EDGAR 10-K Filing

Company CIK: 723646
Filing Year: 2022
Filename: 723646_10-K_2022_0000723646-22-000016.json

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ITEM 1. BUSINESS
Item 1. Business
General
Franklin Financial Services Corporation (the “Corporation”) was organized as a Pennsylvania business corporation on June 1, 1983 and is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”). On January 16, 1984, pursuant to a plan of reorganization approved by the shareholders of Farmers and Merchants Trust Company of Chambersburg (“F&M Trust” or “the Bank”) and the appropriate regulatory agencies, the Corporation acquired all the shares of F&M Trust and issued its own shares to former F&M Trust shareholders on a share-for-share basis.
The Corporation’s common stock is listed under the symbol “FRAF” on the Nasdaq Capital Market. The Corporation’s internet address is www.franklinfin.com. Electronic copies of the Corporation’s 2022 Annual Report on Form 10-K are available free of charge by visiting the “Investor Information” section of www.franklinfin.com. Electronic copies of quarterly reports on Form 10-Q and current reports on Form 8-K are also available at this internet address. These reports are posted as soon as reasonably practicable after they are electronically filed with the Securities and Exchange Commission (SEC). This reference to the Corporation’s internet address shall not, under any circumstances, be deemed to incorporate the information available at such internet address into this Form 10-K or other SEC filings. The information available at the Corporation’s internet address is not part of this Form 10-K or any other report filed by the Corporation with the SEC. The Corporation’s SEC filings can also be obtained on the SEC’s website on the Internet at http://www.sec.gov.
The Corporation conducts substantially all of its business through its wholly owned direct banking subsidiary, F&M Trust. F&M Trust, established in 1906, is a full-service, Pennsylvania-chartered commercial bank and trust company, which is not a member of the Federal Reserve System. F&M Trust operates twenty-one community banking offices in Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania. The Bank engages in general commercial, retail banking and trust services normally associated with community banks and its deposits are insured (up to applicable legal limits) by the Federal Deposit Insurance Corporation (the “FDIC”). F&M Trust offers a wide variety of banking services to businesses, individuals, and governmental entities. These services include, but are not necessarily limited to, accepting and maintaining checking, savings, and time deposit accounts, providing investment and trust services, making loans and providing safe deposit facilities. Franklin Future Fund Inc., a direct subsidiary of the Corporation, is a non-bank investment company that makes venture capital investments, limited to 5% or less of the outstanding shares of any class of voting securities of any company, within the Corporation’s primary market area. Franklin Financial Properties Corp. is a “qualified real estate subsidiary,” a wholly owned subsidiary of F&M Trust and was established to hold real estate assets used by F&M Trust in its banking operations.
F&M Trust is not dependent upon a single customer or a few customers for a material part of its business. Thus, the loss of any customer or identifiable group of customers would not materially affect the business of the Corporation or the Bank in an adverse manner. Also, none of the Bank’s business is seasonal. The Bank’s lending activities consist primarily of commercial real estate, construction and land development, agricultural, commercial and industrial loans, installment and revolving loans to consumers and residential mortgage loans. Secured and unsecured commercial and industrial loans, including accounts receivable and inventory financing, and commercial equipment financing, are made to small and medium-sized businesses, individuals, governmental entities, and non-profit organizations.
The Bank classifies loans in this report by the type of collateral, primarily residential or commercial and agricultural real estate. Loans secured by residential real estate loans may be further broken down into consumer or commercial purposes. Consumer purpose residential real estate loans represent traditional residential mortgages and home equity products. Both of these products are underwritten in generally the same manner; however, home equity products may present greater risk since many of these loans are secured by a second lien position where the Bank may or may not hold the first lien position. Commercial purpose residential real estate loans represent loans made to businesses but are secured by residential real estate. These loans are underwritten as commercial loans and the repayment ability may be dependent on the business operation, despite the residential collateral. In addition to the real estate collateral, it is possible that personal guarantees or UCC filings on business assets provide additional security. In certain situations, the Bank acquires properties through foreclosure on delinquent loans. The Bank initially records these properties at the estimated fair value less cost to sell with subsequent adjustments to fair value recorded as needed.
Commercial and agricultural real estate loans are secured by properties such as hotels, office buildings, apartment buildings, retail sites, and farmland or agricultural related properties. These loans are highly dependent on the business operations for repayment. Compared to residential real estate, this collateral may be more difficult to sell in the event of a default.
Construction loans are made to finance the purchase of land and the construction of residential and commercial buildings and are secured by mortgages on real estate. These loans are primarily comprised of loans to consumers to build a home, and loans to contractors and developers to construct residential properties for resale or rental. Construction loans present various risks that include, but are not limited to: schedule delays, cost overruns, changes in economic conditions during the construction period, and the inability to sell or rent the property upon completion.
Commercial loans are made to businesses and government municipalities of various sizes for a variety of purposes including operations, property, plant and equipment, and working capital. These loans are highly dependent on the business operations for repayment and are generally secured by business assets and personal guarantees. As such, this collateral may be more difficult to sell in the event of a delinquency. Commercial lending, including commercial real estate, is concentrated in the Bank’s primary market, but also includes purchased loan participations originated primarily in south-central Pennsylvania.
Consumer loans are comprised of unsecured personal lines of credit and installment loans. While some of these loans are secured, the collateral behind the loans is often comprised of assets that lose value quickly (e.g., automobiles) and if repossessed, may not fully satisfy the loan in the event of default. Repayment of these loans is highly dependent on the borrowers’ financial condition that can be affected by economic factors beyond their control and personal circumstances.
The Bank offers numerous deposit products including demand deposits (noninterest and interest-bearing accounts), savings, money management accounts, and time deposits (certificates of deposits/CDs) to retail, commercial, and municipal customers.
F&M Trust’s Investment and Trust Services Department offers all of the personal and corporate trust services normally associated with community bank trust departments including: estate planning and administration, corporate and personal trust fund management, pension, profit sharing and other employee benefit funds management, and custodial services. F&M Trust through licensed members of its Investment and Trust Services Department sells mutual funds, annuities and selected insurance products.
Competition
The Corporation and its banking subsidiary operate in a highly competitive environment. The principal market of F&M Trust is in south central Pennsylvania, primarily the counties of Franklin, Cumberland, Fulton and Huntingdon. There are 22 competing commercial banks that have offices within the Corporation’s primary market area. These banks range from large regional banks to independent community banks. In addition, credit unions, mortgage banks, brokerage firms and other on-line competitors compete within the market.
The following table shows the Bank’s market share in its primary market as reported on the June 30, 2021 FDIC Summary of Deposits Report:
(Dollars in thousands)
F&M Trust
County
# of Locations
Deposits
Market Deposits
Market Share
Franklin
$
1,062,351
$
2,726,743
39%
Cumberland
332,142
10,566,277
3%
Fulton
92,222
258,235
36%
Huntingdon
24,247
770,588
3%
$
1,510,962
$
14,321,843
11%
With increasing competition, many nonbanking institutions offer services similar to those offered by the Bank. Some competitors may have access to resources (e.g., financial and technological) sooner than they are available to the Bank, or that may be unavailable to the Bank, thereby creating a competitive disadvantage for the Bank in terms of product, service pricing and delivery. In addition, credit unions increasingly compete with banks for deposits. The Bank utilizes various strategies including its long history of local customer service and convenience as part of a relationship management culture, a wide variety of products and services and, to a lesser extent, the pricing of loans and deposits, to compete. F&M Trust is the largest financial institution headquartered in Franklin County and had total assets of approximately $1.7 billion on December 31, 2021.
Human Capital
F&M Trust is committed to remaining independent by growing our bank to meet the increasing financial needs of our customers, communities, and shareholders. Our employees are critical to us achieving this vision. Fostering and maintaining a strong, healthy culture is a key strategic focus for us. Our core values of integrity, excellence, accountability, teamwork, and concern for our customers and communities reflect who we are collectively and guide our employees in their interactions with one another, our customers, communities, and shareholders. We make decisions with the long-term view in mind and collaborate to achieve the goals and results set forth in the bank’s strategic plan.
Engagement. To ensure we provide a good working environment for our employees, we regularly collect feedback to better understand and improve the employee experience and identify opportunities to continually strengthen our culture. We annually engage an independent third party to conduct employee engagement surveys that provide us with feedback on key engagement drivers (i.e., Organization, Job & Career, Co-worker/Team, and Leader engagement). In 2021, we had a survey response rate of 97% for the fourth consecutive year. The highest scores on our key engagement drivers occurred in the Co-worker/Team and Job & Career indices, with
85% of employees indicating that they are satisfied at work. We consider the candid and robust feedback we receive from our employees to be a gift and take appropriate action to address any areas of employee concern.
Employee Onboarding and Development. Our recruiting practices and decisions on whom to hire are among the most important activities to maintaining our culture. Employees joining the bank are immersed in the bank’s culture and practices through a structured orientation and onboarding process that is supplemented by ongoing internal training opportunities. The bank’s training curriculum includes education tracks in the areas of leadership, engagement, sales, operations, and compliance. We encourage employees to discuss their professional development with their supervisors during coaching sessions to identify interests or possible cross-training areas. Longer-term, our succession planning activities help us to identify and develop internal personnel with potential to advance into key positions within the bank. A Management Trainee program, which will enable to us to develop high potential candidates into key bank positions identified in the Succession Plan, is also in development. A tuition aid program exists for educational pursuits related to present work or possible future positions.
Diversity, Equity, and Inclusion (DEI). At December 31, 2021, we had 280 employees on our team, nearly all of whom are full-time and of which the majority are women. We seek to recognize the unique contribution each individual brings to our company and are committed to supporting diversity, equity, and inclusion in all of our employment practices. We hire the best people for the job regardless of race, gender, ethnicity, or other protected traits, and it is our policy to fully comply with all laws applicable to discrimination in the workplace. Our DEI principles are also reflected in our employee training and policies. We continue to enhance our DEI efforts, which are fully endorsed by our Senior Management team and Board of Directors. A DEI policy was formally adopted in 2021.
Health and Safety. The success of our bank is fundamentally connected to the well-being of our employees. Accordingly, we provide our employees and their families with access to a variety of flexible and convenient health and welfare programs, including benefits that support their physical and mental health by providing tools and resources to help them improve or maintain their health status. We show our employees we care about their personal wellbeing through the offering of a robust wellness program that has been in existence since 2001. Over 63% of our workforce participated in our wellness program last year. In response to the COVID-19 pandemic, we launched a proactive response focused on communication, workplace health and safety, and new productivity measures that adjusted in accordance with public health guidance.
Retention. We continually monitor employee turnover rates as our success depends upon retaining our talented and committed personnel. Our Total Turnover for 2021 was 20.57%. In response to competitive compensation pressure in our markets, we adjusted starting wages for entry-level positions to enable us to recruit and retain employees more effectively. We believe the combination of competitive compensation achieved along with the bank’s culture and career growth and development opportunities have helped to extend employee tenure and reduce voluntary turnover.
Community Involvement. We aim to give back to the communities where we live and work and believe this commitment helps in our efforts to attract and retain employees. We encourage our employees at all levels to volunteer and/or serve on boards of non-profit organizations. The bank also provides financial support for various fundraising activities and programs offered by non-profit organizations in our communities, which are reviewed and approved by our Community Investment Committee. In 2021, the Corporation donated $446 thousand to 248 organizations in our communities and contributed $200 thousand and 251 scholarships to Kindergarten through 12th grade and Pre-Kindergarten schools and organizations through the Pennsylvania Educational Improvement Tax Credit program. In addition, employees of the Bank provided 1,882 volunteer hours to 47 different service organizations.
Supervision and Regulation
Various requirements and restrictions under the laws of the United States and under Pennsylvania law affect the Corporation and its subsidiaries.
General
The Corporation is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (Federal Reserve) under the Bank Holding Act of 1956, as amended. The Corporation has also made an effective election to be treated as a "financial holding company." Financial holding companies are bank holding companies that meet certain minimum capital and other standards and are therefore entitled to engage in financially related activities on an expedited basis as further discussed below. Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve. The Federal Reserve has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve, pursuant to such regulations, may require the Corporation to stand ready to use its resources to provide adequate capital funds to its Bank subsidiary during periods of financial stress or adversity. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.
The Bank Holding Company Act prohibits the Corporation from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board. Additionally, the Bank Holding Company Act prohibits the Corporation from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business, unless such business is determined by the Federal Reserve to be so closely related to banking as to be a proper incident thereto. Federal law and Pennsylvania law also require persons or entities desiring to acquire certain levels of share ownership (generally, 10% or more, or 5% or more for another bank holding company) of the Corporation to first obtain prior approval from the Federal Reserve and the Pennsylvania Department of Banking and Securities.
As a Pennsylvania bank holding company for purposes of the Pennsylvania Banking Code, the Corporation is also subject to regulation and examination by the Pennsylvania Department of Banking and Securities.
The Bank is a state-chartered bank that is not a member of the Federal Reserve System, and its deposits are insured (up to applicable legal limits) by the Federal Deposit Insurance Corporation (FDIC). Accordingly, the Bank's primary federal regulator is the FDIC, and the Bank is subject to extensive regulation and examination by the FDIC and the Pennsylvania Department of Banking and Securities. The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. The Bank is subject to extensive regulation and reporting requirements in a variety of areas, including helping to prevent money laundering, to preserve financial privacy, and to properly report late payments, defaults, and denials of loan applications.
Dodd-Frank Wall Street Reform and Consumer Protection Act
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) became law. Dodd-Frank is intended to affect a fundamental restructuring of federal banking regulation. Among other things, Dodd-Frank created a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. Dodd-Frank additionally created a new independent federal regulator to administer federal consumer protection laws. Dodd-Frank is expected to have a significant impact on our business operations as its provisions take effect. Among the provisions that are likely to affect the Corporation are the following:
FDIC Insurance. The insurance limit was increased to $250,000 per depositor. In addition, the assessment base was changed from a deposit-based calculation to an asset-based calculation. Dodd-Frank also eliminated the federal statutory prohibition against the payment of interest on business checking accounts.
Compensation. At least once every three years, companies must conduct a non-binding shareholder vote (say-on-pay) to approve the compensation of the CEO and the company’s “named executive officers.” At least once every 6 years, shareholders must also vote on whether to hold the non-binding vote on executive compensation every 1, 2, or 3 years. Additionally, banking regulators have established guidance that prohibits incentive-based compensation arrangements that encourage inappropriate risks that could lead to material financial loss to the institution.
Consumer Financial Protection Bureau. Dodd-Frank created a new, independent federal agency called the Consumer Financial Protection Bureau (CFPB), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. Dodd-Frank authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, Dodd-Frank will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. Dodd-Frank permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.
Most of the Dodd-Frank rules and regulations have been implemented. These new rules and regulations have and will continue to significantly change the current bank regulatory structure and affect the lending, deposit and operating activities of financial institutions, including the Corporation. It remains difficult to anticipate or predict the overall future financial impact the Dodd-Frank Act will have on the Corporation, our customers, our financial condition and results of operations. The Corporation continues to monitor and implement rules and regulations as they are adopted and modified, and to evaluate their application to our current and future operations.
Community Reinvestment Act
The Community Reinvestment Act (CRA) requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate-income neighborhoods. The Bank's rating under the Community Reinvestment Act, assigned by the FDIC pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in applications to engage in new activities. The Bank’s present CRA rating is “satisfactory.” Various consumer laws and regulations also affect the operations of the Bank.
Capital Adequacy Guidelines
The Corporation, as a bank holding company, is required to comply with the capital adequacy standards established by Federal Reserve Board. The Bank is required to comply with capital adequacy standards established by the FDIC. In addition, the Pennsylvania Department of Banking and Securities also requires state-chartered banks to maintain minimum capital ratios, defined substantially the same as the federal regulations.
Capital adequacy for the Bank is currently defined by regulatory agencies through the use of several minimum required ratios. The capital ratios to be considered “well capitalized” are: (1) Common Equity Tier 1 (CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. In addition, a capital conservation buffer of 2.50% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum (“adequately capitalized”) for each respective capital measurement. The Bank’s capital conservation buffer at December 31, 2021 was 8.55%. Compliance with the capital conservation buffer is required in order to avoid limitations on certain capital distributions, especially dividends. As of December 31, 2021, the Bank was “well capitalized’ under the Basel III requirements. For additional information on the capital ratios see the section titled Shareholders’ Equity, and Table 13.
In 2019, the Community Bank Leverage Ratio (CBLR) was approved by federal banking agencies as an optional capital measure available to Qualifying Community Banking Organizations (QCBO). If a bank qualifies as a QCBO and maintains a CBLR of 9% or greater, the bank would be considered “well-capitalized” for regulatory capital purposes and exempt from complying with the risk-based capital rule described above. The CBLR rule took effect January 1, 2020 and banks could opt-in through an election in the first quarter 2020 regulatory filing. The Bank met the criteria of a QCBO but did not opt-in to the CBLR.
Prompt Corrective Action Rules
The federal banking agencies have regulations defining the levels at which an insured institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a "well-capitalized" institution as "adequately capitalized" or require an "adequately capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category. Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings). At December 31, 2021, the Bank satisfied the criteria to be classified as "well capitalized" within the meaning of applicable regulations.
Regulatory Restrictions on Dividends
Dividend payments by the Bank to the Corporation are subject to the Pennsylvania Banking Code, the Federal Deposit Insurance Act, and the regulations of the FDIC. Under the Banking Code, no dividends may be paid except from "accumulated net earnings" (generally, retained earnings). The Federal Reserve and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions. The Prompt Corrective Action Rules and the Basel III rules, described above, may further limit the ability of banks to pay dividends or make capital distributions if regulatory capital requirements are not met. There are currently no restrictions on the payments of dividends by either the Bank or the Corporation.
Volker Rule
In December 2013, Federal banking regulators issued rules for complying with the Volker Rule provision of the Dodd-Frank Act. The Bank does not engage in, or expect to engage in, any transactions that are considered “covered activities” as defined by the Volker Rule. Therefore, the Bank does not have any compliance obligations under the Volker Rule.
Consumer Laws and Regulations
The Consumer Financial Protection Bureau (“CFPB”) was created under the Dodd-Frank Act to centralize responsibility for consumer financial protection with broad rulemaking, supervision, and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts, including the Equal Credit Opportunity Act, Truth in Lending Act (“TILA”), Real Estate Settlement Procedures Act (“RESPA”), Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act, and certain other statues. Violations of consumer protection laws may result in litigation and liability from consumers and regulators. It is likely that future CFPB rulemaking action will affect the Bank. Banks with total assets less than $10 billion are not subject to examination by the CFPB. However, the CFPB can require any bank to submit reports it deems necessary to fulfill its mission and it can request to be part of any bank examination.
Ability to Repay / Qualified Mortgages
In July 2013, the Consumer Finance Protection Bureau adopted the final rules that implement the Ability to Repay (ATR) / Qualified Mortgages (QM) provisions of the Dodd-Frank Act. Regulators believe that the ATR/QM rules will prevent many of the loose underwriting practices that contributed to the mortgage crisis in 2008. The ATR/QM rule applies to almost all closed-end consumer credit transactions secured by a dwelling. The ATR rule provides eight specific factors that must be considered during the underwriting process. QMs generally have three types of requirements: restrictions on loan features, points and fees, and underwriting criteria. A QM is presumed to comply with the ATR requirements. The ATR/QM rule was effective January 10, 2014.
Commercial Real Estate Guidance
In December 2015, the federal banking agencies released a “Statement on Prudent Risk Management for Commercial Real Estate Lending” (the “CRE Statement”). The agencies stated that financial institutions should review their policies and practices related to CRE lending and should maintain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk, including maintaining underwriting discipline and exercising prudent risk management practices that identify, measure, monitor and manage the risks arising from their CRE lending activity. Financial institutions were directed to review the interagency guidance on “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” issued in 2006 providing that a financial institution is potentially exposed to significant CRE concentration risk, and should employ enhanced risk management practices where (1) total CRE loans represent 300% or more of total capital, and (2) the outstanding balance of the CRE loan portfolio has increased by 50% or more during the prior 36 months. The agencies state in the CRE Statement that they will focus on those financial institutions that have recently experienced, or whose lending strategy plans for, substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals.
Pennsylvania Regulation and Supervision
In December 2012, the “Banking Law Modernization Package” became effective. The law permits banks to disclose formal enforcement actions initiated by the Pennsylvania Department of Banking and Securities, clarifies that the Department has examination and enforcement authority over subsidiaries as well as affiliates of regulated banks, and bolsters the Department’s enforcement authority over its regulated institutions by clarifying its ability to remove directors, officers and employees from institutions for violations of laws or orders or for any unsafe or unsound practice or breach of fiduciary duty. The Department also may assess civil money penalties of up to $25,000 per violation.
FDIC Insurance
The Bank is a member of the Deposit Insurance Fund (DIF), which is administered by the FDIC. The FDIC insures deposit accounts at the Bank, generally up to a maximum of $250,000 for each separately insured depositor. The FDIC charges a premium to depository institutions for deposit insurance. This rate is based on the risk category of the institution and the total premium is based on average total assets less average tangible equity. As of December 31, 2021, the Bank was considered well capitalized and its assessment rate was approximately 4 basis points of the assessment base.
Insurance of deposits may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not currently know of any practice, condition or violation that might lead to termination of our deposit insurance.
Tax Reform
On December 22, 2017 the Tax Cuts and Jobs Act (the Act) was signed into law. This comprehensive tax legislation provided for significant changes to the U.S. Internal Revenue Code of 1986, as amended, that impact corporate taxation such as the reduction in the federal corporate income tax rate from 35% to 21% effective January 1, 2018. The Act repeals the corporate alternative minimum tax, provides for earlier recognition of certain revenue, accelerates expensing of investments in tangible property and limits several deductions such as FDIC premiums, certain executive compensation and meals and entertainment expenses.
COVID 19 Pandemic
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law. Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” provides banks the option to temporarily suspend certain requirements under U.S. GAAP related to troubled debt restructurings (“TDR”) for a limited period of time to account for the effects of COVID-19. To qualify for Section 4013 of the CARES Act, borrowers must have been current at December 31, 2019. All modifications are eligible so long as they are executed between March 1, 2020 and the earlier of (i) December 31, 2020, or (ii) the 60th day after the end of the COVID-19 national emergency declared by the President of the U.S. Multiple modifications of the same credits are allowed and there is no cap on the duration of the modification. On December 21, 2020, certain provisions of the CARES Act, including the temporary suspension of certain requirements related to TDRs, were extended through December 31, 2021.
In March 2020, various regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, (“the agencies”) issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the Coronavirus. The interagency statement was effective immediately and impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, “Receivables - Troubled Debt Restructurings by Creditors,” (“ASC 310-40”), a restructuring of debt constitutes a troubled debt restructuring (“TDR”) if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not to be considered TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. At December 31, 2020 the Company had $67.6 million of loans modified under Section 4013 of the CARES Act. At December 31, 2021 all loans modified under the CARES ACT have returned to contractual payment schedules. For additional information see Item 1A. Risk Factors.
New Legislation
Congress is often considering new financial industry legislation, and the federal banking agencies routinely propose new regulations. The Corporation cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.
Selected Statistical Information
Certain statistical information is included in this report as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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ITEM 1A. RISK FACTORS
Item 1A. Risk Factors
The following is a summary of the primary risks associated with the Corporation’s business, financial condition and results of operations, and common stock.
Risk Factors Relating to the Corporation
Real estate related loans are a significant portion of our loan portfolio.
The Bank offers a variety of loan products, including residential mortgage, consumer, construction and commercial loans. The Bank requires real estate as collateral for many of its loans. At December 31, 2021, approximately 75% ($747.9 million) of its loans were secured by real estate. Loans secured by real estate and the percent of the loan portfolio are reported in Table 8. These real estate loans are located primarily in the Bank’s market area of south-central Pennsylvania. Real estate values tend to follow changes in general economic cycles. If a loan becomes delinquent as the result of an economic downturn and the Bank becomes dependent on the real estate collateral as a source of repayment, it is likely that the value of the real estate collateral has also declined. A decline in real estate values means it is possible that the real estate collateral may be insufficient to cover the outstanding balance of a delinquent or foreclosed loan, resulting in a loss to the Bank. In addition, the real estate collateral is concentrated in a small market area of south- central Pennsylvania. Localized events such as plant closures or layoffs may affect real estate prices and collateral values and could have a more negative affect on the Bank as compared to other competitors with a more geographically diverse portfolio. As the Bank grows, it is expected that real estate secured loans will continue to comprise a significant part of its balance sheet. Risk of loan default is unavoidable in the banking industry, and Management tries to limit exposure to this risk by carefully monitoring the amount of loans in specific industries and by exercising prudent lending practices and securing appropriate collateral. However, this risk cannot be eliminated, and substantial credit losses could result in reduced earnings or losses.
Commercial loans are a significant portion of our loan portfolio.
The Bank continues to grow its commercial loan portfolio. Commercial purpose loans account for 85% ($845.2 million) of the total loan portfolio. These loans are made to businesses for a variety of commercial purposes and may include fixed and variable rate loans, term loans, and lines of credit. Commercial purpose loans may be secured by real estate, business assets and equipment, personal guarantees, or non-real estate collateral. Commercial purpose loans secured by real estate were $600.7 million at December 31, 2021 and account for 60% of the total commercial loan portfolio. These loans contain all the risks associated with real estate lending as discussed above. In addition, commercial real estate collateral may be more difficult to liquidate for repayment purposes than residential real estate. The repayment of commercial loans is highly dependent upon the success of the business activity and as such maybe more susceptible to risk of loss during a downturn in the economy. Because the Bank’s commercial loan portfolio is concentrated in south-central Pennsylvania, the ability to repay these loans could be affected by deterioration of the economy in this region. As commercial lending continues to be the primary driver of loan growth, these new loans may present additional risk due to a lack of repayment history with the Bank. The Bank attempts to mitigate these risks through its underwriting and loan review process; however, this risk cannot be eliminated, and substantial credit losses could result in reduced earnings or losses.
The allowance for loan losses may prove to be insufficient to absorb inherent losses in our loan portfolio.
The Bank maintains an allowance for loan losses that Management believes is appropriate to provide for any inherent losses in the loan portfolio. The amount of the allowance is determined through a periodic review and consideration of several factors, including an ongoing review of the quality, size and diversity of our loan portfolio; evaluation of nonperforming loans; historical loan loss experience; and the amount and quality of collateral, including guarantees, securing the loan.
Although Management believes the loan loss allowance is adequate to absorb inherent losses in the loan portfolio, such losses cannot be predicted, and the allowance may not be adequate. Excessive loan losses could have a material adverse effect on the Bank’s financial condition and results of operations.
The Bank’s lending limit is smaller than many of our competitors, which affects the size of the loans it can offer customers.
The Bank’s lending limit is approximately $41.3 million. Accordingly, the size of the loans that can be offered to customers is less than the size of loans that many of our competitors, with larger lending limits, can offer. This limit affects the Bank’s ability to seek relationships with larger businesses in its market area. Loan amounts in excess of the lending limits can be accommodated through the sale of participations in such loans to other banks. However, there can be no assurance that the Bank will be successful in attracting or maintaining customers seeking larger loans or that it will be able to engage in participation of such loans or on terms favorable to the Bank.
There is strong competition in the Bank’s primary market areas and its geographic diversification is limited.
The Bank encounters strong competition from other financial institutions in its primary market area, which consists of Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania. In addition, established financial institutions not already operating in the Bank’s primary market area may open branches there at future dates or can compete in the market via the Internet. In the conduct of certain aspects of banking business, the Bank also competes with credit unions, mortgage banking companies, consumer finance companies, insurance companies and other institutions, some of which are not subject to the same degree of regulation or restrictions as are imposed upon the Bank. Many of these competitors have substantially greater resources and lending limits and can offer services that the Bank does not provide. In addition, many of these competitors have numerous branch offices located throughout their extended market areas that provide them with a competitive advantage. No assurance can be given that such competition will not have an adverse effect on the Bank’s financial condition and results of operations.
Changes in interest rates could have an adverse impact upon our results of operations.
The Bank’s profitability is in part a function of the spread between interest rates earned on investments, loans and other interest-earning assets and the interest rates paid on deposits and other interest-bearing liabilities. Interest rates are highly sensitive to many factors that are beyond the Bank’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, will influence not only the interest received on loans and investment securities and the amount of interest we pay on deposits and borrowings, but will also affect the Bank’s ability to originate loans and obtain deposits and the value of our investment portfolio. If the rate of interest paid on deposits and other borrowings increases more than the rate of interest earned on loans and other investments, the Bank’s net interest income, and therefore earnings, could be adversely affected. Likewise, the Bank currently has a very low cost of funds that it may be unable to maintain in a raising rate environment. Earnings could also be adversely affected if the rates on loans and other investments fall more quickly than those on deposits and other borrowings. While Management takes measures to guard against interest rate risk, there can be no assurance that such measures will be effective in minimizing the exposure to interest rate risk.
Uncertainty about the future of LIBOR may adversely affect our business.
LIBOR and certain other interest rate “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform. On November 18, 2020, the ICE Benchmark Administration stated its intention to cease publication of the one- and two-month USD LIBOR, immediately after publication on December 31, 2021, and the remaining USD LIBOR settings (3-, 6- and 12-month LIBOR) immediately following the LIBOR publication on June 30, 2023. The Corporation has material contracts that are indexed to USD-LIBOR. Industry organizations are currently working on the transition plan. While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, a group of market participants convened by the Federal Reserve, the Alternative Reference Rate Committee (ARRC), has selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to LIBOR. The Federal Reserve Bank of New York started to publish the SOFR April 2018. SOFR is a broad measure of the cost of overnight borrowings collateralized by Treasury securities that was selected by the ARRC due to the depth and robustness of the U.S. Treasury repurchase market. In January 2020, the ARRC released a recommendation that new SOFR-based intercompany loans use the 30- or 90-day Average SOFR set in advance with an appropriate reset period.
At this time, it is impossible to predict whether the SOFR will become an accepted alternative to LIBOR. The market transition away from LIBOR to an alternative reference rate, such as the SOFR, is complex and could have a range of adverse effects on our business, financial condition, and results of operations. Management has formed a work group to review the Bank’s exposure to LIBOR, study replacement options and customer communication about the LIBOR change. The Corporation is currently monitoring this activity and evaluating the risks involved.
Our operational or security systems may experience interruption or breach in security, including cyber-attacks.
We rely heavily on communications and information systems to conduct our business. These systems include our internal network and data systems, as well as those of third-party vendors. Any failure, interruption or breach in security or these systems, including a cyber-attack, could result in the disclosure or misuse of confidential or proprietary information. Cyber security risks for financial institutions have significantly increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties, including foreign state actors. Financial services institutions have been subject to, and are likely to continue to be the target of, cyber-attacks, including computer viruses, malicious or destructive code, phishing attacks, denial of service or information or other security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of confidential, proprietary and other information of the institution, its employees or customers or of third parties, or otherwise materially disrupt network access or business operations. Cyber threats could result in unauthorized access, loss or destruction of customer data, unavailability, degradation or denial of service, introduction of computer viruses and other adverse events, causing the Corporation to incur additional costs (such as repairing systems or adding new personnel or protection technologies). Cyber threats may also subject the Corporation to regulatory investigations, litigation or enforcement, require
the payment of regulatory fines or penalties or undertaking costly remediation efforts. While we have systems, policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of client business, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.
A large component of fee income is dependent on stock market values.
Fee income from the Bank’s Investment and Trust Services Department comprises a large percentage of total noninterest income. Fee income from Investment and Trust Services is comprised primarily of asset management fees as measured by the market value of assets under management. As such, the market values are directly related to stock market values. Therefore, any significant negative change in the value of assets under management due to stock market fluctuations could greatly reduce fee income and have a material adverse effect on our financial condition and results of operations.
A large component of fee income is dependent on two deposit services.
Fee income from the Bank’s debit card is a significant contributor of fee income. As technology changes and consumer payment preferences change it is possible that debit card income does not continue to grow or may decline. The Bank’s overdraft protection program has also been a significant contributor of fee income. It is possible that the usage of this product slows or that regulatory changes negatively affect the fees that can be charged for such services.
A large percentage of certificates of deposit have short-term maturities.
Seventy-five percent ($55.7 million) of the Bank’s certificates of deposit are scheduled to mature within one year. If the Bank is unable to retain these deposits, it may require the Bank to access other sources of liquidity that may carry a higher cost. However, these deposits only account for 3.5% of total deposits.
A large percentage of deposits may be highly sensitive to changes in interest rates.
Thirty-seven percent ($579.8 million) of all deposits are in the Bank’s money management product. The interest rate on these deposits generally follows market rates. A large or continuous increase in market rates could result in a rapid increase in the interest expense of these deposits. While the interest rate on this product generally follows market rates, the product is not indexed to a market rate, thereby giving the Bank more control over any rate increases.
Liquidity contingency funding is highly concentrated.
The Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB). Access to funding through the FHLB is the largest component of the Bank’s liquidity stress testing and contingency funding plans. The ability to access funding from FHLB may be critical if a funding need arises. However, there can be no assurance that the FHLB will be able to provide funding when needed, nor can there be assurance that the FHLB will provide funds to the Bank if its financial condition deteriorates. The inability to access FHLB funding, through a restriction on credit or the failure of the FHLB, could have a materially adverse effect on the Bank’s liquidity management.
Our business and financial results could be impacted materially by adverse results in legal proceedings.
The nature of the Corporation’s business generates a certain amount of litigation involving matters arising in the ordinary course of business (and, in some cases, from the activities of companies we have acquired). These legal proceedings, whether founded or unfounded, could result in reputation damage and have an adverse effect on our financial condition and results of operation if they are not resolved in a manner favorable to the Corporation. Although we establish legal accruals for legal proceedings when information related to the loss contingencies represented by these matters indicates that both a loss is probable and that the amount of the loss can be reasonably estimated, we do not have accruals for all legal proceedings where we face a risk of loss. In addition, due to the inherent subjectivity of the assessments and unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation. We discuss these matters further in Part I Item 3 Legal Proceedings and in Note 21 Commitments and Contingencies in the Notes to Consolidated Financial Statements in Part II Item 8 of this Report.
Public health crisis such as epidemics or pandemics could materially and adversely impact our business.
We continue to closely monitor the COVID-19 pandemic and related risks as they evolve. The magnitude, duration, and likelihood of the current outbreak of COVID-19, or its variants; future actions taken by governmental authorities and/or other third parties in response to such outbreaks, and its future direct and indirect effects on the global, national and local economy and our
business and results of operation are highly uncertain. The COVID-19 pandemic may cause prolonged global or national recessionary economic conditions or longer lasting effects on economic conditions than currently exist, which could have a material adverse effect on our business, results of operations and financial condition.
As a result of continued or new outbreaks of COVID-10 or its variants, the demand for our products and services have been and may continue to be significantly impacted, which could adversely affect our revenue and results of operations. Furthermore, the effects of the pandemic could result in the recognition of credit losses in our loan portfolios and an increase in our allowance for credit losses, particularly if businesses are restricted or are required to close again, the impact on the global, national, and local economies worsen, or more customers draw on their lines of credit or seek additional loans to help finance their businesses. Similarly, because of changing economic and market conditions affecting issuers, we may be required to recognize further impairments on the securities we hold as well as reductions in other comprehensive income. Our business operations may also be disrupted if significant portions of our workforce are unable to work effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. The extent to which the COVID-19 pandemic impacts our business, results of operations, and financial conditions, as well as our regulatory capital and liquidity ratios, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.
Due to the Corporation’s participation in the U.S. Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”), the Corporation is subject to additional risks of litigation from its clients or other parties regarding the processing of loans for the PPP and risks that the SBA may not fund some or all of PPP loan guaranties.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted, which included a $349 billion loan program administered through the SBA referred to as the Paycheck Protection Program (PPP). On December 21, 2020, a second round of COVID-19 relief authorized an additional $285 billion in PPP funding. Under the PPP, small businesses and other entities and individuals could apply for loans from existing SBA lenders and other approved regulated lenders. The Corporation participated as a lender in the PPP. Because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there was some ambiguity in the guidance regarding the operation of the PPP along with the continually evolving nature of SBA rules, interpretations and guidelines concerning this program, which exposes us to risks relating to the noncompliance with the PPP. As such, we may be exposed to the risk of litigation, from both clients and non-clients that approached the Corporation regarding PPP loans, regarding its process and procedures used in processing applications for the PPP. If any such litigation is filed against us and is not resolved in a manner favorable to us, it may result in significant financial liability or adversely affect our reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition, and results of operations.
The Corporation also has credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, underwritten, certified by the borrower, funded, or serviced by the Corporation, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, certified by the borrower, funded, or serviced by the Corporation, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from us. At December 31, 2021, the Bank held $7.8 million of PPP loans compared to $52.3 million at the end of 2020.
The Corporation’s operations could be affected by climate change.
The Corporation’s business, as well as the operations and activities of our clients, could be negatively impacted by climate change. Climate change presents both immediate and long-term risks to the Corporation and its clients, and these risks are expected to increase over time. Climate change presents multi-faceted risks, including: operational risk from the physical effects of climate events on the Corporation and its clients’ facilities and other assets; credit risk from borrowers with significant exposure to climate risk; transition risks associated with the transition to a less carbon-dependent economy; and reputational risk from stakeholder concerns about our practices related to climate change, the Corporation’s carbon footprint, and the Corporation’s business relationships with clients who operate in carbon-intensive industries.
Federal and state banking regulators and supervisory authorities, investors, and other stakeholders have increasingly viewed financial institutions as important in helping to address the risks related to climate change both directly and with respect to their clients, which may result in financial institutions coming under increased pressure regarding the disclosure and management of their climate risks and related lending and investment activities. Given that climate change could impose systemic risks upon the financial sector, either via disruptions in economic activity resulting from the physical impacts of climate change or changes in policies as the economy transitions to a less carbon-intensive environment, the Corporation may face regulatory risk of increasing focus on the Corporation’s resilience to climate-related risks, including in the context of stress testing for various climate stress scenarios. Ongoing legislative or regulatory uncertainties and changes regarding climate risk management and practices may result in higher regulatory, compliance, credit, and reputational risks and costs.
Risk Factors Relating to the Common Stock
The stock market can be volatile, and fluctuations in our operating results and other factors could cause our stock price to decline.
The stock market has experienced, and may continue to experience, fluctuations that significantly impact the market prices of securities issued by many companies and financial institutions specifically. Market fluctuations could adversely affect our stock price. These fluctuations have often been unrelated or disproportionate to the operating performance of particular companies. These broad market fluctuations, as well as general economic, systemic, political and market conditions, such as recessions, loss of investor confidence, interest rate changes, government shutdowns, trade wars, pandemics or epidemics, or international currency fluctuations, may negatively affect the market price of our common stock. Moreover, our operating results may fluctuate and vary from period to period due to the risk factors set forth herein. As a result, period-to-period comparisons should not be relied upon as an indication of future performance. Our stock price could fluctuate significantly in response to our quarterly or annual results, annual projections and the impact of these risk factors on our operating results or financial position.
Although the Company’s common stock is quoted on the Nasdaq Capital Market, the volume of trades on any given day has been limited historically, as a result of which shareholders might not have been able to sell or purchase the Company’s common stock at the volume, price or time desired. From time to time, our Common Stock may be included in certain and various stock market indices. Inclusion in these indices may positively impacted the price, trading volume, and liquidity of our Common Stock, in part, because index funds or other institutional investors often purchase securities that are in these indices. Conversely, if our market capitalization falls below the minimum necessary to be included in any of the indices at any annual reconstitution date, the opposite could occur. Further, our inclusion in indices may be weighted based on the size of our market capitalization, so even if our market capitalization remains above the amount required to be included on these indices, if our market capitalization is below the amount it was on the most recent reconstitution date, our Common Stock could be weighted at a lower level. If our Common Stock is weighted at a lower level, holders attempting to track the composition of these indices will be required to sell our Common Stock to match the reweighting of the indices.
The Bank's ability to pay dividends to the Corporation is subject to regulatory limitations that may affect the Corporation’s ability to pay dividends to its shareholders.
As a holding company, the Corporation is a separate legal entity from the Bank and does not have significant operations of its own. It currently depends upon the Bank's cash and liquidity to pay dividends to its shareholders. The Corporation cannot assure you that in the future the Bank will have the capacity to pay dividends to the Corporation. Various statutes and regulations limit the availability of dividends from the Bank. It is possible; depending upon the Bank's financial condition and other factors, that the Bank’s regulators could assert that payment of dividends by the Bank to the Corporation would constitute an unsafe or unsound practice. In the event that the Bank is unable to pay dividends to the Corporation, the Corporation may not be able to pay dividends to its shareholders.

