Pathfinder Bancorp, Inc.: Form 10-Q for the period ended Mar 31, 2021

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, 2021, the Company and subsidiaries had total consolidated assets of $1.3 billion, total liabilities of $1.2 billion and shareholders' equity of $99.9 million plus noncontrolling interest of $304,000, which represents the 49% of FitzGibbons not owned by the Company.

The following discussion reviews the Company's financial condition at March 31, 2021 and the results of operations for the three month periods ended March 31, 2021 and 2020. Operating results for the three months ended March 31, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021.

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 2020 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 30, 2021 (“the consolidated annual financial statements”) as of December 31, 2020 and 2019 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

Certain statements contained herein are “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. 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.
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In addition to the risk factors enumerated above, the continuing economic impact of the COVID-19 outbreak could adversely affect our financial condition and results of operations. The COVID-19 pandemic caused significant economic dislocation in the United States as many state and local governments ordered non-essential businesses to close and residents to shelter in place. While certain restrictions have started to ease, particularly with the recent widespread availability of novel vaccines, the pace at which the economic recovery unfolds and the sustainability of that recovery cannot be predicted with certainty at this time.

Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the full impact of the COVID-19 outbreak on our business. The extent of such impact will depend on future developments, which are highly uncertain, including when the coronavirus can be controlled and abated and when and how the economy may be reopened. As the result of the COVID-19 pandemic and the related adverse local and national economic consequences, we could be subject to any of the following additional risks, any of which could have a material, adverse effect on our business, financial condition, liquidity, and results of operations:

• Demand for our products and services may decline, making it difficult to grow assets and income;
• If the economy is unable to substantially reopen, and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charges and reduced income;
• Collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase;
• Our allowance for loan losses may have to be increased if borrowers experience financial difficulties beyond forbearance periods, which will adversely affect our net income;
• The net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;
• As the result of the decline in the Federal Reserve Board’s target federal funds rate to near 0%, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;
• A material decrease in net income or a net loss over several quarters could result in a decrease in the rate of our quarterly cash dividend;
• Our cyber security risks are increased as the result of an increase in the number of employees working remotely;
• We rely on third party vendors for certain services and the unavailability of a critical service due to the COVID-19 outbreak could have an adverse effect on us; and
• Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.

Moreover, our future success and profitability substantially depends on the management skills of our executive officers and directors, many of whom have held officer and director positions with us for many years. The unanticipated loss or unavailability of key employees due to the outbreak could harm our ability to operate our business or execute our business strategy. We may not be successful in finding and integrating suitable successors in the event of key employee loss or unavailability.

Any one or a combination of the factors identified above could negatively impact our business, financial condition and results of operations and prospects.

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.

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COVID-19 Response

In early January 2020, the World Health Organization issued an alert that a novel coronavirus outbreak was emanating from Wuhan, Hubei Province in China. Over the course of the next several weeks, the outbreak continued to spread to various regions of the world, prompting the World Health Organization to declare COVID-19 a global pandemic on March 11, 2020. In the United States, by the end of March 2020, the rapid spread of the COVID-19 virus invoked various Federal and New York State authorities to make emergency declarations and issue executive orders to limit the spread of the disease. Measures included restrictions on international and domestic travel, limitations on public gatherings, implementation of social distancing and sanitization protocols, school closings, orders to shelter in place and mandates to close all non-essential businesses to the public. To widely varying degrees, largely dependent upon the level of regional and national outbreaks and the resultant levels of strain on available medical resources, these very substantial mandated curtailments of social and economic activity had been relaxed in the United States during the first quarter of 2021. This relaxation of the curtailments followed a pattern of very gradual relaxation of those curtailments in the later part of 2020. However, there are still virtually no localities within the United States that have completely returned to substantively normal business and social activities at the time of this filing. This discussion would apply directly to the curtailments that have occurred and continue to occur, to lessening degrees, within the Company’s primary service areas.

As a result of the initial and continuing outbreak, and governmental responses thereto, the spread of the coronavirus has caused us to modify our business practices, including employee travel, employee work locations, and cancellation of physical participation in meetings, events and conferences. The Company has many employees working remotely and has significantly reduced physical customer contact with employees and other customers. Initially, branch activities were limited to drive-thru transactions whenever possible, teleconferencing and in-branch “appointments only” services. The Bank’s branches are now fully accessible to the public but remain in strict compliance with all applicable social distancing and sanitization guidelines. Since the start of the pandemic, transactional volume has also increased through the Bank’s telephone, mobile and internet banking channels. We will take further actions, focused on safety, as may be required by government authorities or that we determine to be in the best interests of our employees, customers and business partners.

