale investment securities during the three months ended March 31, 2019. The slight increase in retained earnings resulted from $514,000 in net income recorded in the first three months of 2019. Partially offsetting the increase in retained earnings was a $239,000 one-time adjustment related to the cumulative effect of the capitalization of the operating lease right-of-use-assets based on the adoption of ASU 2016-02 - Leases (Topic 842). In addition, retained earnings was further reduced by $256,000 for cash dividends declared on our common stock.

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 March 31, 2019, 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 is now fully implemented at 2.5% of risk-weighted assets as of January 1, 2019. At March 31, 2019, the Bank exceeded all regulatory required minimum capital ratios, including the capital buffer requirements.

On May 24, 2018, The Economic Growth, Regulatory Relief and Consumer Protection Act of 2018 (the “EGRRCPA”) was enacted, which repeals or modifies certain provisions of the Dodd-Frank Act and eases regulations on all but the largest banks. The EGRRCPA’s provisions include, among other things: (i) exempting banks with less than $10 billion in assets from the ability-to-repay requirements for certain qualified residential mortgage loans held in portfolio; (ii) not requiring appraisals for certain transactions valued at less than $400,000 in rural areas; (iii) exempting banks that originate fewer than 500 open-end and 500 closed-end mortgages from HMDA’s expanded data disclosures; (iv) clarifying that, subject to various conditions, reciprocal deposits of another depository institution obtained using a deposit broker through a deposit placement network for purposes of obtaining maximum deposit insurance would not be considered brokered deposits subject to the FDIC’s brokered-deposit regulations; (v) raising eligibility for the 18-month exam cycle from $1 billion to banks with $3 billion in assets; and (vi) simplifying capital calculations by requiring regulators to establish for institutions under $10 billion in assets a community bank leverage ratio (tangible equity to average consolidated assets) at a percentage not less than 8% and not greater than 10% that such institutions may elect to replace the general applicable risk-based capital requirements for determining well-capitalized status. The federal banking agencies have proposed that the community bank leverage ratio be set at 9.0%. However, until the federal banking regulators finalize the proposed rule, the current capital rues remain in effect. In addition, the law required the Federal Reserve Board to raise the asset threshold under its Small Bank Holding Company Policy Statement from $1 billion to $3 billion for bank or savings and loan holding companies that are exempt from consolidated capital requirements, provided that such companies meet certain other conditions such as not engaging in significant nonbanking activities.

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

(Dollars in thousands)

• 56 -

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 provided 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 at the dates indicated in the table above. 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 three nonaccruing TDR loans, with an aggregate carrying value of $143,000 included among the nonaccrual loans detailed in the table above at March 31, 2019.

As indicated in the table above, nonperforming assets at March 31, 2019 were $4.0 million and were $687,000 higher than the $3.3 million reported at December 31, 2018, due primarily to an increase of $1.1 million in nonperforming commercial and commercial real estate loans, partially offset by a decrease of $550,000 in FRE.

As indicated in the nonperforming asset table above, FRE balances decreased $550,000 at March 31, 2019 from December 31, 2018, following two sales from the portfolio and two additions to the portfolio during the three-month period ended March 31, 2019. More information regarding foreclosed real estate can be found in Note 8 of this quarterly report on 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.

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 $7.3 million at both March 31, 2019 and December 31, 2018. The ratio of the allowance for loan losses to total loans decreased 7 basis points to 1.11% at March 31, 2019 from 1.18% at December 31, 2018. 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 March 31, 2019.

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 quicker 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 both March 31, 2019 and December 31, 2018, the Company had $6.0 million in loans which were deemed to be impaired, having established specific reserves of $906,000 and $631,000, respectively, on these loans. Impaired commercial and industrial loans, other consumer loans, and commercial lines of credit increased $228,000, $101,000, and $62,000, respectively. These increases were offset by impaired residential real estate loans and commercial real estate loans, which decreased $405,000 and $10,000, respectively. The $275,000 increase in specific reserves for impaired loans at March 31, 2019, as compared to December 31, 2018 was primarily due to a $209,000 increase in specific reserves for impaired commercial and industrial loans.

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 $14.8 million as of March 31, 2019, an increase of $254,000, or 1.7%, as compared to $14.6 million at December 31, 2018. 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.

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 three months of 2019, as indicated in the consolidated statement of cash flows, the Company reported net cash flows from financing activities of $37.3 million generated principally by increased balances of time deposit, demand, savings, and money market accounts in the amount of $44.4 million and net increases in the aggregate balances of brokered deposits of $34.0 million. Partially offsetting these cash flows from funding activities were decreases in the balance of borrowings of $41.1 million and dividends paid to common shareholders of $263,000. The increase in deposits was the result of organic growth within our existing marketplace coupled with targeted promotions for our time deposit products. Deposit growth occurred in the consumer and municipal customer segments during the first three months of 2019.

In June 2018, the Company renewed 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 alternative means of collateralizing 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 March 31, 2019, total credit available to the Company under the existing lines of credit was approximately $197.2 million at FHLBNY, the Federal Reserve Bank, and two other correspondent banks. As of March 31, 2019, the Company had $89.4 million of the available lines of credit utilized, including encumbrances supporting outstanding letters of credit, described above, on its existing lines of credit with $107.8 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 March 31, 2019, 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 March 31, 2019, the Company had $145.6 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 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 reasonably likely to materially affect, the Company’s internal control over financial reporting.