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ITEM 1B. UNRESOLVED STAFF COMMENTS
Item 1B. Unresolved Staff Comments
None

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ITEM 2. PROPERTIES
Item 2. Properties
The Corporation’s headquarters is located in the main office of F&M Trust at 20 South Main Street, Chambersburg, Pennsylvania. This location also houses a community banking office as well as operational support services for the Bank. The Corporation owns or leases thirty-five properties in Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania, for banking operations, as described below:
Property
Owned
Leased
Facilities used in Banking Operations
Remote ATM Sites
Other Properties
Included in Other Properties is a property leased for future use.
‎

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ITEM 3. LEGAL PROCEEDINGS
Item 3. Legal Proceedings
The nature of the Corporation’s business generates a certain amount of litigation.
We establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable and the amount of the loss can be reasonably estimated. When we are able to do so, we also determine estimates of possible losses, whether in excess of any accrued liability or where there is no accrued liability.
These assessments are based on our analysis of currently available information and are subject to significant judgment and a variety of assumptions and uncertainties. As new information is obtained, we may change our assessments and, as a result, take or adjust the amounts of our accruals and change our estimates of possible losses or ranges of possible losses. Due to the inherent subjectivity of the assessments and the unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation from any legal proceeding. Our exposure and ultimate losses may be higher, possibly significantly higher, than amounts we may accrue or amounts we may estimate.
In management’s opinion, we do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of all litigation to which the Corporation is a party will have a material adverse effect on our financial position. We cannot now determine, however, whether or not any claim asserted against us will have a material adverse effect on our results of operations in any future reporting period, which will depend on, amount other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period. Thus, at December 31, 2021, we are unable to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss with respect to such other matters and, accordingly, have not yet established any specific accrual for such other matters.
No material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.
In management’s opinion, there are no other proceedings pending to which the Corporation is a party or to which its property is subject which, if determined adversely to the Corporation, would be material.

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ITEM 4. MINE SAFETY DISCLOSURE
Item 4. Mine Safety Disclosures
Not Applicable
Part II

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ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Market and Dividend Information
The Corporation had 1,626 shareholders of record as of December 31, 2021.
Restrictions on the Payment of Dividends
For limitations on the Corporation’s ability to pay dividends, see “Supervision and Regulation - Regulatory Restrictions on Dividends” in Item 1 above.
Securities Authorized for Issuance under Equity Compensation Plans
The information related to equity compensation plans is incorporated by reference to the materials set forth under the heading “Executive Compensation - Compensation Tables” in the Corporation’s Proxy Statement for the 2022 Annual Meeting of Shareholders.
Common Stock Repurchases
The Board of Directors, from time to time, authorizes the repurchase of the Corporation’s $1.00 par value common stock. The repurchased shares will be held as Treasury shares available for issuance in connection with future stock dividends and stock splits, employee benefit plans, executive compensation plans, the Dividend Reinvestment Plan and other appropriate corporate purposes.
The following table shows stock repurchase activity under approved plans:
Period
Number of Shares Purchased as Part of Publicly Announced Program
Weighted Average Price Paid per Share
Dollar Amount of Shares Purchased as Part of Publicly Announced Program
Shares Yet To Be Purchased Under Program
October 2021
1,320
32.02
$
42,272
113,436
November 2021
31.97
6,521
113,232
December 2021
1,211
32.07
38,834
149,341
2,735
$
87,627
Performance Graph
The following graph compares the cumulative total return to shareholders of Franklin Financial with selected market indices and a bank peer group, consisting of Mid-Atlantic Banks with assets between $1 billion - $2 billion as of September 30, 2021; for the five year period ended December 31, 2021, in each case assuming an initial investment of $100 on December 31, 2016 and the reinvestment of all dividends. Information is provided by S&P Global Market Intelligence.
Period Ending
Index
12/31/16
12/31/17
12/31/18
12/31/19
12/31/20
12/31/21
Franklin Financial Services Corporation
$
100.00
$
134.41
$
116.78
$
148.08
$
107.96
$
137.67
Peer Group*
$
100.00
$
114.90
$
112.30
$
128.09
$
103.38
$
136.95
SNL Mid-Atlantic Bank
$
100.00
$
122.56
$
104.72
$
148.90
$
134.59
$
169.99
NASDAQ Composite
$
100.00
$
129.64
$
125.96
$
172.18
$
249.51
$
304.85
*Peer Group consists of Mid Atlantic Banks with Assets between $1B-$2B as of 9/30/2021
‎
Shareholders’ Information
Dividend Reinvestment Plan:
Franklin Financial Services Corporation offers a dividend reinvestment program whereby shareholders of the Corporation’s common stock may reinvest their dividend, or make optional cash payment, to purchase additional shares of the Corporation. Beneficial owners of shares of the Corporation’s common stock may participate in the program by making appropriate arrangements through their bank, broker or other nominee. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717-264-6116.
Dividend Direct Deposit Program:
Franklin Financial Services Corporation offers a dividend direct deposit program whereby shareholders of the Corporation’s common stock may choose to have their dividends deposited directly into the bank account of their choice on the dividend payment date. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717-264-6116.
Annual Meeting:
The Annual Meeting of the shareholders of Franklin Financial Services Corporation will be held Tuesday, April 26, 2022 at 9:00 a.m. in a virtual meeting format only. Only shareholders will be granted access to the meeting as described in the Franklin Financial Services Corporation 2022 Proxy Statement.
Websites:
Franklin Financial Services Corporation: www.franklinfin.com
Farmers & Merchants Trust Company: www.fmtrust.bank
Stock Information:
The Corporation’s common stock is traded on the Nasdaq Capital Market under the symbol “FRAF”.
The registrar and transfer agent for Franklin Financial Services Corporation is:
Computershare
P.O. Box 30170
College Station, TX 77842-3170
1-800-368-5948

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ITEM 6. SELECTED FINANCIAL DATA
Item 6. [Reserved]
‎