Concerns about the spread of the disease and its anticipated negative impact on economic activity, severely disrupted both domestic and international financial markets prompting the world’s central banks to inject significant amounts of monetary stimulus into their respective economies. In the United States, the Federal Reserve System’s Federal Open Market Committee, swiftly cut the target Federal Funds rate to a range of 0% to 0.25%, where it remains as of the date of this filing. The reductions in the Fed funds target rate included a 50 basis point reduction in the target federal funds rate on March 3, 2020 and an additional 100 basis point reduction on March 15, 2020. In addition, the Federal Reserve initiated various market support programs to ease the stress on financial markets. This significant reduction in short-term interest rates has reduced, and will continue to reduce, the Bank’s cost of funds and interest earning-asset yields. The long-term effects of the current interest rate environment, resulting from government and central bank responses to the pandemic, on the Bank’s net interest margins cannot be predicted with certainty at this time.

The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), signed into law on March 27, 2020, provided financial assistance in various forms to both businesses and consumers, including the establishment and funding of the Paycheck Protection Program (“PPP”). In addition, the CARES Act also created many directives affecting the operations of financial services providers, such as the Company, including a forbearance program for federally-backed mortgage loans and protections for borrowers from negative credit reporting due to loan accommodations related to the national emergency. The banking regulatory agencies have likewise issued guidance encouraging financial institutions to work prudently with borrowers who are, or may be, unable to meet their contractual payment obligations because of the effects of COVID-19. The Company has worked to assist its business and consumer customers affected by COVID-19. On December 27, 2020, following passage by the United States Congress, President Donald Trump signed into law the Consolidated Appropriations Act, 2021 which included the Coronavirus Response and Relief Supplemental Appropriations Act (“CRRSAA”). The intent of this legislation was to provide another round of Economic Impact Payments to eligible individuals and families, renew the PPP to support small businesses and their employees, ensure needed access to unemployment benefits for Americans who have lost their jobs due to COVID-19, and provide additional funding for schools, vaccine distribution, and other important sectors of the economy.

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On March 11, 2021, President Joseph Biden, signed into law the American Rescue Plan Act of 2021. The intent of this legislation was to provide additional new funding for rural hospitals and health care providers for COVID-19 relief, to increase federal subsidies for COBRA coverage, and make changes to the Medicare wage index. The legislation also includes provisions to bolster the nation’s COVID-19 health care response with additional resources for vaccines, treatment, personal protective equipment (PPE), testing, contact tracing and workforce development. In addition, non-health care specific provisions provide financial support for families and small businesses, as well as extend and expand support for housing, child care, food and the education system. While CRRSSA and the American Rescue Plan Act of 2021 is expected to benefit the economic recovery and be supportive of the Company’s business activities, the effect of this legislation on the operations of the Company cannot be determined with certainty at this time.

The Bank participated in all rounds of the PPP funded by the U.S. Treasury Department and administered by the U.S. SBA pursuant to the CARES Act and subsequent legislation. PPP loans have an interest rate of 1.0% and a two-year or five-year loan term to maturity. The SBA guarantees 100% of the PPP loans made to eligible borrowers. The entire principal amount of the borrower’s PPP loan, including any accrued interest, is eligible to be reduced by the loan forgiveness amount under the PPP so long as employee and compensation levels of the business are maintained and the loan proceeds are used for qualifying expenses. Through March 31, 2021, the Bank has received approval from the SBA for 1,120 loans totaling approximately $109.8 million through this program. The program was initially extended through May of 2021, but as of May 5, 2021 has exhausted the initial allocated funding. The Bank is now also assisting borrowers with the loan forgiveness phase of the process. As of May 3, 2021, the Company has submitted 423 loans totaling approximately $47.5 million to the SBA for forgiveness and has received approximately $41.5 million from the SBA for 414 loans.

Borrowers that were delinquent in their payments to the Bank, prior to requesting a COVID-19 related financial hardship payment deferral were reviewed on a case by case basis for troubled debt restructuring classification and non-performing loan status. In the instances where the Company granted a payment deferral to a delinquent borrower because of COVID-19, the borrower’s delinquency status was frozen as of February 29, 2020, and their loans will continue to be reported as delinquent during the deferment period based on their delinquency status as of that date. The long-term collectability of deferred loan payments will depend on many factors, including the future progression of the pandemic, potential medical breakthroughs in therapeutic treatments and/or vaccines, the pace of vaccine distributions, further economic stimulus from government authorities, the rate at which governmental restrictions on business activities are relaxed and the adequacy and sustainability of other sources of repayment such as loan collateral. Consistent with industry regulatory guidance, borrowers that were granted COVID-19 related deferrals but were otherwise current on loan payments will continue to have their loans reported as current loans during the agreed upon deferral period(s), accrue interest and not be accounted for as troubled debt restructurings.