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Summary of Selected Financial Data as of and for the Year Ended December 31
(Dollars in thousands, except per share)
Balance Sheet Highlights
Total assets
$
1,773,806
$
1,535,038
$
1,269,157
$
1,209,587
$
1,179,813
Investment and equity securities
530,292
397,331
187,873
131,846
127,336
Loans, net
983,746
992,915
922,609
960,960
931,908
Deposits
1,584,359
1,354,573
1,125,392
1,082,629
1,047,181
Shareholders' equity
157,065
145,176
127,528
118,396
115,144
Summary of Operations
Interest income
$
47,573
$
45,939
$
49,235
$
44,868
$
39,885
Interest expense
2,902
3,978
7,113
4,214
2,491
Net interest income
44,671
41,961
42,122
40,654
37,394
Provision for loan losses
(2,100)
4,625
9,954
Net interest income after provision for loan losses
46,771
37,336
41,885
30,700
36,724
Noninterest income
19,488
15,084
15,424
12,629
12,189
Noninterest expense
43,245
39,362
38,314
37,369
43,172
Income before income taxes
23,014
13,058
18,995
5,960
5,741
Federal income tax expense (benefit)
3,398
2,880
(165)
3,565
Net income
$
19,616
$
12,800
$
16,115
$
6,125
$
2,176
Performance Measurements
Return on average assets
1.17%
0.91%
1.29%
0.52%
0.19%
Return on average equity
13.20%
9.56%
13.17%
5.34%
1.80%
Return on average tangible equity (1)
14.05%
10.24%
14.22%
5.80%
1.94%
Efficiency ratio (1)
66.12%
67.32%
65.36%
68.27%
82.59%
Net interest margin, fully tax equivalent
2.88%
3.21%
3.68%
3.78%
3.72%
Shareholders' Value (per common share)
Diluted earnings per share
$
4.42
$
2.93
$
3.67
$
1.39
$
0.50
Basic earnings per share
4.44
2.94
3.68
1.40
0.50
Regular cash dividends paid
1.25
1.2
1.17
1.05
0.93
Book value
35.36
33.07
29.30
26.85
26.44
Tangible book value (1)
33.34
31.02
27.23
24.81
24.37
Market value**
33.10
27.03
38.69
31.50
37.36
Market value/book value ratio
93.61%
81.74%
132.05%
117.32%
141.30%
Market value/tangible book value ratio
99.29%
87.13%
142.11%
126.97%
153.30%
Price/earnings multiple year-to-date
7.49
9.23
10.54
22.66
74.72
Current quarter dividend yield*
3.87%
4.44%
3.10%
3.43%
2.49%
Dividend payout ratio
28.16%
40.83%
31.74%
75.07%
185.25%
Safety and Soundness
Average equity/average assets
8.89%
9.48%
9.78%
9.73%
10.62%
Risk-based capital ratio (Total)
18.41%
17.69%
16.08%
15.21%
15.31%
Leverage ratio (Tier 1)
8.52%
8.69%
9.72%
9.78%
9.73%
Common equity ratio (Tier 1)
15.20%
14.32%
14.82%
13.96%
14.06%
Nonperforming loans/gross loans
0.74%
0.87%
0.42%
0.27%
0.28%
Nonperforming assets/total assets
0.42%
0.57%
0.31%
0.44%
0.45%
Allowance for loan loss/loans
1.51%
1.66%
1.28%
1.28%
1.25%
Net loan recoveries (charge-offs)/average loans
0.02%
0.02%
-0.07%
-0.97%
0.01%
Assets under Management
Trust and Investment Services (fair value)
$
946,964
$
836,381
$
790,949
$
684,825
$
686,941
Held at third-party brokers (fair value)
58,052
112,624
127,976
122,213
158,145
*Annualized
** Based on the closing price of FRAF as quoted on the Nasdaq Capital Market for 2021, 2020 and 2019 and the OTCQX for all prior periods
(1) See the section titled "GAAP versus Non-GAAP Presentation" that follows.
Application of Critical Accounting Policies:
Disclosure of the Corporation’s significant accounting policies is included in Note 1 to the consolidated financial statements. These policies are particularly sensitive requiring significant judgments, estimates and assumptions to be made by Management. Senior management has discussed the development of such estimates, and related Management Discussion and Analysis disclosure, with the Audit Committee of the Board of Directors.
The following accounting policy is identified by management to be critical to the results of operations: Allowance for Loan Losses and the Annual Goodwill Impairment Evaluation.
GAAP versus non-GAAP Presentations - The Corporation supplements its traditional GAAP measurements with certain non-GAAP measurements to evaluate its performance and to eliminate the effect of intangible assets. By eliminating intangible assets, the Corporation believes it presents a measurement that is comparable to companies that have no intangible assets or to companies that have eliminated intangible assets in similar calculations. However, not all companies may use the same calculation method for each measurement. The Efficiency Ratio measures the cost to generate one dollar of revenue. The non-GAAP measurements are not intended to be used as a substitute for the related GAAP measurements. The following table shows the calculation of the non-GAAP measurements.
(Dollars in thousands, except per share)
For the Year Ended December 31
Return on Average Tangible Equity (non-GAAP)
Net income
$
19,616
$
12,800
$
16,115
$
6,125
$
2,176
Average shareholders' equity
148,637
133,958
122,377
114,625
120,993
Less average intangible assets
(9,016)
(9,016)
(9,016)
(9,016)
(9,016)
Average shareholders' equity (non-GAAP)
139,621
124,942
113,361
105,609
111,977
Return on average tangible equity (non-GAAP)
14.05%
10.24%
14.22%
5.80%
1.94%
Tangible Book Value (per share) (non-GAAP)
Shareholders' equity
$
157,065
$
145,176
$
127,528
$
118,396
$
115,144
Less intangible assets
(9,016)
(9,016)
(9,016)
(9,016)
(9,016)
Shareholders' equity (non-GAAP)
148,049
136,160
118,512
109,380
106,128
Shares outstanding (in thousands)
4,441
4,389
4,353
4,409
4,355
Tangible book value (non-GAAP)
33.34
31.02
27.23
24.81
24.37
Efficiency Ratio (non-GAAP)
Noninterest expense
$
43,245
$
39,362
$
38,314
$
37,369
$
43,172
Net interest income
44,671
41,961
42,122
40,654
37,394
Plus tax equivalent adjustment to net interest income
1,466
1,407
1,393
1,522
2,690
Plus noninterest income, net of securities transactions
19,271
15,104
15,102
12,564
12,186
Total revenue
65,408
58,472
58,617
54,740
52,270
Efficiency ratio (non-GAAP)
66.12%
67.32%
65.36%
68.27%
82.59%
Results of Operations:
Management’s Overview
The following discussion and analysis is intended to assist the reader in reviewing the financial information presented and should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein.
Summary
Franklin Financial Services Corporation reported consolidated earnings $19.6 million ($4.42 per diluted share) for 2021 compared with $12.8 million ($2.93 per diluted share) for the same period in 2020.
Year-to-date, net interest income was $44.7 million (including $3.3 million of PPP interest and fees), an increase of 6.5% compared to $42.0 million for the same period in 2020 (including $2.9 million of PPP interest and fees). On a year-over-year comparison, the net interest margin was 2.88% for 2021 compared to 3.21% in 2020. The decrease in the 2021 net interest margin was due primarily to a 0.45% decline in the yield on earning assets from 3.51% in 2020 to
3.06% in 2021 as all asset classes had lower yields in 2021. This decrease was partially offset by a reduction in the cost of interest-bearing liabilities from 0.39% for 2020 to 0.24% for 2021. Likewise, the cost of all deposits decreased from 0.28% in 2020 to 0.12% in 2021.
‎
Average earning assets for 2021 were $1.7 billion compared to $1.4 billion in 2020, an increase of 18.8%. In 2021, the average balance of interest-bearing cash balances increased $34.2 million (45.6%), the average balance of the investment portfolio increased $203.5 million (71.9%) and the average balance of the loan portfolio increased $16.1 million (1.6%), over the prior year averages. Within the loan portfolio, average commercial loan balances increased $5.8 million during the year. The average balance of PPP loans included in the commercial loan portfolio for 2021 was $41.4 million. Total deposits averaged $1.5 billion for 2021, an increase of $232 million (18.5%) over the average balance for 2020. All deposit categories reported a year-over-year increase in average balances, except for time deposits.
‎
The provision for loan loss expense was a reversal of $2.1 million compared to a $4.6 million provision expense for the same period in 2020. The 2020 provision expense was the result of an increase in several qualitative factors in the allowance for loan loss calculation due to the projected economic effects and impact of the COVID-19 pandemic. During 2021, several qualitative factors were reduced, reflecting a lower risk of loss in the loan portfolio, and the twenty-quarter historical average charge-off rate used in the calculation decreased, thereby resulting in a reversal of the provision for loan loss expense. The allowance for loan loss ratio was 1.51% of gross loans as of December 31, 2021, compared to 1.66% at December 31, 2020.
‎
Noninterest income was $19.5 million compared to $15.1 million in 2020. Significant year-to-date variances include the gain on sale of $1.8 million on the sale of the Bank’s headquarters building, increases in Investment and Trust Services fees ($1.1 million), gains on the sale of mortgages (up $894 thousand) and debit card income (up $326 thousand). These increases were partially offset by a decrease of $545 thousand from gains on bank owned life insurance.
‎
Noninterest expense was $43.2 million in 2021 compared to $39.4 million in 2020. The following categories contributed to the year-over-year increase: salaries and benefits increased $2.4 million (primarily incentive compensation and health insurance), FDIC insurance increased $278 thousand, data processing expense increased $607 thousand, and a nonservice pension settlement expense of $425 thousand. Other expenses decreased $293 thousand due primarily to a $636 thousand expense reversal relating to the reversal of a previously established off-balance sheet liability reserve.
‎
The effective tax rate was 14.8% for 2021.
Total assets at December 31, 2021 were $1.774 billion compared $1.535 billion at December 31, 2020, an increase of 15.6%. Significant balance sheet changes since December 31, 2020, include: 
Short-term interest-bearing deposits in other banks increased $124.6 million (310.8%) and the investment portfolio increased $132.9 million (33.5%).
‎
The net loan portfolio decreased $9.2 million over the year-end 2020 balance. Commercial loans were down $13.9 million from year-end 2020 as new production was completely offset by a $44.5 million reduction in PPP loans. The Bank held $7.8 million in PPP loans at December 31, 2021, and $370 thousand of deferred PPP fees remaining to be recognized.
‎
As of December 31, 2021, the Bank had no loans under a COVID modified payment schedule and all loans previously on modified payment have returned to contractual payment schedules.
‎
Deposits increased $230 million (17.0%) over year-end 2020, with all deposit products showing an increase except time deposits. Money management accounts and interest-bearing checking products showed the largest increases over the prior year-end.
‎
Shareholders’ equity increased $11.9 million from December 31, 2020, due primarily to an increase of $14.1 million in retained earnings during 2021 partially offset by a decrease of $3.7 million in accumulated other comprehensive income (AOCI) as the fair value of the investment portfolio declined during the year. At December 31, 2021, the book value of the Corporation’s common stock was $35.36 per share and tangible book value was $33.34 per share. In December 2021, an open market repurchase plan was approved to repurchase 150,000 shares over a one-year period.
Other key performance measurements are presented in Item 6 of this report.
A more detailed discussion of the areas that had the greatest effect on the reported results follows.
Net Interest Income
The most important source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation’s 21% Federal statutory rate. The components of net interest income are detailed in Tables 1, 2 and 3.
Table 1 show the change in tax-equivalent net interest income year over year. Changes in interest income and expense are driven by changes in balance (volume) and changes in the average rate on interest-earning assets and interest-bearing liabilities. The changes attributable to rate or volume are shown in Table 2. The yield on earning assets (Table 3) declined from 3.51% for 2020 to 3.06% for 2021. The benefit provided by tax-exempt income was $1.5 million in 2021.
Table 1. Net Interest Income
Change
(Dollars in thousands)
$
%
Interest income
$
47,573
$
45,939
$
1,634
3.6
Interest expense
2,902
3,978
(1,076)
(27.0)
Net interest income
44,671
41,961
2,710
6.5
Tax equivalent adjustment
1,466
1,407
4.2
Tax equivalent net interest income
$
46,137
$
43,368
$
2,769
6.4
Table 2 identifies increases and decreases in tax equivalent net interest income due to either changes in average volume or to changes in average rates for interest-earning assets and interest-bearing liabilities. Numerous and simultaneous balance and rate changes occur during the year. The amount of change that is not due solely to volume or rate is allocated proportionally to both.
Table 2. Rate-Volume Analysis of Tax Equivalent Net Interest Income
2021 Compared to 2020
2020 Compared to 2019
Increase (Decrease) due to:
Increase (Decrease) due to:
Increase (Decrease) due to:
(Dollars in thousands)
Volume
Rate
Net
Volume
Rate
Net
Interest earned on:
Interest-bearing obligations in other banks
$
$
(386)
$
(227)
$
(11)
$
(1,111)
$
(1,122)
Investment securities:
Taxable
3,262
(771)
2,491
2,555
(580)
1,975
Nontaxable
(168)
(135)
Loans:
Commercial, industrial and agriculture
(924)
(687)
(4,599)
(3,717)
Residential mortgage
(89)
(271)
(360)
(324)
(278)
Home equity loans and lines
(849)
(452)
(1,002)
(711)
Consumer
(159)
(120)
Loans
(1,835)
(1,280)
1,258
(6,084)
(4,826)
Total net change in interest income
4,853
(3,160)
1,693
4,628
(7,910)
(3,282)
Interest expense on:
Interest-bearing checking
(439)
(275)
(671)
(483)
Money management
(988)
(758)
(2,908)
(2,561)
Savings
(59)
(41)
(318)
(274)
Time deposits
(110)
(514)
(624)
(56)
(152)
(208)
Other borrowings
-
-
-
(18)
(18)
(36)
Subordinate Notes
Total net change in interest expense
(1,997)
(1,076)
(3,853)
(3,135)
Change in tax equivalent net interest income
$
3,932
$
(1,163)
$
2,769
$
3,910
$
(4,057)
$
(147)
The following table presents average balances, tax-equivalent (T/E) interest income and expense, and yields earned or rates paid on the assets or liabilities. Nonaccrual loans are included in the average loan balances.
Table 3. Analysis of Net Interest Income
Average
Income or
Average
Average
Income or
Average
(Dollars in thousands)
balance
expense
yield/rate
balance
expense
yield/rate
Interest-earning assets:
Interest-bearing obligations of other banks
$
109,263
$
0.23%
$
75,063
$
0.63%
Investment securities:
Taxable
392,789
7,216
1.84%
219,815
4,725
2.15%
Tax Exempt
93,764
2,661
2.84%
63,246
1,952
3.09%
Investments
486,553
9,877
2.03%
283,061
6,677
2.36%
Loans:
Commercial, industrial and agricultural
849,201
33,982
4.00%
843,412
34,669
4.11%
Residential mortgage
68,581
2,382
3.47%
70,932
2,742
3.87%
Home equity loans and lines
83,465
2,103
2.52%
71,042
2,555
3.60%
Consumer
6,855
6.51%
6,581
3.45%
Loans
1,008,102
38,913
3.86%
991,967
40,193
4.05%
Total interest-earning assets
1,603,918
$
49,039
3.06%
1,350,091
$
47,346
3.51%
Other assets
67,381
63,507
Total assets
$
1,671,299
$
1,413,598
Interest-bearing liabilities:
Deposits:
Interest-bearing checking
$
472,596
$
0.11%
$
379,564
$
0.21%
Money Management
537,010
0.15%
460,447
1,588
0.34%
Savings
112,506
0.06%
93,645
0.11%
Time
72,525
0.60%
81,847
1,062
1.30%
Total interest-bearing deposits
1,194,637
1,853
0.16%
1,015,503
3,551
0.35%
Other borrowings
-
-
-
-
-
-
Subordinate notes
19,571
1,049
5.36%
8,022
5.32%
Total interest-bearing liabilities
1,214,208
2,902
0.24%
1,023,525
3,978
0.39%
Noninterest-bearing deposits
293,027
240,042
Other liabilities
15,427
16,073
Shareholders' equity
148,637
133,958
Total liabilities and shareholders' equity
$
1,671,299
$
1,413,598
T/E net interest income/Net interest margin
46,137
2.88%
43,368
3.21%
Tax equivalent adjustment
(1,466)
(1,407)
Net interest income
$
44,671
$
41,961
Net Interest Spread
2.82%
3.12%
Cost of Funds
0.19%
0.31%
Cost of Deposits
0.12%
0.28%
Provision for Loan Losses
In 2021, the Bank recorded gross loan charge-offs of $330 thousand, which were more than offset by $707 thousand of recoveries, resulting in net loan recovery of $377 thousand. For 2021, the Corporation reversed $2.1 million through the provision for loan loss expense. The allowance for loan losses was $15.1 million at year-end 2021 (1.51% of total loans), compared to $16.8 million at year-end 2020 (1.66% of total loans). Management closely monitors the credit quality of the portfolio in order to ensure that an appropriate ALL is maintained. As part of this process, Management performs a comprehensive analysis of the loan portfolio considering delinquencies trends and events, current economic conditions, and other relevant factors to determine the adequacy of the allowance for loan losses and the provision for loan losses. For more information, refer to the Loan Quality discussion and Table 10.
Noninterest Income
The following table presents a comparison of noninterest income for the years ended December 31, 2021 and 2020:
Table 4. Noninterest Income
Change
(Dollars in thousands)
Amount
%
Noninterest Income
Investment and trust services fees
$
7,111
$
6,040
$
1,071
17.7
Loan service charges
6.0
Gain on sale of loans
2,430
1,536
58.2
Deposit service charges and fees
2,258
1,977
14.2
Other service charges and fees
1,650
1,446
14.1
Debit card income
2,170
1,844
17.7
Increase in cash surrender value of life insurance
(11)
(2.4)
Bank owned life insurance gain
(545)
(64.9)
Net gain on sales of debt securities
337.9
Change in fair value of equity securities
(49)
(283.7)
Gain on sale of bank premises
1,776
-
1,776
N/A
Other
108.1
Total
$
19,488
$
15,084
$
4,404
29.2
The most significant changes in noninterest income are discussed below:
Investment and Trust Service fees: These fees are comprised of asset management fees, estate administration and settlement fees, employee benefit plans, and commissions from the sale of insurance and investment products. Asset management fees are recurring in nature and are affected by the fair value of assets under management at the time the fees are recognized. Asset management fees totaled $6.5 million for 2021, an increase of $865 thousand over 2020. The fair value of trust assets under management was $947.0 million at year-end, compared to $836.4 million at the end of 2020. By the nature of an estate settlement, these fees are considered nonrecurring. Estate fees increased by $260 thousand, to $454 thousand in 2021. Commissions from the sale of insurance and investment products decreased by $48 thousand compared to 2020.
Loan service charges: This category includes primarily commercial letter of credit fees, commercial loan prepayment penalties, mortgage servicing fees and consumer debt protection fees.
Gain on sale of loans: This category is comprised of fees from the sale of mortgages in the secondary market.
Deposit fees: This category is comprised primarily of fees from overdrafts, an overdraft protection program, service charges, and account analysis fees. The increase of $281 thousand in this category was due to the addition of new deposit products.
Other service charges and fees: The most significant items in this category include fees from the Bank’s merchant card program and ATM fees. Merchant card fees increased $45 thousand while ATM fees increased $25 thousand, due to higher usage.
Debit card income: Debit card fees are comprised of both a retail and business card program. Retail fees increased by $268 thousand, 19% increase over the prior year, while business card fees increased $113 thousand, a 25% increase over the prior year. The business debit card offers a cash back rewards program based on usage, while the retail debit card offers reward points based on usage. Debit card income is reported net of reward program expense.
Bank owned life insurance gain: The Bank received larger death benefits from bank-owned life insurance policies in 2020 than in 2021.
Gain on sale of bank premises: The Bank sold its current headquarters at 20 South Main Street, Chambersburg, PA as previously reported.
Noninterest Expense
The following table presents a comparison of noninterest expense for the years ended December 31, 2021 and 2020:
Table 5. Noninterest Expense
(Dollars in thousands)
Change
Noninterest Expense
Amount
%
Salaries and benefits
$
24,780
$
22,392
$
2,388
10.7
Net occupancy
3,580
3,350
6.9
Marketing and advertising
1,533
1,757
(224)
(12.7)
Legal and professional
2,013
1,802
11.7
Data processing
4,026
3,419
17.8
Pennsylvania bank shares tax
1,017
5.4
FDIC insurance
60.8
ATM/debit card processing
1,305
1,088
19.9
Telecommunications
(51)
(11.1)
Nonservice pension
133.3
Other
3,030
3,323
(293)
(8.8)
Total
$
43,245
$
39,362
$
3,883
9.9
The most significant changes in noninterest expense are discussed below:
Salaries and benefits: This category is the largest noninterest expense category and includes expenses for salaries, health benefits, insurance, pension service, taxes and other employee benefit programs. This category increased by $2.4 million compared to the prior year from salary increases of $877 thousand due to higher expense for incentive compensation plans, $710 thousand increase in health insurance expense as the Bank’s self-funded plan generated less surplus in 2021 compared to 2020, and $365 thousand due to merit increases. See Note 17 of the accompanying consolidated financial statements for additional information on benefit plans.
Net Occupancy: This category includes all of the expense associated with the properties and facilities used for bank operations such as depreciation, leases, maintenance, utilities and real estate taxes. Equipment maintenance contracts and depreciation increased during 2021 but were offset by a decrease in depreciation expense as the Bank sold its headquarters building at 20 South Main Street, Chambersburg, PA.
Legal and professional fees: This category consists of fees paid to outside legal counsel, consultants, and audit fees. Legal fees increased $67 thousand due to services provided in the normal course of business. Internal and external audit fees increased by $21 thousand.
Data processing: The largest cost in this category is the expense associated with the Bank’s core processing system and related services and accounted for $2.3 million of the total data processing costs compared to $1.8 million in 2020. The increase was due to increased transaction volume and the introduction of new products. An increase in software expense contributed $347 thousand to the total increase in this category.
FDIC insurance: This category consists of the total fees paid to the Federal Deposit Insurance Corporation (FDIC). The expense for 2021 increased compared to prior year due to growth of the Bank’s balance sheet.
Nonservice pension: The increase in the nonservice pension expense was due to $425 thousand of pension settlement costs related to lump-sum pension payouts during the year.
Provision for Income Taxes
The Corporation recorded a Federal income tax expense of $3.4 million compared to $258 thousand in 2020. The effective tax rate for 2021 and 2020 was 14.8% and 2.0%, respectively. In 2020, Corporation recorded an income tax benefit of $1.1 million due to the passage of the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) in March 2020. The CARES Act allowed for net operating losses (NOL) incurred in 2018, 2019 and 2020 to be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The Corporation incurred an NOL in 2018 that it was able to carryback to prior periods when the statutory rate for the Corporation was 34% as compared to the current rate of 21%. Without the benefit of the NOL carryback, the effective tax rate for 2020 would have been 10.5%. The Corporation’s 2021 effective tax rate was lower than its statutory rate due to the effect of tax-exempt income from certain investment securities, loans, and bank owned life insurance. The Corporation’s 2021 effective tax rate was higher than the comparable rate in 2020 (adjusted of the NOL) due to higher pre-tax, taxable
income. For a more comprehensive analysis of Federal income tax expense refer to Note 14 of the accompanying consolidated financial statements.
Financial Condition
One method of evaluating the Corporation’s condition is in terms of its sources and uses of funds. Assets represent uses of funds while liabilities represent sources of funds. At December 31, 2021, total assets increased 15.6% over the prior year to $1.77 billion from $1.54 billion at the end of 2020.
Interest Bearing Deposits in Other Banks:
This asset increased to $175.2 million at December 31, 2021 compared to $52.8 million at December 31, 2020, as the Bank had excess cash from growth in deposits that outpaced the growth of earning assets. The average balance for 2021 increased to $109.3 million compared to $75.1 million in 2020. At year-end, $10.5 million was in the form of long-term certificates of deposit and $163.3 million was held in an interest-bearing account at the Federal Reserve.
Investment Securities:
AFS Securities
The investment portfolio serves as a mechanism to invest funds if funding sources out pace lending activity, to provide liquidity for lending and operations, and provide collateral for deposits and borrowings. The mix of securities and investing decisions are made as a component of balance sheet management. Debt securities include U.S. Government Agencies, U.S. Government Agency mortgage-backed securities, non-agency mortgage-backed securities, state and municipal government bonds, and corporate debt in the form of bank-issued subordinated debt. The average life of the portfolio is 6.9 years and $160.3 million (fair value) is pledged as collateral for deposits. The Bank has no investments in a single issuer that exceeds 10% of shareholders equity. All securities are classified as available for sale and all investment balances refer to fair value, unless noted otherwise. The following table presents the amortized cost and estimated fair value of investment securities by type at December 31 for the past two years:
Table 6. Investment Securities at Amortized Cost and Estimated Fair Value
Amortized
Fair
Amortized
Fair
(Dollars in thousands)
Cost
value
Cost
value
U.S. Government and Agency securities
$
94,360
$
93,760
$
12,594
$
12,574
Municipal securities
206,501
212,227
236,253
247,054
Corporate securities
24,794
24,939
20,421
20,288
Agency mortgage-backed securities
123,686
122,669
70,443
72,241
Non-Agency mortgage-backed securities
30,904
30,666
8,412
8,453
Asset-backed securities
45,472
45,550
36,246
36,330
Total
$
525,717
$
529,811
$
384,369
$
396,940
The following table presents investment securities at December 31, 2021 by maturity, and the weighted average yield for each maturity presented. The yields presented in this table are calculated using tax-equivalent interest and the amortized cost.
Table 7. Maturity Distribution of Investment Portfolio
After one year
After five years
After ten
One year or less
through five years
through ten years
years
Total
Fair
Fair
Fair
Fair
Fair
(Dollars in thousands)
Value
Yield
Value
Yield
Value
Yield
Value
Yield
Value
Yield
Available for Sale
U.S. Government and
Agency securities
$
-
-
$
1,016
0.94%
$
91,510
1.28%
$
1,234
1.01%
$
93,760
1.27%
Municipal securities
1,862
2.98%
5,171
2.74%
39,635
2.51%
165,559
2.61%
212,227
2.60%
Corporate securities
-
-
-
-
23,688
4.38%
1,251
4.28%
24,939
4.37%
Agency mortgage-backed securities
1,044
1.76%
1,846
2.86%
33,934
1.69%
85,845
0.89%
122,669
1.14%
Non-Agency mortgage-backed
securities
3.83%
7,931
3.77%
5,414
1.78%
16,817
1.82%
30,666
2.34%
Asset-backed securities
2.27%
2.37%
0.80%
44,513
0.88%
45,550
0.90%
Total
$
3,430
2.73%
$
16,500
3.13%
$
194,662
1.99%
$
315,219
1.86%
$
529,811
1.95%
Table 3 shows the two-year trend of average balances and yields on the investment portfolio. The tax-equivalent yield on the portfolio decreased from 2.36% in 2020 to 2.03% in 2021. U.S. Agency mortgage-backed securities and municipal bonds continue to comprise the largest sectors by fair value of the portfolio, approximately 23% and 40% respectively. The Bank expects that the portfolio will continue to remain concentrated in these investment sectors. The portfolio produced $71.3 million in cash flows in 2021 while $215.67 million was invested into the portfolio during the year.
Municipal Bonds: This sector holds $212.2 million or 40% of the total portfolio and the amortized cost decreased by $30.0 million year over year. The Bank’s municipal bond portfolio is well diversified geographically and is comprised of both tax-exempt (46% of the portfolio) and taxable (54% of the portfolio) municipal bonds. Sixty-five percent of the portfolio are general obligation bonds and thirty-five percent are revenue bonds. The portfolio holds bonds from 221 issuers within 34 states. The largest dollar exposure is in the states of Texas (14%) and California and Pennsylvania (11% each). When purchasing municipal bonds, the Bank looks primarily to the underlying credit of the issuer as a sign of credit quality and then to any credit enhancement. The entire portfolio is rated “A” or higher by a nationally recognized rating agency.
Corporate Bonds: This sector is comprised primarily of $20.8 million of subordinate debt from 42 different community bank issuers.
Mortgage-backed Securities (MBS): This sector holds $153.3 million or 29% of the total portfolio. The majority of this sector ($122.7 million) is comprised of bonds issued and guaranteed by the U.S. Government or a government sponsored entity. The non-agency MBS portfolio is comprised of senior private label first-lien commercial and residential mortgages. As senior position bonds, they benefit from credit support in the form of junior tranches and reserve funds that absorb loss prior to the senior bonds.
Asset-backed Securities (ABS): This sector holds $45.6 million, or 9%, of the total portfolio. FFELP (Federal Family Education Loan Program) bonds make up the maturity of this sector and have a 97% guarantee from the US Department of Education. The FFELP bonds are all rated AAA.
Impairment: For securities with an unrealized loss, Management applies a systematic methodology in order to perform an assessment of the potential for other-than-temporary impairment. In the case of debt securities, investments considered for other-than-temporary impairment: (1) had a specified maturity or repricing date, (2) were generally expected to be redeemed at par, and (3) were expected to achieve a recovery in market value within a reasonable period of time. In addition, the Bank considers whether it intends to sell these securities or whether it will be forced to sell these securities before the earlier of amortized cost recovery or maturity. The impairment identified on debt securities and subject to assessment at December 31, 2021, was deemed to be temporary and required no further adjustments to the financial statements, unless otherwise noted. The Bank recorded no impairment charges in 2021.
Equity securities at Fair Value
The Corporation owns one equity investment with a readily determinable fair value. At December 31, 2021, this investment was reported at fair value ($481 thousand) with changes in value reported through income in 2021.
Restricted Stock at Cost
The Bank held $495 thousand of restricted stock at the end of 2021 of which $465 thousand is stock in the Federal Home Loan Bank of Pittsburgh (FHLB). FHLB stock is carried at a cost of $100 per share. FHLB stock is evaluated for impairment primarily based on an assessment of the ultimate recoverability of its cost. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasury that can be used to support it operations. There is not a public market for FHLB stock and the benefits of FHLB membership (e.g., liquidity and low-cost funding) add value to the stock beyond purely financial measures. If FHLB stock were deemed to be impaired, the write-down for the Bank could be significant. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment.
Loans:
The loan portfolio decreased by 1.1% ($10.9 million) in 2021, due primarily to $44.5 million in forgiveness on PPP loans (included in the commercial loan line) partially offset by an increase in commercial real estate loans and in junior liens and lines of credit from the Bank’s FlexLOC product. The FlexLOC was a new product introduced in 2021 that allows consumers to draw on a variable rate line-of-credit and then lock in a fixed rate and repayment term for a portion of the draw. Average gross loans for 2021 increased by $16.1 million to $1.0 billion compared to $992.0 million in 2020. Commercial, mortgage and home equity loans and lines all showed an increase in average balances during the year, which was partially offset by a decline in consumer loans. The yield on the portfolio decreased in 2021 to 3.86% from 4.05% in 2020. Table 3 presents detail on the average balances and yields earned on loans for the past two years.
The following table shows loans outstanding, by class, as of December 31 for the past 2 years.
Table 8. Loan Portfolio
Change
(Dollars in thousands)
Amount
%
Residential real estate 1-4 family
Consumer first lien
$
71,828
$
77,373
$
(5,545)
(7.2)
Commercial first lien
60,655
59,851
1.3
Total first liens
132,483
137,224
(4,741)
(3.5)
Consumer junior lien and lines of credit
67,103
60,935
6,168
10.1
Commercial junior liens and lines of credit
4,841
4,425
9.4
Total junior liens and lines of credit
71,944
65,360
6,584
10.1
Total residential real estate 1-4 family
204,427
202,584
1,843
0.9
Residential real estate construction
Consumer
8,278
6,751
1,527
22.6
Commercial
12,379
9,558
2,821
29.5
Total residential real estate construction
20,657
16,309
4,348
26.7
Commercial real estate
522,779
503,977
18,802
3.7
Commercial
244,543
281,257
(36,714)
(13.1)
Total commercial
767,322
785,234
(17,912)
(2.3)
Consumer
6,406
5,577
14.9
Total loans
998,812
1,009,704
(10,892)
(1.1)
Less: Allowance for loan losses
(15,066)
(16,789)
1,723
(10.3)
Net loans
$
983,746
$
992,915
$
(9,169)
(0.9)
Residential real estate: This category is comprised of first lien loans and, to a lesser extent, junior liens and lines of credit secured by residential real estate. Total residential real estate loans increased $1.8 million in 2021 from 2020, primarily in consumer junior lien and lines of credit. In 2021, the Bank originated $127.6 million in mortgages compared to $125.4 million in 2020, including approximately $107.7 million for sale in the secondary market. The Bank does not originate or hold any loans that would be considered sub-prime or Alt-A and does not generally originate mortgages outside of its primary market area.
Commercial purpose loans in this category represent loans made for various business needs but are secured with residential real estate. In addition to the real estate collateral, it is possible that additional security is provided by personal guarantees or UCC filings. These loans are underwritten as commercial loans and are not originated to be sold.
Residential real estate construction: The largest component of this category represents loans to residential real estate developers and home builders of $12.4 million, while loans for individuals to construct personal residences totaled $8.3 million at December 31, 2021. The Bank’s exposure to residential construction loans is concentrated primarily in south central Pennsylvania. Real estate construction loans, including residential real estate and land development loans, occasionally provide an interest reserve in order to assist the developer during the development stage when minimal cash flow is generated.
Commercial real estate (CRE): This category includes commercial, industrial, and farm loans, where real estate serves as the primary collateral for the loan. This loan category increased by $18.8 million over the prior year. The largest sectors (by collateral) in CRE are: hotel & motel ($75.8 million), apartment units ($69.7 million), office buildings ($50.1 million), development land ($49.2 million) and manufacturing ($38.1 million). The majority of the Bank’s hotel exposure is located along the Interstate 81 (I-81) corridor through south-central Pennsylvania. The portfolio is comprised of properties operating under 18 flagged brands and 3 independent operators.
Also included in CRE are real estate construction loans totaling $92.6 million. At December 31, 2021, the Bank had $25.8 million in real estate construction loans funded with an interest reserve and capitalized $755 thousand of interest in 2021 from these reserves on active projects for commercial construction. Real estate construction loans are monitored on a regular basis by either an independent third-party inspector or the assigned loan officer depending on loan amount or complexity of the project. This monitoring process includes, at a minimum, the submission of invoices or AIA documents (depending on the complexity of the project) detailing costs incurred by the borrower, on-site inspections, and a signature by the assigned loan officer for disbursement of funds. All real estate construction loans are underwritten in the same manner, regardless of the use of an interest reserve.
Commercial: This category includes commercial, industrial, farm, agricultural, and tax-free loans. Collateral for these loans may include business assets or equipment, personal guarantees, or other non-real estate collateral. Commercial loans decreased $36.7 million over the 2020 ending balance, primarily due to PPP loan forgiveness. At December 31, 2021, the Bank had approximately $141 million of tax-free loans in its portfolio. The largest sectors (by industry) are: utilities ($52.0 million), public administration ($49.0 million), real estate, rental and leasing ($18.2 million) and manufacturing ($13.5 million). This category also includes $7.8 million of PPP loans that are 100% guaranteed by the SBA.
Participations: At December 31, 2021, the outstanding commercial participations accounted for 10.1%, or $77.5 million, of commercial purpose loans compared to 8.7%, or $68.7 million, at the prior year-end. The Bank’s total exposure (including unfunded commitments) to purchased participations was $95.9 million at December 31, 2021 and $84.0 million at December 31, 2020. The commercial loan participations are comprised of $23.2 million of commercial loans and $54.3 million of CRE loans, reported in the respective loan segment. The Bank expects that commercial lending will continue to be the primary area of loan growth in the future via in-market lending.
Consumer loans: This category is mainly comprised of unsecured personal lines of credit and showed an increase of $829 thousand in 2021 over 2020 ending balances.
Table 9. Maturities and Interest Rate Terms of Selected Loans
The following table presents the stated maturities (or earlier call dates) of selected loans as of December 31, 2021.
Less than
Over
(Dollars in thousands)
1 year
1-5 years
5-15 years
15 years
Total
Loans:
Residential real estate 1-4 family
Fixed rate
$
$
9,410
$
43,214
$
15,459
$
69,044
Variable rate
5,147
16,614
48,955
64,667
135,383
6,108
26,024
92,169
80,126
204,427
Residential real estate construction
Fixed rate
8,702
-
-
-
8,702
Variable rate
9,417
2,538
-
-
11,955
18,119
2,538
-
-
20,657
Commercial real estate
Fixed rate
2,190
42,004
50,076
-
94,270
Variable rate
33,675
115,893
235,137
43,804
428,509
35,865
157,897
285,213
43,804
522,779
Commercial
Fixed rate
54,292
38,839
8,606
102,463
Variable rate
31,764
16,231
38,398
55,687
142,080
32,490
70,523
77,237
64,293
244,543
Consumer
Fixed rate
2,443
1,688
4,248
Variable rate
1,135
-
2,158
1,225
2,841
1,688
6,406
$
93,807
$
259,823
$
455,271
$
189,911
$
998,812
Loan Quality:
Management utilizes a risk rating scale ranging from 1-Prime to 9-Loss to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either a pass or substandard rating based on the performance status of the loans. Substandard consumer loans are loans that are 90 days or more past due and still accruing. Loans rated 1 - 4 are considered pass credits. Loans that are rated 5-Pass Watch are credits that have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6-Other Asset Especially Mentioned (OAEM) or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7-Substandard or 8-Doubtful exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7-Substandard. The following represent some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt. The Bank monitors overall loan quality of the portfolio by reviewing three primary measurements: (1) loans rated 6-OAEM or worse (collectively “watch list”), (2) delinquent loans, and (3) net-charge-offs.
Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list includes both performing and nonperforming loans. Watch list loans totaled $36.6 million at year-end compared to $66.1 million one year earlier. During 2020, the Bank downgraded its hotel portfolio due to the pandemic. Many of these loans had the risk-rating upgraded during 2021 as the loans moved from a modified payment schedule to regular payment schedule. As a result, the watch list decreased year-over year. At year-end 2020, the Bank had $32.7 million of hotel loans rated 6-OAEM and $14.5 million rated 7-Substandard. At December 31, 2021, 6-rated hotels decreased to $17.1 million and 7-rated hotels decreased to $13.4 million. Included in the watch list are $7.4 million of nonaccrual loans. The composition of the watch list (loans rated 6, 7 or 8), by primary collateral, is shown in Note 6 of the accompanying financial statements.
Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank. See Note 6 in the accompanying financial statements for information on the aging of payments in the loan portfolio.
Nonaccruing loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more, nonaccrual loans, or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7-Substandard.
The Bank’s Loan Management Committee reviews these loans and risk ratings on a quarterly basis in order to proactively identify and manage problem loans. In addition, a committee meets monthly to discuss possible workout strategies for all credits rated 7-Substandard or worse and OREO. Management also tracks other commercial loan risk measurements including high loan to value loans, concentrations, participations and policy exceptions and reports these to the Credit Risk Oversight Committee of the Board of Directors. The Bank also uses a third-party consultant to assist with internal loan review with a goal of reviewing 80% of commercial loans each year. The FDIC defines certain supervisory loan-to-value lending limits. The Bank’s internal loan-to-value limits are all equal to or less than the supervisory loan-to-value limits. However, in certain circumstances, the Bank may make a loan that exceeds the supervisory loan-to-value. At December 31, 2021, the Bank had loans of $17.9 million (1.8% of gross loans) that exceeded the supervisory loan-to value limit, compared to 2.3% at the prior year end.
Nonaccrual loans decreased by $1.3 million from year-end 2020, primarily in the commercial real estate category as a result of paydowns during the year. The most significant nonaccrual loan is a $5.6 million hotel loan that has been on nonaccrual since September 2020 but was current on its payments as of December 31, 2021. The Bank continues to work with the borrower and the hotel management company to monitor operations. The Bank has established a $698 thousand specific reserve on this loan.
In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings (TDR). A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans (excluding consumer purpose loans) and TDR loans are considered impaired.
A loan is considered a troubled debt restructuring (TDR) if the creditor (the Bank), for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. These concessions may include lowering the interest rate, extending the maturity, reamortization of payment, or a combination of multiple concessions. The Bank reviews all loans rated 6-OAEM or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance.
In accordance with financial accounting standards, TDR loans are always considered impaired until they are paid-off or in certain circumstances refinanced. However, an impaired TDR loan can be a performing loan under its modified terms. Impaired loans totaled $11.6 million at year-end compared to $17.3 million at the prior year end. The decrease was due primarily to a refinancing of a TDR loan to a new loan at market rates and terms and therefore being removed from TDR. Included in the impaired loan totals are $5.6 million of TDR loans.
Paycheck Protection Program. In March 2020, Congress passed the CARES Act to provide economic relief to small business and consumers affect by the COVID-19 pandemic. Included in this Act was the Paycheck Protection Program (PPP) administered by the Small Business Administration (SBA). The PPP is a small business loan program designed to assist in allowing small businesses to keep workers on the payroll during the COVID-19 pandemic. When workers are kept on the payroll for the qualifying period, the loan could be forgiven if the small business incurs eligible expenses. The PPP loans are 100 percent guaranteed by the SBA and have a maturity of two-years or five-years with a fixed interest rate of 1% for the life of the loan. Borrowers of PPP loans do not have to make payments on the loan for the first six months, and the loans will fully amortize for the remainder of the two- or five-year terms.
In December 2020, Congress passed a second stimulus package that provided for a second round of funding for small business, that meet certain eligibility requirements, through the PPP. PPP loans under the second round of funding are for a 5-year term with a fixed interest rate of 1% and initial principal payments deferred for up to 10 months under certain circumstances.
The SBA paid originating banks a processing fee ranging from 1% to 5% of the loan, depending on the loan balance for round 1 of PPP funding. The SBA will pay processing fees to originating banks for round 2 of PPP funding at levels similar to those paid in round 1. The Bank will recognize these fees in interest income over the contractual life (two or five years) of the loan. As PPP loans are granted forgiveness by the SBA, fee recognition will accelerate. At December 31, 2021, the Bank had $7. 8 million in PPP loans and $370 thousand of PPP fees remaining to be recognized.
The PPP loans are 100% guaranteed by the SBA, thereby presenting no credit risk to the Bank once the SBA guarantee is fulfilled, if necessary. However, the PPP loan is only designed to cover short-term operating needs of the borrower. If the economy does not recover quickly from the pandemic and the borrower experiences long-term operational problems beyond the PPP funding, the performance of other loans to these customers could begin to deteriorate.
Allowance for Loan Losses:
Management monitors loan performance on a monthly basis and performs a quarterly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan’s collateral. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6-OAEM or worse and obtains a new appraisal or asset valuation for any loans placed on nonaccrual and rated 7 - Substandard or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy quarterly to the Credit Risk Oversight Committee of the Board of Directors. Management believes that the allowance for loan losses at December 31, 2021 is adequate.
The analysis for determining the ALL is consistent with guidance set forth in generally accepted accounting principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The analysis has three components: specific, general and unallocated. The specific component addresses specific reserves established for impaired loans. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Collateral values discounted for market conditions and selling costs are used to establish specific allocations for impaired loans. However, it is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. Commercial loans with a balance less than $250 thousand, and all consumer purpose loans are not included in the specific reserve analysis as impaired loans but are added to the general allocation pool. Loans that are evaluated for a specific reserve, but not needing a specific reserve are not added back to the general allocation pool. The Bank has one loan for $5.8 million with a specific reserve ($698 thousand) at December 31, 2021. Note 6 of the accompanying financial statements provides additional information about the ALL established for impaired loans.
The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates its loan portfolio into the following segments based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (commercial non-real estate), and consumer. Each segment may be further segregated by type of collateral, lien position, or owner/nonowner occupied properties. PPP loans, because of the SBA guarantee, were excluded from the quantitative analysis. The quantitative analysis uses the Bank’s twenty quarter rolling historical loan loss experience as determined for each loan segment to determine a loss factor applicable to each loan segment. The allowance established as a result of the quantitative analysis was $2.8 million compared to $3.7 million at year-end 2020. The decrease in the quantitative component was due primarily to a decrease in the twenty-quarter historical loss factor as older higher loss rates came out of the rolling average.
The qualitative analysis utilizes a risk matrix that incorporates four primary risk factors: economic conditions, delinquency, classified loans, and level of risk, and assigns a risk level (as measured in basis points) to each factor. In determining the risk level for these primary factors, consideration is given to operational factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. The level of risk (as measured in basis points) for each primary factor is set for six risk levels ranging from minimal risk to extreme risk and is determined independently for commercial loans, residential mortgage loans and consumer loans. During 2020, as a result of the negative effects of the pandemic on the economy, the Bank increased the basis point risk factor for certain qualitative components. During 2021, as the level of risk picture became clearer, the Bank reduced certain qualitative risk factors. In addition, in 2021 the Bank discontinued its carve out of modified loans for a separate qualitative assessment that it implemented in 2020. As a result of these changes, the qualitative component of the ALL decreased from $12.1 million at year-end 2020 to $11.0 million at December 31, 2021.
The unallocated component is maintained to cover uncertainties that could affect Management’s estimate of probable loss. The unallocated component of the ALL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The unallocated allowance was $589 thousand at December 31, 2021.
Real estate appraisals and collateral valuations are an important part of the Bank’s process for determining potential loss on collateral dependent loans and thereby have a direct effect on the determination of loan reserves, charge-offs and the calculation of the allowance for loan losses. As long as the loan remains a performing loan, no further updates to appraisals are required. If a loan or relationship migrates to nonaccrual and a risk rating of 7-Substandard or worse, an evaluation for impairment status is made based on the current information available at the time of downgrade and a new appraisal or collateral valuation is obtained. We believe this practice complies with the regulatory guidance.
In determining the allowance for loan losses, Management, at its discretion, may determine that additional adjustments to the fair value obtained from an appraisal or collateral valuation are required. Adjustments will be made as necessary based on factors, including, but not limited to the economy, deferred maintenance, industry, type of property or equipment etc., and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. If an appraisal is not available, Management may make its best estimate of the real value of the collateral or use last known market value and apply appropriate discounts. If an adjustment is made to the collateral valuation, this will be documented with appropriate support and reported to the Loan Management Committee.
The following table shows the allocation of the allowance for loan losses and other loan performance ratios as of December 31, 2021 and 2020:
Table 10. Loan Performance Ratios
(Dollars in thousands)
Residential Real Estate 1-4 Family
Junior Liens &
Commercial
First Liens
Lines of Credit
Construction
Real Estate
Commercial
Consumer
Unallocated
Total
Loans at December 31, 2021
$
132,483
$
71,944
$
20,657
$
522,779
$
244,543
$
6,406
$
-
$
998,812
Average Loans for 2021
133,452
69,083
20,389
509,706
264,772
6,836
-
1,004,237
Nonaccrual Loans at December 31, 2021
6,812
-
-
7,384
Allowance for Loan Losses at December 31, 2021
9,163
5,679
16,789
Net Recoveries/(Charge-offs) for 2021
(10)
-
(195)
(91)
-
Loans/Total Gross Loans at December 31, 2021
13%
7%
2%
52%
24%
1%
-
100%
Nonaccrual Loans/Total Gross Loans at December 31, 2021
0.04%
0.05%
2.05%
1.30%
0.02%
0.00%
-
0.74%
Allowance for Loan Loss/Gross Loans at December 31, 2021
0.42%
0.31%
1.42%
1.75%
2.32%
1.51%
-
1.68%
Net Recoveries (Charge-offs)/Average Loans for 2021
0.00%
-0.01%
0.00%
0.10%
-0.07%
-1.33%
-
0.02%
Allowance for Loan Loss/Nonaccrual Loans at December 31, 2021
227.37%
Loans at December 31, 2020
$
137,224
$
65,360
$
16,309
$
503,977
$
281,257
$
5,577
$
-
$
1,009,704
Average Loans for 2020
141,265
57,409
14,896
500,325
275,037
6,366
-
995,297
Nonaccrual Loans at December 31, 2020
8,033
-
-
8,704
Allowance for Loan Losses at December 31, 2020
8,168
5,127
15,066
Net Recoveries/(Charge-offs) for 2020
-
(28)
(56)
(164)
-
Loans/Total Gross Loans at December 31, 2020
14%
6%
2%
50%
28%
1%
-
100%
Nonaccrual Loans/Total Gross Loans at December 31, 2020
0.03%
0.02%
3.14%
1.59%
0.04%
0.00%
-
0.86%
Allowance for Loan Loss/Gross Loans at December 31, 2020
0.35%
0.39%
1.99%
1.62%
1.82%
2.33%
-
1.49%
Net Recoveries/(Charge-offs)/Average Loans for 2020
0.00%
0.30%
-0.19%
-0.01%
0.17%
-2.58%
-
0.04%
Allowance for Loan Loss/Nonaccrual Loans at December 31, 2020
173.09%
Goodwill:
The Bank has $9.0 million of goodwill recorded on its balance sheet as the result of corporate acquisitions. Goodwill is not amortized, nor deductible for tax purposes. However, goodwill is tested for impairment at least annually in accordance with ASC Topic 350. Goodwill was tested for impairment as of August 31, 2021. The 2021 test was conducted using a qualitative assessment method that requires the use of significant assumptions in order to make a determination of impairment. These assumptions may include, but are not limited to: macroeconomic factors, banking industry conditions, banking merger and acquisition trends, the
Bank’s historical financial performance, the Corporation’s stock price, forecast Bank financial performance, and change of control premiums. Management determined the Bank’s goodwill was not impaired in 2021.
The 2020 impairment test was conducted using several quantitative methods, including an income approach, market value approach and a change of control acquisition approach. Each of these quantitative approaches included different scenarios with different assumptions. These scenarios were weighted based upon Management’s judgement. Based upon this assessment, the estimated fair value of the Corporation exceeded its carrying value by 24% and Management determined the Bank’s goodwill was not impaired.
At December 31, 2021, Management subsequently considered certain qualitative factors affecting the Corporation and determined that it was not likely that the results of the prior test had changed, and it determined that goodwill was not impaired at year-end.
Deposits:
The Bank depends on deposits generated in the normal course of business as its primary source of funds. The Bank offers numerous deposit products including demand deposits (noninterest and interest-bearing accounts), savings, money management accounts, and time deposits (certificates of deposits/CDs) to retail, commercial, and municipal customers. Table 11 shows a comparison of the major deposit categories over a two-year period at December 31, including balances and the percentage change in balances year-over-year. Table 3, presented previously, shows the average balance of the major deposit categories and the average cost of these deposits over a two-year period.
Table 11. Deposits
Change
(Dollars in thousands)
Amount
%
Noninterest-bearing checking
$
298,403
$
259,060
$
39,343
15.2
Interest-bearing checking
511,969
409,178
102,791
25.1
Money management
579,826
501,017
78,809
15.7
Savings
119,908
109,153
10,755
9.9
Time deposits
74,253
76,165
(1,912)
(2.5)
Total
$
1,584,359
$
1,354,573
$
229,786
17.0
Noninterest-bearing checking: This category increased year over year by $39.3 million, primarily in commercial accounts, while the average balance increased by $53.0 million for the year. As a noninterest bearing account, these deposits contribute approximately 9 basis points to the net interest margin.
Interest-bearing checking: This category saw an increase in both the ending and average balance for the year compared to prior year-end, while the cost of these accounts decreased year over year. Both commercial and retail accounts grew during 2021.
Money management: The year over year balance increased $78.8 million, in both retail and commercial accounts and the average balance increased $76.6 million compared to the 2020 average balance. The cost of this product decreased during the year as market rates decreased.
Savings: Savings accounts increased $10.8 million during the year and represents the thirteenth consecutive year of growth, mostly in regular savings accounts in 2021. The cost of this product decreased during the year as market rates decreased.
Time deposits: Time deposits decreased in 2021, as customers moved funds to more liquid accounts and rates decreased.
Reciprocal deposits: At year-end 2021, the Bank had $256.7 million placed in the IntraFi Network deposit program ($185.0 million in interest-bearing checking and $71.7 million in money management) and $4.1 million of time deposits placed into the CDARS program. These programs allow the Bank to offer full FDIC coverage to large depositors, but with the convenience to the customer of only having to deal with one bank. The Bank solicits these deposits from within its market and it believes they present no greater risk than any other local deposit. Only reciprocal deposits that exceed 20% of liabilities are considered brokered deposits. At December 31, 2021, the Bank’s reciprocal deposits were 16.0% of total liabilities.
The Bank continually reviews different methods of funding growth that include traditional deposits and other wholesale sources. Competition from other local financial institutions, internet banks and brokerages will continue to be a challenge for the Bank in its efforts to attract new and retain existing deposit accounts. This competition is not expected to lessen in the future.
Uninsured deposits: Estimated uninsured deposits at December 31, 2021 were $142.0 million (9.0% of total deposits) compared to $150.6 million (11.1% of total deposits at December 31, 2020). The insured deposit data for 2021 and 2020 reflect deposits at an aggregate level, but do not include public funds secured by collateral.
At December 31, 2021, time deposits in excess of the FDIC insurance limit and time deposits that are otherwise uninsured by maturity were as follows:
Table 12. Time Deposits of $250,000 or More
(Dollars in thousands)
Individual Instruments that Meet or Exceed FDIC Insurance Limit
Time Deposits that Meet or Exceed FDIC Insurance Limit
Maturity distribution:
Within three months
$
3,254
$
5,254
Over three through six months
5,409
6,909
Over six through twelve months
1,072
2,572
Over twelve months
Total
$
9,906
$
15,156
Borrowings:
Short-term Borrowings: The Bank has access to short-term borrowings from the FHLB in the form of a revolving term commitment used to fund the short-term liquidity needs of the Bank. These borrowings reprice on a daily basis and the interest rate fluctuates with short-term market interest rates. The Bank’s maximum borrowing capacity with the FHLB at December 31, 2021 was $369.9 million with $369.9 million available to borrow. The Bank had no short-term borrowings at December 31, 2021 and 2020.
Long-term Debt: On August 4, 2020, the Corporation completed the sale of a subordinated debt note offering. The Corporation sold $15.0 million of subordinated debt notes with a maturity date of September 1, 2030. These notes are noncallable for 5 years and carry a fixed interest rate of 5% per year for 5 years and then convert to a floating rate of SOFR plus 4.93% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The Corporation also sold $5.0 million of subordinated debt notes with a maturity date of September 1, 2035. These notes are noncallable for 10 years and carry a fixed interest rate of 5.25% per year for 10 years and then convert to a floating rate of SOFR plus 4.92% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank. The Corporation paid an issuance fee of 2% of the total issue that will be amortized to the call date of each issue on a pro-rata basis. The notes are recorded on the consolidated balance sheet net of unamortized debt issuance costs. The proceeds are intended to be used for general corporate purposes.
Shareholders’ Equity:
Shareholders’ equity increased by $11.9 million to $157.1 million at December 31, 2021. The increase was the result of 2021 net income of $19.6 million, offset by $5.5 million in dividends ($1.25 per share), and a decrease of $3.7 million in accumulated other comprehensive income due primarily to a decrease of the fair value of the investment portfolio. The dividend payout ratio was 28.2% in 2021 compared to 40.8% in 2020.
The Board of Directors frequently authorizes the repurchase of the Corporation’s $1.00 par value common stock. Information regarding stock repurchase plans in place during the year are included in Item 5 Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities. Additional information on Shareholders’ Equity is reported in Note 19 of the accompanying consolidated financial statements.
The Corporation’s dividend reinvestment plan (DRIP) allows for shareholders to purchase additional shares of the Corporation’s common stock by reinvesting cash dividends paid on their shares or through optional cash payments. The Dividend Reinvestment Plan (DRIP) added $2.4 million to capital during 2021. This total was comprised of $1.0 million from the reinvestment of quarterly dividends and $1.4 million of optional cash contributions.
A strong capital position is important to the Corporation as it provides a solid foundation for the future growth of the Corporation, as well as instills confidence in the Bank by depositors, regulators and investors, and is considered essential by Management. The Corporation is continually exploring other sources of capital as part of its capital management plan for the Corporation and the Bank.
Common measures of adequate capitalization for banking institutions are capital ratios. These ratios indicate the proportion of permanently committed funds to the total asset base. Guidelines issued by federal and state regulatory authorities require both banks and bank holding companies to meet minimum leverage capital ratios and risk-based capital ratios.
The leverage ratio compares Tier 1 capital to average assets while the risk-based ratio compares Tier 1 and total capital to risk-weighted assets and off-balance-sheet activity in order to make capital levels more sensitive to the risk profiles of individual banks.
Tier 1 capital is comprised of common stock, additional paid-in capital, retained earnings and components of other comprehensive income, reduced by goodwill and other intangible assets. Total capital is comprised of Tier 1 capital plus the allowable portion of the allowance for loan losses.
The Corporation, as a bank holding company, is required to comply with the capital adequacy standards established by Federal Reserve Board. The Bank is required to comply with capital adequacy standards established by the FDIC. In addition, the Pennsylvania Department of Banking also requires state-chartered banks to maintain a 6% leverage capital level and 10% risk-based capital, defined substantially the same as the federal regulations.
The Corporation and the Bank are subject to the capital requirements contained in the regulation generally referred to as Basel III. The Basel III standards were effective for the Corporation and the Bank, effective January 1, 2015. Basel III imposes significantly higher capital requirements and more restrictive leverage and liquidity ratios than those previously in place. The capital ratios to be considered “well capitalized” under Basel III are: (1) Common Equity Tier 1(CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. The CET1 ratio is a new capital ratio under Basel III and the Tier 1 risk-based capital ratio of 8% has been increased from 6%. The rules also included changes in the risk weights of certain assets to better reflect credit and other risk exposures. In addition, a capital conservation buffer of 2.50% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum (“adequately capitalized”) for each respective capital measurement. The Bank’s capital conservation buffer at December 31, 2021 was 8.54%. Compliance with the capital conservation buffer is required in order to avoid limitations on certain capital distributions, especially dividends. As of December 31, 2021, the Bank was “well capitalized’ under the Basel III requirements. For additional information on the capital ratios see the section titled Shareholders’ Equity, and Table 13.
On August 4, 2020, the Corporation completed the sale of a $20 million subordinated debt note offering. The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank.
In 2019, the Community Bank Leverage Ratio (CBLR) was approved by federal banking agencies as an optional capital measure available to Qualifying Community Banking Organizations (QCBO). If a bank qualifies as a QCBR and maintains a CBLR of 9% or greater, the bank would be considered “well-capitalized” for regulatory capital purposes and exempt from complying with the Basel III risk-based capital rule. The CBLR rule was effective January 1, 2020 and banks could opt-in through an election in the first quarter 2020 regulatory filings. The Bank meets the criteria of a QCBO but did not opt-in to the CBLR.
The consolidated asset limit on small bank holding companies is $3 billion and a company with assets under that limit is not subject to the consolidated capital rules but may file reports that include capital amounts and ratios. The Corporation has elected to file those reports.
The following table presents capital ratios for the Corporation at December 31:
Table 13. Capital Ratios
Corporation
Bank
Corporation
Bank
Common Equity Tier 1 risk-based capital ratio
15.20%
15.28%
14.32%
14.07%
Total risk-based capital ratio
18.41%
16.54%
17.69%
15.33%
Tier 1 risk-based capital ratio
15.20%
15.28%
14.32%
14.07%
Tier 1 leverage ratio
8.52%
8.57%
8.69%
8.54%
For additional information on capital adequacy refer to Note 2 of the accompanying consolidated financial statements.
Local Economy
The Corporation’s primary market area includes Franklin, Fulton, Cumberland and Huntingdon County, PA. This area is diverse in demographic and economic makeup. County populations range from a low of approximately 15,000 in Fulton County to over 260,000 in Cumberland County. Unemployment in the Bank’s market area decreased during 2021 over 2020 as the local economy recovered from the worst effects of the COVID-19 pandemic shutdowns. The market area has a diverse economic base and local industries include, warehousing, truck and rail shipping centers, light and heavy manufacturers, health care, higher education institutions, farming and agriculture, and a varied service sector. The market area provides easy access to the major metropolitan markets on the east coast via trucking and rail transportation. Because of this, warehousing and distribution companies continue to find the area attractive. The local economy is not overly dependent on any one industry or business and Management believes that the Bank’s primary market area continues to be well suited for growth. The following provides selected economic data for the Bank’s primary market at December 31:
Economic Data
Unemployment Rate (seasonally adjusted)
Market area range (1)
3.6% - 5.2%
4.8% - 10.1%
Pennsylvania
5.7%
6.6%
United States
4.2%
6.7%
Housing Price Index - year over year change
PA, nonmetropolitan statistical area
11.5%
5.2%
United States
16.4%
4.7%
Building Permits - year over year change -12 moths
Harrisburg-Carlisle, PA MSA & Chambersburg-Waynesboro, PA MSA
Residential, estimated
7.4%
-2.2%
Multifamily, estimated
-24.0%
-50.0%
(1) Franklin, Cumberland, Fulton and Huntingdon Counties
The assets and liabilities of the Corporation are financial in nature, as such, the pricing of products, customer demand for certain types of products, and the value of assets and liabilities are greatly influenced by interest rates. As such, interest rates and changes in interest rates may have a more significant effect on the Corporation’s financial results than on other types of industries. Because of this, the Corporation watches the actions of the Federal Reserve Open Market Committee (FOMC) as it makes decisions about interest rate changes and monetary policy. In January 2022, the FOMC release included this: “Indicators of economic activity and employment have continued to strengthen. The sectors most adversely affected by the pandemic have improved in recent months but are being affected by the recent sharp rise in COVID-19 cases. Job gains have been solid in recent months, and the unemployment rate has declined substantially. Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.” With the Federal Reserve decreasing its level of bond purchases, and economic improvement coupled with inflation, the possibility of rate increases by the FOMC appears more likely. Over the long-term, the Bank benefits from higher interest rates, but any increase in rates in 2022 is not expected to have a material effect on the Corporation.
Liquidity
The Corporation conducts substantially all of its business through its bank subsidiary. The liquidity needs of the Corporation are funded primarily by the bank subsidiary, supplemented with liquidity from its dividend reinvestment plan.
The Bank must meet the financial needs of the customers that it serves, while providing a satisfactory return on the shareholders’ investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. The Bank regularly reviews it liquidity position by measuring its projected net cash flows (in and out) at a 30 and 90-day interval. The Bank stress tests this measurement by assuming a level of deposit out-flows that have not historically been realized. In addition to this forecast, other funding sources are reviewed as a method to provide emergency funding if necessary. The objective of this measurement is to identify the amount of cash that could be raised quickly without the need to liquidate assets. The Bank also stresses its liquidity position utilizing different longer-term scenarios. The varying degrees of stress create pressure on deposit flows in its local market, reduce access to wholesale funding and limit access of funds available through brokered deposit channels. In addition to stressing cash flow, specific liquidity risk indicators are monitored to help identify risk areas. This analysis helps identify and quantify the potential cash surplus/deficit over a variety of time horizons to ensure the Bank has adequate funding resources. Assumptions used for liquidity stress testing are subjective. Should an evolving liquidity situation or business cycle present new data, potential assumption changes will be considered. The Bank believes it can meet all anticipated liquidity demands.
Historically, the Bank has satisfied its liquidity needs from earnings, repayment of loans, amortizing and maturing investment securities, loan sales, deposit growth and its ability to access existing lines of credit. All investment securities are classified as available for sale; therefore, securities that are unencumbered (approximately $378.8 million fair value) as collateral for borrowings are an additional source of readily available liquidity, either by selling the security or, more preferably, to provide collateral for additional borrowing. The Bank also has access to other wholesale funding via the brokered CD market.
The FHLB system has always been a major source of funding for community banks. There are no indicators that lead the Bank to believe the FHLB will discontinue its lending function or restrict the Bank’s ability to borrow. If either of these events were to occur,
it would have a negative effect on the Bank, and it is unlikely that the Bank could replace the level of FHLB funding in a short time. The Bank has also established credit at the Federal Reserve Discount Window and an unsecured line of credit at a correspondent bank.
The following table shows the Bank’s available liquidity at December 31, 2021.
(Dollars in thousands)
Liquidity Source
Capacity
Outstanding
Available
Federal Home Loan Bank
$
369,860
$
-
$
369,860
Federal Reserve Bank Discount Window
22,125
-
22,125
Correspondent Banks
56,000
-
56,000
Total
$
447,985
$
-
$
447,985
Off Balance Sheet Commitments
The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet loans and lines of credit. Because these unfunded instruments have fixed maturity dates and many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation. Unused commitments and standby letters of credit totaled $375.6 million and $23.3 million, respectively, at December 31, 2021, compared to $312.0 million and $22.3 million, respectively, at December 31, 2020. In the second quarter of 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy in the second quarter of 2018. In the first quarter of 2020, the Bank was notified that one letter of credit for $250 thousand was cancelled and the amount was reversed from the liability with an offsetting amount recorded in other expense. In the second quarter of 2021, the Bank was notified that a second letter of credit for $636 thousand was cancelled and the amount was reversed from the liability with an offsetting amount recorded in other expense. At December 31, 2021, this reserve was $1.5 million.
Management believes that any amounts actually drawn upon can be funded in the normal course of operations. The Corporation has no investment in or financial relationship with any unconsolidated entities that are reasonably likely to have a material effect on liquidity.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market Risk
In the course of its normal business operations, the Corporation is exposed to certain market risks. The Corporation has no foreign currency exchange rate risk, no commodity price risk or material equity price risk. However, it is exposed to interest rate risk. All interest rate risk arises in connection with financial instruments entered into for purposes other than trading. Financial instruments, which are sensitive to changes in market interest rates, include fixed and variable-rate loans, fixed-income securities, derivatives, interest-bearing deposits and other borrowings.
Changes in interest rates can have an impact on the Corporation’s net interest income and the economic value of equity. The objective of interest rate risk management is to identify and manage the sensitivity of net interest income and economic value of equity to changing interest rates in order to achieve consistent earnings that are not contingent upon favorable trends in interest rates.
The Corporation’s primary tool for analyzing interest rate risk is financial simulation modeling which captures the effect of not only changing interest rates but also other sources of cash flow variability including loan and securities prepayments and customer preferences. Financial simulation modeling forecasts both net interest income and the economic value of equity under a variety of different interest rate environments. The Corporation measures the effects of multiple interest rate change scenarios on at least a quarterly basis. The magnitude of each change scenario may vary depending on the current interest rate environment. In addition, the balance sheet is held static in each scenario so that the effect of an interest rate change can be isolated and not distorted by changes in the balance sheet.
Table 14 presents the results of five different rate change scenarios and measures the change in net interest income against a base (unchanged) scenario over one year. As shown, the Bank’s net interest income compared to the base scenario decreases in the down 100 basis point scenario but increases in each of the up scenarios. For each scenario, interest rate changes are ramped up or down over a period of 1 year. The Bank believes a ramp scenario is more realistic than an interest rate shock scenario; however, the Bank also runs scenarios using shocks and yield curve twists.
Computations of prospective effects of hypothetical interest rate changes are based on many assumptions, including relative levels of market interest rates, loan prepayments and deposit repricing that cannot be measured with complete precision. Further, the computations do not contemplate any actions Management could undertake in response to changes in market interest rates.
Table 14. Sensitivity to Changes in Market Interest Rates
(Dollars in thousands)
Net Interest Income
Change in rates (basis points)
Projected
% Change
+400
$
48,235
4.4%
+300
$
47,793
3.2%
+200
$
47,210
2.0%
+100
$
46,671
0.8%
unchanged
$
46,305
-
(100)
$
46,164
(0.3)%
Forward-Looking Statements
Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting Management’s current views as to likely future developments, and use words “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, change in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, effects of government shutdowns and budget negotiations, impacts of the interruption or breach in security of our information systems or other technological risks and attacks, acts of war or terrorism, changes in accounting policies or practices, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors.
Impact of Inflation
The impact of inflation upon financial institutions such as the Corporation differs from its effect upon other commercial enterprises. Unlike most other commercial enterprises, virtually all of the assets of the Corporation are monetary in nature. As a result, interest rates have a more significant impact on the Corporation’s performance than do the effects of general levels of inflation. Although inflation (and inflation expectations) may affect the interest rate environment, it is not possible to measure with any precision the impact of future inflation upon the Corporation.
‎