Through March 31, 2021 the Bank granted payment deferral requests for an initial period of 90 days on 621 loans representing approximately $141.0 million in loan balances. Upon the receipt of borrower requests, additional 90 day deferral periods were generally granted. Of these granted deferrals, 304 loans, totaling $23.2 million, were residential mortgage or consumer loans. At March 31, 2021, 296 residential and consumer loans, totaling $22.4 million, have been returned to non-deferral status. Of these granted deferrals, 317 loans, totaling $117.8 million, were commercial real estate or other commercial and industrial loans. At March 31, 2021, 308 commercial real estate or other commercial and industrial loans, totaling $110.2 million, have been returned to non-deferral status. Therefore, at March 31, 2021, eight residential mortgage and consumer loans, totaling $793,000 and nine commercial real estate and other commercial and industrial loans, totaling $7.6 million remained in deferral status. These loans still in deferral status therefore totaled $8.4 million and represented 0.97% of all loans outstanding at March 31, 2021. On an extremely limited basis, subject to discussions with specific borrowers and further analysis, additional deferral periods will potentially be granted. To the extent that such modifications meet the criteria previously described above, certain loans currently in deferral status (and/or certain future deferrals) have not been classified as troubled debt restructurings nor classified as nonperforming at March 31, 2021. Loans not granted additional deferral periods have been, and will continue to be, categorized as nonaccrual loans if the borrowers fail to make the first scheduled payment following the end of the deferral period.

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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 consolidated financial statements; accordingly, as this information changes, the consolidated 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

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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.

Effective in January 2018, the Company adopted a modification methodology that was at the time newly made available under the New York State tax code, affecting how the Company’s state income tax liability is computed. Under this adopted methodology, management determined in the first quarter of 2019, it was unlikely that the Company would pay material income taxes to New York State in future periods under then-existing income tax laws in the State, and therefore 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. This valuation allowance against the value of those deferred tax assets was established to reduce the net deferred tax asset related to New York State income taxes to $0. Management is continuously monitoring its future tax consequences to determine if the Company’s deferred taxes are properly stated. In the first quarter of 2020, consistent with policy, management reviewed all facts and circumstances related to its deferred taxes and determined that based on the expected filings of future New York State tax returns, the valuation allowance created in 2019 was no longer needed. Therefore management elected to eliminate its New York State net deferred tax asset valuation allowance during the quarter ended March 31, 2020.

On April 7, 2021, the New York State Legislature approved comprehensive tax legislation as part of the State’s 2022 Fiscal Year budget. The legislation includes increased taxes on businesses and high-income individuals among other tax law revisions. Other provisions include amendments to the real estate transfer tax.

The legislation increases the corporate franchise tax rate to 7.25% from 6.5% for tax years beginning on or after January 1, 2021 and before January 1, 2024 for taxpayers with a business income base greater than $5.0 million. In addition, the previously scheduled phase-out of the capital base tax has been delayed. The rate of the capital base was to have been reduced to 0% starting in 2021. The legislation imposes the tax at the rate of 0.1875% for tax years beginning on or after January 1, 2021 and before January 1, 2024, with the 0% rate to take effect in 2024. Management is evaluating the projected impact on the Company’s financial condition and results of operations and believes that these provisions may increase the Company’s income tax expense in the future. However, these potential increases in New York State income taxes are not expected to be material to the future results of the Company’s operations.

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, as well as a the effects of transitional adjustments related to state income taxes and certain taxes payable to states other than New York. The effective tax rate was 20.6% for the three month period ended March 31, 2021.

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”

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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, 2020 evaluation, management has determined that the carrying value of goodwill was not impaired as of that date. Management will continuously evaluate all relevant economic and operational factors potentially affecting the Bank or the fair value of its assets, including goodwill. Should the current pandemic, or the future economic consequences thereof, require a significant and sustained change in the operations of the Bank, re-evaluations of the Bank’s goodwill valuation will be conducted on a more frequent basis. 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, 2021, the Company announced that its Board of Directors had declared a cash dividend of $0.07 per common and preferred share, and a cash dividend of $0.07 per notional share for the issued common stock Warrant. The dividend was payable on May 7, 2021 to shareholders of record on April 15, 2021.

Overview and Results of Operations

The following represents the significant highlights of the Company’s operating results between the first quarter of 2021 and the first quarter of 2020.

• Net income increased $464,000, or 27.5%, to $2.2 million.
• Basic and diluted earnings per share both increased $0.07 to $0.36 per share.
• Return on average assets increased six basis points to 0.68% as the increase in income outpaced the increase in average assets.
• Net interest income, after provision for loan losses, increased $820,000, or 12.2%, to $7.5 million. This increase was primarily a result of an $882,000, or 27%, decrease in total interest expense, combined with an increase in the average balances of interest-earning assets.
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• Net interest margin decreased by 18 basis points to 2.85%, primarily a result of a 67 basis point decrease in the average yield earned on average interest-earning assets, offset by a 52 basis point decrease in the average interest rate paid on average interest-bearing liabilities.
• Total average interest-earning assets were $1.2 billion, an increase of $176.7 million, or 17.2%.
• Total deposits increased $169.0 million, or 18.8%, to $1.1 .billion.
• The effective income tax rate decreased 1.4% to 20.6% for the three months ended March 31, 2021, as compared to 22.0% for the same three month period in 2020.

The following reflects the significant changes in financial condition between March 31, 2021, December 31, 2020 and March 31, 2020.