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Item 8. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and the Board of Directors of Franklin Financial Services Corporation
Chambersburg, Pennsylvania
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Franklin Financial Services Corporation (the "Corporation") as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years then ended, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Corporation as of December 31, 2021 and 2020, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on the Corporation’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Corporation in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Loan Losses - Qualitative Allowance Allocation
As described in Notes 1 and Note 6 to the consolidated financial statements, the Corporation’s allowance for loan losses is a valuation account that reflects the Corporation’s estimation of incurred losses in its loan portfolio to the extent they are both probable and reasonable to estimate. The allowance for loan losses was $15,066,000 at December 31, 2021. The allowance for loan losses consists of two components: (i) a general valuation allowance on loans collectively evaluated for impairment determined in accordance with ASC topic 450 consisting primarily of a “portfolio segments allowance,” based on recent historical losses and a qualitative allowance allocation, based on a subjective evaluation of various factors impacting the collectability of loans, collectively representing $14,368,000; and (ii) a specific valuation allowance on loans individually evaluated for impairment determined in accordance with ASC topic 310 based on probable incurred losses on specific loans held for investment, representing $698,000.
A qualitative allowance allocation is based on consideration of the following: economic conditions, delinquency trends for the portfolio, classified loan trends for the portfolio, and level of risk, which is broken down further to consider nature and volume of loans; experience, ability, and depth of management and lending personnel; quality of loan review system; concentrations of credit and changes in concentrations; and other external conditions (competition, legal, regulatory, etc.). Management translates information about these matters into risk level assignments that are used to determine the amount of qualitative allowance allocations.
Due to the significant auditor judgment involved in evaluating management’s translation of the information in the formulation of the qualitative allowance allocation into risk level assignments, we identified the auditing of the qualitative allowance as a critical audit matter.
The primary procedures we performed to address this critical audit matter included:
Substantively testing management’s process, including evaluating their judgments and assumptions, for developing the qualitative allowance allocation, which included:
oEvaluation of the relevance and reliability of data inputs used as a basis for the factors underlying the qualitative allowance allocation.
oEvaluation of the reasonableness of management’s judgments related to the translation of the data used in the determination of the factors underlying the qualitative allowance allocation into risk level assignments and the resulting allocation to the allowance.
oTesting the mathematical accuracy of the allowance calculation, including the calculation of the qualitative allowance allocation. The test of the calculation of the qualitative allowance allocation included testing the accuracy of the allocation of the underlying factors.
/s/ Crowe LLP
We have served as the Company's auditor since 2019.
Cleveland, Ohio
March 10, 2022
‎
Consolidated Balance Sheets
(Dollars in thousands, except share and per share data)
December 31,
Assets
Cash and due from banks
$
10,463
$
17,059
Short-term interest-bearing deposits in other banks
164,686
40,087
Total cash and cash equivalents
175,149
57,146
Long-term interest-bearing deposits in other banks
10,492
12,741
Debt securities available for sale, at fair value
529,811
396,940
Equity securities
Restricted stock
Loans held for sale
2,827
9,446
Loans
998,812
1,009,704
Allowance for loan losses
(15,066)
(16,789)
Net Loans
983,746
992,915
Premises and equipment, net
19,190
13,105
Right of use asset
4,759
5,272
Bank owned life insurance
21,874
22,288
Goodwill
9,016
9,016
Deferred tax asset, net
3,314
2,401
Other assets
12,652
12,909
Total assets
$
1,773,806
$
1,535,038
Liabilities
Deposits
Non-interest bearing checking
$
298,403
$
259,060
Money management, savings and interest checking
1,211,703
1,019,348
Time
74,253
76,165
Total deposits
1,584,359
1,354,573
Subordinate Notes
19,588
19,555
Lease Liability
4,857
5,332
Other liabilities
7,937
10,402
Total liabilities
1,616,741
1,389,862
Commitments and contingent liabilities
Shareholders' equity
Common stock, $1.00 par value per share,15,000,000 shares authorized with
4,710,972 shares issued and 4,441,443 shares outstanding at December 31, 2021 and
4,710,872 shares issued and 4,389,355 shares outstanding at December 31, 2020
4,711
4,711
Capital stock without par value, 5,000,000 shares authorized with no
shares issued and outstanding
-
-
Additional paid-in capital
43,085
42,589
Retained earnings
116,612
102,520
Accumulated other comprehensive (loss) income
(547)
3,190
Treasury stock, 269,529 shares at December 31, 2021 and 321,517 shares at
December 31, 2020, at cost
(6,796)
(7,834)
Total shareholders' equity
157,065
145,176
Total liabilities and shareholders' equity
$
1,773,806
$
1,535,038
The accompanying notes are an integral part of these financial statements.
Consolidated Statements of Income
(Dollars in thousands, except per share data)
Years ended December 31,
Interest income
Loans, including fees
$
37,993
$
39,186
Interest and dividends on investments:
Taxable interest
7,198
4,710
Tax exempt interest
2,115
1,552
Dividend income
Deposits and obligations of other banks
Total interest income
47,573
45,939
Interest expense
Deposits
1,853
3,551
Subordinate notes
1,049
Total interest expense
2,902
3,978
Net interest income
44,671
41,961
Provision for loan losses
(2,100)
4,625
Net interest income after provision for loan losses
46,771
37,336
Noninterest income
Investment and trust services fees
7,111
6,040
Loan service charges
Gain on sale of loans
2,430
1,536
Deposit service charges and fees
2,258
1,977
Other service charges and fees
1,650
1,446
Debit card income
2,170
1,844
Increase in cash surrender value of life insurance
Bank owned life insurance gain
Net gains on sales of debt securities
Change in fair value of equity securities
(49)
Gain on sale of bank premises
1,776
-
Other
Total noninterest income
19,488
15,084
Noninterest Expense
Salaries and employee benefits
24,780
22,392
Net occupancy
3,580
3,350
Marketing and advertising
1,533
1,757
Legal and professional
2,013
1,802
Data processing
4,026
3,419
Pennsylvania bank shares tax
1,017
FDIC Insurance
ATM/debit card processing
1,305
1,088
Telecommunications
Nonservice pension
Other
3,030
3,323
Total noninterest expense
43,245
39,362
Income before federal income taxes
23,014
13,058
Federal income tax expense
3,398
Net income
$
19,616
$
12,800
Per share
Basic earnings per share
$
4.44
$
2.94
Diluted earnings per share
$
4.42
$
2.93
The accompanying notes are an integral part of these financial statements.
Consolidated Statements of Comprehensive Income
Years ended December 31,
(Dollars in thousands)
Net Income
$
19,616
$
12,800
Debt Securities
Unrealized (losses) gains arising during the period
(8,350)
12,366
Reclassification adjustment for gains included in net income (1)
(127)
(29)
Net unrealized (losses) gains
(8,477)
12,337
Tax effect
1,780
(2,591)
Net of tax amount
(6,697)
9,746
Pension
Unrealized gains (losses) arising during the period
2,187
(1,626)
Reclassification for net actuarial losses included in net income (2)
1,560
Net unrealized gains (losses)
3,747
(722)
Tax effect
(787)
Net of tax amount
2,960
(570)
Total other comprehensive (loss) income
(3,737)
9,176
Total Comprehensive Income
$
15,879
$
21,976
(1) Reclassified to net gains on sales of debt securities
(2) Reclassified to other expense
The accompanying notes are an integral part of these financial statements.
Consolidated Statements of Changes in Shareholders' Equity
For years ended December 31, 2021 and 2020:
Accumulated
Additional
Other
Number
Common
Paid-in
Retained
Comprehensive
Treasury
(Dollars in thousands, except per share data)
of Shares
Stock
Capital
Earnings
Income/(Loss)
Stock
Total
Balance at January 1, 2020
4,352,753
$
4,710
$
42,268
$
94,946
$
(5,986)
$
(8,410)
$
127,528
Net income
-
-
12,800
-
-
12,800
Other comprehensive income
-
-
-
9,176
-
9,176
Cash dividends declared, $1.20 per share
-
-
(5,226)
-
-
(5,226)
Acquisition of treasury stock
(36,401)
-
-
-
-
(1,171)
(1,171)
Treasury shares issued under dividend reinvestment plan
71,227
-
-
-
1,729
1,836
Stock Compensation Plans:
Treasury shares issued
-
-
-
Common shares issued
1,023
-
-
-
Compensation expense
-
-
-
-
Balance at December 31, 2020
4,389,355
$
4,711
$
42,589
$
102,520
$
3,190
$
(7,834)
$
145,176
Net income
-
-
19,616
-
-
19,616
Other comprehensive loss
-
-
-
(3,737)
-
(3,737)
Cash dividends declared, $1.25 per share
-
-
(5,524)
-
-
(5,524)
Acquisition of treasury stock
(38,453)
-
-
-
-
(1,193)
(1,193)
Treasury shares issued under dividend reinvestment plan
77,851
-
-
-
1,922
2,388
Stock Compensation Plans:
Treasury shares issued
12,590
-
(176)
-
-
Common shares issued
-
-
-
-
Compensation expense
-
-
-
-
Balance at December 31, 2021
4,441,443
$
4,711
$
43,085
$
116,612
$
(547)
$
(6,796)
$
157,065
The accompanying notes are an integral part of these financial statements.
Consolidated Statements of Cash Flows
December 31,
(Dollars in thousands)
Cash flows from operating activities
Net income
$
19,616
$
12,800
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
1,202
1,330
Net amortization of loans and investment securities
1,137
3,528
Amortization of subordinate debt issuance costs
Provision for loan losses
(2,100)
4,625
Change in fair value of equity securities
(90)
Debt securities gains, net
(127)
(29)
Loans originated for sale
(107,749)
(105,300)
Proceeds from sale of loans
116,798
99,430
Gain on sale of loans held for sale
(2,430)
(1,536)
Net gain on sale or disposal of premise and equipment
(1,726)
-
Increase in fair value of derivative
(19)
Increase in cash surrender value of life insurance
(446)
(457)
Gain from surrender of life insurance policy
(295)
(840)
Income tax benefit of statutory treatment of net operating loss carryback
-
(1,113)
Stock option compensation
Contribution to pension plan
-
(1,000)
Decrease (increase) in other assets
1,646
(3,626)
Increase (decrease) in other liabilities
(819)
Deferred tax expense (benefit)
(839)
Net cash provided by operating activities
26,349
6,435
Cash flows from investing activities
Net decrease (increase) in long-term interest-bearing deposits in other banks
2,249
(3,995)
Proceeds from sales and calls of investment securities available for sale
36,666
3,141
Proceeds from maturities and pay-downs of securities available for sale
34,587
38,541
Purchase of investment securities available for sale
(215,595)
(240,696)
Net increase in restricted stock
(27)
(3)
Net decrease (increase) in loans
12,547
(77,429)
Proceeds from sales of portfolio loans
-
Proceeds from surrender of life insurance policy
1,142
3,698
Purchase of bank owned life insurance
-
(1,000)
Proceeds from sale of bank owned assets
3,300
-
Capital expenditures
(8,807)
(484)
Net cash used in investing activities
(133,938)
(277,314)
Cash flows from financing activities
Net increase in demand deposits, interest-bearing checking, and savings accounts
231,698
242,364
Net decrease in time deposits
(1,912)
(13,183)
Proceeds from subordinated notes, net of issuance costs
-
19,541
Dividends paid
(5,524)
(5,226)
Purchase of Treasury shares
(1,193)
(1,171)
Cash received from option exercises
Treasury shares issued under dividend reinvestment plan
2,388
1,836
Net cash provided by financing activities
225,592
244,197
Increase (decrease) in cash and cash equivalents
118,003
(26,682)
Cash and cash equivalents as of January 1
57,146
83,828
Cash and cash equivalents as of December 31
$
175,149
$
57,146
Supplemental Disclosures of Cash Flow Information
Cash paid during the year for:
Interest on deposits and other borrowed funds
$
2,999
$
4,234
Income taxes
$
3,049
$
4,367
Noncash Activities:
Lease liabilities arising from obtaining right-of-use assets
$
-
$
The accompanying notes are an integral part of these financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Summary of Significant Accounting Policies
The accounting policies of Franklin Financial Services Corporation and its subsidiaries conform to U.S. generally accepted accounting principles and to general industry practices. A summary of the more significant accounting policies, which have been consistently applied in the preparation of the accompanying consolidated financial statements, follows:
Principles of Consolidation - The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation) and its wholly-owned subsidiaries; Farmers and Merchants Trust Company of Chambersburg and Franklin Future Fund Inc. Farmers and Merchants Trust Company of Chambersburg is a commercial bank (the Bank) that has one wholly-owned subsidiary, Franklin Financial Properties Corp., which holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. is a non-bank investment company that makes venture capital investments within the Corporation’s primary market area. The activities of non-bank entities are not significant to the consolidated totals. All significant intercompany transactions have been eliminated in consolidation.
Nature of Operations - The Corporation conducts substantially all of its business through its subsidiary bank, Farmers and Merchants Trust Company of Chambersburg, which serves its customer base through twenty-two community-banking offices located in Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania. These counties are considered to be the Corporation’s primary market area, but it may do business in the greater South-Central Pennsylvania market. The Bank is a community-oriented commercial bank that emphasizes customer service and convenience. As part of its strategy, the Bank has sought to develop a variety of products and services that meet the needs of both its retail and commercial customers. The Corporation and the Bank are subject to the regulations of various federal and state agencies and undergo periodic examinations by these regulatory authorities.
Use of Estimates in the Preparation of Financial Statements - The preparation of financial statements in conformity with generally accepted accounting principles requires Management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses.
Significant Group Concentrations of Credit Risk - Most of the Corporation’s activities are with customers located within its primary market area. Note 4 of the consolidated financial statements shows the types of securities in which the Corporation invests. Note 5 of the consolidated financial statements shows the types of lending in which the Corporation engages. The Corporation does not have any significant concentrations of any one industry or customer.
Statement of Cash Flows - For purposes of reporting cash flows, cash and cash equivalents include Cash and due from banks, interest-bearing deposits in other banks and cash items with original maturities less than 90 days.
Investment Securities - Management classifies its debt securities at the time of purchase as available for sale or held to maturity. At December 31, 2021 and 2020, all debt securities were classified as available for sale, meaning that the Corporation intends to hold them for an indefinite period of time, but not necessarily to maturity. Available for sale debt securities are stated at estimated fair value, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments of interest income through call date or maturity. The related unrealized gains and losses are reported as other comprehensive income or loss, net of tax, until realized. Declines in the fair value of held-to-maturity and available-for-sale debt securities to amounts below cost that are deemed to be other-than-temporary are reflected in earnings as realized losses. In estimating the other-than-temporary impairment losses, Management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) if the Corporation does not intend to sell the security or it if is not more likely than not that the Corporation will be required to sell the security before recovery of its amortized cost. When a determination is made that an other-than-temporary impairment exists but the Corporation does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, the other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income. Realized securities gains and losses are computed using the specific identification method. Gains or losses on the disposition of debt investment securities are recorded on the trade date, based on the net proceeds and the adjusted carrying amount of the specific security sold. Equity investments are carried at fair value with changes in fair value recognized in net income.
Restricted Stock - Restricted stock, which is carried at cost, consists of stock of the Federal Home Loan Bank of Pittsburgh (FHLB) and Atlantic Central Bankers Bank (ACBB). The Bank held $495 thousand of restricted stock at the end of 2021. With the exception of $30 thousand, this investment represents stock in the FHLB that the Bank is required to hold in order to be a member of
FHLB and is carried at a cost of $100 per share. FHLB stock is divided into two classes: membership stock and activity stock, which is based on outstanding loan balances. Federal law requires a member institution of the FHLB to hold FHLB stock according to a predetermined formula. Management evaluates the restricted stock for impairment in accordance with ASC Topic 320. Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the banks as compared to the capital stock amount for the banks and the length of time this situation has persisted, (2) commitments by the banks to make payments required by law or regulation and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the banks. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasury that can be used to support its operations. There is not a public market for FHLB or ACBB stock and the benefits of membership (e.g., liquidity and low-cost funding) add value to the stock beyond purely financial measures. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment. Management believes no impairment charge is necessary related to the FHLB or ACBB restricted stock as of December 31, 2021.
Financial Derivatives - FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
As required by ASC 815, the Corporation records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Corporation has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Corporation may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply, or the Corporation elects not to apply hedge accounting.
In accordance with the FASB’s fair value measurement guidance (in ASU 2011-04), the Corporation made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. At December 31, 2021, there were no derivatives subject to a netting agreement.
Loans - Loans, that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff, are stated at the outstanding unpaid principal balances, net of any deferred fees. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the yield (interest income) of the related loans using the interest method. The Corporation is amortizing these amounts over the contractual life of the loan.
The accrual of interest is generally discontinued when the contractual payment of principal or interest has become 90 days past due or Management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in a prior year is charged against the allowance for loan losses. Payments received on nonaccrual loans are applied initially against principal, then interest income, late charges and any other expenses and fees. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is no longer in doubt. Consumer loans are typically charged off no later than 180 days past due. Past due status is based on contractual terms of the loans.
Loans Held for Sale - Mortgage loans originated and intended for sale in the secondary market at the time of origination are carried at the lower of cost or estimated fair value (determined on an aggregate basis). All sales are made without recourse. Loans held for sale at December 31, 2021 represent loans originated through third-party brokerage agreements for a pre-determined price and present no price risk to the Bank.
Allowance for Loan Losses - The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is maintained at a level considered adequate to provide for probable incurred losses that can be reasonably anticipated. Management’s periodic evaluation of the adequacy of the allowance is based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ actual or perceived financial and managerial strengths, and other relevant factors. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.
The Corporation’s allowance for probable incurred loan losses consists of three components: specific, general and unallocated. The specific component addresses specific reserves established for impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Nonaccrual loans and troubled debt restructurings (TDRs) are impaired loans. A TDR loan is a loan that has had its terms modified resulting in a concession due to the financial difficulties of the borrower. Factors considered by Management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and commercial real estate loans by one of the following methods: the fair value of the collateral if the loan is collateral dependent, the present value of expected future cash flows discounted at the loan’s effective interest rate or the loan’s obtainable market price. Commercial loans with a balance less than $250 thousand, and all consumer purpose loans are not included in the specific reserve analysis as impaired loans but are added to the general allocation pool. Loans that are evaluated for a specific reserve, but not needing a specific reserve are not added back to general allocation pool.
The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates its loan portfolio into the following segments based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (commercial non-real estate), and consumer. Each segment may be further segregated by type of collateral, lien position, or owner/nonowner occupied properties. The quantitative analysis uses the Bank’s twenty quarter rolling historical loan loss experience as determined for each loan segment to determine a loss factor applicable to each loan segment. The qualitative analysis utilizes a risk matrix that incorporates four primary risk factors: economic conditions, delinquency, classified loans, and level of risk, and assigns a risk level (as measured in basis points) to each factor. In determining the risk level for these primary factors, consideration is given to operational factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. The level of risk (as measured in basis points) for each primary factor is set for six risk levels ranging from minimal risk to extreme risk and is determined independently for commercial loans, residential mortgage loans and consumer loans.
An unallocated component is maintained to cover uncertainties that could affect Management’s estimate of probable incurred loss. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. This estimate, if changed only several basis points, could vary by several hundred thousand dollars. Therefore, management believes some level of unallocated allowance should be maintained to account for this imprecision.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment using historical charge-offs as the starting point in estimating loss. Accordingly, the Corporation may not separately identify individual consumer and residential loans for impairment disclosures.
Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets or the lease term for lease hold improvements, whichever is shorter. When assets are retired or sold, the asset cost and related accumulated depreciation are eliminated from the respective accounts, and any resultant gain or loss is included in net income.
The cost of maintenance and repairs is charged to operating expense as incurred, and the cost of major additions and improvements is capitalized.
Goodwill - Goodwill arises from business combinations and is determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and
liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. The Corporation has selected August 31 as the date to perform the annual impairment test.
Bank Owned Life Insurance - The Bank invests in bank owned life insurance (BOLI) as a source of funding for employee benefit expenses. The Bank purchases life insurance coverage on the lives of a select group of employees. The Bank is the owner and beneficiary of the policies and records the investment at the cash surrender value of the underlying policies. Income from the increase in cash surrender value of the policies is included in noninterest income.
Other Real Estate Owned (OREO) - Foreclosed real estate (OREO) is comprised of property acquired through a foreclosure proceeding or an acceptance of a deed in lieu of foreclosure. Balances are initially reflected at the estimated fair value less any estimated disposition costs, with subsequent adjustments made to reflect further declines in value. Any losses realized upon disposition of the property, and holding costs prior thereto, are charged against income. All properties are actively marketed to potential buyers.
Transfers of Financial Assets - Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Federal Income Taxes - Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance, when in the opinion of Management, it is more likely than not that some portion or all deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted through the provision for income taxes for the effects of changes in tax laws and rates on the date of enactment. ASC Topic 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more-likely-than-not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. ASC Topic 740, “Income Taxes” also provides guidance on the accounting for and disclosure of unrecognized tax benefits, interest and penalties.
Advertising Expenses - Advertising costs are expensed as incurred.
Treasury Stock - The acquisition of treasury stock is recorded under the cost method. The subsequent disposition or sale of the treasury stock is recorded using the average cost method.
Investment and Trust Services - Assets held in a fiduciary capacity are not assets of the Corporation and therefore are not included in the consolidated financial statements. The fair value of trust assets under management (including assets held at third party brokers) at December 31, 2021 was $1.0 billion and $949.0 million at the prior year-end.
Off-Balance Sheet Financial Instruments - In the ordinary course of business, the Bank has entered into off-balance sheet financial instruments consisting of commitments to extend credit and letters of credit. Such financial instruments are recorded on the balance sheet when they are funded. The amount of any liability for the credit risk associated with off-balance sheet financial instruments is recorded in other liabilities and was not material to the financial position of the Corporation at December 31, 2021 or 2020.
Stock-Based Compensation - The Corporation accounts for stock-based compensation in accordance with the ASC Topic 718, “Stock Compensation.” ASC Topic 718 requires compensation costs related to share-based payment transactions to be recognized in the financial statements (with limited exceptions). The amount of compensation cost is measured based on the grant-date fair value of the equity or liability instruments issued and forfeitures are accounted for as they occur. Compensation cost is recognized over the period that an employee provides services in exchange for the award. The Corporation allows the employee to use shares to satisfy employer income tax withholding obligations.
Pension - The provision for pension expense was actuarially determined using the projected unit credit actuarial cost method. The funding policy is to contribute an amount sufficient to meet the requirements of ERISA, subject to Internal Revenue Code contribution limitations.
In accordance with ASC Topic 715, “Compensation - Retirement Benefits”, the Corporation recognizes the plan’s over-funded or under-funded status as an asset or liability with an offsetting adjustment to Accumulated Other Comprehensive Income (AOCI). ASC Topic 715 requires the determination of the fair value of a plan’s assets at the company’s year-end and the recognition of actuarial gains and losses, prior service costs or credits, transition assets or obligations as a component of AOCI. These amounts will be subsequently recognized as components of net periodic benefit costs. Further, actuarial gains and losses that arise in subsequent periods that are not initially recognized as a component of net periodic benefit costs will be recognized as a component of AOCI. Those amounts will subsequently be recorded as component of net periodic benefit costs as they are amortized during future periods.
Earnings per share - Earnings per share are computed based on the weighted average number of shares outstanding during each year. The Corporation’s basic earnings per share are calculated as net income divided by the weighted average number of shares outstanding. For diluted earnings per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents, calculated using the treasury stock method. The Corporation’s common stock equivalents consist of stock options and restricted stock awards.
A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:
(Dollars and shares in thousands, except per share data)
Weighted average shares outstanding (basic)
4,420
4,357
Impact of common stock equivalents
Weighted average shares outstanding (diluted)
4,440
4,366
Anti-dilutive options excluded from calculation
Net income
$
19,616
$
12,800
Basic earnings per share
$
4.44
$
2.94
Diluted earnings per share
$
4.42
$
2.93
Segment Reporting - The Bank acts as an independent community financial services provider and offers traditional banking and related financial services to individual, business and government customers. Through its community offices and electronic banking applications, the Bank offers a full array of commercial and retail financial services, including the taking of time, savings and demand deposits; the making of commercial, consumer and mortgage loans; and the providing of safe deposit services. The Bank also performs personal, corporate, pension and fiduciary services through its Investment and Trust Services Department.
Management does not separately allocate expenses, including the cost of funding loan demand, between the commercial, retail, mortgage banking and trust operations of the Bank. As such, discrete information is not available and segment reporting would not be meaningful.
Risk and Uncertainties - On March 11, 2020, the World Health Organization announced that the COVID-19 outbreak was deemed a pandemic, and on March 13, 2020, the President declared the ongoing COVID-19 pandemic of sufficient magnitude to warrant an emergency declaration. The extent to which the coronavirus may impact business activity or investment results will de pend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of the coronavirus and the actions required to contain the coronavirus or teat its impact, among others. The economic effects of the COVID-19 pandemic may negatively impact significant estimates and the assumptions underlying those estimates. The estimate that is particularly susceptible to material change is the determination of the allowance for loan losses.
Comprehensive Income - Comprehensive income is reflected in the Consolidated Statements of Comprehensive Income and includes net income and unrealized gains or losses, net of tax, on investment securities, reclassifications and the change in plan assets and benefit obligations on the Bank’s pension plan, net of tax.
Reclassification - Certain prior period amounts may have been reclassified to conform to the current year presentation. Such reclassifications did not affect reported net income.
‎
Recent Accounting Pronouncements:
Recently issued but not yet effective accounting standards
ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
Description
This standard requires credit losses on most financial assets measured at amortized cost and certain other instruments to be measured using an expected credit loss model (referred to as the current expected credit loss (CECL) model). Under this model, entities will estimate credit losses over the entire contractual term of the instrument (considering estimated prepayments, but not expected extensions or modifications unless reasonable expectation of a troubled debt restructuring exists) from the date of initial recognition of that instrument. The ASU replaces the current accounting model for purchased credit impaired loans and debt securities. The allowance for credit losses for purchased financial assets with a more-than insignificant amount of credit deterioration since origination (“PCD assets”), should be determined in a similar manner to other financial assets measured on an amortized cost basis. However, upon initial recognition, the allowance for credit losses is added to the purchase price to determine the initial amortized cost basis. The subsequent accounting for PCD financial assets is the same expected loss model described above.
Effective Date
January 1, 2023
Effect on the Consolidated Financial Statements
We have formed an implementation team led by the Corporation's Risk Management function. The team is reviewing the requirements of the ASU and evaluating methods and models for implementation. As of the beginning of the first reporting period in which the new standard is adopted, the Corporation expects to recognize a one-time cumulative-effect adjustment to the allowance for loan losses, which will flow through retained earnings. After adoption, the new standard will result in earlier recognition of additions to the allowance for loan losses and possibly a larger allowance for loan loss balance with a corresponding increase in the provision for loan losses in results of operations; however, the Corporation is continuing to evaluate the impact of the pending adoption of the new standard on its consolidated financial statements. A third-party vendor has been selected to assist with the CECL calculations and the implementation process has started. The Corporation will run the CECL model in test mode in 2022.
ASU 2019-05, Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief
Description
This ASU allows entities to irrevocably elect, upon adoption of ASU 2016-13, the fair value option on financial instruments that (1) were previously recorded at amortized cost and (2) are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. The fair value option election does not apply to held-to-maturity debt securities. Entities are required to make this election on an instrument-by-instrument basis. ASU 2019-05 has the same effective date as ASU 2016-13. On October 16, 2019, FASB approved its August 2019 proposal to grant certain small public companies a delay in the effective date of ASU 2016-13. For the Corporation, the delay makes the ASU effective January 2023. Since the Corporation currently meets the SEC definition of a small reporting company, the delay will be applied to the Corporation. Early adoption is permitted.
Effective Date
January 1, 2023
Effect on the Consolidated Financial Statements
The Corporation continues to review the ASU as part of its adoption of ASU 2016-13.
ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting
Description
This ASU provides temporary, optional guidance to ease the potential burden in accounting for, or recognizing the effects of, the transition away from the LIBOR or other interbank offered rate on financial reporting. To help with the transition to new reference rates, the ASU provides optional expedients and exceptions for applying GAAP to affected contract modifications and hedge accounting relationships. The main provisions include: (1) a change in a contract's reference interest rate would be accounted for as a continuation of that contract rather than as the creation of a new one for contracts, including loans, debts, leases, and other arrangements that meet specific criteria, and (2) when updating its hedging strategies in response to reference rate reform, an entity would be allowed to preserve its accounting. The guidance is applicable only to contracts or hedge accounting relationships that reference LIBOR or another reference rate expected to be discontinued. Because the guidance is meant to help entities through the transition period, it will be in effect for a limited time and will not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022, for which an entity has elected certain optional expedients that are retained through the end of the hedging relationship.
Effective Date
March 12, 2020 through December 31, 2022
Effect on the Consolidated Financial Statements
The Corporation continues to review the ASU as part of its adoption but does not expect it to have a material effect on the consolidated financial statements.
Guidance on COVID-19 Loan Modifications
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law. Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” provides banks the option to temporarily suspend certain requirements under U.S. GAAP related to troubled debt restructurings (“TDR”) for a limited period of time to account for the effects of COVID-19. To qualify for Section 4013 of the CARES Act, borrowers must have been current at December 31, 2019. All modifications are eligible so long as they are executed between March 1, 2020 and the earlier of (i) December 31, 2020, or (ii) the 60th day after the end of the COVID-19 national emergency declared by the President of the U.S. Multiple modifications of the same
credits are allowed and there is no cap on the duration of the modification. On December 21, 2020, certain provisions of the CARES Act, including the temporary suspension of certain requirements related to TDRs, were extended through December 31, 2021.
In March 2020, various regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, (“the agencies”) issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the Coronavirus. The interagency statement was effective immediately and impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, “Receivables - Troubled Debt Restructurings by Creditors,” (“ASC 310-40”), a restructuring of debt constitutes a troubled debt restructuring (“TDR”) if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not to be considered TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. At December 31, 2020 the Company had $67.6 million of loans modified under Section 4013 of the CARES Act still under modified repayment terms.