• Total assets increased $199.5 million, or 18.0%, to $1.3 billion at March 31, 2021 from $1.1 billion at March 31, 2020 and an increase of $79.7 million, or 6.5% at December 31, 2020. The increase was primarily due to increases in loans and investment securities. The increases in loans were funded largely by increases in deposits, including brokered deposits.
• The annualized net loan charge-offs to average loans ratio was 0.05% for the first quarter of 2021, compared to 0.07% for the first quarter of 2020, and 0.08% for the fourth quarter of 2020. Nonperforming loans to total loans increased 185 basis points to 2.47% at March 31, 2021, compared to 0.62% at March 31, 2020. Nonperforming loans to total loans decreased 11 basis points to 2.47% at March 31, 2021, compared to 2.58% at December 31, 2020. Correspondingly, the ratio of the allowance for loan losses to nonperforming loans for first quarter 2021 was 64.16%, as compared to 205.87%, at March 31, 2020, and 59.89% at December 31, 2020.

The Company had net income of $2.2 million for the three months ended March 31, 2021 compared to net income of $1.7 million for the three months ended March 31, 2020. The $464,000 increase in net income was primarily the result of an $882,000 decrease in interest expense, a $97,000 increase in noninterest income, and a decrease of $39,000 in provision for loan losses. These fluctuations were partially offset by a $391,000 increase in noninterest expenses, a $101,000 decrease in interest and dividend income, and an increase in income tax expense of $94,000.

First quarter 2021 net interest income before the provision for loan losses was $8.6 million, an increase of $781,000, or 10.0%, compared to $7.8 million for the same quarter in 2020, primarily a result of an $882,000, or 27.0%, decrease in total interest expense. Interest and dividend income in the first quarter of 2021 was $10.9 million, compared to $11.0 million in the first quarter of 2020. The decrease in interest and dividend income was a result of a 70 basis point decrease in the average yield earned on loans in the first quarter of 2021, compared to the same quarter in 2020, partially offset by an increase of $176.7 million in the average balance of interest-earning assets. This decrease in the average yield earned on loans was consistent with the general decline in the interest rate environment following the onset of the COVID-19 pandemic, as well as the effect that relatively lower-yielding PPP loan balances had on overall loan portfolio yields. The decrease in the first quarter of 2021 interest expense was primarily a result of a 52 basis point decrease in the average interest rate paid on average interest-bearing deposits. As a result of the factors noted above, the net interest margin for the first quarter of 2021 was 2.85%, an 18 basis point decline compared to 3.03% for the first quarter of 2020.

First quarter 2021 noninterest income was $1.8 million, an increase of $97,000, or 5.5%, compared to $1.7 million for the same three-month period in 2020. Excluding gains on equity securities and the sales of loans and foreclosed real estate, as well as premises and equipment, recurring noninterest income for the first quarter of 2021 was $1.3 million, reflecting a $46,000, or 3.7%, improvement over the year-ago period. The $97,000 increase in noninterest income in the quarter ended March 31, 2021, as compared to the same quarterly period in 2020, was primarily the result of an increase of $428,000 in net gains on marketable equity securities, a $201,000 increase on the gain on sale of premises and equipment, a $58,000 increase in debit card interchange fees, and a $41,000 increase in loan servicing fees. These increases were partially offset by a decrease of $552,000 in net gains on sales of loans and foreclosed real estate and a $57,000 decrease in insurance agency revenue. The increase in gains on marketable equity securities was directly correlated with the underlying stock price of those securities, which increased with improving market conditions. The decrease in the gain on the sale of loans and foreclosed real estate was primarily the result of the prior year sale of $35.9 million in seasoned conforming residential mortgage loans that was completed in January 2020. All other noninterest income categories decreased by $42,000, or 8.4%, in the three months ended March 31, 2021, as compared to the same prior year period.

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Total noninterest expense for the first quarter of 2021 was $6.6 million, an increase of $391,000, or 6.3%, in comparison to $6.2 million for the same three-month period in 2020. The increase was primarily a result of higher professional and other services fees, salaries and employee benefits expense and audits and exams expense. Management believes that the increases in professional and other services fees, and audits and exams expense are primarily related to the Bank’s first year of increased internal controls testing under FDICIA requirements for institutions with assets greater than $1 billion and additional expenses for the Company as a result of the COVID-19 pandemic. Accordingly, the increases within these two categories of expenses are not expected to be representative of the levels of expenses expected in the remaining quarters of 2021.

Management extensively reviews recent trends in changes in the size and composition of the loan portfolio, historical loss experience, qualitative factors, and specific reserve needs on loans individually evaluated for impairment, in its determination of the adequacy of the allowance for loan losses. The first quarter 2021 provision for loan losses was $1.0 million, compared to $1.1 million for the prior year quarter. The first quarter 2021 provision for loan losses reflects a prudent addition to reserves considering loan growth, asset quality metrics, and continued COVID-19 economic uncertainty. The credit-sensitive portfolios continue to be carefully monitored, and the Bank will consistently apply its proven conservative loan classification and reserve building methodologies to the analysis of these portfolios.

In comparing the year-over-year first quarter periods, the return on average assets increased six basis points to 0.68% 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). The Company’s net income increased $464,000, or 27.5%, which outpaced the increase in average assets. Average assets increased due to increases in average loans and average taxable investment securities of $88.5 million and $60.6 million, respectively in the first quarter of 2021 as compared to the same quarter of 2020. Average deposits increased $149.6 million in the first quarter of 2021, as compared with the same quarter in 2020, due to strong growth in retail and commercial relationship deposits along with brokered deposit inflows, the seasonally-normal strong deposit inflows related to the Bank’s municipal depositor relationships and the Bank’s participation in the PPP.

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 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.

(Unaudited)

(Unaudited)

(Dollars in thousands)

As indicated in the above table, net interest income, before provision for loan losses, increased $781,000, or 10.0%, to $8.6 million for the three months ended March 31, 2021, as compared to $7.8 million for the same prior year period. The increase was due principally to a decrease of $882,000, or 27.0%, in interest expense. The decrease in interest expense was principally due to the 52 basis point decrease in the average rate paid on these liabilities, partially offset by the $103.8 million, or 11.8%, increase in the average balance of interest-bearing liabilities. These positive factors on net interest income were partially offset by the increase in the average balance of interest earning assets of $176.7 million, offset by a 67 basis point reduction in the average yield earned on these assets. The above analysis should also be viewed in conjunction with the table below which reports the changes in net interest income attributable to rate and volume.

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Interest and dividend income decreased $101,000, or 0.9%, to $10.9 million for the three months ended March 31, 2021 compared to $11.0 million for the same three-month period in 2020. The decrease in interest and dividend income was due principally to a 70 basis point decrease in the average yield earned on the loan portfolio, partially offset by an increase of $88.5 million in the average balance of loans between the year-over-year first quarter periods. The increase in the average balance of loans reflected participation in the PPP loan program and purchased loan growth. Interest income on investment securities increased $323,000 between the two comparable periods due to increased average balances of taxable and tax-exempt investment securities of $60.6 million and $10.9 million, respectively between the two periods, while the average yield on those portfolios decreased 17 and 110 basis points, respectively.

Interest expense for the three months ended March 31, 2021 decreased $882,000, or 27.0%, to $2.4 million when compared to the same prior year period. Deposit interest expense decreased $1.0 million, or 40.3%, to $1.5 million due to a 61 basis point decrease in the average annualized rate paid on deposits to 0.71% for the three months ended March 31, 2021, as compared to 1.32% in the same three-month period in 2020. These decreases were partially offset by the $81.5 million increase in the average balance of interest-bearing deposits. The decrease in the average rate of deposits was primarily due to 90 and 40 basis point decreases in the average rates paid on time deposits and money market deposit accounts (“MMDA”), respectively, during the three months ended March 31, 2021 as compared to the same time period in 2020 due to declining market rates during the first quarter of 2021. The increase in the average balance of deposits was due to increases of $40.8 million in MMDA deposits, a $24.2 million increase in savings and club accounts and a $19.1 million increase in NOW accounts during the first quarter of 2021 as compared to the same period in 2020. The increase in overall deposits was the result of customer activity, related to various governmental economic stimulus receipts deposited by both business and consumer customers in the first quarter of 2021, an increase in business deposits as a result of the Bank’s participation in the PPP program, along with increased short-term brokered deposit acceptances. Interest expense on subordinated loans increased $351,000, or 170.4% for the three months ended March 31, 2021 as compared to the same three month period in 2020. The average balance of subordinated loans increased $24.2 million, or 160.5%, between the two periods due to the issuance of $25.0 million in subordinated debt in October of 2020. The Company exercised its option to redeem $10.0 million of subordinated loans that were outstanding at March 31, 2021 on April 1, 2021. The redemption of this $10.0 million component of the Company’s outstanding subordinated debt will prospectively reduce interest expense after April 1, 2021 by $625,000 annually.

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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 changes in the size and composition of the loan portfolio, historical loss experience, 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 $1.0 million in provision for loan losses for the three-month period ended March 31, 2021 and $1.1 million in provision for loan losses for the three month period ended March 31, 2020. The provisioning in 2021 and 2020 reflects a prudent addition to reserves considering loan growth, asset quality metrics, and continued COVID-19 economic uncertainty. The credit-sensitive portfolios continue to be carefully monitored, and the Bank will consistently apply its proven conservative loan classification and reserve building methodologies to the analysis of these portfolios. Outstanding loan balances, excluding PPP loans, increased $42.9 million, or 5.7%, in the quarter ended March 31, 2021, as compared to the same quarter in the previous year, and therefore required a corresponding increase in the estimable and probable loan losses inherent in the loan portfolio.

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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 2.01% at March 31, 2021 as compared to 1.85% at December 31, 2020. 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 $1.8 million in loans delinquent 30-59 days, and an increase of $1.2 million in loans 60-89 days past due, partially offset by an $917,000 decrease in loans delinquent more than 90 days. At March 31, 2021, there were $17.4 million in loans past due including $5.5 million in loans 30-59 days past due, $6.6 million in loans 60-89 days past due and $5.2 million in loans 90 or more days past due. At December 31, 2020, there were $15.3 million in loans past due including $3.8 million in loans 30-59 days past due, $5.4 million in loans 60-89 days past due and $6.2 million in loans 90 or more days past due.