Note 2. Regulatory Matters
The Bank is limited as to the amount it may lend to the Corporation, unless such loans are collateralized by specific obligations. State regulations also limit the amount of dividends the Bank can pay to the Corporation and are generally limited to the Bank’s accumulated net earnings, which were $103.8 million at December 31, 2021. In addition, dividends paid by the Bank to the Corporation would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements. The Bank is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgements by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Although not adopted in regulation form, the Pennsylvania Department of Banking utilizes capital standards requiring a minimum leverage capital ratio of 6% and a risk-based capital ratio of 10%, defined substantially the same as those by the FDIC. Management believes, as of December 31, 2021, that the Bank met all capital adequacy requirements to which it is subject.
The Corporation and the Bank are subject to the capital requirements contained in the regulation generally referred to as Basel III. The Basel III standards were effective for the Corporation and the Bank, effective January 1, 2015. Basel III imposes significantly higher capital requirements and more restrictive leverage and liquidity ratios than those previously in place. The capital ratios to be considered “well capitalized” under Basel III are: (1) Common Equity Tier 1(CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. The CET1 ratio is a new capital ratio under Basel III and the Tier 1 risk-based capital ratio of 8% has been increased from 6%. The rules also included changes in the risk weights of certain assets to better reflect credit and other risk exposures. In addition, a capital conservation buffer of 2.50% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum (“adequately capitalized”) for each respective capital measurement. The Bank’s capital conservation buffer at December 31, 2021 was 8.54%. Compliance with the capital conservation buffer is required in order to avoid limitations on certain capital distributions, especially dividends. As of December 31, 2021, the Bank was “well capitalized’ under the Basel III requirements. For additional information on the capital ratios see the section titled Shareholders’ Equity, and Table 13.
On August 4, 2020, the Corporation completed the sale of a $20.0 million subordinated debt note offering (see Note 13). The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank.
At December 31, 2021, the Corporation had $20.0 million of unsecured subordinated debt notes payable, $15.0 million which mature on September 1, 2030 and $5.0 million which mature on September 1, 2035. The notes are recorded on the consolidated balance sheet net of remaining debt issuance costs totaling $412.0 thousand at December 31, 2021, which is being amortized on a pro-rata basis over a 5-year and 10-year period, based on the call dates of the notes, on an effective interest method. The subordinated notes totaling $15.0 million have a fixed interest rate of 5.00% through September 1, 2025, then convert to a variable rate of 90-day Secured Overnight Financing Rate (SOFR) plus 4.93% for the applicable interest periods through maturity. The subordinated notes totaling $5.0 million have a fixed interest rate of 5.25% through September 1, 2030, then convert to a variable rate of 90-day SOFR plus 4.92% for the applicable interest periods through maturity. The Corporation may, at its option, redeem the notes, in whole or in
part, at any time 5-years prior to the maturity. The notes are structured to qualify as Tier 2 Capital for the Corporation and there are no debt covenants on the notes.
In 2019, the Community Bank Leverage Ratio (CBLR) was approved by federal banking agencies as an optional capital measure available to Qualifying Community Banking Organizations (QCBO). If a bank qualifies as a QCBR and maintains a CBLR of 9% or greater, the bank would be considered “well-capitalized” for regulatory capital purposes and exempt from complying with the Basel III risk-based capital rule. The CBLR rule was effective January 1, 2020 and banks could opt-in through an election in the first quarter 2020 regulatory filings. The Bank meets the criteria of a QCBO but did not opt-in to the CBLR.
The consolidated asset limit on small bank holding companies is $3 billion and a company with assets under that limit is not subject to the consolidated capital rules but may file reports that include capital amounts and ratios. The Corporation has elected to file those reports.
‎
The following table presents the regulatory capital ratio requirements for the Corporation and the Bank.
As of December 31, 2021
Regulatory Ratios
Adequately Capitalized
Well Capitalized
Actual
Minimum
Minimum
(Dollars in thousands)
Amount
Ratio
Amount
Ratio
Amount
Ratio
Common Equity Tier 1
‎Risk-based Capital Ratio (1)
Corporation
$
148,365
15.20%
$
43,927
N/A
N/A
N/A
Bank
149,087
15.28%
43,901
4.50%
$
63,413
6.50%
Tier 1 Risk-based Capital Ratio (2)
Corporation
$
148,365
15.20%
$
58,569
N/A
N/A
N/A
Bank
149,087
15.28%
58,535
6.00%
$
78,046
8.00%
Total Risk-based Capital Ratio (3)
Corporation
$
179,701
18.41%
$
78,092
N/A
N/A
N/A
Bank
161,335
16.54%
78,046
8.00%
$
97,558
10.00%
Tier 1 Leverage Ratio (4)
Corporation
$
148,365
8.52%
$
69,649
N/A
N/A
N/A
Bank
149,087
8.57%
69,608
4.00%
$
87,009
5.00%
As of December 31, 2020
Regulatory Ratios
Adequately Capitalized
Well Capitalized
Actual
Minimum
Minimum
(Dollars in thousands)
Amount
Ratio
Amount
Ratio
Amount
Ratio
Common Equity Tier 1
‎Risk-based Capital Ratio (1)
Corporation
$
132,970
14.32%
$
41,788
N/A
N/A
N/A
Bank
130,678
14.07%
41,809
4.50%
$
60,390
6.50%
Tier 1 Risk-based Capital Ratio (2)
Corporation
$
132,970
14.32%
$
55,717
N/A
N/A
N/A
Bank
130,678
14.07%
55,745
6.00%
$
74,326
8.00%
Total Risk-based Capital Ratio (3)
Corporation
$
164,230
17.69%
$
74,289
N/A
N/A
N/A
Bank
142,384
15.33%
74,326
8.00%
$
92,908
10.00%
Tier 1 Leverage Ratio (4)
Corporation
$
132,970
8.69%
$
61,191
N/A
N/A
N/A
Bank
130,678
8.54%
61,222
4.00%
$
76,527
5.00%
(1)Common equity Tier 1 capital / total risk-weighted assets, (2) Tier 1 capital / total risk-weighted assets, (3) Total risk-based capital / total risk-weighted assets, (4) Tier 1 capital / average quarterly assets
Note 3. Restricted Cash Balances
In March 2020, the Federal Reserve reduced the reserve requirement on the Bank’s deposit liabilities to 0%. The Bank was not required to hold any reserves at December 31, 2021 and 2020.
Note 4. Investments
Available for Sale (AFS) Securities
The following table summarizes the amortized cost and fair value of securities available-for-sale at December 31, 2021 and 2020 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss).
The amortized cost and estimated fair value of investment securities available for sale as of December 31, 2021 and 2020 is as follows:
(Dollars in thousands)
Gross
Gross
Amortized
unrealized
unrealized
Fair
December 31, 2021
cost
gains
losses
value
U.S. Government and Agency securities
$
94,360
$
$
(715)
$
93,760
Municipal securities
206,501
7,148
(1,422)
212,227
Corporate securities
24,794
(188)
24,939
Agency mortgage-backed securities
123,686
(1,894)
122,669
Non-Agency mortgage-backed securities
30,904
(272)
30,666
Asset-backed securities
45,472
(175)
45,550
Total
$
525,717
$
8,760
$
(4,666)
$
529,811
(Dollars in thousands)
Gross
Gross
Amortized
unrealized
unrealized
Fair
December 31, 2020
cost
gains
losses
value
U.S. Government and Agency securities
$
12,594
$
$
(40)
$
12,574
Municipal securities
236,253
11,020
(219)
247,054
Corporate securities
20,421
(155)
20,288
Agency mortgage-backed securities
70,443
1,905
(107)
72,241
Non-Agency mortgage-backed securities
8,412
(15)
8,453
Asset-backed securities
36,246
(165)
36,330
Total
$
384,369
$
13,272
$
(701)
$
396,940
At December 31, 2021 and 2020, the fair value of investment securities pledged to secure public funds and trust deposits totaled $160.3 million and $137.4 million, respectively. The Bank has no investment in a single issuer that exceeds 10% of shareholders equity.
The amortized cost and estimated fair value of debt securities at December 31, 2021, by contractual maturity are shown below. Actual maturities may differ from contractual maturities because of prepayment or call options embedded in the securities. Mortgage-backed and asset-backed securities without defined maturity dates are reported on a separate line.
(Dollars in thousands)
Amortized
‎cost
Fair
‎value
Due in one year or less
$
1,830
$
1,862
Due after one year through five years
6,039
6,187
Due after five years through ten years
154,192
154,833
Due after ten years
163,594
168,044
325,655
330,926
Mortgage-backed and asset-backed securities
200,062
198,885
Total
$
525,717
$
529,811
The composition of the net realized securities gains for the years ended December 31 is as follows:
(Dollars in thousands)
Proceeds
$
36,666
$
3,141
Gross gains realized
Gross losses realized
(499)
(33)
Net gains realized
$
$
Tax provision on net gains realized
$
(27)
$
(6)
Impairment:
The following table reflects the temporary impairment in the investment portfolio, aggregated by investment category, length of time that individual securities have been in a continuous unrealized loss position and the number of securities in each category as of December 31, 2021 and 2020. For securities with an unrealized loss, Management applies a systematic methodology in order to perform an assessment of the potential for other-than-temporary impairment. In the case of debt securities, investments considered for other-than-temporary impairment: (1) had a specified maturity or repricing date, (2) were generally expected to be redeemed at par, and (3) were expected to achieve a recovery in market value within a reasonable period of time. In addition, the Bank considers whether it intends to sell these securities or whether it will be forced to sell these securities before the earlier of amortized cost recovery or maturity. The impairment identified on debt securities and subject to assessment at December 31, 2021, was deemed to be temporary and required no further adjustments to the financial statements, unless otherwise noted.
December 31, 2021
Less than 12 months
12 months or more
Total
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
(Dollars in thousands)
Value
Losses
Count
Value
Losses
Count
Value
Losses
Count
U.S. Government and Agency securities
$
78,000
$
(701)
$
2,880
$
(14)
$
80,880
$
(715)
Municipal securities
38,997
(910)
15,404
(512)
54,401
(1,422)
Corporate securities
8,954
(132)
1,694
(56)
10,648
(188)
Agency mortgage-backed securities
76,477
(1,517)
10,771
(377)
87,248
(1,894)
Non-Agency mortgage-backed securities
15,215
(215)
1,956
(57)
17,171
(272)
Asset-backed securities
18,829
(149)
2,348
(26)
21,177
(175)
Total temporarily impaired securities
$
236,472
$
(3,624)
$
35,053
$
(1,042)
$
271,525
$
(4,666)
December 31, 2020
Less than 12 months
12 months or more
Total
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
(Dollars in thousands)
Value
Losses
Count
Value
Losses
Count
Value
Losses
Count
U.S. Government and Agency securities
$
3,966
$
(21)
$
4,185
$
(19)
$
8,151
$
(40)
Municipal securities
27,022
(219)
-
-
-
27,022
(219)
Corporate securities
7,576
(37)
3,040
(118)
10,616
(155)
Agency mortgage-backed securities
18,390
(101)
3,355
(6)
21,745
(107)
Non-Agency mortgage-backed securities
2,506
(15)
-
-
-
2,506
(15)
Asset-backed securities
1,458
(12)
11,452
(153)
12,910
(165)
Total temporarily impaired securities
$
60,918
$
(405)
$
22,032
$
(296)
$
82,950
$
(701)
The following table represents the cumulative credit losses on debt securities recognized in earnings as of December 31, 2021:
(Dollars in thousands)
Twelve Months Ended
Balance of cumulative credit-related OTTI at January 1
$
$
Additions for credit-related OTTI not previously recognized
-
-
Additional increases for credit-related OTTI previously recognized when there is
no intent to sell and no requirement to sell before recovery of amortized cost basis
-
-
Decreases for previously recognized credit-related OTTI because there was an intent to sell
-
-
Reduction for increases in cash flows expected to be collected
-
-
Balance of credit-related OTTI at December 31
$
$
Equity Securities at fair value
The Corporation owns one equity investment with a readily determinable fair value. At December 31, 2021 and 2020, this investment was reported at a fair value of $481 thousand and $391 thousand, respectively, with changes in value reported through income.
Note 5. Loans
The Bank reports its loan portfolio based on the primary collateral of the loan. It further classifies these loans by the primary purpose, either consumer or commercial. The Bank’s mortgage loans include long-term loans to individuals and businesses secured by mortgages on the borrower’s real property. Construction loans are made to finance the purchase of land and the construction of residential and commercial buildings thereon and are secured by mortgages on real estate. Commercial loans are made to businesses of various sizes for a variety of purposes including construction, property, plant and equipment, and working capital. Commercial loans also include loans to government municipalities. Commercial lending is concentrated in the Bank’s primary market, but also includes purchased loan participations. Consumer loans are comprised of installment, home equity and unsecured personal lines of credit.
Each class of loans involves a different kind of risk. However, risk factors such as changes in interest rates, general economic conditions and changes in collateral values are common across all classes. The risk of each loan class is presented below.
Residential Real Estate 1-4 family
The largest risk in residential real estate loans to retail customers is the borrower’s inability to repay the loan due to the loss of the primary source of income. The Bank attempts to mitigate this risk through prudent underwriting standards including employment history, current financial condition and credit history. These loans are generally owner occupied and serve as the borrower’s primary residence. The Bank usually holds a first lien position on these properties but may hold a second lien position in some home equity loans or lines of credit. Commercial purpose loans, secured by residential real estate, are usually dependent upon repayment from the rental income or other business purposes. These loans are generally non-owner occupied. In addition to the real estate collateral, these loans may have personal guarantees or UCC filings on other business assets. If a payment default occurs on a 1-4 family residential real estate loan, the collateral serves as a source of repayment, but may be subject to a change in value due to economic conditions.
Residential Real Estate Construction
This class includes loans to individuals for construction of a primary residence and to contractors and developers to improve real estate and construct residential properties. Construction loans to individuals generally bear the same risk as 1-4 family residential loans. Additional risks may include cost overruns, delays in construction or contractor problems.
Loans to contractors and developers are primarily dependent on the sale of improved lots or finished homes for repayment. Risks associated with these loans include the borrower’s character and capacity to complete a development, the effect of economic conditions on the valuation of lots or homes, cost overruns, delays in construction or contractor problems. In addition to real estate collateral, these loans may have personal guarantees or UCC filings on other business assets, depending on the financial strength and experience of the developer. Real estate construction loans are monitored on a regular basis by either an independent third party or the responsible loan officer, depending on the size and complexity of the project. This monitoring process includes at a minimum, the submission of invoices or AIA documents detailing the cost incurred by the borrower, on-site inspections, and an authorizing signature for disbursement of funds.
Commercial Real Estate
Commercial real estate loans may be secured by various types of commercial property including retail space, office buildings, warehouses, hotels and motel, manufacturing facilities and, agricultural land.
Commercial real estate loans present a higher level of risk than residential real estate loans. Repayment of these loans is normally dependent on cash-flow generated by the operation of a business that utilizes the real estate. The successful operation of the business, and therefore repayment ability, may be affected by general economic conditions outside of the control of the operator. On most commercial real estate loans ongoing monitoring of cash flow and other financial performance indictors is completed annually through financial statement analysis. In addition, the value of the collateral may be negatively affected by economic conditions and may be insufficient to repay the loan in the event of default. In the event of foreclosure, commercial real estate may be more difficult to liquidate than residential real estate.
Commercial
Commercial loans are made for various business purposes to finance equipment, inventory, accounts receivables, and operating liquidity. These loans are generally secured by business assets or equipment, non-real estate collateral and/or personal guarantees.
Commercial loans present a higher level of credit risk than other loans because repayment ability is usually dependent on cash-flow from a business operation that can be affected by general economic conditions. On most commercial loans ongoing monitoring of cash flow and other financial performance indicators occur at least annually through financial statement analysis. In the event of a default, collateral for these loans may be more difficult to liquidate, and the valuation of the collateral may decline more quickly than loans secured by other types of collateral.
Loans to governmental municipalities are also included in the Commercial class. These loans generally have less risk than commercial loans due to the taxing authority of the municipality and its ability to assess fees on services.
This class also includes loans made as part of the Paycheck Protection Program (PPP). The PPP is a small business loan program designed to assist in allowing small businesses to keep workers on the payroll during the COVID-19 pandemic. When workers are kept on the payroll for the qualifying period, the loan could be forgiven if the small business incurs eligible expenses. The PPP loans are 100 percent guaranteed by the SBA and have a maturity of two years or five years with a fixed interest rate of 1% for the life of the loan. Because the PPP loans are 100% guaranteed by the SBA, they present no credit risk to the Bank once the SBA guarantee is fulfilled, if necessary. However, if the SBA does not grant loan forgiveness, the PPP loan would present the same risk factors as any other commercial loan. The PPP loan is only designed to cover short-term operating needs of the borrower. If the economy does not recover quickly from the pandemic and the borrower experiences long-term operational problems beyond the PPP funding, the performance of other loans to these customers could begin to deteriorate.
Consumer
These loans are made for a variety of reasons to consumers and include term loans and personal lines-of credit. The loans may be secured or unsecured. Repayment is primarily dependent on the income of the borrower and to a lesser extent the sale of collateral. The underwriting of these loans is based on the consumer’s ability and willingness to repay and is determined by the borrower’s employment history, current financial condition and credit background. Collateral for these loans, if any, usually depreciates quickly and therefore, may not be adequate to repay the loan if it is repossessed. Therefore, the overall health of the economy, including unemployment rates and wages, will have an effect on the credit quality in this loan class.
A summary of loans outstanding, by class, at December 31 is as follows:
(Dollars in thousands)
Residential Real Estate 1-4 Family
Consumer first liens
$
71,828
$
77,373
Commercial first lien
60,655
59,851
Total first liens
132,483
137,224
Consumer junior liens and lines of credit
67,103
60,935
Commercial junior liens and lines of credit
4,841
4,425
Total junior liens and lines of credit
71,944
65,360
Total residential real estate 1-4 family
204,427
202,584
Residential real estate - construction
Consumer
8,278
6,751
Commercial
12,379
9,558
Total residential real estate construction
20,657
16,309
Commercial real estate
522,779
503,977
Commercial
244,543
281,257
Total commercial
767,322
785,234
Consumer
6,406
5,577
998,812
1,009,704
Less: Allowance for loan losses
(15,066)
(16,789)
Net Loans
$
983,746
$
992,915
Included in the loan balances are the following:
Net unamortized deferred loan costs
$
1,289
$
Loans pledged as collateral for borrowings and commitments from:
FHLB
$
614,828
$
734,891
Federal Reserve Bank
45,453
50,605
Total
$
660,281
$
785,496
Paycheck Protection Program (PPP) loans (included in Commercial loans above)
Two-year loans
$
$
5,378
Five-year loans
7,729
46,912
Total Paycheck Protection Program loans
$
7,755
$
52,290
Unamortized deferred PPP loan fees (included in Net unamortized deferred loan fees above)
Two-year loans
$
-
$
(165)
Five-year loans
(370)
(1,178)
Total unamortized deferred PPP loan fees
$
(370)
$
(1,343)
Loans to directors and executive officers and related interests and affiliated enterprises were as follows:
(Dollars in thousands)
Balance at beginning of year
$
10,604
$
10,321
New loans made
3,086
2,401
Repayments
(3,528)
(2,118)
Balance at end of year
$
10,162
$
10,604
Note 6. Loan Quality
Management utilizes a risk rating scale ranging from 1-Prime to 9-Loss to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either a pass or substandard rating based on the performance status of the loans. Substandard consumer loans are loans that are nonaccrual or 90 days or more past due and still accruing. Loans rated 1 - 4 are considered pass credits. Loans that are rated 5-Pass Watch are pass credits but have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6-OAEM or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7-Substandard or 8-Doubtful exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7-Substandard. The following factors represent some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt.
The following table reports on the risk rating for those loans in the portfolio that are assigned an individual risk rating as of December 31, 2021 and 2020:
Pass
OAEM
Substandard
Doubtful
(Dollars in thousands)
(1-5)
(6)
(7)
(8)
Total
December 31, 2021
Residential Real Estate 1-4 Family
First liens
$
132,433
$
-
$
$
-
$
132,483
Junior liens and lines of credit
71,906
-
-
71,944
Total
204,339
-
-
204,427
Residential real estate - construction
20,233
-
-
20,657
Commercial real estate
486,903
19,006
16,870
-
522,779
Commercial
244,315
-
244,543
Consumer
6,406
-
-
-
6,406
Total
$
962,196
$
19,055
$
17,561
$
-
$
998,812
December 31, 2020
Residential Real Estate 1-4 Family
First liens
$
137,156
$
-
$
$
-
$
137,224
Junior liens and lines of credit
65,350
-
-
65,360
Total
202,506
-
-
202,584
Residential real estate - construction
15,797
-
-
16,309
Commercial real estate
449,478
35,947
18,552
-
503,977
Commercial
270,272
10,698
-
281,257
Consumer
5,565
-
-
5,577
Total
$
943,618
$
46,645
$
19,441
$
-
$
1,009,704
Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank.
‎
The following table presents the aging of payments in the loan portfolio as of December 31, 2021 and 2020:
(Dollars in thousands)
Loans Past Due and Still Accruing
Total
Current
30-59 Days
60-89 Days
90 Days+
Total
Non-Accrual
Loans
December 31, 2021
Residential Real Estate 1-4 Family
First liens
$
132,224
$
$
$
-
$
$
$
132,483
Junior liens and lines of credit
71,788
-
-
71,944
Total
204,012
-
204,427
Residential real estate - construction
20,233
-
-
-
-
20,657
Commercial real estate
515,487
-
6,812
522,779
Commercial
244,377
-
-
244,543
Consumer
6,368
-
-
6,406
Total
$
990,477
$
$
$
-
$
$
7,384
$
998,812
December 31, 2020
Residential Real Estate 1-4 Family
First liens
$
137,056
$
$
$
$
$
$
137,224
Junior liens and lines of credit
65,212
-
65,360
Total
202,268
202,584
Residential real estate - construction
15,797
-
-
-
-
16,309
Commercial real estate
495,609
-
8,033
503,977
Commercial
280,930
-
-
281,257
Consumer
5,525
-
5,577
Total
$
1,000,129
$
$
$
$
$
8,704
$
1,009,704
Impaired loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more, nonaccrual loans, or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Commercial loans are charged-off immediately upon identification of a loss. If a loan (commercial or mortgage) is collateral dependent (repayment provided solely by the collateral), the value of the collateral is determined and a partial charge-off may be recorded. Consumer loans are charged-off no later than 180 days past due. At December 31, 2021, the Bank had $38.0 thousand of residential properties in the process of foreclosure compared to $68.0 thousand at the end of 2020.
Interest not recognized on nonaccrual loans was $115.4 thousand and $342.6 thousand for the years ended December 31, 2021 and 2020, respectively. In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans, excluding consumer purpose loans, and troubled-debt restructuring (TDR) loans are considered impaired. Commercial loans with a balance less than $250 thousand, and all consumer purpose loans are not included in the specific reserve analysis as impaired loans but are added to the general allocation pool. Impaired loans totaled $11.6 million at December 31, 2021 compared to $17.3 million at December 31, 2020.
‎
The following tables present information on impaired loans:
Impaired Loans
With No Allowance
With Allowance
(Dollars in thousands)
Unpaid
Unpaid
Recorded
Principal
Recorded
Principal
Related
December 31, 2021
Investment
Balance
Investment
Balance
Allowance
Residential Real Estate 1-4 Family
First liens
$
$
$
-
$
-
$
-
Junior liens and lines of credit
-
-
-
-
-
Total
-
-
-
Residential real estate - construction
-
-
-
Commercial real estate
4,942
5,405
5,578
5,764
Commercial
-
-
-
-
-
Total
$
6,027
$
6,795
$
5,578
$
5,764
$
December 31, 2020
Residential Real Estate 1-4 Family
First liens
$
$
$
-
$
-
$
-
Junior liens and lines of credit
-
-
-
-
-
Total
-
-
-
Residential real estate - construction
-
-
-
Commercial real estate
10,402
11,107
5,702
5,702
Commercial
-
-
-
-
-
Total
$
11,551
$
12,473
$
5,702
$
5,702
$
Twelve Months Ended
December 31, 2021
December 31, 2020
Average
Interest
Average
Interest
(Dollars in thousands)
Recorded
Income
Recorded
Income
Investment
Recognized
Investment
Recognized
Residential Real Estate 1-4 Family
First liens
$
$
$
$
Junior liens and lines of credit
-
-
-
-
Total
Residential real estate - construction
-
-
Commercial real estate
14,530
13,839
Commercial
-
-
-
-
Total
$
15,656
$
$
15,005
$
A loan is considered a troubled debt restructuring (TDR) if the creditor (the Bank), for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. These concessions may include lowering the interest rate, extending the maturity, reamortization of payment, or a combination of multiple concessions. The Bank reviews all loans rated 6-OAEM or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance. The cash basis income recognized is the same as the accrual basis income.
‎
The following table presents TDR loans as of December 31, 2021 and 2020:
Troubled Debt Restructurings
Within the Last 12 Months
That Have Defaulted
(Dollars in thousands)
Troubled Debt Restructurings
on Modified Terms
Number of
Recorded
Number of
Recorded
Contracts
Investment
Performing*
Nonperforming*
Contracts
Investment
December 31, 2021
Residential real estate - construction
$
$
-
$
-
$
-
Residential real estate
-
-
-
Commercial real estate - owner occupied
1,161
1,161
-
-
-
Commercial real estate - farmland
1,664
1,664
-
-
-
Commercial real estate - multi-family residential
1,360
1,360
-
-
-
Commercial real estate
-
-
-
Total
$
5,564
$
5,140
$
-
$
-
December 31, 2020
Residential real estate - construction
$
$
$
-
-
$
-
Residential real estate
-
-
-
Commercial real estate - owner occupied
1,224
1,224
-
-
-
Commercial real estate - farmland
2,257
2,257
-
-
-
Commercial real estate - consturction and land development
6,129
6,129
-
-
-
Commercial real estate
-
-
Total
$
11,011
$
10,803
$
-
$
-
*The performing status is determined by the loan’s compliance with the modified terms.
The following table presents new TDR loans made during 2021, concession granted and the recorded investment as of December 31, 2021:
New During Period
Twelve Months Ended
Number of
Pre-TDR
After-TDR
Recorded
December 31, 2021
Contracts
Modification
Modification
Investment
Concession
Residential real estate
$
$
$
multiple
The following table presents new TDR loans made during 2020, concession granted and the recorded investment as of December 31, 2021:
New During Period
Twelve Months Ended
Number of
Pre-TDR
After-TDR
Recorded
December 31, 2020
Contracts
Modification
Modification
Investment
Concession
Commercial real estate - farm land
$
$
$
multiple
Commercial real estate - owner occupied
maturity
Total
$
1,076
$
1,076
$
1,094
Allowance for Loan Losses:
Management monitors loan performance on a monthly basis and performs a quarterly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan’s collateral. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6-OAEM or worse and obtains a new appraisal or asset valuation for any loans placed on nonaccrual and rated 7 - Substandard or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on
an ongoing basis and reports its adequacy quarterly to the Credit Risk Oversight Committee of the Board of Directors. Management believes that the allowance for loan losses at December 31, 2021 is adequate.
The following table shows the activity in the Allowance for Loan Loss (ALL), for the years ended December 31, 2021 and 2020:
Residential Real Estate 1-4 Family
First
Junior Liens &
Commercial
(Dollars in thousands)
Liens
Lines of Credit
Construction
Real Estate
Commercial
Consumer
Unallocated
Total
ALL at December 31, 2019
$
$
$
$
9,163
$
5,679
$
$
$
16,789
Charge-offs
-
-
(28)
(57)
(50)
(195)
-
(330)
Recoveries
-
-
-
Provision
(80)
(144)
(939)
(1,007)
(186)
(2,100)
ALL at December 31, 2020
$
$
$
$
8,168
$
5,127
$
$
$
15,066
ALL at December 31, 2020
$
$
$
$
6,607
$
4,021
$
$
$
11,966
Charge-offs
-
(10)
-
(55)
(463)
(117)
-
(645)
Recoveries
-
-
-
Provision
2,066
1,853
4,625
ALL at December 31, 2021
$
$
$
$
9,163
$
5,679
$
$
$
16,789
The following table shows the loans that were evaluated for the Allowance for Loan Loss (ALL) under a specific reserve (individually) and those that were evaluated under a general reserve (collectively), and the amount of the allowance established in each category as of December 31, 2021 and 2020:
Residential Real Estate 1-4 Family
First
Junior Liens &
Commercial
(Dollars in thousands)
Liens
Lines of Credit
Construction
Real Estate
Commercial
Consumer
Unallocated
Total
December 31, 2021
Loans evaluated for ALL:
Individually
$
$
-
$
$
10,520
$
-
$
-
$
-
$
11,605
Collectively
131,822
71,944
20,233
512,259
244,543
6,406
-
987,207
Total
$
132,483
$
71,944
$
20,657
$
522,779
$
244,543
$
6,406
$
-
$
998,812
ALL established for
‎ loans evaluated:
Individually
$
-
$
-
$
-
$
$
-
$
-
$
-
$
Collectively
7,470
5,127
14,368
ALL at December 31, 2021
$
$
$
$
8,168
$
5,127
$
$
$
15,066
December 31, 2020
Loans evaluated for ALL:
Individually
$
$
-
$
$
16,104
$
-
$
-
$
-
$
17,253
Collectively
136,587
65,360
15,797
487,873
281,257
5,577
-
992,451
Total
$
137,224
$
65,360
$
16,309
$
503,977
$
281,257
$
5,577
$
-
$
1,009,704
ALL established for
‎ loans evaluated:
Individually
$
-
$
-
$
-
$
$
-
$
-
$
-
$
Collectively
8,935
5,679
16,561
ALL at December 31, 2020
$
$
$
$
9,163
$
5,679
$
$
$
16,789
Note 7. Premises and Equipment
At December 31, premises and equipment consisted of:
(Dollars in thousands)
Estimated Life
Land
$
2,710
$
3,337
Buildings and leasehold improvements
15 - 30 years, or lease term
26,218
24,841
Furniture, fixtures and equipment
3 - 10 years
8,031
13,274
Total cost
36,959
41,452
Less: Accumulated depreciation
(17,769)
(28,347)
Net premises and equipment
$
19,190
$
13,105
The following table shows the amount of depreciation for the years ended December 31:
Depreciation expense
$
1,137
$
1,230
Note 8. Leases
The Corporation leases various assets in the course of its operations that are subject to recognition under the new standard. The Corporation considers all of its leases to be operating leases and it has no finance leases. The leased assets are comprised of equipment, and buildings and land (collectively real estate). The equipment leases are shorter-term than the real estate leases, and generally have a fixed payment over a defined term without renewal options. Certain equipment leases have purchase options and it was determined the option was not reasonably certain to be exercised. The real estate leases are longer-term and may contain renewal options after the initial term, but none of the real estate leases contain a purchase option. The renewal options on real estate leases were reviewed and if it was determined the option was reasonably certain to be renewed, the option term was considered in the determination of the lease liability. There is only one real estate lease with a variable payment based on an index included in the lease liability. None of the leases contain any restrictive covenants and there are no significant leases that have not yet commenced. The discount rate used to determine the lease liability is based on the Bank’s fully secured borrowing rate from the Federal Home Loan Bank for a term similar to the lease term. Operating lease expense is included in net occupancy expense in the consolidated statements of income.
Lease Cost:
The components of total lease cost were as follows for the period ending:
For the years ended
December 31
(Dollars in thousands)
Operating lease cost
$
$
Short-term lease cost
Variable lease cost
Total lease cost
$
1,011
$
Supplemental Lease Information:
For the years ended
(Dollars in thousands)
December 31
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases
$
Weighted-average remaining lease term (years)
11.0
12.4
Weighted-average discount rate
3.37%
3.54%
Lease Obligations:
Future undiscounted lease payments for operating leases with initial terms of one year or more as of December 31, 2021 are as follows:
(Dollars in thousands)
$
2027 and beyond
2,918
Discounted cash flows
5,904
Imputed interest
(1,047)
Total lease liability
$
4,857
Note 9. Other Real Estate Owned
The Bank had no other real estate owned at December 31, 2021 and 2020.
Note 10. Goodwill
The Bank has $9.0 million of goodwill recorded on its balance sheet as the result of corporate acquisitions. Goodwill is not amortized, nor deductible for tax purposes. However, Goodwill is tested for impairment at least annually in accordance with ASC Topic 350. Goodwill was tested for impairment as of August 31, 2021. The 2021 test was conducted using a qualitative assessment method that requires the use of significant assumptions in order to make a determination of likely impairment. These assumptions may include, but are not limited to: macroeconomic factors, banking industry conditions, banking merger and acquisition trends, the Bank’s historical financial performance, the Corporation’s stock price, forecast Bank financial performance, and change of control premiums. Management determined the Bank’s goodwill was not likely impaired in 2021 and did not make a further assessment.
The 2020 impairment test was conducted using several quantitative methods, including an income approach, market value approach and a change of control acquisition approach. Each of these quantitative approaches included different scenarios with different assumptions. These scenarios were weighted based upon Management’s judgement. Based upon this assessment, the estimated fair value of the Corporation exceeded its carrying value by 24% and Management determined the Bank’s goodwill was not impaired.
Note 11. Deposits
Deposits are summarized as follows at December 31:
(Dollars in thousands)
Noninterest-bearing checking
$
298,403
$
259,060
Interest-bearing checking
511,969
409,178
Money management
579,826
501,017
Savings
119,908
109,153
Total interest-bearing checking and savings
1,211,703
1,019,348
Time deposits
74,253
76,165
Total deposits
$
1,584,359
$
1,354,573
Overdrawn deposit accounts reclassified as loans
$
$
Time deposits greater than $250,000 at December 31, 2020and 2020 were $15.2 million and $8.8 million, respectively.
At December 31, 2021 the scheduled maturities of time deposits are as follows:
(Dollars in thousands)
Time Deposits
$
55,721
12,468
2,884
1,878
1,302
Total
$
74,253
The deposits of directors, executive officers, related interests and affiliated enterprises totaled $4.7 million and $6.6 million at December 31, 2021 and 2020, respectively.
Note 12. Other Borrowings
The Bank's short-term borrowings are comprised of a line-of-credit with the Federal Home Loan Bank of Pittsburgh (Open Repo Plus). Open Repo Plus is a revolving term commitment used on an overnight basis. The term of this commitment may not exceed 364 days and it reprices daily at market rates. At December 31, 2021 and 2020, the Bank had no short-term borrowings.
The Bank’s maximum borrowing capacity with the FHLB at December 31, 2021 was $369.9 million with $369.9 million available to borrow. This borrowing capacity is secured by a Blanket Pledge Agreement with FHLB on the Bank’s real estate loan portfolio.
The Bank has established credit at the Federal Reserve Discount Window and as of year-end had the ability to borrow approximately $22 million. The Bank also has $56.0 million in unsecured lines of credit at two correspondent banks.
Note 13. Subordinate Notes
At December 31, 2021 and 2020, the Corporation had $20 million of unsecured subordinated debt notes payable, $15.0 million which mature on September 1, 2030 and $5.0 million which mature on September 1, 2035. The notes are recorded on the consolidated balance sheet net of remaining debt issuance costs totaling $412.0 thousand at December 31, 2021 and $445.3 thousand at December 31, 2020, which is being amortized on a pro-rata basis over a 5-year and 10-year period, based on the call dates of the notes, on an effective interest method. The subordinated notes totaling $15.0 million have a fixed interest rate of 5.00% through September 1, 2025, then convert to a variable rate of 90-day Secured Overnight Financing Rate (SOFR) plus 4.93% for the applicable interest periods through maturity. The subordinated notes totaling $5.0 million have a fixed interest rate of 5.25% through September 1, 2030, then convert to a variable rate of 90-day SOFR plus 4.92% for the applicable interest periods through maturity. The Corporation may, at its option, redeem the notes, in whole or in part, at any time 5-years prior to the maturity. The notes are structured to qualify as Tier 2 Capital for the Corporation and there are no debt covenants on the notes.