The increase of $2.1 million in total loans past due at March 31, 2021, as compared to December 31, 2020, was primarily due to an increase of $1.8 million in loans 30-59 days past due. The increase in loans 30-59 days past due at March 31, 2021 as compared to December 31, 2020 was primarily due to the addition of one commercial real estate loan with an outstanding balance of $1.4 million. Total loans 60-89 days past due increased in aggregate primarily due to the addition of one commercial real estate loan in the amount of $3.1 million, which was offset by a decrease in residential and consumer loans. The decrease in loans 90 days or more past due was primarily a result of a decrease in commercial loans, residential mortgages and consumer loans that were 90 days or more past due.

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, 2021, based on its analyses of the totality of factors related to making that determination.

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 $97,000, or 5.5%, increase in noninterest income in the quarter ended March 31, 2021, as compared to the same quarterly period in 2020, was primarily the result of an increase of $428,000 in gains on marketable equity securities and

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$201,000 in gains on sale of premises and equipment. The increase in gains on marketable equity securities was directly correlated with the underlying stock price of those securities which increased with improving market conditions. The increase in gains on premises and equipment was a result of the sale of property held in the Whispering Oaks subsidiary. These increases were offset by a decrease in net gains on sales of loans and foreclosed real estate and net gains on sales and redemptions of investment securities, which decreased $552,000 and $26,000 when compared to the first quarter of 2020, respectively. All other noninterest income categories increased by $46,000, or 3.7%, in the three months ended March 31, 2021 as compared to the same prior year period primarily due to increases in debit interchange fees, loan servicing fees, and other charges, commissions and fees. These increases were partially offset by a decrease in insurance agency revenue and deposit account fees of $57,000 and $25,000, respectively.

Noninterest Expense

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

(Dollars in thousands)

Total noninterest expense for the first quarter of 2021 was $6.6 million, an increase of $391,000, or 6.3%, in comparison to $6.2 million for the same three-month period in 2020. The increase was primarily a result of higher professional and other services fees, salaries and employee benefit expense and audits and exams expense.

The detail of the components of the overall increase in noninterest expense is as follows:

• The $101,000 increase in professional and other services and the $77,000 increase in audits and exams expense is primarily related to the Bank’s first year of increased internal controls testing under FDICIA requirements for institutions with assets greater than $1 billion and additional expenses placed on the Company as a result of the COVID-19 pandemic. Therefore, management does not believe that the levels of expenses within these two categories of expense are representative of the levels expected in the remaining quarters of 2021.
• The increase in salaries and employee benefits of $94,000 was primarily due to increases in salaries, commissions, bonuses and associated payroll taxes and was offset by a decrease in employee benefits.
• The $76,000 and $39,000 increase in data processing and building occupancy expenses, respectively, is consistent with the Company’s customer and operational growth.
• Advertising expenses increased $70,000 and was primarily the result of increases in the level of brand awareness advertising expenditures primarily focused on the Onondaga County market.
• All other noninterest expenses decreased in aggregate in the year-over-year three-month periods by a total of $66,000, or 6.4%. The Bank is continuously monitoring operating expenses to reduce the annual rate of growth in those operating expenses. The decrease in the various categories of operating expense is consistent with this initiative.

Income Tax Expense

Income tax expense increased $94,000 to $549,000, with an effective tax rate of 20.6% for the quarter ended March 31, 2021, as compared to $455,000, with an effective tax rate of 22.0%, for the same three month period in 2020.

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Effective in January 2018, the Company adopted a modification methodology that was at the time newly made available under the New York State tax code, affecting how the Company’s state income tax liability is computed. Under this adopted methodology, management determined in the first quarter of 2019, it was unlikely that the Company would pay material income taxes to New York State in future periods under then-existing income tax laws in the State, and therefore 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. This valuation allowance against the value of those deferred tax assets was established to reduce the net deferred tax asset related to New York State income taxes to $0. Management is continuously monitoring its future tax consequences to determine if the Company’s deferred taxes are properly stated. In the first quarter of 2020, consistent with policy, management reviewed all facts and circumstances related to its deferred taxes and determined that based on the expected filings of future New York State tax returns, the valuation allowance created in 2019 was no longer needed. Therefore management elected to eliminate its New York State net deferred tax asset valuation allowance during the quarter ended March 31, 2020.

On April 7, 2021, the New York State Legislature approved comprehensive tax legislation as part of the State’s 2022 Fiscal Year budget. The legislation includes increased taxes on businesses and high-income individuals among other tax law revisions. Other provisions include amendments to the real estate transfer tax.

The legislation increases the corporate franchise tax rate to 7.25% from 6.5% for tax years beginning on or after January 1, 2021 and before January 1, 2024 for taxpayers with a business income base greater than $5.0 million. In addition, the previously scheduled phase-out of the capital base tax has been delayed. The rate of the capital base was to have been reduced to 0% starting in 2021. The legislation imposes the tax at the rate of 0.1875% for tax years beginning on or after January 1, 2021 and before January 1, 2024, with the 0% rate to take effect in 2024. Management is evaluating the projected impact on the Company’s financial condition and results of operations and believes that these provisions may increase the Company’s income tax expense in the future. However, these potential increases in New York State income taxes are not expected to be material to the future results of the Company’s operations.