Note 14. Federal Income Taxes
The temporary differences which give rise to significant portions of deferred tax assets and liabilities at December 31 are as follows:
(Dollars in thousands)
Deferred Tax Assets
Allowance for loan losses
$
3,197
$
3,561
Deferred compensation
Purchase accounting
Other than temporary impairment of investments
Accumulated other comprehensive loss
-
Lease liabilities
1,030
1,131
Other
5,710
6,109
Valuation allowance
(58)
(58)
Total gross deferred tax assets
5,652
6,051
Deferred Tax Liabilities
Depreciation
Right-of-use asset
1,010
1,118
Joint ventures and partnerships
Pension
1,163
Accumulated other comprehensive gain
-
Deferred loan fees and costs, net
Total gross deferred tax liabilities
2,338
3,650
Net deferred tax asset
$
3,314
$
2,401
In assessing the realizability of deferred tax assets, Management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based on the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, Management believes it is more likely than not that the Bank will realize the benefits of these deferred tax assets other than those for which a valuation allowance has been recorded.
The components of the provision for Federal income taxes attributable to income from operations were as follows:
For the Years Ended December 31
(Dollars in thousands)
Current tax expense (benefit)
$
3,308
$
2,210
Tax benefit NOL carryback
-
(1,113)
Deferred tax (benefit) expense
(839)
Income tax provision
$
3,398
$
For the years ended December 31, 2021 2020, the income tax provisions are different from the tax expense which would be computed by applying the Federal statutory rate to pretax operating earnings. The Federal statutory rate was 21% for 2021 and 2020. A reconciliation between the tax provision at the statutory rate and the tax provision at the effective tax rate is as follows:
For the Years Ended December 31
(Dollars in thousands)
Tax provision at statutory rate
$
4,833
$
2,747
Income on tax-exempt loans and securities
(1,190)
(1,144)
Tax benefit NOL carryback
-
(1,113)
Investment in solar tax credit
(162)
-
Nondeductible interest expense relating to carrying tax-exempt obligations
Income from bank owned life insurance
(146)
(269)
Stock option compensation
-
Other, net
(6)
Income tax provision
$
3,398
$
Effective income tax rate
14.8%
2.0%
The Corporation recognizes interest accrued related to unrecognized tax benefits and penalties in income tax expense for all periods presented. No penalties or interest were recognized in 2021 or 2020. The Corporation recorded a reversal of $1.1 million to its income tax expense in the second quarter of 2020 due to a benefit from the passage of the CARES Act in March 2020. The CARES Act allowed for NOLs incurred in 2018, 2019 and 2020 to be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The Corporation incurred an NOL in 2018 that was carried back to prior periods when the statutory rate for the Corporation was 34% as compared to the current rate of 21%. The Corporation had no uncertain tax positions at December 31, 2021. The Corporation is no longer subject to U.S. Federal examinations by tax authorities for the years before 2017.
Note 15. Accumulated Other Comprehensive Income/(Loss)
The components of accumulated other comprehensive loss included in shareholders' equity at December 31 are as follows:
For the Years Ended December 31
Net unrealized gains on debt securities
$
4,094
$
12,571
Tax effect
(860)
(2,640)
Ending balance
$
3,234
$
9,931
Accumulated pension adjustment
$
(4,786)
$
(8,533)
Tax effect
1,005
1,792
Net of tax amount
$
(3,781)
$
(6,741)
Total accumulated other comprehensive (loss) income
$
(547)
$
3,190
Note 16. Financial Derivatives
The Corporation is exposed to certain risks arising from both its business operations and economic conditions. The Corporation principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Corporation manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities.
The Corporation’s existing credit derivatives result from participations in interest rate swaps provided by external lenders as part of loan participation arrangements, therefore, are not used to manage interest rate risk in the Corporation’s assets or liabilities. Derivatives not designated as hedges are not speculative and result from a service the Corporation provides to certain lenders which participate in loans.
The table below presents the fair value of the Corporation’s derivative financial instruments as well as their classification on the Balance Sheet as of December 31, 2021:
Fair Value of Derivative Instruments
Derivative Liabilities
(Dollars in thousands)
As of December 31, 2021
As of December 31, 2020
Notional amount
Balance Sheet Location
Fair Value
Notional amount
Balance Sheet Location
Fair Value
Derivatives not designated as hedging instruments
Other Contracts
6,653
Other Liabilities
$
6,836
Other Liabilities
$
Total derivatives not designated as hedging instruments
$
$
The table below presents the effect of the Corporation’s derivative financial instruments that are not designated as hedging instruments on the Income Statement as of December 31, 2021:
Effect of Derivatives Not Designated as Hedging Instruments on the Statement of Financial Performance
Derivatives Not Designated as Hedging Instruments under Subtopic 815-20
Location of Gain or (Loss) Recognized in Income on Derivative
Amount of Gain or (Loss) Recognized in Income on Derivatives
(Dollars in thousands)
Year Ended December 31
Other Contracts
Other income
$
$
(21)
As of December 31, 2021, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $21 thousand.
Note 17. Benefit Plans
The Bank has a 401(k) plan which includes an auto enrollment feature and covers all employees of the Bank who have completed four months of service. Employee contributions to the plan are matched at 100% up to 4% of each participant’s deferrals plus 50% of the next 2% of deferrals from participants’ eligible compensation. Under this plan, the maximum amount of employee contributions in any given year is defined by Internal Revenue Service regulations. In addition, a 100% discretionary profit-sharing contribution of up to 2% of each employee’s eligible compensation is possible provided net income targets are achieved. The related expense for the 401(k) plan, and the discretionary profit-sharing plan was $1.1 million in 2021 and $869 thousand in 2020. This expense is recorded in the Salary and employee benefits line of the Consolidated Statements of Income.
The Bank has a noncontributory defined benefit pension plan covering employees hired prior to April 1, 2007. The pension plan was closed to new participants on April 1, 2007. Benefits are based on years of service and the employee’s compensation using a career average formula. The Bank’s funding policy is to contribute the annual amount required to meet the minimum funding requirements of the Employee Retirement Income Security Act of 1974. Contributions are intended to provide not only for the benefits attributed to service to date but also for those expected to be earned in the future. Employees who are eligible for pension benefits may elect to receive an annuity style payment or a lump-sum payout of their pension benefits. Pension service costs are recorded in Salary and benefits expense while all other components of net periodic pension costs are recorded in other expense. For the next fiscal year, the estimated net loss for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit costs are $588 thousand. The Bank uses December 31 as the measurement date for its pension plan.
The Pension Committee reviews and determines all the assumptions used to determine the benefit obligations and expense annually. Historical investment returns play a significant role in determining the expected long-term rate of return on Plan assets.
The following table sets forth the plan’s funded status, based on the 2020 actuarial valuations:
For the Years Ended December 31
(Dollars in thousands)
Change in projected benefit obligation
Benefit obligation at beginning of measurement year
$
22,511
$
20,779
Service cost
Interest cost
Actuarial (gain) loss
(1,784)
2,275
Benefits paid
(2,518)
(1,400)
Benefit obligation at end of measurement year
19,002
22,511
Change in plan assets
Fair value of plan assets at beginning of measurement year
19,462
18,135
Actual return on plan assets net of expenses
1,518
1,727
Employer contribution
-
1,000
Benefits paid
(2,518)
(1,400)
Fair value of plan assets at end of measurement year
18,462
19,462
Funded status of projected benefit obligation
$
(540)
$
(3,049)
For the Years Ended December 31
Assumptions used to determine benefit obligations:
Discount rate
3.71%
2.33%
Rate of compensation increase
5.00%
4.00%
Expected long-term return on plan assets
6.00%
6.25%
‎
Amounts recognized in accumulated other comprehensive
For the Years Ended December 31
income (loss), net of tax
Net actuarial loss
$
(4,786)
$
(8,533)
Tax effect
1,005
1,792
Net amount recognized in accumulated other comprehensive loss
$
(3,781)
$
(6,741)
For the Years Ended December 31
Components of net periodic pension cost
Service cost
$
$
Interest cost
Expected return on plan assets
(1,115)
(1,079)
Recognized net actuarial loss
1,135
Net periodic pension cost
Settlement expense
-
$
1,238
$
For the Years Ended December 31
Assumptions used to determine net periodic benefit cost:
Discount rate
2.33%
3.13%
Rate of compensation increase
4.00%
4.00%
Expected long-term return on plan assets
6.25%
6.50%
Asset allocations:
Cash and cash equivalents
1%
12%
Common stocks
31%
22%
Corporate bonds
13%
13%
Municipal bonds
26%
26%
Investment fund - debt
9%
9%
Investment fund - equity
13%
12%
Deposit in immediate participation guarantee contract
7%
6%
Total
100%
100%
The following methods and assumptions were used to estimate the fair values of the assets held by the plan. See Note 21 for additional information on the fair value hierarchy.
Cash and Cash Equivalents: The carrying value of this asset is considered to approximate its fair value (Level 1).
Equity Securities, Investment Funds (Debt and Equity): The fair value of assets in these categories are determined using quoted market prices from nationally recognized markets (Level 1).
Bonds (Corporate and Municipal): Fair values of these assets was primarily measured using information from a third-party pricing service. This service provides pricing information by utilizing evaluated pricing models supported with market data information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data from market research publications. Fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models (Level 2).
Immediate Participation Guarantee Contract: The carrying value of this asset is considered to approximate its fair value. (Level 1).
Cash Surrender Value of Life Insurance: The cash surrender value of this asset is considered to approximate its fair value. However, the inputs used to determine the cash surrender value are not readily observable in the market (Level 3).
Certificates of Deposit: The fair value of these assets are calculated by use of a pricing model that uses rate spreads to new market issue quotes and dealer quotes (Level 2).
The following table sets forth by level, within the fair value hierarchy, the Plan's investments at fair value as of December 31, 2021 and 2020. For more information on the levels within the fair value hierarchy, please refer to Note 21.
(Dollars in Thousands)
December 31, 2021
Asset Description
Fair Value
Level 1
Level 2
Level 3
Cash and cash equivalents
$
$
$
-
$
-
Equity securities
5,671
5,671
-
-
Corporate bonds
2,451
-
2,451
-
Municipal bonds
4,722
-
4,722
-
Investment fund - debt
1,690
1,690
-
-
Investment fund - equity
2,381
2,381
-
-
Deposit in immediate participation guarantee contract
1,280
1,280
-
-
Cash surrender value of life insurance
-
-
Certificates of deposit
-
-
Total assets
$
18,462
$
11,211
$
7,223
$
(Dollars in Thousands)
December 31, 2020
Asset Description
Fair Value
Level 1
Level 2
Level 3
Cash and cash equivalents
$
2,305
$
2,305
$
-
$
-
Equity securities
4,236
4,236
-
-
Corporate bonds
2,581
-
2,581
-
Municipal bonds
5,066
-
5,066
-
Investment fund - debt
1,757
1,757
-
-
Investment fund - equity
2,252
2,252
-
-
Deposit in immediate participation guarantee contract
1,187
1,187
-
-
Cash surrender value of life insurance
-
-
Certificates of deposit
-
-
Total assets
$
19,462
$
11,737
$
7,697
$
The following table sets forth a summary of the changes in the fair value of the Plan's level 3 investments for the years ended December 31, 2021 and 2020:
Cash Value of Life Insurance
December 31
Balance at the beginning of the period
$
$
Unrealized gain (loss) relating to investments held at the reporting date
-
-
Purchases, sales, issuances and settlement, net
-
-
Balance at the end of the period
$
$
Contributions
The Bank does not expect to make any additional contributions in 2022.
Estimated future benefit payments at December 31, 2021 (Dollars in Thousands)
$
1,287
1,078
1,012
1,456
1,610
2027-2031
6,652
Total
$
13,095
Note 18. Stock Based Compensation
In 2004, the Corporation adopted the Employee Stock Purchase Plan of 2004 (ESPP). Under the ESPP, options for 250,000 shares of stock can be issued to eligible employees. The number of shares that can be purchased by each participant is defined by the plan
and the Board of Directors sets the option price. However, the option price cannot be less than 90% of the fair market value of a share of the Corporation’s common stock on the date the option is granted. The Board of Directors also determines the expiration date of the options; however, no option may have a term that exceeds one year from the grant date. ESPP options are exercisable immediately upon grant. Any shares related to unexercised options are available for future grant. The Board of Directors may amend, suspend or terminate the ESPP at any time. The exercise price of the 2021 ESPP options was set at 95% of the stock’s fair value at the time of the award.
In 2019, the Corporation approved the 2019 Omnibus Stock Incentive Plan (Stock Plan), replacing the Incentive Stock Option Plan of 2013 (ISOP). No new awards will be made under the 2013 plan; however, any awards made under the 2013 plan remain outstanding under the terms they were issued. Under the Stock Plan, 400,000 shares have been authorized to be issued, inclusive of the remaining shares available under the 2013 plan that were rolled into the Stock Plan and forfeited awards are available for future grants. The Stock Plan allows for various types of awards including incentive stock options, restricted stock and stock appreciation rights.
The ESPP and the incentive stock options (ISO) awarded under the Stock Plan and outstanding at December 31, 2021 are all exercisable. The ESPP options expire on June 30, 2022 and the ISO options expire 10 years from the grant date. The following table summarizes the activity in the ESPP:
Employee Stock Purchase Plan
ESPP
Weighted Average
Aggregate
(Dollars in thousands except share and per share data)
Options
Price Per Share
Intrinsic Value
Balance Outstanding at December 31, 2019
19,111
$
36.21
$
-
Granted
32,209
24.19
Exercised
(753)
25.32
Expired
(20,882)
35.15
Balance Outstanding at December 31, 2020
29,685
$
24.19
$
Granted
26,734
30.24
Exercised
(4,629)
25.80
Expired
(27,541)
24.46
Balance Outstanding at December 31, 2021
24,249
$
30.24
$
Shares available for future grants under the ESPP at December 31, 2021
182,761
The following tables summarize the activity in the Stock Plan:
Omnibus Stock Option Plans
Weighted Average
Aggregate
(Dollars in thousands except share and per share data)
ISO
Price Per Share
Intrinsic Value
Balance Outstanding at December 31, 2019
92,979
$
28.55
$
Granted
-
-
Exercised
(625)
27.62
Forfeited
-
-
Balance Outstanding at December 31, 2020
92,354
$
28.55
$
-
Granted
-
-
Exercised
(100)
22.05
Forfeited
(2,000)
33.08
Balance Outstanding at December 31, 2021
90,254
$
28.46
$
Weighted Average
Restricted
Grant Date
Shares
Fair Value
Nonvested as of December 31, 2019
-
$
-
Granted
14,921
31.02
Vested
(398)
31.02
Forfeited
(990)
31.02
Nonvested as of December 31, 2020
13,533
$
31.02
Granted
6,095
27.54
Vested
(7,418)
30.98
Forfeited
(255)
29.50
Nonvested as of December 31, 2020
11,955
$
29.30
Shares available for future grants under the Stock Plan at December 31, 2021
287,250
Restricted shares awarded under the Stock Plan fully vest in one year for awards to Directors and ratably over three years for awards to other eligible employees. Compensation expense is based on the grant date fair value and was $204 thousand in 2021 and $197 in 2020. The amount of unrecognized compensation expense for restricted shares was $202 thousand at December 31, 2021.
The following table provides information about the options outstanding at December 31, 2021:
Options
Weighted
Outstanding
Exercise Price or
Weighted Average
Average Remaining
Stock Option Plan
and Exercisable
Price Range
Exercise Price
Life (years)
Employee Stock Purchase Plan
24,249
$
30.24
$
30.24
0.5
Incentive Stock Options
30,950
21.27-23.84
21.54
3.8
Incentive Stock Options
29,300
28.97-31.53
30.00
5.2
Incentive Stock Options
30,004
31.53-34.10
34.10
6.2
ISO Total/Average
90,254
$
28.46
5.0
Note 19. Deferred Compensation Agreement
The Bank has a Director’s Deferred Compensation Plan, whereby each director may voluntarily participate and elect each year to defer all or a portion of their Bank director’s fees. Each participant directs the investment of their own account among various publicly available mutual funds designated by the Bank’s Investment and Trust Services department. Changes in the account balance beyond the amount deferred to the account are solely the result of the performance of the selected mutual fund. The Bank maintains an offsetting asset and liability for the deferred account balances and the annual expense is recorded as a component of directors’ fees as if it were a direct payment to the director. The Bank will not incur any expense when the account goes into payout.
Note 20. Shareholders’ Equity
The Board of Directors, from time to time, authorizes the repurchase of the Corporation’s $1.00 par value common stock. The repurchased shares will be held as Treasury shares available for issuance in connection with future stock dividends and stock splits, employee benefit plans, executive compensation plans, the Dividend Reinvestment Plan (DRIP) and other appropriate corporate purposes. The term of the repurchase plans is normally one year. The Corporation held 269,529 and 321,517 treasury shares at cost at December 31, 2021 and 2020, respectively.
The following table provides information about the Corporation’s stock repurchase activity:
Shares Repurchased
Plan Date
Authorized
Expiration
12/17/2020
150,000 shares
12/18/2021
37,320
36,401
12/20/2021
150,000 shares
12/19/2022
N/A
The Corporation’s DRIP allows for shareholders to purchase additional shares of the Corporation’s common stock by reinvesting cash dividends paid on their shares or through optional cash payments. The Corporation has authorized one million (1,000,000) shares of its currently authorized common stock to be issued under the plan or may issue from Treasury shares. The DRIP added $2.4 million to capital during 2021. This total was comprised of $1.0 million from the reinvestment of quarterly dividends and $1.4 million
of optional cash contributions. During 2021, 77,851 shares of common stock were purchased through the DRIP and 311,853 shares remain to be issued.
Note 21. Commitments and Contingencies
In the normal course of business, the Bank is a party to financial instruments that are not reflected in the accompanying financial statements and are commonly referred to as off-balance-sheet instruments. These financial instruments are entered into primarily to meet the financing needs of the Bank’s customers and include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk not recognized in the consolidated balance sheet.
The Corporation’s exposure to credit loss in the event of nonperformance by other parties to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contract or notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments.
The Bank had the following outstanding commitments as of December 31:
(Dollars in thousands)
Financial instruments whose contract amounts represent credit risk
Commercial commitments to extend credit
$
288,075
$
234,975
Consumer commitments to extend credit (secured)
82,095
71,761
Consumer commitments to extend credit (unsecured)
5,389
5,224
$
375,559
$
311,960
Standby letters of credit
$
23,284
$
22,334
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses with the exception of home equity lines and personal lines of credit and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, is based on Management’s credit evaluation of the counterparty. Collateral for most commercial commitments varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties. Collateral for secured consumer commitments consists of liens on residential real estate.
Standby letters of credit are instruments issued by the Bank, which guarantee the beneficiary payment by the Bank in the event of default by the Bank’s customer in the nonperformance of an obligation or service. Most standby letters of credit are extended for one year periods. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds collateral supporting those commitments for which collateral is deemed necessary primarily in the form of certificates of deposit and liens on real estate. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. In the second quarter of 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy in the second quarter of 2018. In the first quarter of 2020, the Bank was notified that one letter of credit for $250 thousand was cancelled and the amount was reversed from the liability with an offsetting amount recorded in other expense. In the second quarter of 2021, the Bank was notified that a second letter of credit for $636 thousand was cancelled and the amount was reversed from the liability with an offsetting amount recorded in other expense. At December 31, 2021, this reserve was $1.5 million.
Most of the Bank’s business activity is with customers located within its primary market and does not involve any significant concentrations of credit to any one entity or industry.
Legal Proceedings
The nature of the Corporation’s business generates a certain amount of litigation.
We establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable and the amount of the loss can be reasonably estimated. When we are able to do so, we also determine estimates of probable losses, whether in excess of any accrued liability or where there is no accrued liability.
These assessments are based on our analysis of currently available information and are subject to significant judgment and a variety of assumptions and uncertainties. As new information is obtained, we may change our assessments and, as a result, take or adjust the amounts of our accruals and change our estimates of possible losses or ranges of possible losses. Due to the inherent subjectivity of the assessments and the unpredictability of outcomes of legal proceedings, any amounts that may be accrued or
included in estimates of probable losses or ranges of probable losses may not represent the actual loss to the Corporation from any legal proceeding. Our exposure and ultimate losses may be higher, possibly significantly higher, than amounts we may accrue or amounts we may estimate.
In management’s opinion, we do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of all litigation to which the Corporation is a party will have a material adverse effect on our financial position. We cannot now determine, however, whether or not any claim asserted against us will have a material adverse effect on our results of operations in any future reporting period, which will depend on, amount other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period. Thus, at December 31, 2021, we are unable to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss with respect to such other matters and, accordingly, have not yet established any specific accrual for such other matters.
No material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.
Note 22. Fair Value Measurements and Fair Values of Financial Instruments
Management uses its best judgment in estimating the fair value of the Corporation’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Corporation could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective year-ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates maybe different than the amounts reported at each year-end.
FASB ASC Topic 820, “Financial Instruments”, requires disclosure of the fair value of financial assets and liabilities, including those financial assets and liabilities that are not measured and reported at fair value on a recurring and nonrecurring basis. The Corporation does not report any nonfinancial assets at fair value. FASB ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:
Level 1: Valuation is based on unadjusted, quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. There may be substantial differences in the assumptions used for securities within the same level. For example, prices for U.S. Agency securities have fewer assumptions and are closer to level 1 valuations than the private label mortgage-backed securities that require more assumptions and are closer to level 3 valuations.
Level 3: Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Corporation’s assumptions regarding what market participants would assume when pricing a financial instrument.
An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The level within the hierarchy does not represent risk.
The following information regarding the fair value of the Corporation’s financial instruments should not be interpreted as an estimate of the fair value of the entire Corporation since a fair value calculation is only provided for a limited portion of the Corporation’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Corporation’s disclosures and those of other companies may not be meaningful.
The following methods and assumptions were used to estimate the fair values of the Corporation’s financial instruments measured at fair value on a recurring and nonrecurring basis at December 31, 2021 and 2020.
Equity Securities: Equity securities are valued using quoted market prices from nationally recognized markets (Level 1). Equity securities are measured at fair value on a recurring basis.
Investment securities: Fair values of investment securities available-for-sale were primarily measured using information from a third-party pricing service. This service provides pricing information by utilizing evaluated pricing models supported with market data information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data from market research publications. Level 2 investment securities are primarily comprised of debt securities issued by states and municipalities, corporations, mortgage-backed securities issued by government
agencies, and government-sponsored enterprises. Fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models. Investment securities are measured at fair value on a recurring basis.
Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals conducted by an independent, licensed appraiser, less cost to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach (Level 2). If the appraiser makes an adjustment to account for differences between the comparable sales and income data available for similar loans, or if management adjusts the appraised value, then the fair value is considered Level 3. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted in accordance with the allowance policy. Partial charge-offs on impaired loans were $0 in 2021 and $35 thousand in 2020. Impaired loans are measured at fair value on a nonrecurring basis.
Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at the lower of cost or the fair value less costs to sell when acquired. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach with data from comparable properties (Level 2). If the appraiser makes an adjustment to account for differences between the comparable sales and income data available for similar loans, or if management adjusts the appraised value, then the fair value is considered Level 3. In connection with the measurement and initial recognition of other real estate owned, losses are recognized through the allowance for loan losses. Subsequent charge-offs are recognized as an expense. Other real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Recurring Fair Value Measurements
For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2021 and 2020 are as follows:
(Dollars in Thousands
Fair Value at December 31, 2021
Asset Description
Level 1
Level 2
Level 3
Total
Equity securities, at fair value
$
$
-
$
-
$
Available for sale:
U.S. Government and Agency securities
84,286
9,474
-
93,760
Municipal securities
-
212,227
-
212,227
Corporate Securities
-
24,939
-
24,939
Agency mortgage-backed securities
-
122,669
-
122,669
Non-Agency mortgage-backed securities
-
30,666
-
30,666
Asset-backed securities
-
45,550
-
45,550
Total assets
$
84,767
$
445,525
$
-
$
530,292
(Dollars in Thousands)
Fair Value at December 31, 2020
Asset Description
Level 1
Level 2
Level 3
Total
Equity securities, at fair value
$
$
-
$
-
$
Available for sale:
U.S. Government and Agency securities
-
12,574
-
12,574
Municipal securities
-
247,054
-
247,054
Corporate Securities
-
20,288
-
20,288
Agency mortgage-backed securities
-
72,241
-
72,241
Non-Agency mortgage-backed securities
-
8,453
-
8,453
Asset-backed securities
-
36,330
-
36,330
Total assets
$
$
396,940
$
-
$
397,331
The fair value of derivative liabilities measured at fair value at December 31, 2021 and 2020 was $21 thousand and $40 thousand, respectively and was considered immaterial.
Nonrecurring Fair Value Measurements
For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2021 and 2020 are as follows:
(Dollars in Thousands)
Fair Value at December 31, 2021
Asset Description
Level 1
Level 2
Level 3
Total
Impaired Loans (1)
$
-
$
-
$
4,880
$
4,880
Total assets
$
-
$
-
$
4,880
$
4,880
(Dollars in Thousands)
Fair Value at December 31, 2020
Asset Description
Level 1
Level 2
Level 3
Total
Impaired Loans (1)
$
-
$
-
$
5,474
$
5,474
Total assets
-
$
-
$
5,474
$
5,474
(1) Includes assets directly charged down to fair value during the year-to-date period or those for which a specific reserve has been established.
The Corporation did not record any liabilities at fair value for which measurement of the fair value was made on a nonrecurring basis at December 31, 2021. For financial assets and liabilities measured at fair value on a recurring basis, there were no transfers of financial assets or liabilities between Level 1 and Level 2 during the period ending December 31, 2021.
The following table presents additional quantitative information about Level 3 assets measured at fair value on a nonrecurring basis:
(Dollars in Thousands)
Quantitative Information about Level 3 Fair Value Measurements
Range
December 31, 2021
Fair Value
Valuation Technique
Unobservable Input
(Weighted Average)
Impaired Loans
$
4,880
Appraisal
Appraisal Adjustment on
Real estate assets
20% (20%)
Non-real estate assets
50% - 100% (83%)
Cost to sell
8%
Range
December 31, 2020
Fair Value
Valuation Technique
Unobservable Input
(Weighted Average)
Impaired Loans
$
5,474
Appraisal
Appraisal Adjustment on
Non-real estate assets
0% - 100% (66%)
The fair value of the Corporation's financial instruments measured at amortized cost are as follows:
December 31, 2021
Carrying
Fair
(Dollars in thousands)
Amount
Value
Level 1
Level 2
Level 3
Financial assets, carried at cost:
Cash and cash equivalents
$
175,149
$
175,149
$
175,149
$
-
$
-
Long-term interest-bearing deposits in other banks
10,492
10,492
10,492
Loans held for sale
2,827
2,940
-
2,940
-
Net loans
983,746
1,003,580
-
-
1,003,580
Accrued interest receivable
5,217
5,217
-
-
5,217
Financial liabilities:
Deposits
$
1,584,359
$
1,616,128
$
-
$
1,616,128
$
-
Subordinate notes
19,588
19,909
-
19,909
-
Accrued interest payable
-
-
December 31, 2020
Carrying
Fair
(Dollars in thousands)
Amount
Value
Level 1
Level 2
Level 3
Financial assets, carried at cost:
Cash and cash equivalents
$
57,146
$
57,146
$
57,146
$
-
$
-
Long-term interest-bearing deposits in other banks
12,741
12,741
12,741
Loans held for sale
9,446
9,446
-
9,446
-
Net loans
992,915
990,867
-
-
990,867
Accrued interest receivable
6,410
6,410
-
-
6,410
Financial liabilities:
Deposits
$
1,354,573
$
1,355,086
$
-
$
1,355,086
$
-
Accrued interest payable
-
-
Note 23. Parent Company Condensed (Franklin Financial Services Corporation) Financial Information
Balance Sheets
December 31
(Dollars in thousands)
Assets:
Cash and cash equivalents
$
17,637
$
20,109
Investment securities
Equity investment in subsidiaries
157,620
142,949
Other assets
1,282
Total assets
$
176,656
164,731
Liabilities:
Subordinate notes
$
19,588
$
19,555
Other liabilities
-
Total liabilities
19,591
19,555
Shareholders' equity
157,065
145,176
Total liabilities and shareholders' equity
$
176,656
$
164,731
Statements of Income
Years Ended December 31
(Dollars in thousands)
Income:
Dividends from Bank subsidiary
$
4,050
$
6,639
Change in fair value of equity securities
(49)
Dividends
-
4,149
6,590
Expenses:
Interest expense
1,048
Operating expenses
1,536
1,474
Income before income taxes and equity in undistributed income
‎ of subsidiaries
1,565
4,689
Income tax benefit
Equity in undistributed income of subsidiaries
17,534
7,702
Net income
19,616
12,800
Other comprehensive (loss)/income of subsidiary
(3,737)
9,176
Comprehensive income
$
15,879
$
21,976
‎
Statements of Cash Flows
Years Ended December 31
(Dollars in thousands)
Cash flows from operating activities
Net income
$
19,616
$
12,800
Adjustments to reconcile net income to net cash provided
by operating activities:
Equity in undistributed (income) of subsidiary
(17,534)
(7,702)
Stock option compensation
Change in fair value of equity security
(90)
(49)
Increase in other assets/liabilities
(474)
(317)
Net cash provided by operating activities
1,722
4,929
Cash flows from financing activities
Dividends paid
(5,524)
(5,226)
Proceeds from subordinated notes, net of issuance costs
-
19,541
Cash received from option exercises
Common stock issued under dividend reinvestment plan
2,388
1,836
Treasury stock purchase
(1,193)
(1,171)
Net cash (used in) provided by financing activities
(4,194)
15,016
(Decrease) increase in cash and cash equivalents
(2,472)
19,945
Cash and cash equivalents as of January 1
20,109
Cash and cash equivalents as of December 31
$
17,637
$
20,109
Note 24. Revenue Recognition
All of the Corporation’s revenue from contracts with customers within the scope of ASC 606 is recognized in non-interest income as presented in our consolidated statements of income. Revenue generating activities that fall within the scope of ASC 606 are described as follows:
Investment and Trust Service Fees - these represent fees from wealth management (assets under management), fees from the management and settlement of estates and commissions from the sale of investment and insurance products.
Asset management fees are generally assessed based on a tiered fee schedule, based on the value of assets under management, and are recognized monthly when the service obligation is completed. Fees recognized were $6.5 million for 2021 and $5.6 million for 2020.
Fees for estate management services are based on the estimated fair value of the estate. These fees are generally recognized monthly over an 18-month period that Management has determined to represent the average time to fulfill the performance obligations of the contract. Management has the discretion to adjust this time period as needed based upon the nature and complexity of an individual estate. Fees recognized were $454 thousand for 2021 and $194 thousand for 2020.
Commissions from the sale of investment and insurance products are recognized upon the completion of the transaction. Fees recognized were $164 thousand for 2021 and $212 thousand for 2020.
Loan Service Charges - these represent fees on loans for services or charges that occur after the loan has been booked, for example, late payment fees. All of these fees are transactional in nature and are recognized upon completion of the transaction which represents the performance obligation.
Deposit Service Charges and Fees - these represent fees from deposit customers for transaction based, account maintenance, and overdraft services. Transaction based fees include, but are not limited to, stop payment fees and overdraft fees. These fees are recognized at the time of the transaction when the performance obligation has been fulfilled. Account maintenance fees and account analysis fee are earned over the course of a month, representing the period of the performance obligation, and are recognized monthly.
Debit Card Income - this represents interchange fees from cardholder transactions conducted through the card payment network. Cardholders use the debit card to conduct point-of-sale transactions that produce interchange fees. The fees are transaction based and the fee is recognized with the processing of the transaction. These fees are reported net of cardholder rewards.
Other Service Charges and Fees - these are comprised primarily of merchant card fees, credit card fees, ATM surcharges and interchange fees and wire transfer fees. Merchant card fees represent fees the Bank earns from a third party for enrolling a customer in the processor’s program. Credit card fees represent a fee earned by the Bank for a successful referral to a card-issuing company. ATM
surcharges and interchange fees are the result of Bank customers conducting ATM transactions that generate fee income and are processed through multiple card networks. All of these fees are transaction based and are recognized at the time of the transaction.
Other Income - these items are transactional in nature and recognized upon completion of the transaction which represents the performance obligation. Certain items included in this category may be excluded from the scope of ASC 606.
Gains/Losses on the Sale of Other Real Estate - these are recognized when control of the property transfers to the buyer.
Contract Balances
A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals such as asset management fees based on month-end market values. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into longer-term revenue contracts with customers, and therefore, does not experience significant contract balances.
Contract Acquisition Costs
The Corporation expenses all contract acquisition costs as costs are incurred.

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.

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ITEM 9A. CONTROLS AND PROCEDURES
Item 9A. Controls and Procedures
Evaluation of Controls and Procedures
The Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s Management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon the evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2021, the Corporation’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in the Corporation’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Management Report on Internal Control Over Financial Reporting
The Management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. The Corporation’s internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2021, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework (2013). Based on this assessment, Management concluded that, as of December 31, 2021, the Corporation’s internal control over financial reporting is effective based on those criteria.
There were no changes during the fourth quarter of 2021 in the Corporation’s internal control over financial reporting which materially affected, or which are reasonably likely to affect, the Corporation’s internal control over financial reporting.

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ITEM 9B. OTHER INFORMATION
Item 9B. Other Information
None.

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ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this Item relating to the directors and executive officers of the Corporation is incorporated herein by reference to the information set forth under the heading “ELECTION OF DIRECTORS - Information about Nominees, Continuing Directors and Executive Officers” and under the heading “ADDITIONAL INFORMATION - Key Employees” appearing in the Corporation's 2022 proxy statement.
The information required by this item relating to compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the information set forth under the heading “ADDITIONAL INFORMATION - Compliance with Section 16(a) of the Exchange Act” appearing in the Corporation's 2022 proxy statement.
The information required by this item relating to the Corporation's code of ethics is incorporated herein by reference to the information set forth under the heading “CORPORATE GOVERNANCE POLICIES, PRACTICES AND PROCEDURES” appearing in the Corporation's 2022 proxy statement. The Corporation will file on Form 8-K any amendments to, or waivers from, the code of ethics applicable to any of its directors or executive officers.
The information required by this item relating to material changes to the procedures by which the Corporation's shareholders may recommend nominees to the Board of Directors is incorporated herein by reference to the information set forth under the heading “ELECTION OF DIRECTORS - Nominations for Election of Directors” appearing in the Corporation's 2022 proxy statement.

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ITEM 11. EXECUTIVE COMPENSATION
Item 11. Executive Compensation
The information required by this item relating to executive compensation is incorporated herein by reference to the information set forth under the heading “EXECUTIVE COMPENSATION” appearing in the Corporation's 2022 proxy statement.

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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item relating to securities authorized for issuance under executive compensation plans is incorporated herein by reference to the information set forth under the heading “EXECUTIVE COMPENSATION - Compensation Tables and Additional Compensation Disclosure” appearing in the Corporation's 2022 proxy statement.
The information required by this item relating to security ownership of certain beneficial owners is incorporated herein by reference to the information set forth under the heading “GENERAL INFORMATION - Voting of Shares and Principal Holders Thereof'” appearing in the Corporation's 2022 proxy statement.
The information required by this item relating to security ownership of management is incorporated herein by reference to the information set forth under the heading “ELECTION OF DIRECTORS - Information about Nominees, Continuing Directors and Executive Officers” appearing in the Corporation's 2022 proxy statement.

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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item relating to transactions with related persons is incorporated herein by reference to the information set forth under the heading “ADDITIONAL INFORMATION - Transactions with Related Persons” appearing in the Corporation's 2022 proxy statement.
The information required by this item relating to director independence is incorporated herein by reference to the information set forth under the heading “ELECTION OF DIRECTORS - Director Independence” and under the heading “ADDITIONAL INFORMATION - Transactions with Related Persons” appearing in the Corporation's 2022 proxy statement.

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ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Item 14. Principal Accountant Fees and Services
The information required by this item relating to principal accountant fees and services is incorporated herein by reference to the information set forth under the heading “RELATIONSHIP WITH INDEPENDENT REGISTERED PUBLIC ACCOUNTANTS” appearing in the Corporation's 2022 proxy statement.
‎
Part IV

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ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this report:
(1) The following Consolidated Financial Statements of the Corporation:
Report of Independent Registered Public Accounting Firm (PCAOB ID 173)
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements.
(2) All financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and have therefore been omitted.
(3) The following exhibits are part of this report:
Item
Description
3.1
Amended and Restated Articles of Incorporation of the Corporation (Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the quarter ended June 30, 2020 and incorporated herein by reference.)
3.2
Bylaws of the Corporation (Filed Bylaws of the Corporations Exhibit 3.2 of Current Report on Form 8-K as filed with the Commission on July 9, 2021 and incorporated herein by reference.)
4.
Instruments defining the rights of securities holders, including indentures, are contained in the Articles of Incorporation (Exhibit 3.1) and Bylaws (Exhibit 3.2)
10.1
Deferred Compensation Agreements with Bank Directors* (Filed as Exhibit 10.1 to Annual Report on Form 10-K for the year ended December 31, 2014 and incorporated herein by reference.)
10.2
Director’s Deferred Compensation Plan* (Filed as Exhibit 10.2 to Annual Report on Form 10-K for the year ended December 31, 2014 and incorporated herein by reference.)
10.3
Senior Management Annual Incentive Plan* (Filed as Exhibit 10.3 to Annual Report on Form 10-K for the year ended December 31, 2019 and incorporated herein by reference.)
10.4
Senior Management and Directors Incentive Stock Plan* (Filed as Exhibit 10.4 to Annual Report on Form 10-K for the year ended December 31, 2019 and incorporated herein by reference.)
10.5
Incentive Stock Option Plan of 2013 (Filed as Exhibit 10.1 to Registration Statement No. 333-193655 on Form S-8 filed January 30, 2014 and incorporated herein by reference)*
10.6
2019 Omnibus Stock Incentive Plan (Filed as Appendix A to the Definitive Proxy statement on Schedule 14A as filed with the Commission on March 18, 2019 and incorporated herein by reference.)*
10.7
Employment Agreement by and among Franklin Financial Services Corporation (“Corporation”), Farmers and Merchants Trust Company of Chambersburg (“Bank”), and Timothy G. Henry, incorporated by reference to Exhibit 99.1 to the Registrant’s form 8-K filed March 4, 2021
10.8
Employment Agreement by and among Franklin Financial Services Corporation (“Corporation”), Farmers and Merchants Trust Company of Chambersburg (“Bank”), and Steven M. Poynot, incorporated by reference to Exhibit 99.2 to the Registrant’s form 8-K filed March 4, 2021
10.9
Employment Agreement by and among Franklin Financial Services Corporation (“Corporation”), Farmers and Merchants Trust Company of Chambersburg (“Bank”), and Mark R. Hollar, incorporated by reference to Exhibit 99.3 to the Registrant’s form 8-K filed March 4, 2021
10.10
Employment Agreement by and among Franklin Financial Services Corporation (“Corporation”), Farmers and Merchants Trust Company of Chambersburg (“Bank”) and Steven D. Butz, incorporated by reference to Exhibit 99.4 to the Registrant’s form 8-K filed March 4, 2021
14.
Code of Ethics posted on the Corporation’s website
Subsidiaries of Corporation - filed herewith
23.1
Consent of Crowe LLP - filed herewith
31.1
Rule 13a-14(a)/15d-14(a) Certification (Chief Executive Officer) - filed herewith
31.2
Rule 13a-14(a)/15d-14(a) Certification (Chief Financial Officer) - filed herewith
32.1
Section 1350 Certification (Chief Executive Officer) - filed herewith
32.2
Section 1350 Certification (Chief Financial Officer) - filed herewith
Interactive Data File (XBRL)
* Compensatory plan or arrangement.
(b) The exhibits required to be filed as part of this report are submitted as a separate section of this report.
(c) Financial Statement Schedules: None.