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, as well as the effects of transitional adjustments related to state income taxes and certain taxes payable to states other than New York. 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, 2021, these effects reduced the Company’s effective tax rate by 0.3%. The increase in income tax expense, as compared to the previous year’s same period, was primarily attributable to the year-over-year first quarter increase in pre-tax net income.

Earnings per Share

Basic and diluted earnings per share were $0.36 for the first quarter of 2021, as compared to $0.29 per basic and diluted share for the same quarter of 2020. These $0.07 increases in basic and fully diluted earnings per share, respectively, were driven principally by the increase 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 $79.7 million, or 6.5%, to $1.3 billion at March 31, 2021, as compared to $1.2 billion at December 31, 2020. This increase was due primarily to increases in cash and cash equivalents, investment securities, loans and bank owned life insurance.

Cash and cash equivalents increased $8.5 million, or 19.6%, to $52.0 million at March 31, 2021, as compared to $43.5 million at December 31, 2020. This increase in cash and cash equivalents was transitory in nature. Total restricted cash was $1.6 million at March 31, 2021 and December 31, 2020.

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Investment securities increased $25.6 million, or 8.4%, to $331.4 million at March 31, 2021, as compared to $305.7 million at December 31, 2020, due principally to purchases of securities during the first quarter of 2021.

Total net loans receivable increased $38.9 million, or 4.8%, to $851.6 million at March 31, 2021 from $812.7 million at December 31, 2020. This increase was primarily the result of an increase in commercial loans of $27.3 million and a $14.6 million increase in consumer loans during the first quarter of 2021. The increase in commercial loans was primarily due to increases of $11.6 million in advances to customers on commercial lines of credit, a net $11.2 million increase in outstanding PPP loan balances and a $2.9 million increase in commercial real estate loans. The increase in consumer loans was due to the $17.1 million purchase of a pool of secured consumer installment loans, partially offset by a decrease in home equity and junior lien loans of $2.4 million.

Bank owned life insurance increased $5.1 million due to the $5.0 million purchase of additional coverage on bank owned life insurance policies.

Liabilities

Total liabilities increased $77.2 million to $1.2 billion at March 31, 2021 compared to $1.1 billion at December 31, 2020. Deposits increased $73.0 million, or 7.3%, to $1.1 billion at March 31, 2021, compared to $995.9 million at December 31, 2020. Noninterest-bearing deposits were up $35.4 million, or 21.9%, from the 2020 year end, primarily the result of the Bank’s participation in the PPP, as well as ongoing growth in business banking relationships. The increase in deposits compared to December 31, 2020 was due to growth in retail and commercial relationship deposits 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, 2021, deposits obtained through the use of these services decreased $5.8 million to $164.1 million as compared to $170.0 million at December 31, 2020. Borrowed funds balances from the FHLB-NY increased $4.4 million, or 5.4%, to $86.5 million at March 31, 2021 from $82.1 million at December 31, 2020.

Shareholders’ Equity

The Company’s shareholders’ equity, exclusive of the noncontrolling interest, increased $2.5 million to $99.9 million at March 31, 2021 from $97.5 million at December 31, 2020. This increase in shareholders’ equity during the quarter ended March 31, 2021 was principally due to a $1.7 million increase in retained earnings, a $468,000 decrease in accumulated other comprehensive loss, a $234,000 increase in paid-in capital, and a $45,000 increase in earned ESOP shares.

The increase in retained earnings resulted from $2.2 million in net income recorded in the first three months of 2021. Retained earnings was partially offset by $312,000 for cash dividends declared on our common stock, $97,000 for cash dividends declared on our preferred stock, and $9,000 for cash dividends declared on our issued warrant.

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, 2021, 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

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assets. At March 31, 2021, the Bank exceeded all regulatory required minimum capital ratios, including the capital buffer requirements.

As a result of the recently enacted Economic Growth, Regulatory Relief, and Consumer Protection Act, the federal banking agencies developed a “Community Bank Leverage Ratio” (the ratio of a bank's tier 1 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 have set the Community Bank Leverage Ratio at 9%. Pursuant to the CARES Act, the federal banking agencies in April 2020 issued interim final rules to set the Community Bank Leverage Ratio at 8% beginning in the second quarter of 2020 through the end of 2020. Beginning in 2021, the Community Bank Leverage Ratio will increase to 8.5% for the calendar year. Community banks will have until January 1, 2022, before the Community Bank Leverage Ratio requirement will return to 9%. A financial institution can elect to be subject to this new definition. The Bank did not elect to become subject to the Community Bank Leverage Ratio.

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

(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 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 $1.6 million included among the nonaccrual loans detailed in the table above at March 31, 2021.

Pursuant to the CARES Act, financial institutions have the option to temporarily suspend certain requirements under U.S. generally accepted accounting principles related to troubled debt restructurings for a limited period of time to account for the effects of COVID-19. This provision allows a financial institution the option to not apply the guidance on accounting for troubled debt restructurings to loan modifications, such as extensions or deferrals, related to COVID-19 made between March 1, 2020 and the earlier of (i) January 1, 2022 or (ii) 60 days after the end of the COVID-19 national emergency. The relief can only be applied to modifications for borrowers that were not more than 30 days past due as of December 31, 2019. The Bank elected to adopt these provisions of the CARES Act.

As indicated in the table above, nonperforming assets at March 31, 2021 were $21.3 million and were consistent with the $21.3 million reported at December 31, 2020 and increased $16.6 million from March 31, 2020. The increase from March 31, 2020 was due primarily to an increase of $14.9 million in nonperforming commercial loans and a $1.9 million increase in nonperforming residential loans, partially offset by a decrease of $55,000 in nonperforming consumer loans and residential mortgages loans and a $58,000 decrease in FRE.

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 $13.7 million and $12.8 million at March 31, 2021 and December 31, 2020, respectively. The ratio of the allowance for loan losses to total loans increased 3 basis points to 1.58% at March 31, 2021 from 1.55% at December 31, 2020. 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, 2021.

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 March 31, 2021 and December 31, 2020, the Company had $23.4 million and $22.8 million in loans, which were deemed to be impaired, having established specific reserves of $2.9 million and $2.8 million, respectively, on these 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 $26.7 million as of March 31, 2021, an increase of $3.6 million, or 15.3%, as compared to $23.1 million at December 31, 2020. These loans have been internally classified as special mention, substandard, or doubtful, yet are not currently considered impaired.

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

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For the first three months of 2021, cash and cash equivalents increased by $8.5 million. The Company reported net cash flows from financing activities of $77.2 million generated primarily by increased customer deposit balances of $78.8 million. The increase in deposits was the result of organic growth in consumer, business and municipal segments within our existing marketplace. This increase was combined with an increase in net cash of $4.5 million from borrowings and was offset by dividends paid to common and preferred shareholders, and decreased balances in brokered deposits. The Company reported net cash outflows from investing activities of $72.0 million, primarily due to the purchase of securities and funding of loans, offset by proceeds and principal reductions in investment securities. Additionally, $3.3 million was provided through operating activities, primarily from the sale of residential loans to the secondary market.

The Company has a number of existing credit facilities available to it. At March 31, 2021, total credit available to the Company under the existing lines of credit was approximately $146.7 million at FHLBNY, the Federal Reserve Bank, and two other correspondent banks. As of March 31, 2021, the Company had $86.5 million of the available lines of credit utilized on its existing lines of credit with $60.2 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, 2021, management reported to the Board of Directors that the Company was 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, 2021, the Company had $180.1 million in outstanding commitments to extend credit and standby letters of credit.

Disclosure Controls and Procedures

Under the supervision and with the participation of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”) (the Company’s principal executive officer and principal financial officer), management conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of March 31, 2021. The term “disclosure controls and procedures,” under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to our management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Based on the evaluation of our disclosure controls and procedures as of March 31, 2021, our CEO and CFO concluded that, solely as a result of the material weaknesses in internal control over financial reporting described below, which continued to exist as of March 31, 2021, our disclosure controls and procedures were not effective as of March 31, 2021.

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Previously Disclosed Material Weakness

The Company disclosed in Item 8 – Financial Statements and Supplementary Data in its Annual Report on Form 10-K for the year ended December 31, 2020 two areas that, under applicable SEC accounting rules, each constituted a “material weakness.” The first material weakness identified ineffectiveness in the controls related to Related Party (as defined in applicable regulations) transactions that included procedural and documentary deficiencies related to underwriting risk ratings and the completeness of borrower reviews. The second identified area of material weakness related to loan authorization, disbursement and file maintenance controls. As a result of the material weaknesses described above, management has concluded that, as of March 31, 2021, our internal control over financial reporting was not effective.

Management’s Financial Reporting Remediation Initiatives

In order to remediate the material weakness related to transactions with Related Parties, management has commenced to initiate enhanced training programs and revise internal operating procedures designed to identify, summarize and monitor all such transactions and relationships.

In order to remediate the material weakness related to loan authorization, disbursement and file maintenance controls, management has commenced the redesign of specific processes and controls associated with each of the loan operations and will increase staffing levels where appropriate, improve training, increase the use of certain automated productivity tools, and install enhanced process oversight and functional controls to ensure that these internal controls are effective.

Management is committed to maintaining a strong internal control environment and believes these remediation efforts will result in an improvement in existing controls. Management anticipates that the new controls, as implemented and when tested for a sufficient period of time, will remediate the material weaknesses. As we continue to evaluate and work to improve our internal control over financial reporting, we may determine to take additional measures to address control deficiencies or modify certain activities of the remediation measures described above.

Changes in Internal Control over Financial Reporting

There were no changes made in our internal controls during the quarter ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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